[Senate Hearing 107-]
[From the U.S. Government Publishing Office]



                                                       S. Hrg. 107- 835


        FEDERAL RESERVE'S SECOND MONETARY POLICY REPORT FOR 2002

=======================================================================

                                HEARING

                               before the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                      ONE HUNDRED SEVENTH CONGRESS

                             SECOND SESSION

                                   ON

      OVERSIGHT ON THE MONETARY POLICY REPORT TO CONGRESS PURSU- 
       ANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF 1978

                               __________

                             JULY 16, 2002

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs



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                            WASHINGTON : 2003
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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

                Thomas Leo, Republican Senior Economist

   Joseph R. Kolinski, Chief Clerk and Computer Systems Adminstrator

                       George E. Whittle, Editor

                                  (ii)
?

                            C O N T E N T S

                              ----------                              

                         TUESDAY, JULY 16, 2002

                                                                   Page

Opening comments of Chairman Sarbanes............................     1

Opening statements, comments, or prepared statements of:
    Senator Gramm................................................     1
    Senator Dodd.................................................     2
    Senator Shelby...............................................     3
    Senator Akaka................................................     4
    Senator Allard...............................................     5
    Senator Corzine..............................................     5
        Prepared statement.......................................    40
    Senator Enzi.................................................     5
    Senator Bayh.................................................     6
    Senator Bunning..............................................     6
        Prepared statement.......................................    40
    Senator Miller...............................................     7
    Senator Hagel................................................     7
    Senator Ensign...............................................     7
    Senator Bennett..............................................    30
    Senator Carper...............................................    32
    Senator Schumer..............................................    34

                                WITNESS

Alan Greenspan, Chairman, Board of Governors of the Federal 
  Reserve System, Washington, DC.................................     7
    Prepared statement...........................................    41
    Response to written questions of:
        Senator Sarbanes.........................................    47
        Senator Miller...........................................    49

              Additional Material Supplied for the Record

Monetary Policy Report to the Congress, July 16, 2002............    51

                                 (iii)

 
                   FEDERAL RESERVE'S SECOND MONETARY
                         POLICY REPORT FOR 2002

                              ----------                              


                         TUESDAY, JULY 16, 2002

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.

    The Committee met at 10:05 a.m., in room SH-216 of the Hart 
Senate Office Building, Senator Paul S. Sarbanes (Chairman of 
the Committee) presiding.

         OPENING COMMENTS OF CHAIRMAN PAUL S. SARBANES

    Chairman Sarbanes. The hearing will come to order.
    We are very pleased this morning to welcome back before the 
Committee Chairman Alan Greenspan to testify on the Federal 
Reserve's Semi-Annual Monetary Policy Report to the Congress.
    This is a time of significant uncertainty for the U.S. 
economy and a time of considerable stress. Just a few months 
ago, it appeared that the economy might emerge strongly from 
last year's recession. Economic growth in the first quarter 
this year was 6.1 percent and there were some Fed watchers who 
were even predicting that the Fed would have to raise rates by 
the middle of this year.
    That outlook has clearly changed. The economic growth in 
the first quarter was largely influenced by a one-time swing in 
inventories as the FMOC noted in the statement it released 
after its most recent meeting on June 26. And the blue chip 
consensus now calls for second-quarter growth of about 2\1/2\ 
percent.
    We have seen a significant decline in jobs in the private 
sector, more than in the previous recession, and we have a 
worrisome job situation, resembling in some respects the 
jobless recovery period after the last recession in 1990 and 
1991.
    I was going to go through the various indicatorsm, but 
rather than using the Committee and the Chairman's time in 
order to do that, I will forgo that exercise and I may come 
back and address it to the Chairman when we get to the question 
and answer period.
    Actually, I am anxious to get to the Chairman and have an 
opportunity to hear from him this morning. And with that, I 
will yield to my colleagues.
    Senator Gramm.

                 COMMENTS OF SENATOR PHIL GRAMM

    Senator Gramm. Mr. Chairman, thank you very much.
    I just want to make a personal comment. This will be the 
last of these hearings that I will have with Chairman 
Greenspan. I have had the privilege over an extended period of 
time as a Member, as Chairman, as Ranking Member, to work with 
Alan 
Greenspan in his capacity as Chairman of the Board of 
Governors, and it is something that I will always be proud of. 
I will always be proud to be able to say that I worked with the 
greatest central banker of the era.
    I want to thank you, Mr. Chairman, for your great work in 
this period during which I have had an opportunity to serve in 
the Senate. We have seen many issues come and go, but we have 
had a stable monetary policy.
    When I was a boy in graduate school, we had a lot of focus 
on what the money supply was. One was a monetarist or a 
Keynesian. Now, we can hardly define the money supply. And yet, 
under your leadership, we have had a monetary policy which has 
been the envy of the world. It has been the foundation of our 
economic stability, and I want to thank you for your 
leadership.
    I also want to thank you for one additional thing. It is so 
easy to duck tough issues. It is so easy when you have massive 
swings in public opinion, to simply not be available for 
comment or to not have an opinion on a subject.
    I think one of the great services you provided to this 
country has been the wisdom of your views and the credibility 
that they contain when you have been willing to speak out on 
issues like energy derivatives, a complicated subject that very 
few people know anything about, but a critically important 
subject. And your willingness, when asked, to state your 
opinion on an issue like that, in an era such as the one we 
currently are operating in, has been critically important and 
has had a profound effect on the policy of the Government and 
the country.
    And so, I just want to take this opportunity to thank you 
for the great job you have done.
    Chairman Greenspan. Thank you, Senator.
    Chairman Sarbanes. I just want to observe that Senator 
Gramm is being very restrained in his praise this morning, Mr. 
Chairman. He said you were the greatest central banker of the 
era. I remember one hearing when he said you were the greatest 
central banker in the history of the world. I think that is the 
way it was put.
    Senator Gramm. Well, it is true.
    [Laughter.]
    I would say, Mr. Chairman, the problem is, when I say it, 
people do not know that one of my areas of specialization in 
economics was monetary theory and history. In reviewing the 
great bankers in world history, I think Alan Greenspan 
qualifies as the greatest central banker in the history of the 
world.
    People not knowing my background think that that is some 
blowhard making an overstatement. So, I simply stated it in a 
form where no living person that has any knowledge would 
disagree.
    [Laughter.]
    Chairman Sarbanes. Senator Dodd.

            COMMENTS OF SENATOR CHRISTOPHER J. DODD

    Senator Dodd. How do you follow that?
    [Laughter.]
    Welcome, Mr. Chairman. It is always a pleasure to have you 
before the Committee.
    Chairman Greenspan. Thank you, Senator.
    Senator Dodd. I am sure you are going to get to this, but 
there are some very conflicting indicators out there, at least 
it seems to me conflicting.
    Consumer confidence is down, yet consumer spending is up, 
and we see problems obviously related to the events of the last 
number of months in terms of people's trust and confidence in 
the markets.
    Integrity has always been, I think, one of the marketing 
points of our Nation. The world has come here for many reasons, 
not the least of which has been the integrity of our markets 
and that there is a tremendous sense of fairness and 
transparency about them.
    I am concerned about the capital flight. We have seen 
foreign capital not coming here, going elsewhere, specifically, 
the Pacific Rim, and what observations you may have about that.
    I know it has been said, and repeated here this morning, 
the Senate did itself proud by supporting the bill dealing with 
the accounting reforms, 97 to 0.
    While it may not be perfect, and while we may find in time 
there are some additional changes that may be necessary, I 
think it was the right step for the Senate to take.
    I would be interested in any observations you may have 
generally about these steps, or additional steps that you think 
we could take in the remaining weeks of this Congress that 
would be our form of participation in restoration of investor 
confidence.
    Thank you, Mr. Chairman.
    Chairman Sarbanes. Thank you.
    Senator Shelby.

             STATEMENT OF SENATOR RICHARD C. SHELBY

    Senator Shelby. Thank you, Mr. Chairman.
    Chairman Greenspan, I want to thank you for coming here 
today. Senator Gramm has already talked for us all this morning 
in praise, and praise that I think is deserved. But it is very 
important, Chairman Greenspan, important to the Committee and 
for the country, to be hearing from you today at this 
particular time.
    Obviously, Mr. Chairman, there are some very strong, very 
real concerns about the conditions in our markets today. 
Perhaps the phrase, irrational exuberance, that you accurately 
commented on a few years ago led to irrational expectations. 
For whatever reason, numerous publicly traded corporations 
began misstating their financial condition. The professionals' 
charge was sifting through that information and I believe they 
failed to properly perform their role as gatekeepers. 
Ultimately, bad information, information that obscured economic 
reality, was admitted into the marketplace. American investors 
then relied upon it when making billions of dollars of 
investment decisions.
    As you well know, Mr. Chairman, Congress and the Bush 
Administration are now addressing the systemic weaknesses that 
allowed this to occur. There are, however, other areas, I 
believe outside the direct influence of Congress that require 
reform. Principally, the accounting rules need to be changed, I 
believe, so that stock options are treated as an expense on the 
balance sheets. You have spoken to this before, Mr. Chairman.
    Stock options provide material value to recipients, dilute 
shareholder ownership, and can be deducted, as we all know, by 
the granting company on their tax returns. Keeping their costs 
off the books does not provide a firm with tangible value. It 
only contributes, I believe, to an illusion of profitability. 
Allowing a firm to take tax deductions without expensing 
defines the expression--having one's cake and eating it, too.
    For the sake of investors, it is my hope that the Financial 
Accounting Standards Board, provided greater independence under 
the bill that Senator Sarbanes has sponsored and we passed last 
night, I hope will revisit this rule and develop a new standard 
that requires companies, Mr. Chairman, to provide information 
that affords investors the most reliable picture of economic 
reality. In other words, the truth.
    Chairman Greenspan, while an element of uncertainty remains 
in investors' minds because of their lack of confidence in 
financial information, I believe we would be wrong if we failed 
to point out that there are significant positive factors in 
place in our economy right now. Strong fundamentals provide the 
underpinnings of strong economic growth. Inflation, under your 
stewardship, Mr. Chairman, I might add, has been kept in check, 
and productivity has advanced to never-beforeseen levels. We 
have a great economy, but we have some problems, and I hope you 
will speak to that and continue to do that.
    Thank you.
    Chairman Sarbanes. Thank you, Senator Shelby.
    Senator Akaka.

              COMMENTS OF SENATOR DANIEL K. AKAKA

    Senator Akaka. Thank you very much, Mr. Chairman.
    I join you and the Committee in welcoming Chairman 
Greenspan. I look forward to his presentation of the Federal 
Reserve's Semi-Annual Monetary Policy Report.
    It appears that the economic recovery is continuing. This 
growth can be partially attributed to substantial inventory 
adjustment, large increases in work productivity and housing 
construction, which is approaching record levels, even in 
Hawaii.
    However, despite the continuing economic recovery, the 
stock markets have lost significant amounts of their value. And 
if I had a question to ask you now, I would certainly ask about 
what your impression was of the vote yesterday on the 
accounting bill when the vote came out 97 to 0. It was quite 
outstanding. I think that 
reflects what has happened recently. Accounting fears, 
corporate misdeeds, and concerns about earnings have all 
contributed to the current equity price levels.
    Chairman Greenspan, I look forward to hearing your thoughts 
on the economy and monetary policy.
    Thank you.
    Chairman Sarbanes. Thank you, Senator Akaka.
    Senator Allard.

                COMMENTS OF SENATOR WAYNE ALLARD

    Senator Allard. Mr. Chairman, thank you.
    Chairman Greenspan, I always look forward to your comments 
and views on the economy and I am under the impression that the 
country is in pretty good shape right now. I am here today to 
listen to what you are going to say on the economic and 
monetary policy issues.
    I do not know what we can do as a Congress to help this 
recovery. My thought is that we need to deal with the problems 
in Medicare and Social Security, but more importantly, as that 
applies to making sure that we do not allow our public debt to 
get out of hand and to get deficit spending under control. And 
if you have an opportunity to comment on that, I would be 
anxious to hear what your have to say.
    Thank you, and I look forward to hearing your testimony.
    Chairman Sarbanes. Senator Corzine.

               COMMENTS OF SENATOR JON S. CORZINE

    Senator Corzine. Thank you. Mr. Chairman, I would just echo 
what I presume most of my colleagues have said. Congratulations 
on your extraordinary leadership in passing the Accounting 
Investor Protection Act yesterday. I very much am anxious to 
hear Chairman Greenspan's remarks with regard to that as well. 
As always, I welcome him and thank him for the service he gives 
our Nation.
    I think that we have all had concern about the dissonance 
of what we see in markets, not only equity markets, but the 
dollar as well, with regard to this expansion that seems to be 
in place and taking hold, at least by macroeconomic statistics. 
I think we have an unprecedented situation here, certainly in 
post-World War II, where you are well into an expansion and we 
get reinforcement of that by data, and seeing the decline in 
markets. Is that simply a reflection of the corporate 
malfeasance or earnings restatements that maybe are not 
reflective of malfeasance, but aggressive accounting? Or is 
there something else here?
    I note that the Board asked for a staff study of some of 
the issues that surrounded the decline of the Japanese economy 
in the late 1980's and early 1990's, and whether there is 
anything to be learned from that, are there any parallels? 
Certainly, I would like to hear your views on that.
    And more broadly, our erosion of debt or our fiscal 
stability is certainly something that is of concern to me. So, 
I am anxious to hear your remarks on a number of these issues 
and I appreciate you joining us.
    Again, I thank you for your service.
    Chairman Sarbanes. Thank you very much, Senator Corzine.
    Senator Enzi.

               COMMENT OF SENATOR MICHAEL B. ENZI

    Senator Enzi. Thank you, Mr. Chairman.
    As with everyone else on the panel, I am anxious to hear 
and anxious about the comments that Chairman Greenspan will 
make.
    Chairman Sarbanes. Senator Bayh.

                  COMMENT OF SENATOR EVAN BAYH

    Senator Bayh. Thank you, Mr. Chairman.
    I believe we are here to listen to Chairman Greenspan, not 
to me. So, I will defer to him.
    Chairman Sarbanes. Senator Bunning.

                STATEMENT OF SENATOR JIM BUNNING

    Senator Bunning. Thank you, Mr. Chairman, for holding this 
hearing and I would like to thank Chairman Greenspan for coming 
before this Committee today.
    We have a crisis in our economy, a crisis of confidence. We 
have all seen it. The majority of Americans have felt it. 
Whether they own stock, have a 401(k) plan, or any other type 
of pension plan, millions have been personally hit very hard by 
the recent market dips.
    Since you visited us 2 years ago, over $10 trillion has 
been taken out of the markets--$10 trillion. It may at this 
point only be paper losses, but we all know how to add and 
subtract, and the sheer drop of the Dow, Nasdaq, and the S&P in 
the last few weeks obviously has people on edge.
    To make things worse, the markets are dropping at a time 
when most of us think that the overall economic news is pretty 
good. The economy grew at a little better than 6 percent in the 
first quarter. Retail sales were up in June, and inflation is 
almost nonexistent. But the last I heard, over one thousand 
companies--over one thousand companies--have restated their 
earnings.
    The stock markets are in the tank. Investors keep waiting 
for the other shoe to drop--again. They are waiting to see if 
there will be another Enron or Global Crossing or Worldcom.
    To be fair, the retail investor seems to be more willing to 
ride out the market and sit on their hands. It would be nice if 
the institutional investors would do the same. But the bottom 
line is that investors large and small are going to do what is 
right for them. No one can blame them.
    We must restore confidence in our markets. And I am very 
glad that yesterday, we passed, I hope, a first step, 97 to 0, 
to help to restore some of that confidence. But it is going to 
take more than enacting a bill to restore the confidence. The 
President has taken some good steps, too, and I think his ideas 
will help greatly.
    I think it would be nice if some of the political opponents 
would stop taking potshots at the President for things that 
started long before he came into office. Some of the rhetoric 
that has been flying around the past few days has been 
dangerous and irresponsible. Clearly, it has been more about 
political agendas than the overall economic mood of the 
country. But those who try to use recent problems for political 
gain, whether they be Republican or Democrat, are playing with 
fire. Markets can go up just as fast as they go down.
    I think that one way we could restore some confidence in 
the market would be for the public to see some of the 
executives who have committed fraud to walk around in handcuffs 
and orange jumpsuits. When the American people see that the 
system works and those who have committed crimes pay the piper, 
they will feel a lot more sincere about their investments and 
security.
    I would like to figure out a legal constitutional way to 
expedite the prosecution of those who have committed crimes and 
get them in jail right away. I know that is a little far afield 
from this hearing, but I really believe that it is one of the 
real, tangible things that could be done that would send out 
the right signal to investors, markets, and businesses.
    I look forward to hearing from Chairman Greenspan about our 
economy. I would hope to hear any suggestions on what else he 
thinks can be done to restore confidence in our markets. And I 
look forward to talking with you during the question and answer 
period.
    Thank you very much, Mr. Chairman.
    Chairman Sarbanes. Thank you, Senator Bunning.
    Senator Miller.

                COMMENTS OF SENATOR ZELL MILLER

    Senator Miller. Mr. Chairman, I do not have any opening 
remarks, except to thank you again for all that you did to make 
sure that we got that needed bill through the Senate, and I am 
looking forward to hearing Chairman Greenspan's remarks 
especially on the current market situation.
    Chairman Sarbanes. Thank you.
    Senator Hagel.

                 COMMENT OF SENATOR CHUCK HAGEL

    Senator Hagel. I have no statement. Thank you.
    Chairman Sarbanes. Senator Ensign.

                 COMMENT OF SENATOR JOHN ENSIGN

    Senator Ensign. Pass.
    Chairman Sarbanes. Chairman Greenspan, we would be very 
happy to hear from you.
    Chairman Greenspan. Thank you very much.
    Chairman Sarbanes. Let me just note that we have received 
from the President two nominees to the Federal Reserve Board: 
Donald Kohn and Ben Bernanke. Their nominations have been 
received. Their papers are not yet fully in order. So, we are 
waiting for all of the papers, and once that is in place, we 
intend to move promptly to hold their hearings and to consider 
the nominees, so that we can have a fully nominated and 
confirmed board at the Federal Reserve.
    Chairman Greenspan. We would appreciate that, Mr. Chairman.
    Mr. Chairman, I will excerpt from fairly extended written 
remarks and request that the full text be included for the 
record.
    Chairman Sarbanes. The full text will be included in the 
record, without objection.

                  STATEMENT OF ALAN GREENSPAN,

   CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

    Chairman Greenspan. Over the four and one-half months since 
I last testified before this Committee on monetary policy, the 
economy has continued to expand largely along the broad 
contours we had anticipated at that time. Although the 
uncertainties of earlier this year are as yet not fully 
resolved, the U.S. economy appears to have withstood a set of 
blows--major declines in equity markets, a sharp retrenchment 
in investing spending, and the tragic terrorist attacks of last 
September--that in previous business cycles almost surely would 
have induced a severe contraction. The mildness and brevity of 
the downturn, as I indicated earlier this year, are a testament 
to the notable improvement in the resilience and flexibility of 
the U.S. economy.
    But while the economy has held up remarkably well, not 
surprisingly, the depressing effects of recent events linger. 
Spending will continue to adjust for some time to the declines 
that have occurred in equity prices. In recent weeks, those 
prices have fallen further on net, in part under the influence 
of growing concerns about corporate governance and business 
transparency problems that evidently accumulated during the 
earlier run-up in these markets. Considerable uncertainties--
about the progress of the adjustment of capital spending and 
the rebound in profitability, about the potential for 
additional revelations of corporate malfeasance, and about 
possible risks from global political events and terrorism--
still confront us.
    Nevertheless, the fundamentals are in place for a return to 
sustained healthy growth: Imbalances in inventories and capital 
goods appear largely to have been worked off; inflation is 
quite low and is expected to remain so; and productivity growth 
has been remarkably strong, implying considerable underlying 
support to household and business spending as well as potential 
relief from cost and price pressures. In considering policy 
actions this year, the Federal Open Market Committee has 
recognized that the accommodative stance of policy adopted last 
year in response to the substantial forces restraining the 
economy likely will not prove compatible over time with maximum 
sustainable growth and price stability. But, with inflation 
currently contained and with few signs that upward pressures 
are likely to develop any time soon, we have chosen to maintain 
that stance pending evidence that the forces inhibiting 
economic growth are dissipating enough to allow the strong 
fundamentals to show through more fully.
    As has often been the case in the past, the behavior of 
inventories provided substantial impetus for the initial 
strengthening of the economy. However, as inventories start to 
grow more in line with sales in coming quarters, the 
contribution of inventory investment to real GDP growth should 
lessen. As a result, the strength of final demand will play its 
usual central role in determining the vigor of the expansion. 
While final demand has been increasing, the pace of forward 
momentum remains uncertain.
    Household spending held up quite well during the downturn 
and through recent months, and thus served as an important 
stabilizing force for the overall economy. Spending was boosted 
by ongoing increases in incomes, which were spurred by strong 
advances in productivity as well as by legislated tax 
reductions and, in recent months, by extended unemployment 
insurance benefits.
    Monetary policy also played a role in cutting short-term 
interest rates, which helped lower household borrowing costs. 
Particularly important in buoying spending were the very low 
levels of mortgage interest rates, which encouraged households 
to purchase homes, refinance debt and lower debt service 
burdens, and extract equity from homes to finance expenditures. 
Fixed mortgage rates remain at historically low levels and thus 
should continue to fuel reasonably strong housing demand and, 
through equity extraction, to support consumer spending as 
well.
    But those sources of strength probably will be tempered by 
other influences. As we noted in February, because consumer and 
residential expenditures did not decline during the overall 
downturn, there is little pent-up demand to be satisfied. 
Consequently, a surge in household spending early in this 
recovery is unlikely. Moreover, the declines in household 
wealth that have occurred over the past couple of years should 
continue to restrain spending in the period ahead. Still, 
despite concerns about economic prospects, equity valuations, 
terrorism, and geopolitical conflicts, consumers do not appear 
to have retrenched in retail markets. Indeed, consumers 
responded strongly to the new interest rate incentives of motor 
vehicle manufacturers this month. Early reports indicate a 
significant improvement in sales over June.
    By contrast, business spending has been depressed. The 
recent downturn was driven, in large measure, by the sharp 
falloff in the demand for capital goods that occurred when 
firms suddenly realized that stocks of such goods were 
excessive. Overall, the level of real business fixed investment 
plunged about 11 percent between its quarterly peak in the 
final months of 2000 and the first quarter of this year.
    With the adjustment of the capital stock to desired levels 
now evidently well advanced, business fixed investment may be 
set to improve. A recovery in this category of spending is 
likely to be gradual by historical standards and uneven across 
sectors. Still, firms should respond increasingly to the 
expected improvement in the outlook for sales and profits, low 
debt financing costs, the heightened incentives resulting from 
the partial expensing tax provisions legislated earlier this 
year, and especially the productivity enhancements offered by 
continuing advances in technology.
    Indeed, despite the recent depressed level of investment 
expenditures, the productivity of the U.S. economy has 
continued to rise at a remarkably strong pace. The magnitude of 
the recent gains would not have been possible without ongoing 
benefits from the rapid pace of technological advance and from 
the heavy investment over the latter half of the 1990's in 
capital equipment incorporating such advances.
    Despite these encouraging developments regarding longer-
term prospects for the economy, financial markets have been 
notably skittish of late, and business managers remain 
decidedly cautious. In part, these attitudes reflect the 
lingering effects of the shocks that our economy endured in 
2000 and 2001.
    Also contributing to the dispirited attitudes among many 
corporate executives is the intensely competitive business 
environment facing their firms. Increased competition, while 
producing manifold benefits for consumers and for the economy 
as a whole, clearly makes individual firms' operations more 
difficult.
    Those businesses where heightened competition has 
engendered a loss of pricing power have sought ways to raise 
profit margins by employing technology to lower costs and 
improve efficiency. In the United States, as a consequence of 
the interaction of monetary policy, globalization, and cost-
reducing productivity advances, price inflation has fallen in 
recent years to its lowest level in four decades, as has the 
recent growth rate of nominal GDP and consolidated corporate 
revenues.
    In part because nominal corporate revenues, although no 
longer declining, are growing only tepidly, managers seem to 
remain skeptical of the evidence of an emerging upturn. Profit 
margins do appear to be coming off their lows registered late 
last year, but, unsurprisingly, the recovery in economic 
activity from a shallow decline appears less vigorous than in 
the past. The lowest sustained rates of inflation in 40 years 
imply that nominal growth in sales and profits looks 
particularly anemic. Reflecting concerns about the strength of 
the recovery, managers continue to limit capital spending to 
only the most pressing needs.
    Given the key role of perceptions of subdued profitability 
in the current period, it is ironic that the practice of not 
expensing stock option grants, which contributed to the surge 
in earnings reported to shareholders from 1997 to 2000, has 
imparted a deceptive weakness to the growth of earnings 
reported to shareholders in recent quarters. According to 
estimates by Federal Reserve staff, the value of stock option 
grants for S&P 500 corporations fell about 15 percent from 2000 
to 2001, and grant values have likely declined still further 
this year. Moreover, options grants are presumably being 
replaced over time by cash or other forms of compensation, 
which are expensed, contributing further to less robust growth 
in earnings reported to shareholders from its trough last year.
    In contrast, the measure of profits calculated by the 
Department of Commerce for the National Income and Products 
Accounts is designed to gauge the economic profitability of 
current operations. It excludes a number of one-time charges 
that appear in shareholder reports, and, importantly, records 
options as an expense, albeit at the time of exercise. Although 
this treatment of the cost of options is not ideal, it is 
arguably superior to their treatment in shareholder reports, 
where options are generally not expensed at all. NIPA profits 
closely approximate those obtained from reports submitted for 
tax purposes, and, for obvious reasons, corporations tend not 
to inflate taxable earnings. Consequently, NIPA profits have 
been far less subject to the spin evident in reports to 
shareholders in recent years. NIPA profits have increased 
sharply since the third quarter of last year, partly reflecting 
the dramatic jump in productivity and decline in unit labor 
costs.
    The difficulties of judging earnings trends have been 
intensified by revelations of misleading accounting practices 
at some prominent businesses. The resulting investor skepticism 
about earnings reports has not only depressed the valuation of 
equity shares, but it also has been reportedly a factor in the 
rising risk spreads on corporate debt issued by the lower rung 
of investment-grade and below-investment grade firms, further 
elevating the cost of capital for these borrowers.
    The recent impressive advances in productivity suggest that 
to date any impairment of efficiency of U.S. corporations 
overall has been small. Nonetheless, the danger that breakdowns 
in governance could at some point significantly erode business 
efficiency 
remains worrisome. Well-functioning markets require accurate 
information to allocate capital and other resources, and market 
participants must have confidence that our predominantly 
voluntary system of exchange is transparent and fair. Although 
business transactions are governed by laws and contracts, if 
even a modest fraction of those transactions had to be 
adjudicated, our courts would be swamped into immobility. Thus, 
our market system depends critically on trust--trust in the 
word of our colleagues and trust in the word of those with whom 
we do business.
    In recent years, shareholders and potential investors would 
have been protected from widespread misinformation if any one 
of the many bulwarks safeguarding appropriate corporate 
evaluation had held. In too many instances, none did.
    Why did corporate governance checks and balances that 
served us reasonably well in the past break down? At root was 
the rapid enlargement of stock market capitalizations in the 
latter part of the 1990's that arguably engendered an outsized 
increase in opportunities for avarice. An infectious greed 
seemed to grip much of our business community. Our historical 
guardians of financial information were overwhelmed. Too many 
corporate executives sought ways to harvest some of those stock 
market gains. As a result, the highly desirable spread of 
shareholding and options among business managers perversely 
created incentives to artificially inflate reported earnings in 
order to keep stock prices high and rising. This outcome 
suggests that the options were poorly structured, and, 
consequently, they failed to properly align the long-term 
interests of shareholders and managers, the paradigm so 
essential for effective corporate governance. The incentives 
they created overcame the good judgment of too many corporate 
managers. It is not that humans have become any more greedy 
than in generations past. It is the avenues to express greed 
had grown so enormously.
    Perhaps the recent breakdown of protective barriers 
resulted from a once-in-a-generation frenzy of speculation that 
is now over. With profitable opportunities for malfeasance 
markedly diminished, far fewer questionable practices are 
likely to be initiated in the immediate future. To be sure, 
previously undiscovered misdeeds will no doubt continue to 
surface in the weeks ahead as chastened CEO's restate earnings. 
But even if the worst is over, history cautions us that 
memories fade. Thus, it is encumbent upon us to apply the 
lessons of this recent period to inhibit any recurrence in the 
future.
    A major focus of reform of corporate governance, of course, 
should be an improved functioning of our economy. A related, 
but separate, issue is that shareholders must perceive that 
corporate governance is properly structured so that financial 
gains are fairly negotiated between existing shareholders and 
corporate officeholders. Shareholding is now predominantly for 
investment, not corporate control. This has placed de facto 
control in the hands of the chief executive officer. Generally, 
problems need to become quite large before CEO's are dislodged 
by dissenting shareholders or hostile takeovers.
    Manifestations of lax corporate governance, in my judgment, 
are largely a symptom of a failed CEO. Having independent 
directors, whose votes are not controlled by the CEO, is 
essential, of course, for any effective board of directors. 
However, we need to be careful that in the process, we do not 
create a competing set of directors and conflicting sources of 
power that are likely to impair a corporation's effectiveness. 
The functioning of any business requires a central point of 
authority.
    In the end, a CEO must be afforded full authority to 
implement corporate strategies, but also must bear the 
responsibility to accurately report the resulting condition of 
the corporation to shareholders and potential investors. Unless 
such responsibilities are 
enforced with very stiff penalties for noncompliance, as many 
now recommend, our accounting systems and other elements of 
corporate governance will function in a less than optimum 
manner.
    Already existing statutes, of course, prohibit corporate 
fraud and misrepresentation. But even a small increase in the 
likelihood of large, possibly criminal penalties for egregious 
behavior of CEO's can have profoundly important effects on all 
aspects of corporate governance because the fulcrum of 
governance is the chief executive officer. If a CEO 
countenances managing reported earnings, that attitude will 
drive the entire accounting regime of the firm. If he or she 
instead insists on an objective representation of a company's 
business dealings, that standard will govern recordkeeping and 
due diligence. It has been my experience on numerous corporate 
boards that CEO's who insist that their auditors render 
objective accounts get them. And CEO's who discourage corner-
cutting by subordinates are rarely exposed to it.
    I recognize that I am saying that the state of corporate 
governance to a very large extent reflects the character of the 
CEO, and that this is a very difficult issue to address. 
Although we may not be able to change the character of 
corporate officers, we can change behavior through incentives 
and penalties. That, in my judgment, could dramatically improve 
the state of corporate governance.
    Our most recent experiences clearly indicate, however, that 
adjustments to the existing structure of regulation of 
corporate governance and accounting beyond addressing the role 
of the CEO are needed. In designing changes to our regulatory 
framework, we should keep in mind that regulation and 
supervision of our financial markets need to be flexible enough 
to adapt to an ever-changing and evolving financial structure. 
Regulation cannot be static or it will soon distort the 
efficient flow of capital from savers to those who invest in 
plant and equipment. There will be certain areas where Congress 
will choose to provide a specific statutory direction that will 
be as applicable 30 years from now as today. In other cases, 
agency rulemaking flexibility under new or existing statutes is 
more appropriate. Finally, there are some areas where private 
supervision would be most effective, such as that of the New 
York Stock Exchange, which requires certain standards of 
governance for listing.
    Above all, we must bear in mind that the critical issue 
should be how to strengthen the legal base of free market 
capitalism: the property rights of shareholders and other 
owners of capital. Fraud and deception are thefts of property. 
In my judgment, more generally, unless the laws governing how 
markets and corporations function are perceived as fair, our 
economic system cannot achieve its full potential.
    To sum up, the U.S. economy has confronted very significant 
challenges over the past year or so. Those problems, however, 
led to only a relatively brief and mild downturn in economic 
activity, reflecting the underlying strength and increased 
resiliency that the economy has achieved in recent years. The 
effects of the recent difficulties will linger for a bit 
longer, but, as they wear off, and absent significant further 
adverse shocks, the U.S. economy is poised to resume a pattern 
of sustainable growth. Our prospects for 
extending this performance over time can be enhanced through 
the implementation of sound monetary, financial, fiscal, and 
trade policies.
    Thank you, Mr. Chairman. I look forward to your questions.
    Chairman Sarbanes. Thank you, Chairman Greenspan.
    It is my intention to do 6 minute rounds, given the number 
of Members who are here. That will probably take us about an 
hour and a half. And then if the Chairman's time permits, we 
will do a second round if some Members have other questions 
they want to ask. But I think we have to hold down the amount 
of time in order to move though and give everyone a fair chance 
here.
    Mr. Chairman, I want to address first your comments in your 
statement, traditionally, consumer spending on housing and 
autos and other consumer goods has led both the downturn and 
the upturns in the business cycle, while business investment 
has lagged. Traditionally, the swings in housing and autos have 
been wider than for business investment. But that has not 
happened this time. Housing and autos and other durables 
remained relatively stable in 2001. In fact, spending on 
housing and durables has been at cyclical highs relative to 
GDP. Meanwhile, business investment began a sharp decline early 
and has not turned around.
    Ordinarily, we come out of these because housing and autos 
and other durables give us a good boost coming out of the 
recession. This time, they did not go down the way they have in 
previous economic downturns. And so, we do not expect we are 
going to get the same boost coming out, and we have not thus 
far. What are the implications for that for hopes for an 
economic recovery as we look ahead?
    Chairman Greenspan. Mr. Chairman, the only difference that 
one would perceive between past business cycle recoveries where 
the economy had gone down appreciably and then rebounded, is 
that the phase of sharp decline and sharp recovery is 
essentially truncated, but the expansionary elements that are 
building in the economy today will create, as best we can 
judge, a level of economic growth which was typically what we 
would perceive after the very sharp upswings that occurred in 
past economic contractions and 
expansions.
    So the best way I think to view the current situation is to 
essentially take past business cycles and excerpt out that 
sharp decline and rise, and I think we will find that the 
pattern of expansion is pretty much similar to ones we have 
seen in the past.
    And indeed, the financial markets--I should say the money 
markets, the structure of credits and a number of other 
measures of that type--all are consonant with that type of 
outlook.
    Chairman Sarbanes. I might note for the record, since the 
media makes a lot of this nowadays, that at the beginning of 
the Chairman's statement, the Dow was down 200 points. And at 
the end of his testimony, it was down 132 points. So, in other 
words, it rose 70 points over the course of his testimony. The 
Nasdaq, which was down 8.65 at the beginning of his statement, 
was up 5.56 at the end of his testimony.
    Senator Shelby. Mr. Chairman, can you let him continue his 
statement.
    [Laughter.]
    Chairman Sarbanes. I invite Members to yield back their 
time and we will give it to Chairman Greenspan to continue.
    [Laughter.]
    Senator Dodd. Filibuster.
    [Laughter.]
    Chairman Greenspan. I thought you were going to dismiss me 
for the rest of the day, Mr. Chairman.
    [Laughter.]
    Senator Gramm. It started down when you started talking.
    [Laughter.]
    Senator Shelby. Yield to the Chairman.
    [Laughter.]
    Chairman Sarbanes. Let me ask you. When we get the rates 
down as low as you have them, how much stimulative benefit do 
we derive from a further lowering of the rates? I think the 
Japanese actually got their rates down so far that they really 
could not exercise that monetary policy any further. Is that 
correct?
    Chairman Greenspan. That is correct. They have run into 
very significant problems with endeavoring to enhance liquidity 
and have it spill over into economic activity. For a number of 
structural reasons, they have had difficulty in doing that.
    Mr. Chairman, our general view of monetary policy is to 
evaluate what the interaction between our policies and the 
economy are, and endeavor to adjust accordingly.
    Chairman Sarbanes. As you get down at these lower levels 
where you do not have too much room to go before you are at 
zero, are you inhibited in reducing rates in order to stimulate 
the economy because you think to yourself, well, the economy 
may get worse. We may need a clearer signal that we need to 
provide some stimulus, and therefore, we should hold off at the 
moment.
    Chairman Greenspan. Well, Mr. Chairman, all the evidence 
that we have been able to accumulate in recent weeks suggests 
that the economy is improving. It is pretty much in line with 
our expectations. And since our monetary policy posture was 
based on those projections, it is fairly evident that things at 
this particular stage are not behaving in a manner which 
creates a significant amount of uncertainty on our part as to 
what is happening.
    Chairman Sarbanes. Okay. Let me get one final question in 
before my time expires. The Euro edged past the dollar for the 
first time in more than 2 years. What are we to make of that, 
and what are its implications for the state of our own economy?
    Chairman Greenspan. First of all, as I stipulated in my 
prepared remarks, all issues with respect to the exchange rate 
are left----
    Chairman Sarbanes. You skipped over that and I wanted to 
draw you out a little bit on it.
    Chairman Greenspan. Yes. The particular issue of what the 
actual exchange rate number is is wholly arbitrary, so that the 
fact that it is above or less than 1.0 has no economic 
significance whatsoever. Beyond that, Mr. Chairman, that is as 
much as I am going to say on the exchange rate, and I suggest 
that you address further questions to the Secretary of the 
Treasury.
    Chairman Sarbanes. Senator Gramm.
    Senator Gramm. Well, Mr. Chairman, let me thank you for an 
outstanding statement. I want to ask you three questions that 
have to do with corporate governance and accounting.
    We have passed a bill in the Senate--it is obvious by the 
vote that Senators believe that the bill addresses the right 
issues. Obviously, as we try to put together a compromise with 
the House bill, the question becomes how do we address these 
issues. And I want to ask you about your views in terms of 
basic principles of what works and does not work in three 
related areas.
    First of all, the question of whether or not we should give 
the board the power to set standards. For example, there are 
many strong feelings that Members have and the public has about 
what auditors should do in providing other services. Obviously, 
everything we do in this bill that we have adopted applies to 
16,254 different publicly-traded companies, some of them big, 
some of them not too big. As a matter of principle, would you 
rather have standards set by the board or set in law?
    Chairman Greenspan. Senator, it depends on whether the 
types of issues we are concerned about are immutable. In other 
words, for example, certain issues with respect to rights and 
penalties are not going to change from one year or maybe one 
generation to the next, and it is far better that they be hard-
wired into a statute.
    If you conclude that the particular elements within a 
regulatory structure are likely to be changing or need to be 
changed through time, then I think the appropriate procedure is 
to empower, say, the Securities and Exchange Commission to do 
certain things under a statute specifically delineated by the 
Congress.
    Then, finally, there are areas where it is far better that 
the Government were not involved at all. And as I indicated in 
my prepared remarks, the issue of the, I think, very helpful 
activities of the New York Stock Exchange in this regard is an 
example.
    I myself do not know enough about a number of the areas of 
the accounting profession as such. I know a lot about 
accounting, but not about the business of accounting. So, in 
general, I find that the elements within the bill that you just 
passed strike me as really to the point about what has to be 
addressed. But I have no real judgment because I do not have 
competence in the area of knowing which of the various 
elements, which of the various different areas would be most 
effectively addressed by either hard-wiring or by empowering 
the SEC.
    Senator Gramm. Let me ask you a second question. You are 
familiar with the securities litigation reform that we did. We 
had all these strike lawsuits. We had one law firm that did 80 
percent of the work. Senator Dodd was a leader in that effort. 
Do you see any evidence that we should be backtracking from 
that reform?
    Chairman Greenspan. I do not, Senator.
    Senator Gramm. So, you would think that, for example, 
changing the statute of limitations set in that reform would 
not be something based on what you have seen that would be 
desirable?
    Chairman Greenspan. Well, let me put it this way. I have 
seen nothing in the structure of corporate governance as it has 
evolved in the last year or two, or last several years, which 
suggests that significant changes in that area are needed. But, 
again, let me emphasize, these are areas in which I do not 
perceive to have significant competence and I do not wish to 
suggest that I do. I am just merely giving you my impression 
that as I evaluate the relationship between corporate 
governance and the economy, this is not an issue that has 
surfaced which suggests to me a problem.
    Senator Gramm. Let me on a third question raise the issue 
of stock options. I want to conclude by asking you to explain 
your view on stock options so that everybody knows exactly what 
it is. But no matter what the view is, do you believe that 
Congress should vote on the issue of setting an accounting 
standards with regard to how stock options are treated? In 
other words, should Congress be making accounting rules by law?
    For example, a proposal that clearly at some point will be 
voted on is should stock options be expensed? One can have a 
view for or against. The question I am posing, and then I am 
going to conclude by asking your view on the issue, should 
Congress be voting on that or should that be set by FASB or 
some similar system?
    Chairman Greenspan. I frankly do not think that one needs 
to do anything, as best I can judge, with what is happening. My 
own impression is that FASB will rule in a manner which I 
think, from listening to what the various discussions are, 
would appropriately expense stock options, which is a very 
important issue.
    If you take a look at what is happening, for example, two 
companies yesterday are moving to stock option expensing, and I 
suspect we are going to see many more. I think we are going to 
find that the advantages of not expensing stock options which 
were so evident in the earnings reports to shareholders from 
1997 to 2000, are now reversing and working adversely. So those 
corporations which switch to expensing are probably going to 
find that an underlying trend of earnings growth is going to be 
more apparent as they switch. So my own judgment is that 
nothing needs to be done at all. I think it is going to happen, 
and I think quite correctly so.
    Senator Gramm. Thank you, Mr. Chairman.
    Chairman Sarbanes. Senator Dodd.
    Senator Dodd. Thank you very much, Mr. Chairman.
    Mr. Chairman, let me commend you for your statement. It is 
an excellent statement.
    Just as a personal note here, I wish that these remarks had 
been given a week ago by someone else when it comes to the 
issue of corporate governance. And some of the suggestions that 
you have made here have been very strong and very worthwhile, 
and I appreciate them immensely.
    You mentioned specifically in your testimony, and I 
indicated in the question in my brief opening comments about 
other areas in which you think Congress might act. I have 
listened to you very clearly and I understand what you are 
saying, that in many areas, we ought to be careful about 
statutory changes because they are so hard to change.
    There is a rule for the private sector and self-regulatory 
organizations that can be very helpful. And then, of course, 
there is a regulatory framework as well which allows far 
greater flexibility as circumstances change.
    But you made some pretty strong statements in here about 
corporate governance and the issue of directorships and the 
like questions. I wonder if you might make some suggestions to 
us here about whether or not these are areas in which you think 
Congress should act statutorily. Some of us are reluctant to 
get into the corporate governance issues, but it may be at a 
moment when we probably should. I am curious whether you think 
such a moment has arrived.
    Chairman Greenspan. Senator, it is crucially important to 
diagnose what the nature of the problem is. If there are 
differing views as to what is causing the problem that clearly 
created what is a massive degree of accounting imagination, if 
I may choose a new word, unless you get it right, the 
initiatives that you are going to employ to fix it will not 
work. And what I am concerned about is, having served on 15 or 
20 boards, from the first board I was on, where shares were 
publicly held, in 1962, I have seen the evolution of corporate 
governance over a long period of time. And one thing I have 
become acutely aware of is how crucial the issue of what the 
chief executive officer believes and does is to governance.
    If you have a situation in which the chief executive 
officer basically takes his external auditor aside and says, 
look, you are not doing me any favors by managing my earnings 
or making me look better. The purpose of accounting from my 
point of view is to find out whether the corporate strategy I 
have initiated is working or not. And if it is not working, I 
want to change it.
    My impression or my experience over the years is that CEO's 
that have done that have gotten very effective auditing. They 
have gotten very effective governance because they have 
basically changed the view from trying to make the company look 
better whether it was or it was not, to really finding out 
whether the strategy of producing goods and services, enhancing 
the wealth of the company, was actually working.
    I do not wish to make a generalized statement, but I 
suspect that if the CEO issue were fully and completely 
resolved, which it never will be because we are dealing with 
human beings, I think all of the rest of the problems will just 
disappear. Now that is not going to happen and therefore, it is 
appropriate to do what I think the Senate did yesterday and 
pass a whole series of changes in corporate governance which, 
in my judgment, are moving in the right direction and will be 
helpful.
    But I will say this, that if you do not get the CEO 
changing in the way that particular position functions, a 
goodly part of the work of the Senate is not going to be very 
effective. There are just too many people out there who, for 
example, will get a legal opinion from a general counsel and 
then say, I do not like that. Get me a different opinion. If 
you are going to have that going on, you are dealing with human 
nature and I do not see how one can effectively legislate 
morality or character. But what you can do is to try to create 
an environment and a legal structure which very significantly 
penalizes malfeasance.
    Senator Dodd. The yellow light is on, but--I think we are 
doing that. Part of the bill yesterday incorporated some 
stiffer penalties, criminal penalties.
    Chairman Greenspan. I think that was the most important 
part of the bill, frankly.
    Senator Dodd. Senator Leahy will be happy to hear that.
    But you mentioned one thing here, just quickly. You say 
shareholding is now predominantly for investment, not corporate 
control. If that is in fact the case, then the character of the 
CEO becomes a diminished factor, it seems to me almost. If that 
is what we are doing here, then control and discipline within 
the corporation by shareholders and people who serve them on 
boards seems to be diminishing, and will continue to do so. 
Therefore, it seems to speak more loudly to the need for some 
legislative action in the area of audit committees, 
institutional investors having seats on boards. Again, 
legislating in this area is dangerous, but----
    Chairman Greenspan. It is dangerous. And I would suggest 
that you be careful about how you move in this direction 
because, remember, the system is frayed, but it is not broken. 
If we, indeed, had a very extraordinarily weak corporate 
governance or the system broke down, we would not be 
experiencing the productivity growth that we are basically 
seeing.
    Remember, our economy is remarkably efficient. It has 
developed a resiliency and a flexibility in recent years which 
makes it very difficult to understand how this is going on in 
the context of what clearly is many breaches of what 
appropriate corporate governance is. What it basically is 
saying is, beneath all of the problems that we have is still a 
very sound structure. And if we endeavor to try to change the 
system in a fundamental way, we may end up doing more damage 
than help.
    I am merely saying to go slow in this area, but there is 
not a need at this point to rush because I will tell you, 
corporate governance will be just fine for the next 2 years 
because everyone has been chastened. The opportunities and, 
indeed, the incentives to do the types of things that people 
did, are no longer there. They do not have these huge stock 
market capitalizations from which to draw off large earnings 
for themselves. It is not there.
    We do not need to worry about the short term. We do, 
however, have to be concerned about the next episode. And 
unless and until structure is put in place so that if 5, 7, 10 
years from now a similar situation arises, we will be much 
better able to handle it. So, I would say that speed and 
expeditiousness are not important here. Doing it right is very 
important.
    Senator Dodd. Thank you, Mr. Chairman.
    Chairman Sarbanes. In the extended hearings which the 
Committee held on the corporate governance and accounting 
issue, we received very strong testimony from those who had 
chaired previous commissions that examined the situation, the 
O'Malley Commission, and a number of others. The constant 
refrain that we heard from them was that they had made very 
important recommendations, that they had not been adopted 
because in the short run, there was this kind of reaction and 
pick-up.
    The consequence, though, was that then there was a lapse 
back in terms of behavior subsequently, and the structural 
changes had not been accomplished to help forestall that. And 
of course, that is one of the things that the legislation we 
passed yesterday is designed to accomplish.
    So at the moment, everyone is very uptight and measuring up 
to--presumably, high standards. But the danger that they will 
simply slip back, as has happened on past occurrences, and that 
is one of the reasons that we want to put the legislation in 
place, in order to help ensure that that does not happen.
    Chairman Greenspan. Well, I agree with that, Mr. Chairman. 
While there is very little chance, in my judgment, for really 
significant new initiatives towards manipulation of markets or 
anything else like that, it is the case that, as I said in my 
prepared remarks, memories do fade. Optimizing that trade-off 
is a very tricky issue.
    Chairman Sarbanes. Yes.
    Senator Shelby.
    Senator Shelby. Thank you. Mr. Chairman, I only have 6 
minutes. I am going to cede most of it to you with quick 
questions because maybe the market will respond positively if 
you keep doing it like it is.
    Mr. Chairman, how long do you think it will take roughly 
for all these restatements to come through? I know the 
environment is there today of fear, of concern. And the sooner 
they clean up, the better off we are going to be. But I figure 
there are going to be continuous restatements.
    Chairman Greenspan. I think that is correct, Senator. 
Remember that there is a deadline of August 14, which the SEC 
has promulgated for these statements to come in place, and I 
think we are going to see a lot of restatements in the process.
    Senator Shelby. So it is going to be about 4 weeks of hard 
work.
    Chairman Greenspan. I would think so. Remember that it is 
most unlikely we have seen all of the undiscovered events. But 
as I said in my prepared remarks, this is old stuff. It is 
history. We will learn something from it.
    Senator Shelby. It is history, in a sense. You are right. 
But it is not history to a lot of the investors until it comes 
out and they see what the real truth on the restatements are. 
Isn't that correct?
    Chairman Greenspan. I agree with that. And indeed, I think 
that until it becomes fairly clear that the degree of spin in 
earnings estimates is gone, it is going to be very difficult.
    Remember, it is not as though everybody should be shocked 
by this. We had these pro forma statements for months and 
quarters back when the market was roaring away and it was the 
most imaginative accounting I have ever seen.
    In other words, the pro forma earnings were your revenues, 
however you wished to present them, less some of the expenses, 
and you determined which of them they were. Everybody knew that 
was going on. So it was not as though people were creating 
forms of accounting which people who were watching the numbers 
were not aware of.
    Senator Shelby. Sir, you are not saying that all the 
investors in America knew it was going on.
    Chairman Greenspan. No, they certainly did not. We are 
talking about security analysts.
    Senator Shelby. Absolutely. The security analysts and the 
accountants and a lot of the CEO's and chief financial officers 
knew a lot of this accounting stuff was going on. But a lot of 
the investors in America obviously did not know it was going 
on.
    Chairman Greenspan. They did not. That is certainly true.
    Senator Shelby. Because they would have gone into bonds 
fast, I believe.
    Chairman Greenspan. Well, let me just take a step back.
    Senator Shelby. Sure.
    Chairman Greenspan. We do have a set of profits data which, 
for all practical purposes, are free of spin. That is the 
numbers I was mentioning, the National Income and Product 
Accounts numbers, which essentially take corporate reports and 
make the types of adjustments that one is required to see what 
is going on. Those numbers are improving fairly dramatically, 
as indeed they must, because the necessary implications of a 
productivity growth at 7 percent annual rate in the average of 
the fourth and first quarters are very difficult to engender 
without a very major increase in operating earnings. And 
indeed, that is exactly what is happening.
    Senator Shelby. Mr. Chairman, you used the word spin just a 
few minutes ago, and it is a term that we see used here a lot. 
But what we are looking for in the capital markets is accuracy, 
which is basically truth, isn't it?
    Chairman Greenspan. Yes.
    Senator Shelby. What is the true situation, not what is the 
spin or something, maybe even fraud, that comes from that.
    Chairman Greenspan. Yes. I was encouraged, incidentally, 
yesterday by the fact that when Coca-Cola announced it was 
going to expense, its stock price went up, not down.
    Senator Shelby. Along those lines, could you see in the 
future the emergence of a credibility premium--you just alluded 
to it--in the markets? In other words, will honesty, Mr. 
Chairman, lead to higher share prices and to a lower cost of 
capital? I am talking about real stocks.
    Chairman Greenspan. I think it is already happening. I 
think that there is a definite tiering that is going on.
    Senator Shelby. People believe that people are honest and 
this is true, they are going to invest, aren't they?
    Chairman Greenspan. The risk premiums of investing go down 
because, first of all, it is tough enough to make a judgment of 
what the real earning capacity of a corporation is. It is not 
simple. To have on top of that a question as to whether the 
data are accurate creates an additional risk premium.
    Senator Shelby. That is essentially the whole problem, 
isn't it?
    Chairman Greenspan. Yes. In other words, earnings estimates 
are very complex. The best of the earnings analysts spend a 
good deal of time on 10-K reports to try to unearth what the 
underlying profitability is. If on top of that there are 
serious questions of whether or not the numbers they are 
working with are correct, then you are imposing an additional 
risk premium on the earnings estimates, which, of necessity, 
lowers the potential market value of the firm. And there is 
definite tiering, as we say in the marketplace, that 
differentiates these various different types of views. And I 
hope, as indeed I expect, this will become a far more prevalent 
experience.
    Senator Shelby. Mr. Chairman, when do we reach the point 
where productivity gains are maximized and firms have to then 
turn to new hiring to make additional gains?
    Chairman Greenspan. That is a very good question. We are 
finding that productivity is still moving at a really quite 
remarkable pace. And indeed, as I am sure you may know, the 
Federal Reserve released this morning a fairly significant 
increase in industrial production. We also know that this is 
occurring without a major 
increase in employment in manufacturing. That is true for the 
economy as a whole.
    It is not possible for productivity to advance at the pace 
that it did in the 6 months ending March 31, and indeed, the 
second quarter, as best we can judge, shows some positive, 
continued positive productivity gains, but nowhere near what 
they were previously.
    At some point, these very dramatic gains are going to slow 
down to a more sustainable, long-term pace, at which point 
there will be a fairly marked pick-up in employment.
    Senator Shelby. Thank you, Mr. Chairman.
    Chairman Sarbanes. Thank you, Senator Shelby.
    Senator Akaka.
    Senator Akaka. Thank you very much, Mr. Chairman.
    Chairman Greenspan, I was very interested in your remarks 
about the need for trust in our system. It made me recall 
discussions I had with Mr. Hiyami. This is a few years back, 
when Japan was early into their financial problems, and how 
even at that time, the word trust was not really a part of 
their system. I was indicating that this is where they need to 
go. I was very interested, therefore, in your comment about 
trust.
    Also lately, as far as last Tuesday, the Chief Cabinet 
Secretary of Japan made comments about whether they should be 
discussing whether the yen is moving too fast.
    The Associated Press has reported that Japan has intervened 
in the currency markets to weaken the yen against the dollar 
seven times since last May. AP also reported that the U.S. 
Federal Reserve and the European Central Bank have sold yen and 
bought dollars on the Bank of Japan's behalf. So my question to 
you, Mr. Chairman, is this intervention occurring and is the 
Federal Reserve providing assistance to the Bank of Japan? If 
so, what is your evaluation of the intervention? And what will 
be the immediate and long-term effects of these actions?
    Chairman Greenspan. Well, Senator, I cannot confirm any 
individual degree of intervention on the Bank of Japan. But 
what does happen is that we and the European Central Bank will, 
at the request of the Bank of Japan, engage in exchange rate 
activity in terms of yen against our individual currencies 
outside the trading hours of Tokyo. So that what has happened 
on occasion over the years is that when the Bank of Japan has 
decided that it wanted a 24-hour degree of intervention, it 
requested the other central banks to act on their behalf, and 
we do it as their agent.
    Senator Akaka. Secretary of the Treasury Paul O'Neill has 
been quoted as saying that the current account deficit is a 
meaningless concept. Please share your thoughts on the 
significance of the current account deficit and potential 
problems that it could cause.
    Chairman Greenspan. I know that comment is attributed to 
the Secretary and I am not sure it is in the full context.
    Chairman Sarbanes. If the comment was properly in context, 
I take it you would disagree with it.
    Chairman Greenspan. Yes, indeed I do. The current account 
deficit is a meaningful statistic. It does not, however, 
necessarily mean that it is bad because one of the things that 
obviously must be the case is that the current account deficit 
must be exactly matched by a capital account surplus of the 
same order of magnitude because balance sheets must balance.
    What, therefore, is the problem in evaluation is that 
unless you see what is happening to the exchange rate, you 
cannot make a judgment as to whether the demand for dollars, 
for example, is much larger than the financing requirements of 
those, for example, who import goods and services. In that case 
the dollar exchange rate would rise.
    If, on the other hand, U.S. importers had a far more 
significant demand to borrow foreign currency to finance their 
imports than foreigners' demand for dollars to invest in the 
United States, the exchange rate would go down.
    All we can observe is the end result. It is a very complex 
issue, and indeed, I addressed that in part in my prepared 
remarks, Senator, as to how difficult it is to forecast 
exchange rates.
    Senator Akaka. Chairman Greenspan, last week, Ernst & Young 
issued a report which indicated that nonperforming loans in 
Asia have risen 33 percent to $2 trillion over the past 2 
years. What factors have led to the increase in nonperforming 
loans in Asia? And what impact could these nonperforming loans 
have on the global economic recovery?
    Chairman Greenspan. Well, Senator, I did not see the 
particular report, but it is certainly the case that, for 
example, nonperforming loans in the Japanese banking system 
have gone up measurably and it is one of the major difficulties 
confronting the Japanese government who are looking to reform 
the underlying structure of the banking industry.
    And in part, one of the big problems that they have in the 
restructuring is how to resolve the issue of these 
nonperforming loans. Nonperforming loans are not good. 
Obviously, it merely indicates that a considerable amount of 
capital was moved out into the private sector and essentially 
used in an inefficient manner and it did not create wealth to 
pay off the loans.
    Clearly, it is not a good issue. Having nonperforming loans 
is not good. But let me hasten to add that to have zero 
nonperforming loans is not good, either. That basically tells 
you that your banking systems are not doing what you would like 
them to do. There is a trade-off here, and I think what 
concerns the Japanese authorities is that, however one wants to 
look at this, the nonperforming loan issue is too high in 
Japan.
    Senator Akaka. Thank you very much for your responses, 
Chairman Greenspan.
    Thank you, Mr. Chairman.
    Chairman Sarbanes. Thank you, Senator Akaka.
    Senator Allard.
    Senator Allard. Thank you, Mr. Chairman.
    Chairman Greenspan, the housing sector has been I think 
relatively strong since our downturn started early in year 
2000. Would you elaborate a little bit about why you think that 
is happening? The interest rates I know are very low right now, 
around 5 percent, 6 percent. Do you think that this is a major 
factor or not? I would like to hear some of your discussion.
    Chairman Greenspan. Well, I think that there are three 
issues which are driving the housing market, new home 
construction to begin with. First, is mortgage interest rates, 
which are at really quite low levels, lower than they have been 
in a really long time. Second is the issue, as I point out in 
my prepared remarks, of the increasing shortage of buildable 
land. And third, a very important issue which is not discussed 
often, is immigration. The increase in household formation in 
the United States is essentially about one-third immigration, 
and that is enough to put a demand on the system and on the 
capacity to produce homes in this country which has been fairly 
pressing.
    And so, what we have seen is very good housing markets. 
Prices are going up. Home equities are going up. In a sense, we 
have an expanding population to a large extent being driven by 
immigration. The net effect of that has been a very buoyant 
element within the housing market. It would not have been if 
interest rates were not lower. So it is a combination of those 
three factors.
    Senator Allard. Do you think that the investors are perhaps 
looking at housing as perhaps a stable area where they could 
put their money where they could count on at least some 
increase in equity and perhaps some inflation to protect their 
value?
    Chairman Greenspan. I think the answer to that is clearly 
yes. We also have to remember, Senator, that if you 
disaggregate the issue of equity ownership and homeownership by 
income groups--it is pretty evident that the lower four-fifths 
of households arrayed by income have a far greater proportion 
of their wealth in housing than they do in the stock market, 
and for the upper fifth, it is the other way around.
    As a consequence of the fact that there is such a 
predominance of homeownership in the upper middle-income 
groups, which, while they hold stock, do not hold as much as 
they do in home equity, the impact on the economy, the 
stabilizing effect from housing, both from construction and the 
extraction of equity which is assisted very significantly in 
supporting consumer expenditures, has been critical.
    Senator Allard. I would like to get back to this issue of 
corporate governance again. I have always been under the 
impression that the transparency of our financial sheets and 
what not with businesses was much greater than other countries 
throughout the world, and that was one of the strengths of our 
system here, which actually encouraged investors from other 
countries to invest in our stocks here in this country. What is 
your view on our transparency as it compares to the rest of the 
world?
    Chairman Greenspan. I still think that, as best I can 
judge, we are far more transparent than most. Even with the 
problems that have surfaced in the last 6 to 9 months, our 
system is still quite superior, in my judgment, to competing 
systems around the world.
    And, indeed, if we can resolve the corporate governance 
issue, the underlying improvements in the American economy, 
this really quite notable improvement in resilience and 
flexibility in our economy, bodes exceptionally well for the 
future.
    So, we will get past this corporate governance issue. It is 
most unfortunate and I think very regrettable, and it has had 
negative effects, unquestionably. But beneath it all is still a 
very soundly functioning system, as best I can see it.
    Senator Allard. I noticed in your comments that you did not 
say anything about our unemployment figures. I wondered if you 
might comment on those. The unemployment figures have gone up 
here. Is this something that could have been predicted or not?
    Chairman Greenspan. Indeed, I think it was predicted. If 
you have a slowdown in economic growth in the context of very 
strong growth in productivity, the algebra is almost inevitable 
that the unemployment rate will rise. As I pointed out in my 
prepared remarks, the projection of the Federal Open Market 
Committee at its last meeting was that the unemployment rate 
will peak and come down from where it is.
    Senator Allard. What has to happen to expedite our 
unemployment to make those figures go down?
    Chairman Greenspan. I think that the lingering impact of 
the negative events of the last 2 years, which are still 
pressuring our economy but are dissipating, have to finally 
work their way through. That will take some time.
    It is going through, as far as I can judge, pretty much on 
schedule in the sense that, as I indicated in my earlier 
remarks, the economy over the last 6 months has pretty much 
followed the pattern that we had expected it would earlier in 
the year. What that suggests is that it is going to take a 
while, but that things are gradually improving as the negatives 
continually become less.
    Senator Allard. Finally, what can the Congress do in order 
to help assure that we have economic growth in the short term?
    Chairman Greenspan. There are two areas in which I think 
action could be quite helpful. First is to restore the various 
elements of fiscal discipline which really worked so well in 
the early 1990's through the point where we ran into a surplus. 
To get effective discretionary caps and PAYGO rules back in 
place would be a very important issue to create a fiscal 
environment which would be helpful to maintain low long-term 
interest rates, which have been critical to the housing area.
    Second is in the area of trade. I do not think we fully 
appreciate how important the gradual breaking down of trade 
barriers during the post-World War II period has been on 
economic growth globally and especially in the United States. 
And it is most important that we continue to move forward in 
that area because the ever increasing division of labor that is 
implicit in globalization has been a very major factor which 
has enabled our high-tech industries in general, but our 
economy overall, to function as well as it has.
    Senator Allard. Mr. Chairman, I see my time has expired. 
Thank you.
    Chairman Sarbanes. Thank you.
    Senator Corzine.
    Senator Corzine. Thank you, Mr. Chairman. I appreciate the 
remarks of Chairman Greenspan, thoughtful as always.
    Let me say ask a question in specifics. Do you believe that 
it would be appropriate for FASB to put back on its calendar of 
consideration stock options, sooner rather than later?
    Chairman Greenspan. Yes, Senator.
    Senator Corzine. Second, do you feel that in the context of 
the developments that have occurred, certainly been revealed in 
the last several months, that the SEC's funding is appropriate, 
that pay parity issues are appropriate consideration for the 
Congress, and that the additional resources to match up with 
the $10 trillion economy are reasonable requests that we should 
pursue?
    Chairman Greenspan. Senator, I have testified over the last 
2 or 3 years, when the occasion arose, that the SEC is 
underfunded.
    Senator Corzine. I presume that underfunding means under-
resourced.
    Chairman Greenspan. Yes.
    Senator Corzine. With regard to people to review 
statements.
    Chairman Greenspan. Yes. But most specifically, their 
salary level for lawyers, for example, is much lower than it 
would be at the Federal Reserve. One of the reasons that has 
occurred is that we had the same problems that they did many 
years ago, and with the assistance of the Congress, we were 
able to pay premiums to get the types of people we need to 
supervise and regulate the banking system.
    In my judgment, if we are going to implement the type of 
legislation which you have just passed, we are going to need a 
fairly expanded capability which at this particular stage does 
not exist. If you are going to pass laws and not enforce them, 
you are doing an injustice to a democratic system.
    Senator Corzine. I could not agree more. And that is one of 
the reasons, and I do not expect you to comment on it, a $100 
million increase in the SEC's budget, I think was 
disappointingly recom-
mended, when in fact, we need serious funding resources, and 
pay parity for the individuals who----
    Chairman Greenspan. Pay parity is very important.
    Senator Corzine. I was interested in your comments to 
Senator Allard with regard to the fiscal environment. You 
talked about PAYGO and the spending issues. But conditions do 
change through time and policies need to change, spending 
policies, potentially. Do you still believe we can afford the 
tax cuts that are expected to roll through the economy in the 
context of the fiscal deterioration that we have seen, 
certainly with the issue of irreducible minimum debt not being 
quite the problem that it was a year ago at this time, or 18 
months?
    Chairman Greenspan. Senator, I have always believed that 
one of the things that we do poorly at this stage is project 
and simulate various different outlooks into the future for our 
Federal budget.
    Thirty years ago, there was nothing in the budget that 
really had a major impact in years forward. We now no longer 
have a 1, 2, or even a 3 year budget. We have commitments, both 
contingent and otherwise, which go many years into the future.
    I think we need far more in the way of analysis and 
projections and trade-offs with our whole budget, both receipts 
and outlays. That is specifically the case, as I have testified 
before, 
because we are running into an unquestioned significant shift 
in demographics toward the end of this decade, which is going 
to mean that the number of retirees which are going to put 
pressure on resources in this economy is going to be very 
significant.
    Now my view has always been that I think that we can 
curtail spending far more than we do. And my own personal view 
is that the best way in which the economy can function is to 
hold spending down and get as low a tax base as you can to 
enable the economy to expand as rapidly as you can. But, having 
said that, whatever it is that is done should at least be 
projected in a manner which is consonant with credible long-
term outlooks.
    I am not going to address the specific question that you 
asked because that question can then lead to five or six other 
questions of what do I think about one specific program, 
another program.
    Senator Corzine. That would be fun.
    [Laughter.]
    Chairman Sarbanes. What a path to go down.
    [Laughter.]
    Senator Corzine. Right.
    Chairman Greenspan. I have tried----
    Senator Corzine. I guess the central point of what I was 
trying to make, though, is that there are two tracks. And I 
will interpret your statement that one needs to look at 
receipts and outlays, and one needs to prioritize those in the 
context of the importance that we have. One of those that is, 
and I think I just heard you say that making sure that we had 
the proper resources at the SEC is going to mean that we have 
to increase spending, at least in one area. Now, we have a huge 
budget and we have lots of choices. But those choices need to 
be made and they need to be made inside the context of receipts 
and outlays, depending on what the needs of the Nation and 
projections are.
    Chairman Greenspan. Yes, that is precisely why I am 
somewhat distressed by what has been a breaking down of fiscal 
responsibility in the process of engendering budgets.
    Senator Corzine. Thank you.
    Chairman Sarbanes. Senator Bunning.
    Senator Bunning. Thank you, Mr. Chairman.
    I ask this question always to you and you spoke about it 
earlier. You see no evidence of inflation in our economy 
presently?
    Chairman Greenspan. None that is evident to any of the 
analysts in our organization.
    Senator Bunning. Thank you. I want to make sure that is the 
case.
    You spoke to stock options and you spoke to Coca-Cola. I 
received a fax--not a fax, but an e-mail from Bank One today 
announcing, effective with today's earnings announcement, it is 
reporting stock options granted to executives and other 
employees as expenses. So here is another one joining the team 
voluntarily. I think that when we see the effect of what 
voluntary compliance does in reporting stock options as 
expenses, we may not need to react with some type of 
legislation.
    Last Friday, after the markets closed, both Fannie Mae and 
Freddie Mac agreed to voluntarily register their securities 
with the SEC. The TVA or the Tennessee Valley Authority has 
about $20 billion in public-traded securities, but they are 
exempt from SEC's jurisdiction. Do you think TVA should also be 
under SEC's jurisdiction with that amount of debt out?
    Chairman Greenspan. Senator, I am not familiar with the 
TVA's issue. But I do know that Under Secretary Peter Fisher of 
the Treasury Department is testifying today on the GSE's issues 
of registration and the like.
    There are several questions here which are emerging. One is 
not only on their securities, but also on mortgage-backed 
securities, which is a much more controversial issue. I think 
that this issue requires further examination, as indeed it is 
getting. I do not know what the consequence of the testimony is 
this morning. But I do think that issues such as you raise 
should be examined to determine what the appropriate role of 
GSE's and related organizations are with respect to the 
questions of disclosure.
    Senator Bunning. Let me talk to you about something that 
has been in the news as of yesterday, about wash sales, that 
Enron and others have been accused of. In other words, buying 
and selling on the same day in the electric and gas markets. Do 
you have an opinion on those?
    Chairman Greenspan. People do that all the time. I do not 
think that is the issue. It is how they record it on their 
books which I think is what the real question is. And there 
have been allegations, which I frankly do not know whether they 
are accurate or not, that part of this problem we are having 
with dubious accounting procedures is they bloat revenues by 
essentially double-counting activities. For example, if you and 
I were, say, two corporations, I could sell you something and 
you could sell me back the same thing, and both of us would 
increase our revenues, where really, as a practical matter, 
nothing important happened. There has been a good deal of that 
going on. I am a little puzzled in certain respects as to why 
some people do that because, while it is the case that revenues 
do rise, margins, by definition, go down.
    There are, unfortunately, certain types of incentives which 
are tied to revenues within a corporation and not profits, and 
so that there is an incentive to play those types of games. I 
am not sure that it makes any sense whatever. But clearly, it 
does not do credit to those who are trying to keep credible 
books.
    Senator Bunning. Okay. Last question, and it has to do with 
the electricity market, since we have had some major problems 
in certain areas of the country. Do you believe more regulation 
is needed in our electricity markets to stabilize the supply 
and demand that occurs in certain areas of the country?
    Chairman Greenspan. Well, Senator, we are undergoing a 
major change in the technology of electric power. Remember, one 
of the crucial characteristics of electric power is we cannot 
store it, which means that there is no buffer involved between 
supply and demand. For generations, we therefore constructed a 
public utility 
operation in which individual utilities would function under a 
regulatory scheme in which they would be guaranteed rates of 
return, and in the process, function in an adequate manner.
    What became apparent, however, was that capital was being 
grossly misused in the sense that because you were able to get 
a guaranteed rate of return on stand-by capacity, there was a 
tendency to create more of it than we really needed. And with 
the increased ability to wheel power from one area to the other 
and get improved technologies, we have perceived a major 
capability of reducing the amount of capital we need to produce 
the amount of energy that we have. The trouble is that in this 
transition, we are getting all sorts of very technically 
difficult problems arising.
    I do not think that we should go back to the regulatory 
structure we had in the past. I think what we have to do is 
address the issues as best we can, but not to stop the 
continuous deregulation of electric power, which in the long 
run will be very helpful to this economy.
    Senator Bunning. The only question is, which everybody 
asks, should the Feds do it or should it be done State by 
State? Obviously, the Federal Government has not chosen to do 
it and it is being done by all the 50 States.
    Chairman Greenspan. Well, one of the problems basically is 
that when you start to wheel power across grids, it is an 
interstate action. So it is difficult to avoid the fact that 
there is a Federal role in this regard.
    Senator Bunning. Thank you very much, Mr. Chairman.
    Chairman Sarbanes. Thank you, Senator Bunning.
    Senator Bayh.
    Senator Bayh. Chairman Greenspan, thank you for being with 
us. Your testimony, as always, is substantively insightful and 
rhetorically Delphic, which is appropriate since, as our 
Chairman pointed out, your words, can literally move markets.
    [Laughter.]
    So it is good to have you with us today.
    I would like to begin with a couple of questions about 
productivity growth, which is so important at both the macro 
and the microlevel, and specifically how it relates to your 
anticipated acceleration of capital expenditures and 
investments.
    You mentioned four factors that may contribute to improved 
capital expenditures. One of them was profitability of the 
firms, improved clarity. But there things seem to be a little 
murky. You mentioned that revenues are growing only tepidly. 
Profit margins are less vigorous than in the past. Growth in 
sales and profits are particularly weak.
    Mr. Chairman, it seems to me, reading between the lines of 
your testimony, that you expect capital investment to 
accelerate largely because of a productivity imperative 
before clarity and profitability improves. Is that an accurate 
interpretation?
    Chairman Greenspan. Senator, when you are confronted with a 
situation in which pricing power is nonexistent, and you are 
endeavoring to improve your profitability, there is only one 
way to do it, and that is improve your profit margins. And the 
only way to do that is to increase productivity of your firm.
    That is the process that is going on. And it has been very 
successful, and indeed, surprisingly so because I cannot 
imagine anybody who projected the extraordinary acceleration in 
output per hour that has occurred in the last 9 months as 
recently, let us say, as a year ago. It has been a very 
interesting indication of how much progress we have made in the 
underlying capabilities and efficiency of our system.
    Senator Bayh. Which leads me to my second productivity-
related question. You have spoken to us in the past about 
cycles of innovation and productivity acceleration, which then 
at some future point level off to a mean average. What would we 
look at to try and anticipate approaching a saturation point of 
information technology of other new information, suggesting 
that this wonderful acceleration in productivity growth that we 
have experienced may at some point--how can we anticipate at 
what point it might subside?
    Chairman Greenspan. That is of course the crucial issue in 
forecasting, Senator. What we try to do is to glean from 
various surveys what the extent of the application of existing 
technology has been put in place in firms. What has been a 
remarkably consistent survey, when purchasing managers, for 
example, who have these various different capabilities of 
reporting what companies are doing, are asked, ``What 
proportion of the existing technology currently available to 
you today is already in place?'' The usual number is 50 
percent, which essentially says that the part that is as yet 
unexploited is still very significant. But because the 50 
percent does not change, it is essentially saying that it is 
expanding at the other end.
    Senator Bayh. Innovation and application seem to be 
proceeding apace.
    Chairman Greenspan. Yes. So, obviously, at some point, they 
are going to find that there is an element of saturation and we 
have exploited the potentials as much as we can.
    Senator Bayh. But we are nowhere near at this point.
    Chairman Greenspan. But we have not seen any evidence of 
that yet.
    Senator Bayh. I am going to try to fit two additional 
questions in before my time expires, Mr. Chairman. The first 
deals with housing. I was interested in your remarks about the 
role of immigration, scarcity of land, and low mortgage rates, 
seem to have offset for the time being the fact that housing 
prices--I believe that housing price escalation has exceeded 
personal income growth for some time. Is it your view that this 
can go on indefinitely?
    Chairman Greenspan. Well, it is an interesting question as 
to whether prices of homes, by the nature of the industry, will 
tend to rise relative to the underlying level of prices 
generally in an economy.
    I am sure there are a lot of people who would argue with me 
on this question. But my impression is that because so much of 
our home construction is individual and customized, that the 
level of productivity advance that you can get in the economy 
as a whole is not feasible in the housing construction area. 
Indeed, people do not want it. You want to have something which 
is unique. And if it is unique, you cannot create significant 
productivity.
    Now, I am not saying that productivity in housing is not 
going anywhere. It is going at a quite remarkable pace, but 
less than the economy as a whole, which means, over the long 
run, the prices of homes will rise relative to the average.
    Senator Bayh. I am on the yellow light, Mr. Chairman. I 
will just slip in a very short question here. And I do not 
intend to ask you about the value of the dollar. I understand 
why that would be a perilous territory to tread upon. But are 
there factors that you would look at that would allow you to 
judge whether the revaluation of the dollar is proceeding in an 
orderly manner, or at some point would be more precipitous and 
thereby would verge upon the disorderly or run the risk of 
destabilizing or creating inflationary pressures? Or is it not 
possible to address that without implicitly getting into the 
value of the dollar?
    Chairman Greenspan. Correct.
    Senator Bayh. Okay. I understand. I was interested, not in 
what the valuation point might be, but instead, the rate of 
revaluation and the risk of instability and the economy 
resulting from that. But it is a conversation for another time.
    Thank you, Mr. Chairman.
    Chairman Sarbanes. Thank you very much, Senator Bayh.
    Senator Bennett.

             COMMENTS OF SENATOR ROBERT F. BENNETT

    Senator Bennett. Thank you very much, Mr. Chairman.
    Chairman Greenspan, when you come in a little bit late, 
that means you are in a circumstance where virtually everything 
has already been explored. I am going to take you in a 
direction that probably has nothing to do with your testimony 
today, but takes advantage of your presence and might have some 
implications for the situation in which we find ourselves. I 
want to talk to you about tax treatment of dividends.
    It is very easy to--not very easy, but it is possible as we 
have seen to deal with the books in such a way as to manipulate 
earnings, or at least manage earnings. That is a concept I 
never learned at the beginning of my business career and it 
started coming up at the end. Well, we are going to manage the 
earnings. I always thought that earnings were a factor of how 
well you manage the business and came or did not come, 
depending on----
    Chairman Greenspan. Doesn't that sound like an old-
fashioned concept, Senator?
    Senator Bennett. Yes.
    [Laughter.]
    Chairman Greenspan. I wish we could restore it.
    [Laughter.]
    Senator Bennett. Now, dividends cannot be managed nearly as 
easily as earnings. But when the question was raised in the 
company where I was involved as to whether or not we should 
start to pay some dividends because we had some fairly 
significant cash, the response we got from the people who were 
Wall Street savvy--we started out as a private company, 
obviously, so we did not have any of those folks around. But as 
we became a public company, then we had to have people with 
that expertise.
    They said, no, no, you do a disservice to the shareholders 
if you pay dividends because, if you pay dividends, what you 
are saying to them is that you do not expect the company to 
grow as rapidly as other companies into which they could put 
after-tax dollars. And since you expect that you can manage 
their money better than they can manage their money, and you 
are dealing with pre-tax dollars, you do the shareholders the 
best service by hanging onto the money and investing it in your 
own company.
    It raises the issue, then, of tax treatment of dividends 
because if the investor had the opportunity to take his or her 
money out in the form of a dividend and not pay the tax on it, 
he or she might say, I can do a better job than the managers of 
this company.
    Now, you and I have questioned each other in what has been 
kind of a Kabuki ritual over the years when I have asked you 
what the capital gains tax should be, and you looked thoughtful 
and then tell me you think the optimum capital gains tax should 
be zero, and then we both say, yes, that is the thing we want. 
Then I do it again at the next hearing.
    Let us talk about taxes on dividends because dividends, 
like capital gains, represent a return on capital. And since 
every other issue has been discussed and we have a little bit 
of time, let us get philosophical about this issue, and 
particularly against the backdrop of dividends as a measure of 
corporate performance, as opposed to managed earnings as a 
measure of corporate performance.
    Chairman Greenspan. Senator, I think there are two 
interesting aspects to this question. I remember, and I am sure 
you do, when yields on stocks were 5 and 6 percent.
    Senator Bennett. Yes.
    Chairman Greenspan. This goes back 50 years but people 
bought stocks for dividends. They did not buy them for 
earnings. And one of the problems that we did not have back 
then is earnings manipulations were not very important because 
nobody cared.
    Earnings are very difficult to estimate. In fact, there is 
no such thing as an objective earning level of incorporation 
until a corporation is fully liquidated. So earnings are always 
provisional.
    Cash dividends are not. As I indicate in my prepared 
remarks, there is a question here as to the value of cash 
dividends inducing corporations to start to build up cash, and 
in that process probably think in terms of increasing cash 
dividends.
    Now that changed very dramatically. And indeed, there is 
another element here: remember, one of the reasons why 
dividends as a means of pay-out have gone down somewhat is that 
there has been an awful lot of stock buy-back which effectively 
does not 
address the question of taxation. At root, this question, or 
the fundamental aspect of this question, really gets down to 
the double taxation of dividends and the issue of the 
integration of the corporate tax with the individual tax. And I 
think a lot of economists will tell you that that is an 
extraordinarily useful and efficient way, if you can do it, to 
put all of the tax burden on shareholders and not have double 
taxation of dividends through taxing the corporation and then 
taxing the dividends again.
    My own impression is that we should have a very large 
expansion of Subchapter S corporations which effectively would 
enable dividends to be paid out and effectively taxed only 
once. I do not expect that to happen at this particular stage 
and there are very good reasons why problems of revenue loss 
are creating a concern. There are issues of equity.
    But if you are asking as an economist and looking strictly 
at the question of the optimum allocation of capital in the 
system, eliminating double taxation of dividends is a very 
valuable thing to do. And indeed, as you may be aware, the 
Secretary of the Treasury has very strongly been proposing 
that.
    Senator Bennett. Just quickly, with the time gone, the 
company that I managed that was most successful was in fact an 
S corporation. And as shareholders in that S corporation, we 
could make the decision as to whether or not we were going to 
leave the money in the company to make it grow or take it out. 
Since there were no shares to sell in the public arena, the 
whole question of stock options did not come up. So, we watched 
very carefully the amount of cash accumulating in the company 
and the amount that we could take out in the form of dividends. 
And as you say, it was not double-taxed.
    Thank you very much.
    Chairman Sarbanes. Senator Carper.

              COMMENTS OF SENATOR THOMAS R. CARPER

    Senator Carper. Thanks, Mr. Chairman.
    Chairman Greenspan, welcome. It is good to see you and we 
thank you for meeting with us today. I have been in and out. We 
have had a couple other hearings going on and I am in and out 
of another one dealing with clean air. So, I apologize for not 
being here to hear all of the questions. I heard most of your 
statement.
    I want to revisit an issue that revolves around the 
legislation that the Senate passed yesterday, which the House 
passed their own version of it a month or so ago. We will now 
create a conference committee, as you know, and we will hammer 
out our differences. Somewhere along the line we are going to 
be asking you publicly or privately for your own counsel as to 
which provisions are most important that we retain from the 
Senate bill or maybe in which instances you think the House 
language is preferable. Do you have today any particular 
thoughts that you might share with us as to what provisions of 
the Senate bill that you feel are most worth preserving as we 
go forward?
    Chairman Greenspan. Senator, I thought that the initiative 
that the Senate produced was very important and very effective.
    As I said to the Chairman before the hearing, my original 
view was that taking accounting standards and moving them out 
of the private sector was really unnecessary because my view 
was always that accountants basically knew or had to know that 
the market value of their companies rested on the integrity of 
their operations and that, indeed, that signature that they put 
on an order form is where the net worth of the company comes 
from.
    And that, therefore, their self-interest is so strongly 
directed at making certain that their reputation was 
unimpeachable, that regulation by Government was utterly 
unnecessary and, indeed, most inappropriate. I was wrong.
    I was really deeply distressed to find that actions were 
being taken which very clearly indicated a lack of awareness of 
where the market value of accounting is. Consequently, what 
essentially your bill, the Chairman's bill, and that of the 
House is endeavoring to do, is to substitute for something 
which should not have been necessary in the first place. I have 
no views as to what pieces of what bills to take. I frankly 
have not read the bills in detail. Is it 112 pages or 
something?
    Senator Carper. It is a quick read.
    [Laughter.]
    Chairman Greenspan. I am not competent to answer a number 
of these questions. I think I am in the area of accounting 
where I have some very considerable history. But in the 
business of accounting, I do not, and I am not really 
knowledgeable enough to be able to make judgments.
    Senator Carper. All right. Thank you.
    I have heard you testify a number of times and I thought 
today your testimony was uncommonly clear and precise. Some 
have suggested that it is not always that way, and I always 
thought it was just me.
    Senator Bennett. If I may, Senator, you are just getting 
better at decoding it.
    [Laughter.]
    Senator Carper. Well, I hope so. I thought your testimony 
was just very clear and very compelling.
    Chairman Sarbanes. It is better than Volcker. You had to 
decode the smoke rings that he was blowing from his cigar.
    [Laughter.]
    Senator Carper. I thought one of the things you said that 
really struck home with me was, and I will paraphrase, you said 
that the state of corporate governance within a corporation 
reflects the character of the CEO. I thought that was a very 
telling statement.
    Let me just change gears a little bit, if I could, and ask 
us to focus on our trade deficit, which is large and seems to 
be growing, and to relate to that. Maybe you could just take a 
moment and give us a little primer on the financing of the 
trade deficit. Last year I think it exceeded $300 billion. The 
role that foreign investment plays in enabling us to finance 
that trade deficit, and why restoring investor confidence in 
our markets is important as we deal with financing the trade 
deficit.
    Chairman Greenspan. Well, Senator, as I indicated 
previously, thinking in terms of the broader issue, the current 
account deficit is distinct from the trade deficit, you have to 
determine how it is being financed. And by construction, the 
current account deficit, as I indicated earlier, has to be 
exactly the same amount with the sign changed as the capital 
accounts surplus because it is double-entry bookkeeping. One 
must balance the other.
    And obviously, when the demand to invest in the United 
States is increasing or is very large, it may very well create 
a demand for dollars to invest in the United States much larger 
than the demand for foreign currency by our importers who need 
to finance goods from abroad. That is in fact the best simple 
explanation of why the dollar goes up or down. When the demand 
for investment is greater than the demand for foreign 
currencies to import, the dollar will be up, and vice-versa.
    The notion, however, that you have to be careful about is 
that we are talking about the rate of increase in investment. 
In other words, you can have a significant decline in the rate 
of inflow of capital investment in the United States, but it is 
still positive and so the aggregate amount of investment is 
growing. It is the rate of change which determines whether in 
fact the pressures are for or against the dollar--whether the 
price of the currency is going up or going down. And I think, 
as I indicated in my prepared remarks, it is such a complex 
type of structure--that is, the markets are so efficient and so 
complex in exchange rate markets, that it is very difficult to 
forecast them much in advance.
    We at the Federal Reserve have spent an inordinate amount 
of time trying to find models which would successfully project 
exchange rates, not only ours but everybody else's. It is not 
the most profitable investment we have made in research time. 
Indeed, it is really remarkable how difficult it is to 
forecast, which is another way of saying how successful the 
markets have become in absorbing the knowledge that everyone 
has about supply and demand for currency, supply and demand for 
goods and services, imports and exports. So, our inability to 
forecast is a testament to how good the markets have basically 
become.
    Senator Carper. Thank you, Chairman Greenspan.
    Thank you, Mr. Chairman.
    Chairman Sarbanes. Thank you, Senator Carper.
    Senator Schumer.

             COMMENTS OF SENATOR CHARLES E. SCHUMER

    Senator Schumer. Thank you, Mr. Chairman. And thank you, 
Chairman Greenspan, for your dedication to our country and its 
economy.
    I have one general question and two specifics. My general 
relates to this. Many of us are scratching our heads here 
wondering why are the markets to skittish, so far up, so far 
down. And I guess you hear a whole melange of reasons--
corporate governance, obviously, September 11 and the residue 
from September 11, people's fear about the future and unwilling 
to say, well, we will have a great future.
    But then maybe there is the other answer, which is that 
stock price ratios are still very high. Maybe they were just so 
high that the exact details of what brings them back to 
traditional levels is less important than they come back to 
traditional levels and are not going to pop back up again. So, 
I guess my questions are; could you comment on that generally? 
How much is this specifically driven by the situations of the 
times, the Enron's and the Worldcom's, as well as the September 
11's? How much is just possibly a return to more normal ratios 
of stock price ratios? And related to that, just a specific--
how great is the confidence of the markets in Washington's 
ability to get on top of all of this?
    Chairman Greenspan. I am glad you are asking such easy 
questions this morning. If we were dealing with, as you put it, 
normal stock price valuation processes, then we could just very 
readily look at a chart and say, price/earnings ratios are 
higher or lower, equity premiums are higher or lower, and make 
judgments accordingly. There is a tricky problem here, and the 
problem basically is the productivity problem. The change in 
structural productivity, the order of magnitude of which is not 
all that easy to judge, clearly must have an effect on the 
long-term equilibrium price/earnings ratio. Obviously, with 
productivity growth rising, the equilibrium P/E ratio is 
higher. What we do not know is where it is. And so, it makes it 
very difficult to answer that question.
    Senator Schumer. So the traditional valuations do not work. 
We do not know where they end up, but they do not work. Or as 
well.
    Chairman Greenspan. They do not work as well. No, I am not 
saying that we throw them out. I am just basically saying----
    Senator Schumer. Let me ask then the second part of that. 
How great do you think is the confidence in the markets of 
Washington's ability to get on top of this crisis of confidence 
that we have?
    Chairman Greenspan. I do not know the answer to that.
    Senator Schumer. When the President gives a speech, then 
the markets go down, things like that.
    Chairman Greenspan. Well, I do not know.
    Senator Schumer. You know, I am not saying cause and 
effect.
    Chairman Greenspan. Well, confidence is a difficult thing 
to put your finger on. You do not reverse investor, consumer, 
or other confidence----
    Senator Schumer. By a speech.
    Chairman Greenspan. ----overnight, or by any particular 
action by anybody. And the reason is that we have an 
extraordinarily complex economy which is fairly stable, in the 
sense that it used to be that we had many regional economies in 
the United States. I remember the time when mortgage interest 
rates were 50 basis points higher in California than in New 
York. We now have a single financial market--indeed, I would 
argue, international financial market--which does not move with 
minor changes.
    Senator Schumer. So, again, maybe what you are saying here, 
and I do not want to put words in your mouth, is that it has 
become--even creating that kind of confidence in a complicated 
economy has become complicated. So the jury is out as to 
whether we can do it.
    Chairman Greenspan. Yes. At root, confidence occurs when 
you have a stable economic environment from which to function. 
We know, for example, that inflation is very antithetical to 
investor confidence, and we see it in the marketplace. 
Stability and predictability are crucial elements to 
confidence. And those are not easy issues to really produce.
    Senator Schumer. You had mentioned that you supported the 
Leahy part of the bill, the increase in the penalties to the 10 
years.
    Chairman Greenspan. I supported all of the elements in 
which the issue of taking fraud as an action of theft and 
treated accordingly is appropriate.
    Senator Schumer. Right. There was some talk yesterday or 
this morning of backing off some of those tougher provisions as 
we get to the conference. I take it you would regard that as a 
bad idea.
    Chairman Greenspan. Well, now you are getting into areas of 
jurisprudence and criminal law in which my expertise is zero or 
less. I do not know how one should basically interpret it. All 
I can tell you, from an economist's point of view, that the 
issue of fraud and misrepresentation are extraordinarily 
deleterious to the functioning of a voluntary free market 
capitalist system, and that if you want the benefits from the 
type of system that we have, you cannot have issues of fraud, 
which are the equivalent of violence to the markets themselves.
    Senator Schumer. I would read into that that we ought to 
stick with the tougher penalties.
    Chairman Greenspan. I have really said what I believe as an 
economist. How that is interpreted into the criminal law is 
something which I do not have a clue about.
    Senator Schumer. Okay. One final question. A proposal has 
been put together. I could not offer it in this bill because it 
was not germane. But being aware, and this again relates to 
transparency and knowledge, which I think are really the main 
functions of how we ought to regulate the markets, rather than 
with a heavier hand. But you have large numbers of companies, 
when they file their earnings under the Securities Act and 
others, so differ with the filings of their taxable income on 
their IRS statements.
    For instance, Worldcom supposedly reported $16 billion of 
earnings to its shareholders between 1996 and 2001, and yet, 
reported only a billion dollars of taxable earnings, to the 
IRS. Now, admittedly, the accounting standard and the tax 
standard are different. They do not seem to be so different.
    Chairman Greenspan. Partly. Partly illusion, Senator.
    Senator Schumer. Yes. But the proposal being that with ways 
to protect proprietary information of the companies, in other 
words, not filing the whole tax return, but some kind of 
summary, what would be your initial thinking on a proposal that 
said that companies had to file those tax returns with the SEC 
and they would be made public to the investing public, again, 
with the caveat of leaving out specific proprietary 
information. Not to say they would be the same, but maybe they 
would have some salutary, prophylactic effect of having fewer 
disparities.
    Chairman Greenspan. Well, my initial reaction is that 
unless you can see some real advantages in doing it, which I 
cannot, I would not be in favor of that. And I think that the 
issue really gets to the question of appropriate governance.
    For example, there is no question that the accounting 
treatment for tax purposes is not the same thing as the 
accounting treatment for other corporation puposes. Indeed, 
there used to be jokes that everyone had two or three sets of 
books, as though that was something bad. The truth of the 
matter is you might want two or three separate sets of books.
    You may want, for example, and the most important one from 
the point of view of the chief executive officer is to have a 
set of accounts which says, as I indicated earlier today, 
whether in fact a particular corporate strategy is successful. 
That is a very specific request and you would keep your 
accounts in a certain manner.
    There is another set of accounts which you may want to keep 
to determine, what is the probability that you will default? 
And that is a different set. You value assets differently.
    For example, in one case, you try to get an exact measure 
of the value of assets. In a default issue, you want to get a 
very conservative estimate, to lean over backwards. Then you 
have tax accounting, which is different again.
    And all I would suggest is that, as I indicated in my 
prepared remarks, in the National Income and Product Accounts, 
which, as I indicated, profits are rising quite significantly, 
are essentially derived from the IRS data system, and in that 
regard offer the macrodata more accurately.
    Senator Schumer. No one is disputing there should be 
different types of books and accounts. What is wrong with 
having the public see them? What is wrong with more knowledge 
rather than less?
    Chairman Greenspan. Well, largely because I do not think 
you can effectively maintain the confidentiality that is 
required for proprietary purposes, no matter how hard you try.
    Senator Schumer. Thanks, Mr. Chairman.
    Chairman Sarbanes. As we draw the hearing to a close, first 
of all, Senator Schumer, you talked about restoring confidence 
and so forth. I do not think you were here at the outset. When 
Chairman Greenspan began his testimony, the Dow was down 200 
points and the Nasdaq was down 8.65. When he concluded his 
testimony, the Dow was down 132 and the Nasdaq was up 5.56. And 
we checked, just a moment ago, now that we are about to 
complete the questioning. The Dow is now down 20, and it was 
down 200 when he began. So through his testimony, and then the 
question and answer session, we have gone from minus 200 to 
minus 20. And the Nasdaq has gone from minus 8.65 to plus 21.
    Senator Schumer. We should keep talking, Mr. Chairman.
    [Laughter.]
    Chairman Sarbanes. I was going to say, regrettably, we are 
not going to be able to extend this hearing indefinitely. And 
so, we take no responsibility for what happens the balance of 
the day.
    [Laughter.]
    Mr. Chairman, I want to put just a couple of questions to 
you before we draw to a close. First of all, I want to 
underscore how much I agree with you when you made the point 
that fraud undercuts the very fundamentals of the workings of 
our economic system. That is why we have penalties, severe 
penalties, in the bill for corporate executive officers who 
engage in fraud or misleading information. Second, the ability 
of investors to rely on information in order to make judgments 
as to where they invest their money is why we have developed 
this strengthening of the system in terms of oversight of the 
accounting industry and the effort to eliminate the conflicts 
of interest that affect auditors making a tough call as they 
audit the books, or stock analysts in terms of their buy or 
sell recommendations. So that is certainly something that the 
legislation is addressed to accomplish.
    I just want to ask two questions as we close. You referred 
to the Federal Reserve's release this morning on industrial 
production, that it was up, I think, eight-tenths of a point.
    I note in the material that the production of business 
equipment, however, fell in June, that it fell at a 6.6 percent 
rate in the second quarter, and that capacity utilization, 
while up a bit, remains at the lowest levels in almost 20 
years. What will it take to get our capital goods sector back 
to reasonable growth?
    Chairman Greenspan. I think that underlying profitability 
is by far the most important way of doing that. It is fairly 
evident that the cutting edge of technologies continue to be 
important in this economy. And that should in itself be the 
major force which will induce recovery.
    Remember that one of the problems we ran into subsequent to 
the early months of the year 2000 was that we found that even 
though demand for high tech was rising at a fairly significant 
pace, the supply was rising at twice the pace, and that 
inevitably created a glut which had to be worked off. And as 
best we can judge, as I indicated in my prepared remarks, that 
is largely complete.
    Chairman Sarbanes. I want to invite you to think with me 
for a moment about an issue that I think is out there in the 
future, but I want to try to anticipate it. It has been raised 
in my mind by the question I put to you earlier about the Euro 
now being worth more than the dollar, but it really addressed 
the European Union and what that possibly represents as a 
challenge.
    I am prompted to this by a story in The Wall Street Journal 
a few weeks ago. The headline was: U.S. Loses Sparkle as Icon 
of Market Place. Wave of Corporate Scandals Could Tilt World 
Business Away From American Model. There are comments from the 
Europeans. One of their leading industrialists in Germany says, 
``I warn people not to simply take over rules from the United 
States without first reflecting on them critically.'' And then 
they go on to say, ``European leaders are also pushing for 
greater acceptance of their auditing rules, known as the 
International Accounting Standards, as an alternative to 
American rules. The great virtue of the International 
Accounting Standards, which all European Union companies will 
have to adopt by 2005, is that it is a simple and fairly 
compact list of basic principles.''
    The chief executive of KPMG in India said that there had 
been a painful loss of face for consultants and accountants 
representing American companies. The scandal has been 
unhelpful, especially since we as a profession operate on a 
reputation and the implicit trust that follows.
    The point I want to make is, that the American accounting 
industry needs, in effect, to cleanse itself and shape up and 
have a proper system in which it functions, or it is going to 
end up finding itself severely challenged internationally.
    Traditionally, the United States has this reputation for 
the most transparent markets, the ones with the most integrity. 
It has been our standard so to speak--that is the prevailing 
standard. That is in part, I think, because we have been 
overwhelmingly the largest economy, although the EU now is fast 
approaching equivalency with the United States in terms of the 
size of the economy.
    Also, as this notes, all the countries are going to adopt 
the same international accounting standards in the EU by 2005. 
And I think this is going to be, looking down the road, a very 
serious challenge to the preeminence of the American accounting 
profession which it has had up to this point.
    Which it seems to me is just another very strong argument 
why we need to put these changes into place to get it back up 
to a standard that commands universal respect, because it is 
very clear now that the Europeans looking at it no longer 
concede that we have this established lead, that our system is 
necessarily better than theirs. They are now large enough 
economically, in a sense, to challenge it. And so I see a 
competition developing down the road which, it seems to me, we 
need to pay attention to.
    I think the integrity of the American capital markets has 
been a great economic asset for the United States, and that 
anything that jeopardizes that carries with it the erosion of 
our economic strength and our international economic position. 
Do you have a view on this issue?
    Chairman Greenspan. I agree with the general comments you 
are making, Mr. Chairman. We thought at one point that the 
detailed GAAP rules actually produced clarity. What we 
regrettably found in too many cases is that the various sets of 
GAAP rules were used as a hurdle for legal cover of various 
different types of actions. And the reason I think that, as in 
your bill and other requirements, that a CEO or CFO certifies 
the overall accounts, what is in effect occurring is not merely 
a stipulation that we passed say 104 of GAAP requirements and 
we met them all and therefore, we have disclosed what needs to 
be disclosed. What we have learned, regrettably, is that in 
order to get a really important understanding of what the 
underlying profitability and the nature of a corporation is, 
you need far more than merely a listing of whether or not you 
met a certain set of GAAP requirements.
    Now what that says is that you are requiring over and above 
having met individual GAAP requirements that the CFO and CEO 
are certifying, that irrespective of that, the system has 
basically--the set of accounts that are being offered does 
indeed correctly portray, as best one can, what the nature of 
the company is. A combination of GAAP and oversight by the CEO, 
certification by the CEO, may be an important way of looking at 
accounting.
    Now, I am not denying that having principles rather than 
specifics has certain advantages, and I think that the 
competition that we now see between the two different systems 
is very healthy. What will ultimately emerge out of it, in my 
judgment, is probably an international system which will 
combine the best of both systems and be applicable on a 
worldwide basis.
    Chairman Sarbanes. Mr. Chairman, we thank you very much. It 
has been a very interesting and informative hearing.
    The hearing stands adjourned.
    [Whereupon, at 12:35 p.m., the hearing was adjourned.]
    [Prepared statements, response to written questions, and 
additional material supplied for the record follow:]
              PREPARED STATEMENT OF SENATOR JON S. CORZINE
    Mr. Chairman, I want to again congratulate you on the overwhelming 
passage of the accounting and investor protection reform legislation 
yesterday, your leadership in that effort was nothing short of stellar. 
I also want to thank you for holding this hearing this morning, and of 
course want to welcome Chairman Greenspan before the Committee and 
thank him for joining us today.
    Chairman Greenspan, I look forward to your testimony on the issue 
of the state of our Nation's economy. In a speech in Alabama yesterday, 
President Bush outlined that with low interest rates, relatively low 
inflation, and increasing productivity that ``our economy is 
fundamentally strong.'' That may well be true, but we have this 
unprecedented decline of equity markets and at the beginning of an 
economic recovery. My question is ``why?''
    Are we facing the risk of slipping into a deflationary spiral that 
parallels what we witnessed during the Japanese crisis of the 1990's? 
Or is this all attributable to the fact that corporate scandals, like 
we have witnessed at Enron and Worldcom, have led to a crisis of 
confidence in corporate management and corporate financial statements 
that have called many to question not only the integrity of our 
equities markets, but also the fundamental underpinnings of our 
economic well-being.
    Hopefully, last night's reform package passed here in the Senate 
will be embraced not only in conference by the House membership, but 
also by President Bush, who to date has been reluctant to state his 
support for this bill over the far weaker legislation passed by the 
House.
    Like the rest of my colleagues, I look forward to your perspectives 
about what, if any, impact you believe the legislative proposal passed 
by the Senate yesterday will have toward helping to soothe the fragile 
psyche of investors.
    Finally, Chairman Greenspan, I look forward to a discussion about 
some of the elements the legislation did not deal with, in particular, 
the issue of expensing stock options. And whether you believe more 
companies will follow suit in light of Coca-Cola's announcement 
yesterday that they would begin expensing employee stock 
options.
    As always, Chairman Greenspan, it is a pleasure to have you serve 
in front of this Committee, I look forward to your testimony and to 
perspectives on America's future economic prospects.
    Thank you, Mr. Chairman.
                               ----------
               PREPARED STATEMENT OF SENATOR JIM BUNNING
    Mr. Chairman, I would like to thank you for holding this hearing, 
and I would like to thank Chairman Greenspan for coming before the 
Committee today.
    We have a crisis in our economy today--a crisis of confidence. We 
have all seen it, and the majority of Americans have felt it. Whether 
they own stock, have a 401(k) or another type of pension plan, millions 
have been personally hit by the recent market dips. At this point, the 
losses might be only on paper. But we all know how to add and subtract. 
And the sheer drop of the Dow, Nasdaq, and S&P 500 in the last few 
weeks has folks on edge.
    To make things worse, the markets are dropping in a time when, 
overall, most of the economic news is pretty good. The economy grew at 
6 percent in the first quarter. Retail sales were up in June. And 
inflation is almost nonexistent. But the last I heard, over one 
thousand companies have restated earnings.
    The stock markets are in the tank. Investors keep waiting for the 
other shoe to drop--again. They are waiting to see if there will be 
another Enron, or Global Crossing, or Worldcom. To be fair, the retail 
investor seems to be more willing to ride out the market and sit on 
their hands. It would be nice if institutional investors would do the 
same. But the bottom line is that investors large and small are going 
to do what is right for them. No one can blame them.
    We must restore confidence in our markets. I am glad that Congress 
is well on its way to passing legislation to help. But it is going to 
take more than enacting a bill to restore that confidence. The 
President has taken some good steps too. I think his ideas will help 
greatly.
    It would be nice if some of his political opponents would stop 
taking potshots at the President for things that started long before he 
came into office. Some of the rhetoric that has been flying around the 
past few days has been dangerous and irresponsible. Clearly it has been 
more about political agendas than the overall economic mood of the 
country. But those who try to use recent problems for political gain--
whether they be Republican or Democrat--are playing with fire. Markets 
can go back up just as fast as they go down.
    Personally, I think that one way we could restore some confidence 
in the market would be for the public to see some of these executives 
who have committed fraud to walk around in handcuffs and orange 
jumpsuits. When the American people see that the system does work and 
those who have committed crimes pay the piper, they will feel a lot 
more secure about their investments and security. I would like to 
figure out a legal, constitutional way to expedite the prosecution of 
those who have committed crimes and get them in jail right away. I know 
that is a little far afield for this hearing. But I really believe that 
it is one of the real, tangible things that could be done that would 
send out the right signal to investors, markets, and business.
    I look forward to hearing from Chairman Greenspan about our 
economy. I would hope to hear any suggestions on what else he thinks 
can be done to restore confidence in our markets. And I look forward to 
talking with you further during the question and answer period.
    Thank you, Mr. Chairman.
                               ----------
                  PREPARED STATEMENT OF ALAN GREENSPAN
       Chairman, Board of Governors of the Federal Reserve System
                             July 16, 2002
    I appreciate this opportunity to present the Federal Reserve's 
Monetary Policy Report to the Congress. Over the four and one-half 
months since I last testified before this Committee on monetary policy, 
the economy has continued to expand, largely along the broad contours 
we had anticipated at that time. Although the uncertainties of earlier 
this year are as yet not fully resolved, the U.S. economy appears to 
have withstood a set of blows--major declines in equity markets, a 
sharp retrenchment in investment spending, and the tragic terrorist 
attacks of last September--that in previous business cycles almost 
surely would have induced a severe contraction. The mildness and 
brevity of the downturn, as I indicated earlier this year, are a 
testament to the notable improvement in the resilience and flexibility 
of the U.S. economy.
    But while the economy has held up remarkably well, not surprisingly 
the depressing effects of recent events linger. Spending will continue 
to adjust for some time to the declines that have occurred in equity 
prices. In recent weeks, those prices have fallen further on net, in 
part under the influence of growing concerns about corporate governance 
and business transparency problems that evidently accumulated during 
the earlier rapid runup in these markets. Considerable uncertainties--
about the progress of the adjustment of capital spending and the 
rebound in profitability, about the potential for additional 
revelations of corporate malfeasance, and about possible risks from 
global political events and terrorism--still confront us.
    Nevertheless, the fundamentals are in place for a return to 
sustained healthy growth: Imbalances in inventories and capital goods 
appear largely to have been worked off; inflation is quite low and is 
expected to remain so; and productivity growth has been remarkably 
strong, implying considerable underlying support to household and 
business spending as well as potential relief from cost and price 
pressures. In considering policy actions this year, the Federal Open 
Market Committee has recognized that the accommodative stance of policy 
adopted last year in response to the substantial forces restraining the 
economy likely will not prove compatible over time with maximum 
sustainable growth and price stability. But, with inflation currently 
contained and with few signs that upward pressures are likely to 
develop any time soon, we have chosen to maintain that stance pending 
evidence that the forces inhibiting economic growth are dissipating 
enough to allow the strong fundamentals to show through more fully.
    As has often been the case in the past, the behavior of inventories 
provided substantial impetus for the initial strengthening of the 
economy. Manufacturers, wholesalers, and retailers took vigorous steps 
throughout 2001 to eliminate an unwanted buildup of stocks that emerged 
when final demand slowed late in 2000. By early this year, with 
inventory levels having apparently come into better alignment with 
expected sales, the pace of inventory reduction began to ebb, and 
efforts to limit further drawdowns provided a considerable boost to 
production. The available evidence suggests that, in some sectors, 
liquidation may be giving way to a rebuilding of 
inventories. However, as inventories start to grow more in line with 
sales in com-
ing quarters, the contribution of inventory investment to real GDP 
growth should lessen. As a result, the strength of final demand will 
play its usual central role in determining the vigor of the expansion. 
While final demand has been increasing, the pace of forward momentum 
remains uncertain.
    Household spending held up quite well during the downturn and 
through recent months, and thus served as an important stabilizing 
force for the overall economy. Real consumer outlays and spending on 
residential construction each rose about 3 percent over the course of 
2001, even as the growth of real GDP fell off to only \1/2\ percent. 
Household spending was boosted by ongoing increases in incomes, which 
in turn were spurred by strong advances in productivity as well as by 
legislated tax reductions and, in recent months, by extended 
unemployment insurance benefits.
    Monetary policy also played a role by cutting short-term interest 
rates, which helped lower household borrowing costs. Particularly 
important in buoying spending were the very low levels of mortgage 
interest rates, which encouraged households to purchase homes, 
refinance debt and lower debt service burdens, and extract 
equity from homes to finance expenditures. Fixed mortgage rates remain 
at historically low levels and thus should continue to fuel reasonably 
strong housing demand and, through equity extraction, to support 
consumer spending as well. Indeed, recent sizable increases in home 
prices, which reflect the effects on demand of low mortgage rates, 
immigration, and shortages of buildable land in some areas, have 
significantly increased the equity in houses that homeowners can 
readily tap through home equity loans and mortgage refinancing.
    But those sources of strength probably will be tempered by other 
influences. As we noted in February, because consumer and residential 
expenditures did not decline during the overall downturn, there is 
little pent-up demand to be satisfied. Consequently, a surge in 
household spending early in this recovery is unlikely. Moreover, the 
declines in household wealth that have occurred over the past couple of 
years should continue to restrain spending in the period ahead. Still, 
despite the concerns about economic prospects, equity valuations, 
terrorism, and geopolitical conflicts, consumers do not appear to have 
retrenched in retail markets. Indeed, consumers responded strongly to 
the new interest rate incentives of motor vehicle manufacturers this 
month. Early reports indicate a significant improvement in sales over 
June.
    By contrast, business spending has been depressed. The recent 
economic downturn was driven, in large measure, by the sharp falloff in 
the demand for capital goods that occurred when firms suddenly realized 
that stocks of such goods--both those already in place as well as those 
in inventory--were excessive. The resulting declines in the production 
of capital goods were particularly sizable in the high-tech sector. 
Monthly shipments of computers and peripherals, for example, fell by 
about 40 percent from their peak in 1999 through their trough in 2001. 
Sales by communications equipment producers slumped just as sharply. 
Outside the high-tech sector, production also declined. Assemblies of 
commercial aircraft slowed abruptly. In addition, the construction of 
office and industrial buildings fell off noticeably. The collapse of 
many Internet firms and the difficulties of the high-tech sector more 
generally led to a significant drop in the demand for office space that 
was exacerbated as the economic slowdown widened beyond the tech 
sector. Overall, the level of real business fixed investment plunged 
about 11 percent between its quarterly peak in the final months of 2000 
and the first quarter of this year.
    With the adjustment of the capital stock to desired levels now 
evidently well advanced, business fixed investment may be set to 
improve. A recovery in this category of spending is likely to be 
gradual by historical standards and uneven across sectors. For example, 
an upturn in production of semiconductors and computers has been under 
way now for nearly a year, but with significant overcapacity still 
prevailing in some segments of the telecom industry, investment in 
communications equipment is likely to remain subdued for some time to 
come. Overall capital 
expenditures should strengthen with time. In particular, firms should 
respond increasingly to the expected improvement in the outlook for 
sales and profits, low debt financing costs, the heightened incentives 
resulting from the partial expensing tax provisions legislated earlier 
this year, and especially the productivity enhancements offered by 
continuing advances in technology.
    Indeed, despite the recent depressed level of investment 
expenditures, the productivity of the U.S. economy has continued to 
rise at a remarkably strong pace. In the nonfarm business sector, 
output per hour is currently estimated to have soared at an average 
annual rate of about 7 percent over the fourth quarter of 2001 and 
first quarter of 2002, and the available evidence points to continued 
gains last quarter--though not at the frenetic pace of the preceding 
half year. In part, these increases in productivity reflect the very 
cautious attitudes of managers toward hiring. But the magnitude of the 
recent gains would not have been possible without ongoing benefits from 
the rapid pace of technological advance and from the heavy investment 
over the latter half of the 1990's in capital equipment incorporating 
such advances.
    Despite these encouraging developments regarding the longer-term 
prospects for the economy, financial markets have been notably skittish 
of late, and business managers remain decidedly cautious. In part, 
these attitudes reflect the lingering effects of the shocks that our 
economy endured in 2000 and 2001. Particularly given the dimensions of 
those shocks, some persistent uncertainty and concern are not 
surprising.
    Also contributing to the dispirited attitudes among many corporate 
executives is the intensely competitive business environment facing 
their firms. Increased competition, while producing manifold benefits 
for consumers and for the economy as a whole, clearly makes individual 
firms' operations more difficult. Past deregulation and, more recently, 
the enhanced speed and efficiency of information flows resulting from 
technological advances are strengthening competition domestically. In 
addition, globalization is intensifying competition in a broad range of 
markets and damping pricing power across developed and developing 
nations alike.
    Those businesses where heightened competition has engendered a loss 
of pricing power have sought ways to raise profit margins by employing 
technology to lower costs and improve efficiency. In the United States, 
as a consequence of the interaction of monetary policy, globalization, 
and cost-reducing productivity advances, price inflation has fallen in 
recent years to its lowest level in four decades, as has the recent 
growth rate of nominal GDP and consolidated corporate revenues.
    In part because nominal corporate revenues, although no longer 
declining, are growing only tepidly, managers seem to remain skeptical 
of the evidence of an emerging upturn. Profit margins do appear to be 
coming off their lows registered late last year, but, unsurprisingly, 
the recovery in economic activity from a shallow decline appears less 
vigorous than in the past. The lowest sustained rates of inflation in 
40 years imply that nominal growth in sales and profits looks 
particularly anemic. In contrast, in the 1950's and early 1960's, the 
last period of stable prices, populations and employment were growing 
considerably faster than the recent pace so that growth in nominal GDP, 
consolidated corporate sales, and profits was seen as still quite 
respectable. Reflecting concerns about the strength of the recovery, 
managers continue to limit capital spending to only the most pressing 
needs.
    Given the key role of perceptions of subdued profitability in the 
current period, it is ironic that the practice of not expensing stock 
option grants, which contributed to the surge in earnings reported to 
shareholders from 1997 to 2000, has imparted a deceptive weakness to 
the growth of earnings reported to shareholders in recent quarters. As 
stock market gains turned to losses a couple of years ago, the 
willingness of employees to accept stock options in lieu of cash or 
other forms of compensation apparently diminished. According to 
estimates by Federal Reserve staff, the value of stock option grants 
for the S&P 500 corporations fell about 15 percent from 2000 to 2001, 
and grant values have likely declined still further this year. 
Moreover, options grants are presumably being replaced over time by 
cash or other forms of compensation, which are expensed, contributing 
further to less robust growth in earnings reported to shareholders from 
its trough last year.
    In contrast, the measure of profits calculated by the Department of 
Commerce for the National Income and Product Accounts is designed to 
gauge the economic profitability of current operations. It excludes a 
number of one-time charges that appear in shareholder reports, and, 
importantly, records options as an expense, albeit at the time of 
exercise. Although this treatment of the cost of options is not ideal, 
it is 
arguably superior to their treatment in shareholder reports, where 
options are generally not expensed at all. NIPA profits closely 
approximate those obtained from reports submitted for tax purposes, 
and, for obvious reasons, corporations tend not to inflate taxable 
earnings. Consequently, NIPA profits have been far less subject to the 
spin evident in reports to shareholders in recent years. NIPA profits 
have increased sharply since the third quarter of last year, partly 
reflecting the dramatic jump in productivity and decline in unit labor 
costs.
    The difficulties of judging earnings trends have been intensified 
by revelations of misleading accounting practices at some prominent 
businesses. The resulting investor skepticism about earnings reports 
has not only depressed the valuation of equity shares, but it also has 
been reportedly a factor in the rising risk spreads on corporate debt 
issued by the lower rung of investment-grade and below-investment grade 
firms, further elevating the cost of capital for these borrowers. 
Businesses concerned about the impact of possible adverse publicity 
regarding their accounting practices on their access to finance could 
revert to a much heavier emphasis on cash generation and accumulation. 
Such an emphasis could slow new capital investment initiatives.
    The recent impressive advances in productivity suggest that to date 
any impairment of efficiency of U.S. corporations overall has been 
small. Efficiency is of course a key measure of corporate governance. 
Nonetheless, the danger that breakdowns in governance could at some 
point significantly erode business efficiency remains worrisome. Well-
functioning markets require accurate information to allocate capital 
and other resources, and market participants must have confidence that 
our predominately voluntary system of exchange is transparent and fair. 
Although business transactions are governed by laws and contracts, if 
even a modest fraction of those transactions had to be adjudicated, our 
courts would be swamped into immobility. Thus, our market system 
depends critically on trust--trust in the word of our colleagues and 
trust in the word of those with whom we do business. Falsification and 
fraud are highly destructive to free-market capitalism and, more 
broadly, to the underpinnings of our society.
    In recent years, shareholders and potential investors would have 
been protected from widespread misinformation if any one of the many 
bulwarks safeguarding appropriate corporate evaluation had held. In too 
many cases, none did. Lawyers, internal and external auditors, 
corporate boards, Wall Street security analysts, rating agencies, and 
large institutional holders of stock all failed for one reason or 
another to detect and blow the whistle on those who breached the level 
of trust essential to well-functioning markets.
    Why did corporate governance checks and balances that served us 
reasonably well in the past break down? At root was the rapid 
enlargement of stock market capitalizations in the latter part of the 
1990's that arguably engendered an outsized increase in opportunities 
for avarice. An infectious greed seemed to grip much of our business 
community. Our historical guardians of financial information were 
overwhelmed. Too many corporate executives sought ways to ``harvest'' 
some of those stock market gains. As a result, the highly desirable 
spread of shareholding and options among business managers perversely 
created incentives to artificially inflate reported earnings in order 
to keep stock prices high and rising. This outcome suggests that the 
options were poorly structured, and, consequently, they failed to 
properly align the long-term interests of shareholders and managers, 
the paradigm so 
essential for effective corporate governance. The incentives they 
created overcame the good judgment of too many corporate managers. It 
is not that humans have become any more greedy than in generations 
past. It is that the avenues to express greed had grown so enormously.
    Perhaps the recent breakdown of protective barriers resulted from a 
once-in-a-generation frenzy of speculation that is now over. With 
profitable opportunities for malfeasance markedly diminished, far fewer 
questionable practices are likely to be initiated in the immediate 
future. To be sure, previously undiscovered misdeeds will no doubt 
continue to surface in the weeks ahead as chastened CEO's restate 
earnings. But even if the worst is over, history cautions us that 
memories fade. Thus, it is incumbent upon us to apply the lessons of 
this recent period to inhibit any recurrence in the future.
    A major focus of reform of corporate governance, of course, should 
be an improved functioning of our economy. A related, but separate, 
issue is that shareholders must perceive that corporate governance is 
properly structured so that financial gains are fairly negotiated 
between existing shareholders and corporate officeholders. Share-
holding is now predominately for investment, not corporate control. Our 
vast and highly liquid financial markets enable large institutional 
shareholders to sell their shares when they perceive inadequacies of 
corporate governance, rather than fix them. This has placed de facto 
control in the hands of the chief executive officer. Shareholders 
routinely authorize slates of directors recommended by the CEO. 
Generally, problems need to become quite large before CEO's are 
dislodged by dissenting shareholders or hostile takeovers.
    Manifestations of lax corporate governance, in my judgment, are 
largely a symptom of a failed CEO. Having independent directors, whose 
votes are not controlled by the CEO, is essential, of course, for any 
effective board of directors. However, we need to be careful that in 
the process, we do not create a competing set of directors and 
conflicting sources of power that are likely to impair a corporation's 
effectiveness. The functioning of any business requires a central point 
of authority.
    In the end, a CEO must be afforded the full authority to implement 
corporate strategies, but also must bear the responsibility to 
accurately report the resulting condition of the corporation to 
shareholders and potential investors. Unless such responsibilities are 
enforced with very stiff penalties for noncompliance, as many now 
recommend, our accounting systems and other elements of corporate 
governance will function in a less than optimum manner.
    Already existing statutes, of course, prohibit corporate fraud and 
misrepresentation. But even a small increase in the likelihood of 
large, possibly criminal penalties for egregious behavior of CEO's can 
have profoundly important effects on all aspects of corporate 
governance because the fulcrum of governance is the chief executive 
officer. If a CEO countenances managing reported earnings, that 
attitude will drive the entire accounting regime of the firm. If he or 
she instead insists on an objective representation of a company's 
business dealings, that standard will govern recordkeeping and due 
diligence. It has been my experience on numerous corporate boards that 
CEO's who insist that their auditors render objective accounts get 
them. And CEO's who discourage corner-cutting by subordinates are 
rarely exposed to it.
    I recognize that I am saying that the state of corporate governance 
to a very large extent reflects the character of the CEO, and that this 
is a very difficult issue to address. Although we may not be able to 
change the character of corporate officers, we can change behavior 
through incentives and penalties. That, in my judgment, could 
dramatically improve the state of corporate governance.
    Our most recent experiences clearly indicate, however, that 
adjustments to the 
existing structure of regulation of corporate governance and accounting 
beyond addressing the role of the CEO are needed. In designing changes 
to our regulatory framework, we should keep in mind that regulation and 
supervision of our financial markets need to be flexible enough to 
adapt to an ever-changing and evolving financial structure. Regulation 
cannot be static or it will soon distort the efficient flow of capital 
from savers to those who invest in plant and equipment. There will be 
certain areas where Congress will choose to provide a specific 
statutory direction that will be as applicable 30 years from now as 
today. In other cases, agency rulemaking flexibility under new or 
existing statutes is more appropriate. Finally, there are some areas 
where private supervision would be most effective, such as that of the 
New York Stock Exchange, which requires certain standards of governance 
for listing.
    Above all, we must bear in mind the critical issue should be how to 
strengthen the legal base of free market capitalism: The property 
rights of shareholders and other owners of capital. Fraud and deception 
are thefts of property. In my judgment, more generally, unless the laws 
governing how markets and corporations function are perceived as fair, 
our economic system cannot achieve its full potential.
    A considerable volume of market commentary in recent weeks has 
suggested that concerns about earnings prospects and the proliferating 
revelations of serious governance and accounting issues have 
contributed not only to lower equity prices but also to a decline in 
the foreign exchange value of the dollar. And some of that commentary 
has extrapolated the trend of dollar weakness. As you know, the 
Secretary of the Treasury speaks for our Government on exchange rate 
policy. But, given the recent intense interest in the future course of 
the dollar, I would like to raise a technical issue and a flag of 
caution regarding those forecasts--or, for that matter, any forecast of 
exchange rates. There may be more forecasting of exchange rates, with 
less success, than almost any other economic variable.
    The reason that it is so difficult is that an exchange rate is a 
very complex price that balances, on the one hand, the demand for, for 
example, dollars stemming from the demand for dollar investments and 
for U.S. exports against, on the other hand, the demand for foreign 
currencies by U.S. investors desiring to acquire foreign 
assets and by U.S. importers of foreign goods and services. Hence, 
exchange-rate movements depend on shifting perceptions of the relative 
returns from investing in different countries and on the myriad 
influences on relative tendencies to import and export. The net effect 
of these factors over any future time period is extraordinarily 
difficult to assess in advance. Although measures such as real interest 
rate differentials, differential rates of productivity gains, and 
chronic external deficits are often employed to explain exchange rate 
behavior, none has been found to be consistently useful in forecasting 
exchange rates even over substantial periods of 1 or 2 years.
    Our ability to attract foreign capital in coming years will help 
facilitate the 
increases in investment that will promote continued gains in 
productivity and standards of living. But policymakers should also 
recognize the important role that prudent fiscal policy can play in 
promoting national saving and maintaining conditions conducive to 
investment and continued strong growth of productivity. Beginning in 
the late 1980's, impressive progress was made in reining in Federal 
expenditures and restoring a better balance between spending and 
revenues. The lower Federal deficits and, for a time, the realization 
of surpluses contributed significantly to improved national saving and 
thereby put downward pressure on real interest rates. This, in turn, 
enhanced the incentives of businesses to invest in productive plant and 
equipment.
    Recently, however, some of those gains have been given up. To a 
degree, the return to budget deficits has been a result of temporary 
factors, especially the falloff in revenues and the increase in outlays 
associated with the economic downturn. Those influences should tend to 
reverse over the next year or two, other things equal, although the 
decline in revenues reflecting the drop in capital gains realizations, 
including those on options is unlikely to be fully reversed. And the 
necessary rise in expenditures related to the war on terrorism and 
enhanced homeland security has also played a role, as have the tax 
reductions legislated last year. Unfortunately, there are also signs 
that the underlying disciplinary mechanisms that formed the framework 
for Federal budget decisions over most of the past 15 years have 
eroded. The Administration and the Congress can make a valuable 
contribution to the prospects for the growth of the economy by taking 
measures to restore this discipline and return the Federal budget over 
time to a posture that is supportive of long-term economic growth.
    To sum up, the U.S. economy has confronted very significant 
challenges over the past year or so. Those problems, however, led to 
only a relatively brief and mild downturn in economic activity, 
reflecting the underlying strength and increased resiliency that the 
economy has achieved in recent years. The effects of the recent 
difficulties will linger for a bit longer but, as they wear off, and 
absent significant further adverse shocks, the U.S. economy is poised 
to resume a pattern of sustainable growth. Indeed, the central tendency 
of Federal Reserve policymakers' forecasts is for expansion of real GDP 
over the four quarters of 2002 of 3\1/2\ to 3\3/4\ percent, somewhat 
above the rates anticipated in our February report. Economic growth is 
projected to be solid again next year, with real output rising 3\1/2\ 
to 4 percent. Monetary policymakers anticipate that these gains should 
be sufficient to bring the unemployment rate down to 5\1/4\ to 5\1/2\ 
percent by the end of next year. Inflation is expected to be subdued 
throughout, with prices for personal consumption expenditures 
increasing at only a 1\1/2\ to 1\3/4\ percent rate. Our prospects for 
extending this performance over time can be enhanced through 
implementation of sound monetary, financial, fiscal, and trade 
policies.

  RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES FROM ALAN 
                           GREENSPAN

Budget for Economic Statistics
    The Senate Appropriations Committee has recently voted out 
the Fiscal 2003 spending levels for the Bureau of Economic 
Analysis and the Bureau of the Census. The bill covers only pay 
raises for personnel and nothing more for economic statistics. 
According to the Bureau of the Census, the Senate bill does not 
provide the funds necessary to carry out the once every 5 years 
2002 Economic Census that forms the foundation for many monthly 
and economic statistics over the next 5 years. It also provides 
no funding for the quarterly survey of service industries, the 
earlier release of trade statistics, or the modernization of 
the GDP that were included in the President's budget.

Q.1. What is your view about providing the funds necessary to 
carry out the 2002 Economic Census?

A.1. As you know, I am reluctant to support increased spending. 
In the case of certain economic statistics, however, the 
benefits are so large relative to cost that there should be 
little question as to its desirability.
    Because the Economic Census, which is taken every 5 years 
by the Census Bureau, covers all businesses and not just a 
sample of businesses, the data collected in this effort are 
among the most fundamental building blocks of the Nation's 
economic statistics. The information gathered by the Economic 
Census is critical to maintaining the quality of our national 
income accounts and a host of other economic statistics, 
including the Federal Reserve's industrial production and 
capacity programs. I support full funding, at the level 
requested by the President, for the Economic Census.
    The President's budget also requests funding for other 
important statistical initiatives at both the Census Bureau and 
the Bureau of Economic Analysis. These include several 
initiatives important to the Federal Reserve, such as 
establishing a new quarterly indicator of service sector 
activity, collecting more information on business purchases of 
services and materials, and the earlier release of trade 
statistics. I also support funding of such initiatives at the 
levels requested by the President.

Dynamic Scoring
    On January 10, 1995, you testified on the issue of budget 
estimating before a joint hearing of the House and Senate 
Budget Committees. You stated at that time that:

          . . . full dynamic estimates of individual budget 
        initiatives should be our goal. Unfortunately, the 
        analytical tools required to achieve it are deficient. 
        In fact, the goal may ultimately be unreachable. The 
        estimation of full dynamic effects requires a model 
        that captures micro and macroeconomic processes and 
        produces reliable long-term forecasts of economic 
        outcomes. Unfortunately, no such model exists. Indeed, 
        no model currently in use can predict macroeconomic 
        effects without substantial ad hoc adjustments that 
        effectively override the internal structure of the 
        model. We should not assume that models can capture the 
        long run dynamic effects of specific tax and outlay 
        changes any better than they can forecast the economy.

    (1) Have economists improved their analytical tools over 
the last 7\1/2\ years enough so that we can reach the goal of 
full dynamic estimates of individual budget initiatives now or 
in the near future?

    At a Senate Banking Committee hearing March 7, 2002, 
Senator Bennett asked your views on a series of columns by 
Robert Bartley that had raised the issue of the relationship 
between taxes, surpluses, and economic growth. A transcript of 
your response includes the following:

          I also come out pretty much where he does on most of 
        those issues, but in certain places I do not. And I 
        think on the issue of surpluses in the most recent 
        period, I think that created some value, especially in 
        reducing long-term real interest rates, and I think 
        that has been an effective factor in the last several 
        years.
          But there is no question that it is important that, 
        in approaching those different forms of economic policy 
        in Government, that we have answers to those questions.
          As you know, Senator, most economists will agree that 
        in evaluating the effects of various different fiscal 
        policies, it would be far better to use what we call 
        dynamic scoring--that is, the ability to get the 
        interaction of the effect as well as the initial 
        impact.
          The only problem is, is that the interaction is a 
        function of the particular model you are using, and no 
        one can quite agree on what the appropriate model is. 
        So that we have fallen back to a static analysis which 
        we all can somehow agree on as the first stage of the 
        effect. . . .
          In certain instances, we are making very specific 
        adjustments in our budgetary analysis. We are seeing 
        that the secondary impacts of tax and spending programs 
        are zero. Now, we know that to be false. But we are 
        making those judgments because we have no alternative.

    (2) Is one of the reasons that ``we have no alternative'' 
to assuming ``that the secondary impacts of tax and spending 
programs are zero'' because the macroeconomic feedback effects 
can plausibly be modeled to be either positive or negative, 
depending on whether the ``ad hoc adjustments'' are more or 
less favorable? What are other reasons that ``we have no 
alternative?''
    (3) Would you recommend that the Congressional Budget 
Office or the Joint Committee on Taxation devote the resources 
necessary to make alternative dynamic scoring estimates that 
were both positive and negative?
    (4) Do you believe that the budget packages of 1990 or 1993 
that reduced future budget deficits by raising taxes and 
putting limits on spending probably had the effects of (a) 
raising national savings? (b) lowering longer-term interest 
rates? (c) raising the level of investment by businesses and 
households? (d) raising the growth rate of the economy?

Q.2. Do you support increased funding for the statistical 
initiatives in the President's budget, particularly the 
quarterly survey of service industries, the earlier release of 
trade statistics, and the BEA's plans to modernize its GDP 
measures?

A.2. With regard to dynamic scoring, my assessment has not 
changed. Full dynamic estimates of the budget and economic 
effects of fiscal policy decisions should be our goal, but, 
unfortunately, the econometric tools that we have available to 
evaluate the effects of fiscal policy on the economy are still 
inadequate for the task. 
Essentially, the profession has yet to reach a consensus on the 
magnitudes of a variety of key behavioral responses, such as 
the response of labor supply to changes in the after-tax real 
wage, as well as the expectations formation process that are 
necessary to 
reliably evaluate the effects of fiscal policy on the economy. 
The short-run impact of either a tax cut or an outlay increase 
under almost all dynamic scoring models tends to exhibit a 
lower increase in the budget deficit than does static analysis. 
Longer term, the results will depend on the specific nature of 
the policy initiative.
    In such an environment, the current framework of evaluating 
the fiscal effects of a policy is a standard approach. The 
Congressional Budget Office and Joint Committee on Taxation 
allow for behavioral adjustments at the micro level, while 
leaving the macroeconomic projection unchanged. The second 
step, evaluating the macroeconomic effects, is typically 
conducted by numerous public and private sector analysts which 
allows decisionmakers to incorporate judgements about these 
effects.
    An example of the difficulties of reaching a consensus on 
the macroeconomic effects of fiscal policy changes is the range 
of views regarding the macroeconomic impact of the budget 
reduction packages passed in the early 1990's. It is my 
judgement that the move to budget surpluses contributed to the 
rise in national saving and the reduction in long-term interest 
rates. The increase in net investment, and higher productive 
capacity of the economy largely reflected increased long-run 
expected profit growth, though lower long-term interest rates 
doubtless helped.

   RESPONSE TO WRITTEN QUESTION OF SENATOR MILLER FROM ALAN 
                           GREENSPAN

Q.1. Are you aware of any factors or information that would 
have caused the California energy crisis? Have you seen 
anything further to suggest that energy derivatives trading 
contributed either to the California energy crisis or to 
Enron's bankruptcy?

A.1. I am aware of no solid evidence that energy derivatives 
trading contributed to the California energy crisis. The 
primary cause of the crisis clearly was a deeply flawed 
approach to the deregulation of electricity prices in 
California. As I understand it, the CFTC and the FERC are 
investigating whether energy derivatives trading may have 
exacerbated the imbalances created by the flawed deregulation, 
but those investigations have not been completed. Nor have I 
seen evidence that energy derivatives trading contributed to 
Enron's bankruptcy. To the contrary, Enron's energy derivatives 
trading business seems to have been profitable--in fact, its 
EnronOnline energy trading business was purchased by another 
firm. Available evidence suggests Enron's implosion resulted 
from a loss of market confidence following revelations that it 
been hiding large losses on merchant investments in a variety 
of other businesses.
    I continue to oppose legislation providing for additional 
regulation of energy derivatives because the public policy case 
for such legislation has not been made and because such 
legislation has the potential to impair the important risk 
transfer functions that such instruments perform.



















































































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