[Senate Hearing 108-232]
[From the U.S. Government Publishing Office]



                                                       S. Hrg. 108- 232
 
        FEDERAL RESERVE'S FIRST MONETARY POLICY REPORT FOR 2003
=======================================================================

                                HEARING

                               before the

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

                      ONE HUNDRED EIGHTH CONGRESS

                             FIRST SESSION

                                   ON

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

                               __________

                           FEBRUARY 11, 2003

                               __________

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











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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah              PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado               CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming             TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska                JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania          CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky                EVAN BAYH, Indiana
MIKE CRAPO, Idaho                    ZELL MILLER, Georgia
JOHN E. SUNUNU, New Hampshire        THOMAS R. CARPER, Delaware
ELIZABETH DOLE, North Carolina       DEBBIE STABENOW, Michigan
LINCOLN D. CHAFEE, Rhode Island      JON S. CORZINE, New Jersey

             Kathleen L. Casey, Staff Director and Counsel
               Peggy R. Kuhn, Senior Financial Economist
     Steven B. Harris, Democratic Staff Director and Chief Counsel
             Martin J. Gruenberg, Democratic Senior Counsel
   Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
                       George E. Whittle, Editor

                                  (ii)













                            C O N T E N T S

                              ----------                              

                       TUESDAY, FEBRUARY 11, 2003

                                                                   Page

Opening statement of Chairman Shelby.............................     1

Opening statements, comments, or prepared statements of:
    Senator Dodd.................................................     2
    Senator Allard...............................................     4
    Senator Reed.................................................     4
    Senator Bunning..............................................     5
    Senator Schumer..............................................     6
    Senator Sununu...............................................     6
    Senator Bayh.................................................     7
    Senator Dole.................................................     7
        Prepared statement.......................................    44
    Senator Miller...............................................     7
    Senator Crapo................................................     7
    Senator Carper...............................................     8
    Senator Sarbanes.............................................     9
        Prepared statement.......................................    44
    Senator Johnson..............................................    11
        Prepared statement.......................................    45
    Senator Corzine..............................................    13
    Senator Stabenow.............................................    39

                                WITNESS

Alan Greenspan, Chairman, Board of Governors of the Federal 
  Reserve System, Washington, DC.................................    13
    Prepared statement...........................................    46
    Response to written questions of:
        Senator Shelby...........................................    52
        Senator Reed.............................................    60
        Senator Bunning..........................................    63
        Senator Miller...........................................    64
        Senator Crapo............................................    65
        Senator Sarbanes.........................................    68

              Additional Material Supplied for the Record

Monetary Policy Report to the Congress, February 11, 2003........    70

                                 (iii)



















        FEDERAL RESERVE'S FIRST MONETARY POLICY REPORT FOR 2003

                              ----------                              


                       TUESDAY, FEBRUARY 11, 2003

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

    The Committee met at 10:15 a.m., in room SH-216 of the Hart 
Senate Office Building, Senator Richard C. Shelby (Chairman of 
the Committee) presiding.

        OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

    Chairman Shelby. The hearing will come to order.
    I believe we have a quorum. Since we have a quorum present, 
I would ask that the Committee favorably report the nomination 
of William Donaldson, to be a Member of the Securities and 
Exchange Commission for the remainder of the term expiring June 
5, 2007.
    Can we do a voice vote?
    Senator Dodd. I second the nomination on that, Mr. 
Chairman.
    Chairman Shelby. The nomination has been seconded by 
Senator Dodd. All in favor, say aye.
    [A chorus of ayes.]
    Chairman Shelby. All opposed, no.
    [No response.]
    Chairman Shelby. The ayes have it.
    The nomination is favorably reported. We will leave the 
record open so that any Member who is not present will have an 
opportunity to record their votes, if they care to.
    I am very pleased this morning to welcome Chairman 
Greenspan before the Committee on Banking, Housing, and Urban 
Affairs, to testify on the Federal Reserve's Semi-Annual 
Monetary Policy Report to the Congress.
    Chairman Greenspan, our Nation's economy appears to be 
highly resilient. Last year, accounting scandals and corporate 
misdeeds unnerved investors and weakened trust in financial 
markets. The war on terrorism and our continuing efforts to 
enhance homeland security consumed valuable resources, but are 
necessary to preserve long-term security and freedom.
    Despite these challenges, the economy grew at a 2.8 percent 
pace in 2002, with inflation remaining low at only 1.3 percent. 
Productivity growth was more impressive. On an annual average 
basis, productivity in both the business and nonfarm business 
sectors rose 4.7 percent in 2002--the fastest pace since 1950, 
and more than four times the 1.1 percent gain posted in 2001. 
On the unemployment front, the unemployment rate decreased to 
5.7 percent in January, falling three-tenths of a percentage 
point from December's 6.0 percent, and hit its lowest level 
since September 2002.
    On the economic front, consumers continue to be a source of 
strength to this economy. Many homeowners have benefited from 
record low interest rates as they purchase new homes and 
refinance mortgages. Residential investment remains strong, but 
business investment continues to be weak. This is certainly a 
source of concern as we look to businesses to purchase new 
equipment and hire new workers.
    I believe that ending the double tax on corporate income 
and permanently raising expensing limits for small firms would 
stimulate more of this needed investment. While it would be 
very difficult to repeat the productivity gains of this past 
year, we need to continue to focus on what can be done to 
further grow the economy, to improve productivity, and 
ultimately the standard of living for all our workers.
    This requires that we look to our fiscal policy for 
improvement. I believe the President has put forward a very 
thoughtful, targeted, and balanced plan that would not only 
stimulate the economy in the short term, but make very positive 
long-term policy changes that would sustain strong economic 
growth.
    But just as vital to our success in achieving these goals 
is the underlying credibility and integrity of our capital 
markets.
    Earlier this morning, just a few minutes ago, this 
Committee voted to send forward the nomination of William 
Donaldson to chair the Securities and Exchange Commission. I 
believe he has the stature and the experience to provide the 
strong leadership that will be necessary to help set the tone 
for the high standards of corporate governance and financial 
reporting that our markets demand.
    Mr. Chairman, we are pleased to have you with us this 
morning, and we look forward to you discussing with us the 
necessary actions we must take to ensure that our economy grows 
and prospers in the coming years. I look forward to hearing 
your remarks.
    Senator Dodd.

            STATEMENT OF SENATOR CHRISTOPHER J. DODD

    Senator Dodd. Mr. Chairman, Senator Sarbanes, I am sure, 
will be along shortly. Let me make a couple of opening 
comments, and then leave the record open for Senator Sarbanes 
to add his thoughts as well.
    First of all, Mr. Chairman, we welcome you once again 
before this Committee to discuss the Federal Reserve's Monetary 
Policy and the state of the economy. It is always a pleasure to 
have you here before us.
    Since you last appeared before the Committee, Mr. Chairman, 
the unemployment rate has lingered near 6 percent and the stock 
market continues to tumble. Consumer confidence levels remain 
low and economic growth has been reduced to a near stand-still, 
at 0.07 percent. All this, in addition to the looming war and 
rising oil prices, has led some analysts to continue to express 
concern that we may see a double-dip recession.
    When President Bush took office, the Nation was in the 
midst of its fourth consecutive year of budget surpluses. Both 
the Congressional Budget Office and the Office of Management 
and Budget projected surpluses of more than $5.6 trillion over 
fiscal years 2002 through 2011.
    At that time, the President submitted his first budget 2 
years ago and he promised that the Nation could afford to use 
projected surpluses to pay for his $1.3 trillion tax cut, and 
still have enough to meet our spending needs in the Nation. I 
believe he was wrong. His tax cuts have brought about soaring 
deficits and instead of trying to decrease the deficit, the 
President continues to add to it.
    Last week, President Bush submitted his fiscal year 2004 
budget proposal to Congress, which substantiates how much the 
economy has deteriorated during his first 2 years in office.
    In the Bush Administration's first budget, it projected a 
2004 surplus of $262 billion. In his second budget, a year ago, 
the Administration projected a $14 billion deficit for the year 
2004. And now the budget for fiscal year 2004 projects a record 
deficit of $304 billion this year and $307 billion next year.
    During President Clinton's last year in office, we were 
looking at record surpluses of $236 billion. This is the 
swiftest fiscal deterioration our Nation has seen in its 
history. This is even worse than the record deficit set by 
President Bush's father.
    Even though the numbers show that the President's previous 
economic policies hurt the economy, this year's budget contains 
much of the same centerpieces as the first budget 
demonstrated--tax cuts for some of the wealthiest Americans. 
This year's proposed tax cuts will cost $1.3 trillion.
    I see, by the way, my colleague from Maryland has arrived.
    Just yesterday, more than 10 Nobel Laureates, together with 
450 respected economists from universities and institutes from 
all across the Nation signed a statement expressing caution 
that the tax cut plan proposed by the President will not only 
fail to help the economy in the short run, but also will weaken 
it over the long term by enlarging projected deficits.
    Any growth package, of course, that Congress passes should 
go to the people who most feel the ills of the economy. After 
all, since before President Truman, no President has presided 
over an economy registering net job loss until now.
    Since President Bush took office, the economy has lost 2.3 
million private-sector jobs, averaging about 75,000 jobs lost a 
month. In contrast to the previous Administration, we saw the 
creation of 239,000 jobs gained per month.
    In 2001, it was projected that we would be debt-free by 
2008. The Congressional Budget Office now forecasts that the 
Nation's publicly held debt will skyrocket to close to $4 
trillion.
    History has shown us that if we ignore fiscal discipline, 
the debt continues to increase and we will see high long-term 
interest rates and lower productivity growth. Businesses will 
be less likely to invest and spend.
    Chairman Greenspan himself has said this throughout the 
years.
    Mr. Chairman, these are trying times both home and abroad. 
But the decisions we make on the economy today will have long-
lasting implications for all of us, and generations to come 
hereafter.
    We need to understand that circumstances have changed 
profoundly. Our surpluses have turned into deficits. We are 
seeing a record number of job losses. Our economy's growth rate 
has been the slowest in 50 years. The Dow and NASDAQ stock 
markets have lost roughly $5 trillion in market value.
    It would be foolish for anyone to think that our policies 
should not change in response to these circumstances. It is 
unfortunate that thus far the Administration, in my view, has 
failed to see this.
    So, Mr. Chairman, we look forward to hearing from you this 
morning to talk about what can be done to change the direction 
that we presently seem to be heading in.
    Chairman Shelby. Senator Allard.

                COMMENTS OF SENATOR WAYNE ALLARD

    Senator Allard. Thank you, Mr. Chairman, for holding this 
hearing. I would like to join you in welcoming Chairman 
Greenspan before this Committee again. It is always a delight 
to hear his comments as we move forward with the next 
Congressional session.
    I happen to feel that when the President assumed office, 
the economy was beginning to head in the wrong direction. It 
was headed in a negative direction. And I believe now, that the 
economy is beginning to head back in a positive direction.
    I want to thank Chairman Greenspan for his efforts to get 
us on the right track.
    Yet, the American economy still has some elements of 
uncertainty. But I still believe it is critical that the 
Congress move to address the long-term solvency of Social 
Security and Medicare, to put the Government on a plan to pay 
down the national debt, and to continue to cut taxes. I believe 
by pursuing policies of low taxation, limited Federal 
regulation, free trade, and monetary policy, the United States 
will experience great wealth and opportunity. We will create 
new jobs.
    I believe that we should follow these policies of limited 
Government. And Chairman Greenspan, having shared a few of my 
thoughts with you, I now look forward to your comments.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Reed.

                 STATEMENT OF SENATOR JACK REED

    Senator Reed. Thank you very much, Mr. Chairman. And thank 
you, Chairman Greenspan, for joining us.
    I would like to associate myself with Senator Dodd's 
comments. I thought he was quite eloquent in his discussion of 
the current economic situation. Like him, I am afraid that the 
fiscal discipline of the 1990's is a fading memory and we are 
headed for a repeat of the fiscal mistakes of the 1980's.
    The 1980 tax cuts were a mistake at that time, but similar 
policies would be an even greater mistake now. At least in the 
1980's, the pressures on the budget from the retirement of the 
baby-boom generation were off in the relatively distant future 
and there was time to restore fiscal discipline.
    This time, however, the biggest tax cuts will be kicking in 
at just about the same time that the baby boomers start 
retiring and start claiming the Social Security benefits that 
they have contributed and the Medicare they expect.
    There is a fundamental question that we have to address--is 
this Government going to break its commitments to the 
beneficiaries of Social Security who have contributed to the 
system and to American citizens who reasonably expect that 
their health bills will be paid by Medicare?
    Also, we have a commitment to fund an ongoing war against 
terrorism and perhaps other military operations, a commitment I 
do not think anyone around this table, and Chairman Greenspan 
would say, we will not fulfill totally.
    With the context of Social Security, Medicare, and 
expenditures for war, we have to be concerned about the 
proposed tax cuts, which are I think both unwise and unfair.
    Indeed, one of the economists today who associated himself 
with the hundred other economists in the United States, 
including several Nobel Prize Winners, indicated that the 
President's tax plans are a weapon of mass destruction aimed at 
the middle class.
    I think we have to be cognizant of those types of comments 
and recognize and understand that the policies being advanced 
today by the President will not help restore our economy, nor 
will they help us face the responsibilities to fund Social 
Security, Medicare, and to conduct an international war against 
terrorists.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Bunning.

                STATEMENT OF SENATOR JIM BUNNING

    Senator Bunning. Thank you, Mr. Chairman.
    I would like to thank you for holding the hearing, and I 
would like to thank Chairman Greenspan for coming before the 
Committee today.
    As we all know, and as has been said before, our Nation's 
economy has been sputtering. We had good growth in the first 
quarter of last year. We had weak growth in the second quarter. 
We had good growth again in the third quarter. And we had 
almost no growth at all in the fourth quarter.
    Seasonally adjusted unemployment was down in January, after 
a sharp rise in December. The stock market was up and now on 
the uncertainty of a possible war, it is down. Energy prices 
are up, but interest rates are still low.
    As I have pointed out many times, I believe that you waited 
too long to cut the Federal funds rate when the economy started 
tanking in 2000. I believe that delay has greatly contributed 
to the state of our economy right now. Unfortunately, we do not 
have a time machine to fix past mistakes. You did aggressively 
cut rates to try to help right the economy, so much so that it 
is pretty difficult to cut much more. Unfortunately, it was 
late in the game.
    Hopefully, you will have some good news for us today. The 
American people still do not have strong confidence in this 
economy. They may see a light at the end of the tunnel, but 
they still think it might be a train.
    Your words matter, Chairman Greenspan, maybe more than they 
should. But they still matter.
    You make statements on fiscal policy, which you should not 
be doing. I understand that sometimes making statements, you 
believe you are off the record, and your comments about the 
President's economic plan may have been taken out of context. 
But this is Washington. Every microphone is ``wired and hot.''
    You have been in this town for a long time. Some might say 
too long. You know ``how to play the game'' and you have played 
it well. If you are innocent and if the statement you made 
about the President's plan were off the record and out of 
context, you should have known better.
    If it was neither off the record, nor out of context, then 
you are once again interjecting yourself into matters where you 
have no business. Like you, I believe the Federal Reserve 
should be fiercely independent. No President should try and set 
monetary policy. That is not his job.
    But the Fed Chairman should not try to set fiscal policy. 
That is not your job. It is a two-way street. I understand you 
are asking questions about fiscal policy. I am sure you will be 
asked some fiscal policy questions at this hearing, and you 
should answer them truthfully. But just as the President should 
not undermine you on monetary policy, you should not undermine 
him or Congress on fiscal policy.
    Once again, thank you, Mr. Chairman, for holding this 
hearing.
    Thank you, Chairman Greenspan, for running the gauntlet 
today. I look forward to talking with you further during the 
question and answer period.
    Chairman Shelby. Senator Schumer.

             COMMENTS OF SENATOR CHARLES E. SCHUMER

    Senator Schumer. Thank you, Mr. Chairman.
    I want to thank Chairman Greenspan for being with us 
because I believe that there is no more respected economist in 
the world, and we greatly value your time and perspective.
    Seeing Chairman Greenspan here today makes me think of the 
classic Yogi Berra line, it is like deja vu all over again.
    We are all here together again. It is almost 2 years to the 
day when Chairman Greenspan testified before us, and again, the 
President has proposed tax cuts that have a profound fiscal 
impact. Again, we are trying to sort through it all to find the 
best policy.
    But one thing is different today. Instead of surpluses, we 
have ever-widening deficits as far as the eye can see. And I 
believe we need strong and independent voices to speak out 
against this ever-increasing fiscal imprudence.
    I disagree with my good friend from Kentucky. We need your 
voice. It is our hope that you will be one of those voices that 
speaks out against this fiscal imprudence because there is no 
stronger, no more respected, and no more needed voice than 
yours today.
    Our hope is that we do not end up in a true fiscal morass 
down the road. I very much look forward to the Chairman's 
comments.
    Chairman Shelby. Senator Sununu.

               COMMENTS OF SENATOR JOHN E. SUNUNU

    Senator Sununu. Thank you, Mr. Chairman.
    Welcome, Chairman Greenspan. I appreciate your taking the 
time. I know these hearings are extremely time-consuming and 
you are faced with Members of Congress, on the House side and 
on the Senate side, that would like to explain to you exactly 
how we would act if we had your job. So, I appreciate your 
patience.
    This is an important time internationally and domestically. 
I would be very interested in hearing your thoughts today about 
how the long-term prospects of establishing greater stability 
overseas, such as in Iraq and North Korea, can promote a better 
investment climate and can help accelerate whatever benefits--
either from tax policy or fiscal policy--here in the United 
States, I look forward to your testimony.
    Thank you.
    Chairman Shelby. Senator Bayh.

                 COMMENTS OF SENATOR EVAN BAYH

    Senator Bayh. Thank you, Chairman Shelby.
    Chairman Greenspan, thank you for being with us today. We 
are all here to hear from you and so I am going to save my 
comments for the question period.
    Chairman Shelby. Senator Dole.

               COMMENTS OF SENATOR ELIZABETH DOLE

    Senator Dole. Thank you, Mr. Chairman.
    Mr. Greenspan, I certainly appreciate very much the 
opportunity as a new Member of the Committee to hear your 
report this morning. And in the interest of time, I am going to 
submit my formal statement for the record.
    Chairman Shelby. Without objection, it will be made part of 
the record.
    Senator Miller.

                COMMENTS OF SENATOR ZELL MILLER

    Senator Miller. Thank you, Chairman Shelby, for holding 
this hearing.
    I have no opening statement, but we are glad to have you 
with us again, Chairman Greenspan.
    Chairman Shelby. Senator Crapo.

                 COMMENTS OF SENATOR MIKE CRAPO

    Senator Crapo. Thank you, Mr. Chairman. I will be brief as 
well.
    Chairman Greenspan, I appreciate the opportunity to meet 
with you again and look forward to your testimony.
    Obviously, from some of the comments that have already been 
made, it is very clear that your opinion on economic matters 
carries a significant amount of weight. I, along with the 
others that are here, are going to be looking very closely at 
your evaluation of what is needed in our economy, not only in 
terms of some of the economic policy decisions that we will be 
making here in Congress with regard to the President's 
proposal, but also with regard to some of the issues that have 
been around previously.
    For example, the derivatives issue still may arise. And I 
expect that during the question and answer period, to have an 
opportunity to discuss that with you, to see if your opinion 
has changed at all on how we should approach those types of 
issues.
    But, again, as some of my collegues have indicated, we are 
here to listen to you. And I look forward to the opportunity 
that we have to visit with you today.
    Thank you.
    Chairman Shelby. Senator Carper.

             STATEMENT OF SENATOR THOMAS R. CARPER

    Senator Carper. Thanks, Mr. Chairman.
    Chairman Greenspan, welcome. We are delighted to have you 
with us today.
    One of my colleagues said earlier today that the President 
should not try to fix monetary policy any more than the 
Chairman of the Federal Reserve should try to fix fiscal 
policy.
    I was just thinking--how many Presidents have we seen in my 
lifetime who tried to fix monetary policy? I am not going to 
ask you to address that question. But I think most of us here 
know that there has been some precedent for that.
    I share with you a conversation we had with some Democratic 
and Republican centrist Senators not so long ago, conversations 
I had with some business leaders back in my own State of 
Delaware, where we talked about what we needed to do to get the 
economy moving.
    They talked a whole lot about uncertainty. They spoke of 
the uncertainty that we have faced with investor confidence, 
lack of investor confidence over the last year and hopefully, 
the steps that we have taken here today in moving forward the 
nomination of Bill Donaldson to chair the Securities and 
Exchange Commission will help to alleviate some of that 
uncertainty.
    As time goes by, the implementation of the Sarbanes-Oxley 
legislation will hopefully help to boost investor confidence as 
well.
    We have uncertainty because of the fear of terrorist 
attacks. What are we in--orange alert these days, and a whole 
lot of uncertainty that continues to swirl around that.
    We have faced the uncertainties of the elections. We have 
survived the elections. We now know who is in the majority and 
who is not.
    We still face the uncertainty of a potential war with Iraq, 
the effect that that war will have on energy prices, on the 
availability of oil, the prospect of an altercation with North 
Korea as we deal with them and their problems.
    We have all kinds of uncertainty that flow out of class 
action lawsuits where little local courts in places like East 
St. Louis, Illinois and places in Alabama and Texas are making 
national class action law for our country.
    We see uncertainty facing companies with little exposure to 
asbestos that are actually taking them under and putting them 
into bankruptcy.
    We see uncertainty with spiraling health care costs. And we 
see the uncertainty of a trade deficit, where we have gotten 
better at exporting jobs. Not just manufacturing jobs, but jobs 
that are high-paying jobs--software jobs, technology jobs that 
are going abroad faster than we would like to think.
    The last thing that I wanted to say is I had an interesting 
meeting with Dan Crippen, our recently departed CBO Chairman. 
He put in context the Administration's tax cut proposal and 
talked about its effect on the economy.
    He looked ahead for the next 10 years and said, GDP for the 
next 10 years will be about $120, $130, maybe $140 trillion. He 
also said the size of this tax cut proposal that we are looking 
at is about $650 billion. An economy of $140 trillion for the 
next 10 years, about a $650 billion tax cut.
    And what he said then really helped me put it in context. 
He said it is a 65-cent change to a $140 economy.
    Sometimes we delude ourselves, I think, by presuming that a 
tax cut or a spending policy is going to somehow move the 
economy, when actually what we do is relatively small compared 
to the size of the economy itself.
    I would just say to my colleagues, and certainly to you, 
and to the Administration, that we need to deal with 
uncertainty to get the economy moving.
    You have done a great job on monetary policy. You have done 
a terrific job and you are to be commended for that.
    Thank you.
    Chairman Shelby. Senator Sarbanes.

             STATEMENT OF SENATOR PAUL S. SARBANES

    Senator Sarbanes. Thank you very much, Mr. Chairman.
    First, I want to commend our new Chairman for producing an 
immediate quorum this morning to report Mr. Donaldson out of 
the Committee, and I would like to join that favorable vote. In 
fact, Mr. Chairman, with your indulgence and that of my 
colleagues, I would like to make just a short statement about 
Mr. Donaldson.
    In my view, he brings considerable relevant experience to 
this new assignment as Chairman of the SEC. He founded and 
managed a major investment company, Donaldson, Lufkin & 
Jenrette. He served as Chairman and CEO of the New York Stock 
Exchange. He was Chairman and President and CEO of a 
multibillion dollar public company. And he was the first Dean 
and Professor at the Yale School of Management.
    He will face a daunting task as the new Chairman of the 
SEC. He must join with his fellow Commissioners in appointing 
the Chairman of the Public Company Accounting Oversight Board. 
He must address the challenge of restoring confidence to the 
capital markets. And I very much hope that he would move 
immediately to implement pay parity at the SEC.
    I am pleased in his appearance before the Committee of 
recognizing the importance and immediate challenge of 
implementing the accounting responsibility and investor 
protection legislation we passed here in the Congress last 
year.
    At his confirmation hearing, he testified that he will 
vigorously enforce Sarbanes-Oxley and the rules and regulations 
already put forth by the SEC.
    He went on to say: ``I will demand accountability from all 
responsible parties. I will aggressively enforce civil 
penalties and work cooperatively with the State and Federal law 
enforcement agencies and the President's Corporate Fraud Task 
Force to bring those who break the law to justice.''
    He went on to pledge to call on corporate America and Wall 
Street to restore the principles of honesty and integrity to 
their proper place. He indicated a strong concern for the 
welfare of the employees of the SEC. He pledged to address 
issues of morale and union relations at that Agency.
    I am hopeful that Mr. Donaldson will effectively manage the 
SEC and effectively enforce the Federal securities laws and 
that he will bring about a new era of respect for the Agency 
and confidence in the U.S. securities markets.
    And I know, Mr. Chairman, you have indicated an intention 
on the part of this Committee to follow closely with oversight 
hearings the activities at the SEC.
    Chairman Shelby. Absolutely.
    Senator Sarbanes. I am very pleased to join with my 
colleagues in welcoming Chairman Greenspan before our Committee 
this morning to testify on the Federal Reserve's Semi-Annual 
Monetary Policy Report to the Congress.
    The Federal Reserve was created with an act of Congress. We 
have the oversight responsibility over the activities of the 
Federal Reserve.
    We have tried to formalize those with these semi-annual 
reports to the Congress, which I think are extremely important. 
I am pleased that Chairman Greenspan is back before us carrying 
out this responsibility.
    I want to make brief reference to the statement that was 
signed by the economists, including 10 Nobel Prize Winners, 
that was just released yesterday. They have pointed out the 
slowdown in the economic growth, the loss of private-sector 
jobs, the over-capacity, corporate scandals, and uncertainty 
weigh down the economy.
    They view with considerable concern--one might say almost 
alarm--the tax cut plan proposed by the President, as a 
permanent change in the tax structure rather than directed 
toward the short-term problem of creating jobs and growth, and 
note that it would worsen the long-term budget outlook, adding 
to the Nation's projected chronic deficits.
    Some of my colleagues have pointed out, when President Bush 
came into office in January 2001, that the Federal Government 
was projecting a 10-year surplus of $5.6 trillion. In fact, 
Chairman Greenspan came before the Senate at that time 
supporting a tax cut proposed by President Bush on the grounds 
that the Government was paying off its debt too fast. I 
remember that hearing as though it were yesterday. Chairman 
Greenspan argued that a tax cut was needed, to ``smooth the 
glide path,'' so that the Government debt would not be paid off 
too quickly and put the Government in the position of acquiring 
private assets.
    Well, that was then and this is now.
    If the President's program were enacted into law, the 
program currently being proposed, the budget projections for 
the same 10-year period would be a $2.1 trillion deficit. In 
other words, we have gone from projecting a $5.6 trillion 
surplus to where we would now project a $2.1 billion. Trillion. 
Excuse me--$2.1 trillion deficit. That is obviously a shift of 
$7.7 trillion. That projected figure does not include the cost 
of a possible war with Iraq--probably one should strike the 
word possible. It also does not include tax changes such as the 
reform of the alternative minimum tax and the extension of tax 
provisions currently scheduled to sunset, which almost 
certainly will be extended. We have done that continuously.
    By any measure, we are in the process of transforming the 
fiscal position of the United States from one of fiscal surplus 
to one of large fiscal deficits. Given the scale of the 
deficits that would be created by the President's plan, 
fundamental questions are raised about the impact of deficits 
on interest rates, investment, growth, and jobs in our economy.
    Witnesses for the Administration are downplaying the impact 
of budget deficits. I might note that many of these witnesses 
not very long ago were in here testifying in favor of the 
balanced budget amendment to the Constitution of the United 
States, to require that the Federal Government have a balanced 
annual budget.
    In the face of the uncertain demands on public resources 
imposed by the war on terrorism, by homeland defense, by our 
difficulties with North Korea, and the march toward war with 
Iraq, I think the President's fiscal proposals are reckless and 
irresponsible.
    It would deny us the public resources we need to meet 
current and future challenges. It would put upward pressure on 
long-term interest rates, which would reduce economic growth 
and impose greater hardship on middle and working class 
Americans.
    Mr. Chairman, I look forward to reviewing these and other 
issues with Chairman Greenspan this morning.
    Thank you very much.
    Chairman Shelby. Senator Johnson.

                STATEMENT OF SENATOR TIM JOHNSON

    Senator Johnson. Thank you, Chairman Shelby, and Ranking 
Member Sarbanes. And thank you for convening today's hearing to 
examine the monetary policy of the United States. We are 
privileged to have before us Chairman Alan Greenspan, and I 
welcome him here today to the Senate Banking Committee.
    Today, as we gather to hear about the state of America's 
economy, we face a grim picture. It is sobering to note, as 
Ranking Member Sarbanes has just observed, that just 2 years 
ago, in this very room, Chairman Greenspan cautioned this 
Committee about the dangers of paying down the national debt 
too quickly. Now just a short time later, we face a $304 
billion deficit this year alone, and a deficit of more than $2 
trillion projected over the next 10 years. That is without 
counting the costs of war, the AMT fix, or homeland security, 
the war and homeland security both being particularly unknown 
and contingent in terms of the nature of the expense that that 
will entail, other than the obvious observation that it will be 
extraordinarily costly.
    I speak in a somewhat unique circumstance among my 
colleagues in that in 2001, I voted to support President Bush's 
$1.3 trillion tax cut. And while I worked to moderate the cost 
of that tax cut in its initial proposal, and while I worked to 
redirect more of those resources toward middle class and 
working families, I agreed with Chairman Greenspan, who has 
often warned that Government should not accumulate taxpayer 
dollars. At the time that I voted for that tax relief, this 
country faced historically high surpluses projected at $5.6 
trillion for fiscal years 2002 through 2011, and I committed 
myself to assisting to return surplus funds to the taxpayer at 
that time. I did so, however, on the condition that President 
Bush himself reiterated during his most recent State of the 
Union address when he said: ``We will not pass along our 
problems to other Congresses, other Presidents, and other 
generations.''
    It is difficult to believe that our circumstances have 
changed so dramatically since President Bush took office 2 
short years ago. It is even more difficult to believe that 
President Bush appears determined to do exactly the opposite of 
what he pledged not to do. That is, pass along our actions to 
the next generation.
    And frankly, I am appalled at the President's recklessness 
in proposing a massive tax cut targeted for the rich, while so 
many of our Nation's basic needs go unmet and while the 
prospect of enormously deep budget deficits loom before us. I 
simply cannot understand the impulse to plunge our Nation into 
even more staggering deficits at this time.
    Now, I believe that any stimulus plan has to meet three 
simple conditions: One, it should give tax relief to working 
families who need it and who will spend it. Two, it should give 
tax relief now, while the economy is weak. And three, it should 
not saddle our children and grandchildren with additional debt.
    In 2001, we were faced with record surpluses. Times have 
changed radically. And as I look, and as my constituents look 
back at what has gone on over the last several years, we have 
gone from a time when, frankly, the Democrats were in control 
in the White House and the Congress and the economy was deep in 
red ink. And the advice was to balance the budget, and that 
should come ahead of education and health care and other 
domestic needs. And that was done.
    Then, we reached a time when Democrats again were in 
control in Congress, at the White House, and times were good, 
and we had budget surpluses. Again, the recommendation was tax 
cuts should come ahead of education, health care, and other 
domestic needs.
    Now, we find ourselves with our Republican friends at the 
White House and in Congress, and the circumstances again deep 
in red ink and the advice yet again is tax cuts ahead of 
education, health care and other domestic needs.
    My constituents are wondering whether this is economic 
advice we are receiving or whether it is simply political 
ideology, whether this has less to do with the economy than it 
does with bankrupting the Federal Government so that we do not 
find ourselves in a position where we can invest in our 
schools, in our families, in our kids, in the infrastructure 
that we need to have, in the health care needs of our people.
    I have to tell you that the observations that I hear from 
my constituents are grim, indeed, about where this country is 
going and what the prospects are going to be in the future 
years if we continue to follow down this road of fiscal 
irresponsibility.
    I appreciate the opportunity to listen to your words of 
advice, Mr. Greenspan, here today. I share with you the 
observations of so many of my constituents and the great fear 
and concern they have.
    I look forward to a very constructive hearing today. Thank 
you, Mr. Chairman.
    Chairman Shelby. Senator Corzine.

               COMMENTS OF SENATOR JON S. CORZINE

    Senator Corzine. Thank you, Mr. Chairman.
    First of all, I am pleased that we are having this hearing 
and I welcome Chairman Greenspan. It is ironically disturbing 
to me that I am bouncing back and forth between the Foreign 
Relations Committee and here today. The two issues on the table 
are very much interconnected. We have a tragedy of the war on 
terrorism ongoing, a real element of concern to the American 
public. We have risks of war, and we are having a hearing on 
the costs of reconstruction of Iraq in a post-conflict period. 
And I am hearing from Under Secretary Grossman in that hearing 
that it will take a long and sustained commitment.
    Times have changed. The world has changed, whether it is 
with regard to national security issues. And certainly, 
anyone's reading of the budget and economic conditions, which 
we have heard my colleagues speak of.
    I look forward to hearing how the Federal Reserve and one 
of those people most respected in the world believes we should 
change, given the changing circumstances and environment we 
face with regard to the economy.
    These are truly times of challenge for our Nation. And it 
is very hard for one to understand how we can, in the first 
time in our history at least that I know of, that we have 
chosen to have tax cuts in the midst of such great national 
challenge.
    I will be anxious to hear what the Chairman has to say 
about these kinds of issues.
    Thank you.
    Chairman Shelby. Mr. Chairman, welcome again to the 
Committee. Your written statement will be made a part of the 
record in its entirety. You may proceed as you wish.

             STATEMENT OF ALAN GREENSPAN, CHAIRMAN

        BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

    Chairman Greenspan. My written statement, as you know, Mr. 
Chairman, is rather extended and I do not intend to speak more 
than 10 to 12 minutes, which would be a significant excerpt out 
of that long testimony.
    Mr. Chairman and Members of the Committee, when I testified 
before this Committee last July, I noted that, while the growth 
of economic activity over the first half of the year had been 
spurred importantly by a swing from rapid inventory drawdown to 
modest inventory accumulation, that source of impetus would 
surely wind down in subsequent quarters, as it did. We at the 
Federal Reserve recognized that a strengthening of final sales 
was an essential element of putting the expansion on a firm and 
sustainable track. To support such a strengthening, monetary 
policy was set to continue its accommodative stance.
    In the event, final sales continued to grow only modestly, 
and business outlays remained soft. Concerns about corporate 
governance, which intensified for a time, were compounded over 
the late summer and into the fall by growing geopolitical 
tensions. Equity prices weakened further, the expected 
volatility of equity prices rose to unusually high levels, 
spreads on corporate debt and credit default swaps 
deteriorated, and liquidity in corporate debt markets declined. 
The economic data and the anecdotal information suggested that 
firms were tightly limiting hiring and capital spending and 
keeping an unusually short leash on inventories.
    By early November, conditions in financial markets had 
firmed somewhat. But on November 6, with economic performance 
remaining subpar, the Federal Open Market Committee chose to 
ease the stance of monetary policy, reducing the Federal funds 
rate 50 basis points, to 1\1/4\ percent. We viewed that action 
as an insurance against the possibility that the still 
widespread weakness would become entrenched.
    In the weeks that followed, financial market conditions 
continued to improve, but only haltingly. Mounting concerns 
about geopolitical risks and energy supplies were mirrored by 
the worrisome surge in oil prices, continued skittishness in 
financial markets, and substantial uncertainty among businesses 
about the outlook.
    Partly as a result, growth of economic activity slowed 
markedly late in the summer and in the fourth quarter. Much of 
that deceleration reflected a falloff in the production of 
motor vehicles from the near-record level that had been reached 
in the third quarter when low financing rates and other 
incentive programs sparked a jump in sales. The slowing in 
aggregate output also reflected aggressive attempts by 
businesses more generally to ensure that inventories remained 
under control. Thus far, those efforts have proven successful 
in that business inventories, with only a few exceptions, have 
stayed lean.
    Apart from these quarterly fluctuations, the economy has 
largely extended the broad patterns of performance that were 
evident at the time of my July testimony. Most notably, output 
has continued to expand, but only modestly. As previously, 
overall growth has simultaneously been supported by relatively 
strong spending by households and weighed down by weak 
expenditures by businesses. Importantly, the favorable 
underlying trends in productivity have continued. One 
consequence of the combination of sluggish output growth and 
rapid productivity gains has been that the labor market has 
remained quite soft.
    Another consequence of the strong performance of 
productivity has been its support of household incomes despite 
the softness of labor markets. Those gains in income, combined 
with the very low interest rates and reduced taxes, have 
permitted relatively robust advances in residential 
construction and household expenditures. The increases in 
consumer outlays have been financed partly by the large 
extraction of built-up equity in homes.
    While household spending has been reasonably vigorous, we 
have yet to see convincing signs of a rebound in business 
outlays. The emergence of a sustained and broad-based pick-up 
in capital spending will almost surely require the resumption 
of substantial gains in corporate profits.
    Of course, the path of capital investment will also depend 
on the resolution of the uncertainties surrounding the business 
outlook.
    The intensification of geopolitical risks makes discerning 
the 
economic path ahead especially difficult. If these 
uncertainties diminish considerably in the near term, we should 
be able to tell far better whether we are dealing with a 
business sector and an economy poised to grow more rapidly--our 
more probable expectation--or one that is still laboring under 
persisting strains and imbalances that have been misidentified 
as transitory.
    If instead, contrary to our expectations, we find that, 
despite the removal of the Iraq-related uncertainties, 
constraints to expansion remain, various initiatives for 
stimulus will doubtless move higher on the policy agenda. But 
as part of that process, the experience of recent years may be 
instructive. As I have testified before this Committee in the 
past, the most significant lesson to be learned from recent 
American economic history is arguably the importance of 
structural flexibility and the resilience to economic shocks 
that it imparts.
    I do not claim to be able to judge the relative importance 
of conventional stimulus and increased economic flexibility to 
our ability to weather the shocks of the past few years. But 
the improved flexibility of our economy, no doubt, has played a 
key role. That increased flexibility has been in part the 
result of the ongoing success in liberalizing global trade, a 
quarter-century of bipartisan deregulation that has 
significantly reduced rigidities in our markets for energy, 
transportation, communication, and financial services, and, of 
course, the dramatic gains in information technology that have 
markedly enhanced the ability of businesses to address 
festering economic imbalances before they inflict significant 
damage. This improved ability has been facilitated further by 
the increasing willingness of our workers to embrace innovation 
more generally.
    It is reasonable to surmise that but, not only have such 
measures contributed significantly to the long-term growth 
potential of the economy this past decade, but they have also 
enhanced its short-term resistance to recession. That said, we 
have too little history to measure the extent to which 
increasing flexibility has boosted the economy's potential and 
helped damp cyclical fluctuations in activity.
    Even so, the benefits appear sufficiently large that we 
should be placing special emphasis on searching for policies 
that will engender still greater economic flexibility and 
dismantling policies that contribute to unnecessary rigidity. 
The more flexible an economy, the greater its ability to self-
correct in response to inevitable, often unanticipated, 
disturbances, thus reducing the size and the consequences of 
cyclical imbalances. Enhanced flexibility has the advantage of 
adjustments being automatic and not having to rest on the 
initiatives of policymakers, which often come too late or are 
based on highly uncertain forecasts.
    Policies intended to improve the flexibility of the economy 
seem to fall outside the sphere of traditional monetary and 
fiscal policy. But decisions on the structure of the tax system 
and spending programs surely influence flexibility and thus can 
have major consequences for both the cyclical performance and 
long-run growth potential of our economy.
    As we approach the next decade, we need to focus attention 
on this necessity to make difficult choices from among programs 
that, on a stand-alone basis, appear very attractive.
    Because the baby boomers have not yet started to retire in 
force, and accordingly, the ratio of retirees to workers is 
still relatively low, we are in the midst of a demographic 
lull. But short of an outsized acceleration of productivity to 
well beyond the average pace of the past 7 years or a major 
expansion of immigration, the aging of the population now in 
train will end this state of relative budget tranquility in 
about a decade's time. It would be wise to address this 
significant pending adjustment and the associated potential for 
the emergence of large and possibly unsustainable deficits 
sooner rather than later. As the President's just-released 
budget put it: ``The longer the delay in enacting reforms, the 
greater the danger, and the more drastic the remedies will have 
to be.''
    Reestablishing budget balance will require discipline in 
both revenue and spending actions, but restraint on spending 
may prove the more difficult. Tax cuts are limited by the need 
for the Federal Government to fund a basic level of services--
for example, national defense. No such binding limits constrain 
spending. If spending growth were to outpace nominal GDP, 
maintaining budget balance would necessitate progressively 
higher tax rates that would eventually inhibit the growth in 
the revenue base on which those rates are imposed. Deficits, 
possibly ever widening, would be the inevitable outcome.
    Faster economic growth, doubtless, would make the deficits 
far easier to contain. But faster economic growth alone is not 
likely to be the full solution to currently projected long-term 
deficits. To be sure, underlying productivity has accelerated 
considerably in recent years. Nevertheless, to assume that 
productivity can continue to accelerate to rates well beyond 
the current underlying pace would be a stretch, even for our 
very dynamic economy. So short of a major increase in 
immigration, economic growth cannot be safely counted upon to 
eliminate deficits and the difficult choices that will be 
required to restore fiscal discipline.
    By the same token, in setting budget priorities and 
policies, attention must be paid to the attendant consequences 
for the real economy. Achieving budget balance, for example, 
through actions that hinder economic growth is scarcely a 
measure of success. We need to develop policies that increase 
the real resources that will be available to meet our longer-
term needs. The greater the resources available--that is, the 
greater the output of goods and services produced by our 
economy--the easier will be providing real benefits to retirees 
in coming decades without unduly restraining the consumption of 
workers.
    These are challenging times for all policymakers. 
Considerable uncertainties surround the economic outlook, 
especially in the period immediately ahead. But the economy has 
shown remarkable resilience in the face of a succession of 
substantial blows. Critical to our Nation's performance over 
the past few years has been the flexibility exhibited by our 
market-driven economy and its ability to generate substantial 
increases in productivity. Going forward, these same 
characteristics, in concert with sound economic policies, 
should help to foster a return to vigorous growth of the U.S. 
economy to the benefit of all our citizens.
    Thank you very much, Mr. Chairman. I look forward to your 
questions.
    Chairman Shelby. Thank you.
    Chairman Greenspan, you are well known for your comments 
several years ago concerning the irrational exuberance of 
financial markets.
    Over the past year, we have seen a significant decline in 
financial markets, due in part to not only an economic 
slowdown, but also because of a decline in investor confidence. 
In fact, the NASDAQ is below the level it was when you made 
your comments several years back. In your opinion, have we now 
moved from irrational exuberance to excessive anxiety?
    Chairman Greenspan. Well, it is always difficult to make 
those judgments, Mr. Chairman, but the fact that there is some 
anxiety in the markets I think is very evident.
    Indeed, the general context of my prepared remarks is that, 
pending full confirmation of the impact of what we call 
geopolitical risks, we do not know what the underlying strength 
of this economy is. My suspicion, and I emphasize it is very 
difficult to know for sure, is that that geopolitical risk is 
hanging very heavily on economic decisionmaking and hence, 
economic growth. And its elimination should, in my judgment, 
make a very considerable 
difference.
    Chairman Shelby. Thank you. Do you believe that sufficient 
actions have been taken to restore investor confidence or that 
we need to do more to restore market credibility?
    Chairman Greenspan. I think that the statute which was 
essentially formulated by Senator Sarbanes and Congressman 
Oxley has gone a very significant way in eliminating a 
considerable amount of the incredible corporate malfeasance 
which we saw over the last year or so; or at least was exposed 
over the last year or so.
    I do think that the issue of the statute is not wholly 
related to the short-term. It is mainly, in my judgment, 
related to the longer term when the next generation, having 
accrued irrational exuberance, is apt to go down very similar 
paths that we have seen the current generation go down.
    I do think that, as best I can judge, a considerable amount 
of the malfeasance which I think is so rightly addressed by the 
Senator's and the Congressman's statute, is not a major problem 
for the immediate future. I do not deny that we are likely to 
find additional examples of rather atrocious accounting, 
atrocious behavior, and I find that more likely than not.
    But I would be very surprised if it were initiated beyond 
mid-2002 because the decline in the market and the response of 
the Congress and the political system to some of the actions I 
think chastised the business community in a way which had the 
equivalent of almost eliminating a high fever which seemed to 
have gripped people who were otherwise very ethical, very 
responsive to their shareholders, and responsive to making 
their companies as best as they could.
    Virtually all of them, listening to their commentary, have 
seemingly come out of this fever-ridden view toward how to 
harvest those huge capital gains and restored, in many 
respects, some of the actions which they did in a more sensible 
way in years past.
    Chairman Shelby. Mr. Chairman, homeowners have benefited 
greatly in recent years from continued low interest rates and 
rising home values. The outstanding value of revolving home 
equity loans at commercial banks rose from $155.5 billion in 
December 2001, to $212.3 billion in December 2002, just 1 year. 
Homeowners use this money to make other purchases or to pay 
down some debt. Should we have any concerns about consumers 
being over-extended through these home equity loans? Would 
there be an adverse impact if home prices no longer appreciate 
or even decline?
    Chairman Greenspan. Senator, we have looked at that in some 
considerable detail, and the result of our analysis is the 
following: If you take overall mortgage debt, which would 
include home equity debt and you compare it to the level of 
disposable income of homeowners only, the level of the debt is 
rising relative to income, but not significantly so. However, 
with the very marked decline in interest rates, the debt 
service cost as a percent of disposable income of owner-
occupied households, is actually average or, if anything, 
somewhat less than average.
    Now, I hasten to add that a goodly part of this is the 
rather low interest rates that exist in the mortgage market. 
But unless interest rates come back very sharply, which would 
presumably occur in the context of rapid economic recovery or 
an acceleration of inflation, which I do not anticipate, the 
balance of debt in the mortgage market generally, even though 
very large, is not, in our judgment, a cause of concern.
    We would be concerned if the price of homes in general 
across the country moved down rather considerably. And there 
was a good deal of concern, as you know, about this housing 
bubble. But our evaluation of the data and the outlook suggests 
that, while obviously there are potential problems, they are 
not serious ones that need to be addressed in any material way 
as far as we can judge.
    Chairman Shelby. Senator Sarbanes.
    Senator Sarbanes. Thank you very much, Mr. Chairman.
    Chairman Greenspan, The Washington Post this morning has a 
story headlined: ``Greenspan Likely To Back Dividend Plan,'' 
referring to the President's proposal with respect to the 
taxation of corporate dividends. It points out later that the 
tax changes that the President is seeking would cost well over 
a trillion dollars in the next 10 years. Do you back the 
dividend plan?
    Chairman Greenspan. Let me make two points with respect to 
this, Senator.
    The first thing is, I have always supported the elimination 
of the double taxation of dividends because I think it is a 
major factor restraining flexibility in our economy. And as I 
pointed out in my prepared remarks, moving in the direction of 
improving flexibility I think has very large, long-term 
payoffs.
    However, I also commented in my prepared remarks and, 
indeed, testified before the House Budget Committee, that PAYGO 
rules, which expired in September in the House, and will expire 
here, are very important for the budgetary process.
    So, I do support the elimination of the double taxation of 
dividends. I would prefer that it be done at the corporate 
level. But I think the way it is constructed in the President's 
program makes a good deal of sense over the long run as well.
    But in my judgement, any such initiative should be in the 
context of PAYGO rules, which means that the deficit must be 
maintained at minimal levels.
    Senator Sarbanes. Just last July, you testified before this 
Committee, and I am now going to read you a quote and follow up 
with a couple of questions on the double taxation of dividends. 
You said:

    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 it 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.
    Now it seems to me that the key question is not whether you 
support ending double taxation of dividends as a matter of 
abstract tax policy. But whether you think it should be 
financed by deficit spending or whether it should be paid for.
    That in turn raises the fundamental issue of whether 
deficits matter and whether deficits affect long-term interest 
rates, savings, investment, and growth.
    You are on the record on that issue as well, but I would 
like you to respond to two questions. And in the course of 
asking them, I note that the economists who issued the 
statement opposing the Bush tax cuts, the 10 Nobel Prize 
winners and many, many others, said in the course of that 
statement--the permanent dividend tax cut in particular is not 
credible as a short-term stimulus.
    As tax reform, the dividend tax cut is misdirected in that 
it targets individuals rather than corporations, is overly 
complex, and could be, but is not, part of a revenue-neutral 
tax reform effort.
    Now given that your position has been that you want to 
address the double taxation, do you think it should be financed 
out of deficits in order to correct that problem?
    Chairman Greenspan. Well, if I support, and I argued very 
strenuously at the House Budget Committee last September, and 
indeed, repeated part of that testimony in my prepared remarks, 
that the process that you go through in constructing the budget 
has been very effectively enhanced by PAYGO rules and 
discretionary caps, then the way I would answer the question 
is, yes, I do think that eliminating the double taxation of 
dividends in any of the various forms, including subchapter S 
or taking the tax deduction at the individual level or at the 
corporate level--and as I said, from a commerce point of view, 
it is the latter that is the best. But they are all I think 
quite important and useful.
    The reason is that they improve the flexibility of the 
economy. And the one thing I have sensed as the last 2 or 3 
years have gone on is how really important that apparently is.
    Having said that, there is no question that as deficits go 
up, contrary to what some have said, it does affect long-term 
interest rates. It has a negative impact on the economy, unless 
attended.
    As I have indicated in my prepared remarks and, indeed, in 
my oral remarks, I think that there are major problems which 
must be addressed, which means that we just cannot keep adding 
programs of one form or another to a limited expansion 
capability in the economy.
    I would argue that we should be doing both, namely trying 
to move toward increased flexibility, but being very careful 
not to allow deficits to get out of hand, especially when we 
are going to be running into a significant problem starting 
2010, 2012, and beyond with a very significant acceleration in 
beneficiaries for both Social Security and Medicare.
    Senator Sarbanes. Mr. Chairman, let me just close.
    Two years ago almost to the day, you said before this 
Committee, and I want to see whether you still adhere to this 
statement, and I am now quoting you: ``In recognition of the 
uncertainties in the economic and budget outlook, it is 
important that any long-term tax plan or spending initiative . 
. .'' let me just emphasize that, long-term tax plan or 
spending initiative ``. . . for that matter, be phased in. 
Conceivably, it could include provisions that in some way would 
limit surplus-reducing actions if specified targets for the 
budget surplus and Federal debt were not satisfied.''
    Now this is when we are dealing with a surplus question. We 
are dealing with a deficit question. Even the Administration 
itself is projecting deficits of $300 billion over the next 2 
fiscal years.
    Then to go on with your quote: ``Now, what I am obviously 
referring to is the desirability of eliminating the Federal 
debt, which is still frankly, my first priority because I think 
that it has had an extraordinarily important impact on the 
economy, on the financial markets, on long-term interest rates, 
and on economic growth.''
    Do you still hold to that statement?
    Chairman Greenspan. I do, Senator.
    Senator Sarbanes. All right. Thank you.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Allard.
    Senator Allard. Thank you, Mr. Chairman.
    Around September 2002, many of the opponents of the 
temporary tax cut of 2 years ago, admitted that they felt like 
it kept the economy from bottoming out at a potentially lower 
number. In other words, the tax cut did help the economy some. 
That was even noted in an editorial in The Washington Post in 
September.
    What conditions have changed now that would show that we 
should not advance those tax cuts or make them permanent in 
order to further help the economy?
    Chairman Greenspan. Senator, as I implied in my remarks, I 
am one of the few people who still are not as yet convinced 
that stimulus is a desirable policy at this particular point.
    It depends very much on how one reads what is effectively 
going on under the whole structure of geopolitical and other 
risk. And unless and until we can make a judgment as to 
whether, in fact, there is underlying deterioration going on, 
and my own judgment is I suspect not, then stimulus is actually 
premature.
    I support the President's proposal on eliminating the 
double taxation, not as a short-term stimulus measure, but as 
long-term, good corporate tax policy and something which would 
add to the long-term flexibility and potential growth of the 
economy. But unless it turns out that there really is a very 
weak underlying structure even beneath this degree of 
uncertainty, which I will grant you will then change our view 
with respect to the desirability of stimulus beyond what has 
already been put in place by the Federal Reserve in its fairly 
significant decline in short-term interest rates, we have to be 
in a position to be able to state that we see that as a very 
significant problem and one which must be addressed in a manner 
which would then clearly be necessary.
    I suspect it is not. But I cannot say with any degree of 
assurance that I feel comfortable with that conclusion.
    Senator Allard. Mr. Chairman, we are possibly facing the 
need for Congress to increase the debt limit. The debt limit 
reflects not only public debt--it is a total debt limit. It 
reflects obligations, as you know, to the general fund, both 
from the trusts, as well as the public debt.
    There is some discussion as to whether, in dealing with the 
debt limit, we should just concern ourselves with public debt 
or whether we should concern ourselves just with the total debt 
limit figure. In other words, instead of putting that limit on 
total debt, maybe modify it so that it is just on the public 
debt. I would like to hear your comments on that, sir.
    Chairman Greenspan. Well, I have testified on this 
previously, Senator, and I will just repeat what I said then, 
which is, if you are going to do this, then putting it on debt 
to the public, which is now a number which excludes debt held 
by investment accounts of the Federal Government, obviously, 
that is the economic variable you should be adjusting it to.
    But having said that, you have already, or will have 
already, constructed a debt limit by the various votes that you 
have had with respect to authorizing receipts and outlays. And 
either that debt limit is redundant, meaning that it is the 
same number that is implicit in the difference between receipts 
and expenditures, coupled with the debt at the beginning of the 
period, or it is inconsistent and you are creating 
contradictory law.
    So, I conclude, as I did in my prepared remarks, that the 
debt ceiling is not a useful fiscal tool and, indeed, has never 
in my judgment been successful in doing what it is supposed to 
have been doing--namely, constrain spending. I would think it 
would be wise to eliminate it.
    Senator Allard. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Dodd.
    Senator Dodd. Thank you, Mr. Chairman. Let me pick up, if I 
can, a bit on what Senator Sarbanes was raising.
    In your testimony here this morning, you said:

    As I testified before this Committee in the past, the most 
significant lesson to be learned from recent American economic 
history is arguably the importance of structural flexibility 
and the resilience to economic shocks . . .

    I want to raise the question of the permanency of the tax 
cuts that are being sought, the ones that were adopted in the 
spring of 2001. Obviously, major events have occurred since 
then that have caused us to have to examine our fiscal policies 
for all the obvious reasons.
    I note that you have taken the position, before the Joint 
Economic Committee, that the tax cuts are not stimulative. You 
do not believe them to have any stimulative effect.
    But you also argue that because there is a presumption that 
these tax cuts are already permanent in the economy, that to 
not make them permanent would be unwise. And I want to raise 
that particular issue.
    These are tax cuts that go out 10 years. How do you square 
agreeing to a permanency of a 10-year tax cut proposal with 
structural flexibility at a time when we have so many demands 
that are going to be made on us for all the obvious reasons, 
both including domestic pressures, as well as anywhere from, 
according to some economists, $100 billion to in excess of $1 
trillion, the cost of the war in Iraq and the after-effects?
    Chairman Greenspan. Well, Senator, my response to that 
question at an earlier time was the endeavor to try to 
recognize that it is just not credible to have a significant 
tax cut which sunsets 10 years out. Markets do not believe it. 
It makes no fiscal sense and you are far better off making it 
permanent, but putting everything under PAYGO in a manner which 
addresses the broad issues of the deficit.
    The Congress has to make judgments because it is the only 
vehicle which ultimately has the authority to make choices 
among some very difficult programs. That is, I do not know a 
single program which has been authorized by the Congress over 
the years which was not perceived to be beneficial, either as a 
spending program or a tax cut.
    The trouble is that when you add them all up, they come to 
a total larger than the fiscal capacity of the country as 
measured by our gross domestic product, which means choices 
must be among things which on a stand-alone basis are very 
good, desirable, and meet any cost-benefit analysis you can 
think of.
    So what we are dealing with is the issue of how to make 
choices. And the most difficult problem that exists with 
respect to long-term budget issues is getting them right.
    But as I have said in previous testimony--indeed, I said it 
in the current testimony--we almost surely will never get it 
right. Therefore, we have to consider issues of triggers and 
sunset legislation in order to make midcourse corrections, not 
if, but when policies go off the long-term, expected track.
    And because there has been a very substantial change in 
budgetary policy over the last 20, 30, 40 years, in the sense 
that we have moved from 1-year budgets and essentially two-
thirds discretionary spending to exactly the reverse, and 
indeed, we have gone from, as I said, the 1-year, to then 5-
year, mandated under the 1979 Act, and by the mid-1990's, to 
10-year horizons, because our programs are projecting out that 
far, even though we know we cannot estimate them with any great 
accuracy, we need new devices for long-term fiscal policy.
    In my judgment, the most significant ones that we need are 
the ones which we are allowing to basically expire, the PAYGO 
and discretionary caps, and importantly, over the longer-term, 
triggers, and to the extent that it is important, sunset 
legislation. Because the existing tools that we now employ for 
budgetary policy are not significantly different from what they 
were 30, 40 years ago. And these are very different budget 
processes that we are involved in.
    Senator Dodd. Just a quick follow-up, then. I am somewhat 
confused here.
    The permanency of these tax cuts over the next 10 years, I 
do not disagree. In fact, I have supported over the years pay-
as-you-go proposals and so forth. I understand the value of 
that.
    We are looking, for instance, at budget cuts that are 
occurring in a number of areas where people anticipated that 
there would be a Federal commitment in certain areas and seeing 
the pressures occur at the State and local level as a result of 
our changing direction here. Just most recently in the COPS 
program, for instance, in which local departments and States 
counted on over the years. All of a sudden, that program is 
going to be eliminated, just to use one example.
    I am not arguing. Maybe it should be. But the point is that 
there is an anticipation by local governments and State 
governments for some time that this would be forthcoming. We 
are changing that.
    It seems to me that we need to send some mechanism here. I 
am hearing you saying that with regard to these tax cuts, that 
the permanency of them, that you would like to see something 
put in place, rather than just the pure permanency of them, 
some trigger mechanism or some pay-as-you-go proposal that you 
attach to their permanency.
    Chairman Greenspan. Yes. I do not think that we can have 
permanent tax cuts or permanent spending programs in the sense 
that they exist independently of the tax base or the revenue-
raising base of the economy.
    In a sense, it would be desirable to have permanent, 
irrevocable fiscal policy. But if it adds up to a claim on 
resources which exceeds what is available given our economic 
condition, something has to give. So the notion of permanence 
cannot rationally be consistent with the programs we are 
involved with.
    Senator Dodd. Thank you.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Bunning.
    Senator Bunning. Thank you very much, Mr. Chairman.
    I always start out just to ask one question of you. Do you 
see any evidence of inflation in the economy presently?
    Chairman Greenspan. I do not, Senator.
    Senator Bunning. Thank you. In regards to some of the 
testimony you have given in the past, I would like to just 
mention a couple things that have happened since that 
testimony.
    We had September 11, 2001. We have a war on terrorism. We 
have had a surplus and now we have a deficit. We had a 
discussion about the cost of the war, if there is one with 
Iraq, by OMB Director Mitch Daniels. He thinks the cost can be 
under $100 billion. I heard a trillion dollars mentioned here 
just a minute ago.
    What I am saying is for 40 years in the Congress that we 
had some deficit spending. So before the year 1997, when we 
finally got it right and we turned it around we then had some 
surplus years.
    You testified that surpluses are not always good, but can 
create problems. And sure enough, they have created a problem 
because we got on a spending spree of about annually 10 to 12 
percent in discretionary spending. We cannot sustain that, Mr. 
Chairman, and expect our surpluses to last very long.
    Besides that, we have the cost of the war on terrorism and 
we have the cost of the war for homeland security.
    What I am saying to you is a temporary deficit in the 
amount of $300 billion is bad. I do not like it any more than 
you do. But if we do not change the policies that we now have, 
we may have that forever as we go out. And we have to change 
our fiscal policy to deal with that.
    Are you saying that we need to do that to stabilize our 
economy in the out-years, even though you do not think that the 
tax cuts are stimulus as they are now proposed?
    Chairman Greenspan. I certainly think that it is crucial 
that we have a budget policy which does not destabilize the 
economy. What that turns out to be, Senator, amongst a number 
of different criteria, is at least the necessary condition that 
the level of debt-to-GDP not be rising.
    Now, you can have in today's environment a level of debt-
to-GDP which is flat, but still have modest, small deficits, 
indeed, somewhere in the area of 1 to 2 percent. That is not 
inconsistent with stability.
    But if we get into a position, as I pointed out in my 
prepared remarks, where we are finding that the debt-to-GDP 
ratio begins to accelerate, we have to be very careful because 
there is no self-equilibrating mechanism when that is occurring 
because a rise in the debt increases the amount of interest 
payments, which in turn increases the debt still further and 
there is an accelerating pattern after you reach a certain 
point of no return.
    So it is crucial that we keep in mind the long-term pattern 
of debt-to-GDP on a unified basis. And I even go on further to 
discuss in some detail the desirability of moving to an accrued 
budgetary system as well, which would take into consideration 
the value of the commitments which the Congress is making over 
a protracted period and make judgments far better than we can 
now as to whether those are long-term, sustainable fiscal 
policies.
    Senator Bunning. As you know, the Fed recently announced 
that they will be eliminating 72 jobs from the Louisville 
office. I know that your staff has assured my office that the 
Fed will try to help those workers that are displaced. But I 
think those workers who may be displaced would feel much better 
if they had assurance from the Chairman that the Fed will do 
what they can to assist them in finding new work. Will you give 
that commitment to the Federal workers in Louisville and 
throughout the country who are losing their jobs?
    Chairman Greenspan. Most certainly, Senator. We have a 
program which endeavors either to find alternate jobs for the 
people who are displaced in the check-clearing operations, or 
if that is not feasible, to do whatever we can to find ways in 
which they can be reemployed as expeditiously as possible.
    Senator Bunning. I have some other questions but my time 
has run out. If I can, I will just submit them to you and you 
can give me a written response.
    Chairman Greenspan. I would be delighted to.
    Senator Bunning. Thank you.
    Chairman Shelby. Senator Reed.
    Senator Reed. Thank you, Mr. Chairman.
    Chairman Greenspan, let me make one comment and then ask 
one question.
    In your testimony, you quite fervently argue for 
flexibility. But one aspect of flexibility in the American 
economic and in the political system is the flexibility of 
leaders who recognize changed 
circumstances. In fact, I think the President's proposal is 
quite 
inflexible. It is the same approach that he was advocating 
before September 11. It is the same approach he was advocating 
before we saw a surplus turn into a growing deficit. And I 
would hope that if you are arguing for flexibility before the 
Congress, you would argue for flexibility of mind with the 
Administration so that they could adjust their policies.
    Let me ask just one specific question. Actually, two 
premises and a conclusion. I will ask you to comment on my 
premises and the conclusion.
    The first premise--the American public expects to be paid 
fully the Social Security benefits which they have contributed.
    The second premise--by exhausting the Social Security Trust 
Fund, which is the effect, if not the intent, of the 
President's proposals, accomplishing that expectation is very, 
very difficult, if not impossible.
    The conclusion might be, then, those who support these 
proposals of the Administration either have no intention of 
paying fully the benefits of Social Security, and I could add 
Medicare also, or they are irresponsible in advocating such 
proposals.
    Now the first premise. Do you believe that, not that the 
American people expect to have the benefits, we will in fact 
pay full Social Security benefits to everyone who is entitled 
at this moment?
    Chairman Greenspan. I think, as best I can judge, it has 
always been my expectation that the payments of benefits under 
law had very little to do with what the assets in the Social 
Security Trust Fund were, because I cannot conceive of a 
political situation in which those benefits run out. And under 
law, there are curtailments in payments. I know that is what 
the law says. I have no expectation that the Congress would 
allow that law to stay in place.
    Senator Reed. The second premise is that, by exhausting the 
Social Security Trust Fund, which is the effect of the 
proposals that we have seen 2 years ago in the tax cuts and the 
current proposals, making those payments is extraordinarily 
difficult and will put extraordinary pressure on this Congress 
in terms of other programs and other priorities. Do you agree 
with that premise, also?
    Chairman Greenspan. Actually, the Social Security benefits 
are reasonably capable of being estimated well into the future 
because they have many of the characteristics of a defined 
benefit pension plan. The really major fiscal problem is not 
Social Security. It is Medicare.
    Senator Reed. I agree with you. However I was raising an 
issue that is less complicated in terms of discretionary 
spending. But as I think you recognize, and we all do, we are 
talking about, particularly after 2017, huge contingent 
liabilities which we can define right now, as you said, we have 
reserved some funds for it. But we are going to exhaust those 
funds by proposed tax cuts. Doesn't it follow then that we are 
making life impossible for us?
    Chairman Greenspan. Well, I merely fall back to my previous 
answer. These are the crucial issues of the determination of 
how one allocates resources available to the Government amongst 
a series of programs, both tax and spending programs, all of 
which have very strong supporters and very good resumes, if I 
may put it that way, as to why these programs are indispensable 
to the American people.
    It is the Congress' very difficult task to make those 
judgments because we have no other mechanism in this democratic 
society to effectively try to translate the value system of the 
American people into how we cut these priorities--I do not mean 
cutting, I mean by paring--how we lay them out.
    As you know, I was Chairman of the Social Security 
Commission back in 1983. It was a fascinating experience to be 
exposed to a number of what were then your predecessors in a 
number of the seats around this table, on how they negotiated 
what ultimately actually turned out to be a remarkably sensible 
compromise. It pleased nobody. But everyone signed on.
    Senator Reed. I think that is the only thing we can agree 
on. It won't please anybody what we do, but we have to do 
something.
    Again, let me thank you. I see from your response, which is 
my intuition also, that we will not step away from Social 
Security spending, but we are going to make it extraordinarily 
difficult to fulfill that commitment by these tax cuts.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Sununu.
    Senator Sununu. Thank you, Mr. Chairman.
    Mr. Greenspan, in your testimony, you talk about the fact 
that business inventories have stayed pretty lean and then 
indicate that that is probably a good prognosticator of maybe 
future manufacturing activity, and note that purchasing manager 
information suggests the improvement on manufacturing activity 
has continued into the beginning of this year. Could you 
elaborate on that a little bit and talk about what signs you 
see from purchasing managers or other sources that the early 
trends in the first quarter now are somewhat positive?
    Chairman Greenspan. Yes. First of all, the fact that 
inventories are low is a very positive sign in the sense that 
if there is any evidence that the economy is picking up, 
inventory accumulation will begin to move at a fairly 
pronounced pace.
    The data for January, which we have, as you know, for 
purchasing managers, says that in their diffusion index, 
production went up. But more importantly, we have a lot of 
weekly statistics on production for motor vehicles, steel, 
electric power, and a set of individual products which account 
for something in the area of a sixth of the total industrial 
production index which we publish.
    Senator Sununu. Is that a pretty good proxy?
    Chairman Greenspan. Actually, it is better than a proxy in 
the sense that we actually have on a weekly basis the 
industrial production index for part of the total.
    Senator Sununu. But does the other 84 percent tend to track 
the weekly numbers?
    You can get weekly information on 50 percent. But if the 
other 50 percent is incredibly volatile, it may be of no use.
    Chairman Greenspan. We have other indicators that tend to 
proxy for the remainder, mainly, insured unemployment data, 
which we find has been useful in combination with the weekly 
data to suggest what patterns are emerging in the manufacturing 
or, more exactly, in the industrial production area.
    Senator Sununu. I consider myself somewhat an optimist. And 
so, the parts of your testimony that, at least over the last 2 
or 3 years, that I have found most interesting or most 
encouraging, is your repetition of the degree to which you are 
impressed with the resilience of our economy, the degree to 
which technological improvements have lent themselves to 
productivity increases and the flexibility you talk about being 
important. Also, I have been impressed with the resilience of 
the consumer demand, which you note in your testimony has been 
quite stable through all of this uncertainty. But business 
investment continues to lag.
    Could you talk a little bit about the elements of the 
President's proposal that do target business investment? There 
is a provision for small businesses to allow them to expense 
$75,000 a year instead of $25,000 a year.
    To what degree is that kind of an approach effective, given 
that it is targeted at small businesses? Are they a big enough 
part of our business investment economy to make a difference?
    I am not asking you to write legislation. I know that is 
not appropriate. But other types of approaches that might 
address the lagging business investment and, as a result, have 
a good, long-term impact on our economy?
    Chairman Greenspan. Senator, I have not looked at some of 
the details enough to make an evaluation. But the most 
important stimulus, if you want to put it that way, in my 
judgment, is the removal of the uncertainties which overhang 
the capital investment markets, which, as I have indicated 
earlier, I believe are quite significant and that one does not 
need stimulus, if I may put it that way----
    Senator Sununu. You are talking about the geopolitical 
concerns that you outlined in your testimony.
    Chairman Greenspan. Yes.
    Senator Sununu. Beyond that, you have no thoughts to offer 
about the accelerating depreciation or the reforming 
depreciation schedules to encourage business investment? Or do 
you think they just pale in comparison to the geopolitical 
concerns?
    Chairman Greenspan. The answer is, yes, I do think that it 
is small in comparison. But I have in the past discussed the 
various different issues which economists have evaluated with 
respect to capital investment, namely, there are ways to 
accelerate capital investment in the short run.
    But the most fundamental stimulus to capital investment is 
the prospect for higher earnings on real investment over the 
longer run. There is no substitute.
    Senator Sununu. I have one final question about the 
mortgage industry.
    You talked about the degree to which mortgage rates being 
at historic lows encourage refinancing and the refinancing 
activity is at a very high level right now.
    In the past, you have been very candid about your concerns 
regarding the GSE's and your thoughts regarding changing some 
of the current legislation that provides benefits to GSE's.
    Let me talk about one particular reform, which I think is 
topical because of the Sarbanes-Oxley bill, and that is greater 
oversight or involvement of the SEC in the mortgage market and 
the secondary mortgage markets in particular.
    To what extent do you or would you support SEC oversight or 
involvement in the GSE's--but to what extent would that affect 
the costs of mortgages and the liquidity in the mortgage 
markets?
    Chairman Greenspan. Without stipulating whether I would 
agree with any particular proposal because without seeing the 
specific proposal, basically saying that this agency should 
oversee this part of the economy, I do not think there is 
enough information.
    But having said that, the major issue here is the subsidy 
which is implicit in the GSE debentures, even though they are 
not legally an obligation of the U.S. Government. They are not 
backed by the full faith and credit of the United States. It is 
the market which presumes that they will be bailed out that 
effectively enables them to sell mortgages at a number of basis 
points below what the market otherwise would be.
    As a consequence of that, some of that does go through into 
lower mortgage interest rates. But as best we can judge, it is 
a very small number.
    So, I am not at all convinced that many of the proposals 
really make all that much difference to the secondary mortgage 
market or to the level of mortgage interest rates to the 
American public.
    Senator Sununu. I don't want to let you completely off the 
hook. On the first part of your response, it is the SEC, the 
Securities and Exchange Commission, we do task them with 
oversight of securities markets. We are talking about 
collateralized obligations. Do you think that they would be an 
appropriate oversight agency? Or is there something unique to 
the mortgage markets that would make you say that this has to 
be treated somewhat differently?
    Chairman Greenspan. No, no. As you know, the SEC is already 
involved in the question of making judgments as to whether 
certain types of securities should be registered or not 
registered. I think these are legally private corporations and 
should be handled the way private corporations are handled.
    Senator Sununu. With regard to registration and fees.
    Chairman Greenspan. With regard to issues that revolve 
around the SEC. But going beyond that, I do not know because I 
do not know what the particular proposals would be.
    Senator Sununu. I appreciate that. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Schumer.
    Senator Schumer. Thank you, Mr. Chairman. And I want to 
thank you for your answers.
    I would like to refer, Mr. Chairman, to an exchange that 
you and I had just about 2 years ago that still rings fresh in 
my mind. And it rings fresh in my mind because it was cited in 
The Washington Post today, evidently.
    As you may recall, you appeared before our Committee in 
2001, as we were considering the President's first tax cut 
package and its potential impact on dividends. And I am just 
going to quote a little bit of our exchange:

    Schumer: I take it you, Chairman Greenspan, would say 
deficit reduction is a reasonable priority.
    Greenspan: I would say, Senator, that we do not wish to go 
back into unified budget deficits.
    Schumer: Right.

    Okay. That sounds like me.
    [Laughter.]

    Schumer: So the question is, given the numbers that you 
have been talking about, when do we get to a level where it is 
too high?
    Greenspan: I repeat--when we project our way back into 
deficit, which I think would be a mistake.

    That is pretty unequivocal.
    Now according to the Congressional Budget Office, and 
validated by the President's own budget and advisors, we are 
going to have a unified deficit of $199 billion in 2003, and 
unified deficits through 2007. If we exclude the Social 
Security Trust Fund surplus, all of those figures are worse and 
the budget remains in deficit through 2011.
    To me, this passes the test of, as you put it, projecting 
our way back into deficits. So given this new budget outlook, 
do you maintain, as you stated a while ago, that a large tax 
cut that further sends us into deficits, would be a mistake?
    Chairman Greenspan. I support the program to reduce double 
taxation on dividends and the necessary other actions in the 
Federal budget to make it revenue-neutral.
    Senator Schumer. Right.
    Chairman Greenspan. I think that that would be a 
significant value to the American economic system.
    Senator Schumer. Okay. Let me just probe your fertile mind.
    I generally like cutting the tax on dividends in an 
abstract world. All things being equal, not thinking of the 
deficit, it seems to me something that would be a good idea. 
Although I think I agree with you that it probably would have 
more bang for the buck in a sense at the corporate level than 
at the individual level.
    So be it. I am not President and making that decision.
    But one way we could make it revenue-neutral, and not get 
into the age-old fight between the spending side because you 
and I know that with war coming and with everything else, we 
are not going to make up for that huge revenue loss that the 
dividend tax cut would produce on spending.
    Even the President's budget goes up 4 percent. It doesn't 
go up as much as maybe it might have. And I know the President 
is trying to rein in spending, but it still goes up. It doesn't 
do anything to balance the dividend tax cut.
    What about looking at some corporate tax loopholes. Give 
something to the corporate side, but take it away. Give it in a 
general and nonspecific way, which is generally preferred in 
tax theory.
    The Cato Institute, not an organization I always agree 
with, but they said that Federal subsidies to business costs 
taxpayers an estimated $87 billion a year. These are the rifle 
shots aimed at very specific businesses or specific industries.
    Congressional Research says that corporate tax expenditures 
are over $100 billion. And most troubling to me, offshore tax 
havens--and I have a proposal which is different. I would like 
the shareholders to vote before the company goes offshore.
    If this is supposed to benefit the company, let's see if 
the shareholders have that view, which I think is a little bit 
unpatriotic that we should go overseas to reduce our revenues.
    But in any case, these offshore tax havens cost an 
estimated $92 billion in otherwise taxable profits. So those 
are enormous figures--$3 trillion in lost revenues over 10 
years, which would pay, of course, for the dividend reduction, 
the dividend elimination, eliminating the tax on dividends 
several times over.
    It has been a tough issue to address politically. But do 
you think that combining these two things might be--I am not 
asking you to comment on any of the specific proposals I 
mentioned, but general corporate reform, and then come out in a 
much more revenue neutral way, but still do the tax elimination 
on dividends and given general corporations a break, a good 
idea?
    Chairman Greenspan. Senator, I have always opposed 
subsidies to corporations. If you are a private business, you 
should function as a private business and getting special 
preferences from the Federal Government has never been 
something which I have been supportive of.
    Senator Schumer. So, you might think that combining the 
two, in the abstract, would be a good idea.
    Chairman Greenspan. I do not want to comment on the 
specifics of your proposal.
    Senator Schumer. All right. I tried. I do not know. Is my 
time up, Mr. Chairman?
    Chairman Shelby. Your time is up.
    Senator Schumer. Okay. Well, I have more questions.
    Chairman Shelby. Senator Dole.
    Senator Dole. Chairman Greenspan, I would like you to focus 
on the long-term effects of very low-interest rates. With the 
Federal funds rate at a record low and the high rate of 
mortgage refinancing, do you see a long-term problem with 
future mortgage-backed securities which will yield historically 
low returns?
    Chairman Greenspan. There is no necessary problem that 
mortgage-backed securities are in difficulty with low-interest 
rates in the sense, remember that these securities are fully 
backed by whole mortgages and in many respects, because they 
are so-called conforming mortgages, they have reasonably good 
credit ratings.
    Indeed, it is really interesting to observe that even 
though the loans are on individual properties, they have 
something close to an ``A'' rating individually and in total. 
So, unless there is something I am missing in your question, 
Senator, I have not been concerned about the level of interest 
rates as such.
    There are questions that are involved in the size of the 
secondary mortgage market and its efficiency and how it 
functions. I think the movement of interest rates, and low-
interest rates, do cause some problems for some of the GSE's as 
a consequence of that.
    Because there is a one-sided option where a homeowner can 
refinance, but the bank cannot, at its will, refinance, you 
have difficulties in knowing what the maturity of these 
particular mortgages are which combined into any form of these 
collateralized vehicles. And I suspect there are some 
difficulties with them.
    So far, that market has worked really quite well. And 
indeed, I would even go further. I would say the ability to 
have been able to get the extent of refinancing which has 
reduced the debt service charges for the American homeowner, 
but also the very large cash-outs, which is borrowing over and 
above just refinancing the mortgage, has been a very important 
issue in financing consumers in maintaining a fairly robust 
consumer market, which I think has been a major factor helping 
us through the last 2 years of very difficult problems with the 
corporate investment and inventory sectors.
    Senator Dole. Thank you. Two other questions, please.
    Wholesale heating oil prices jumped enormously. Yesterday, 
it was up 30 cents from a week earlier to $1.20 a gallon. Do 
you have any information on what may happen if indeed there is 
a conflict with Iraq, whether others in OPEC might step up and 
fill the shortfall?
    Chairman Greenspan. Senator, this is a very crucial 
question which we in the Federal Reserve watch very closely and 
obviously, other members of the Government are doing the same.
    There are problems in the sense that the sum of the 
capacity of Iraq and Venezuela is greater than the gap between 
overall world oil capacity and presumed consumption. And it is 
that which has been driving up crude oil prices which has 
spilled over into home heating oil. But it has been very 
considerably exacerbated by the obviously colder-than-expected 
winter that we have gone through.
    We have gone through certain calculations which suggest 
that inventory levels which seem to be quite low at the primary 
distributor level, have actually moved up quite considerably in 
both households and in the secondary distribution level, so 
that there has been a bulge in heating oil inventories which we 
do not directly measure.
    This cannot continue on, obviously, because we are 
gradually moving out of the heating season and into effectively 
a much lower level of aggregate world demand for oil, which is 
between the North American heating season and the motoring 
season, which dominates world markets.
    In that regard, the outlook, other than the impact of a 
war, is really obviously quite favorable.
    The crucial question here is whether, in a war, that the 
Iraqi oil fields are under stress. So without being able to 
forecast for both the final outcome of the problems in 
Venezuela, which has cut production from about 3 million 
barrels a day down to now a little over one million barrels a 
day, and the Iraqi oil production capability, so long as those 
issues overhang us, they will continue to press prices higher. 
But the fundamentals are for much lower prices, eventually.
    Senator Dole. Thank you.
    Mr. Chairman, my mother is 101 years old. America is aging, 
as we all know. We will have a savings crunch in the next 20 
years. I would like to have your thoughts on what we might do 
to increase savings and what you think of the President's 
proposals in this regard.
    Chairman Greenspan. About half of productivity growth in 
the United States is attributable to the actual capital 
investment input which we make year upon year, and that is a 
prominent force in productivity. It is not 100 percent, but it 
is a very big chunk.
    The more savings that we have that are productively used in 
our economy, the greater the productivity, the greater the 
growth, the greater the prosperity that we have. Any proposal 
which augments savings has a positive effect on long-term 
economic growth.
    I cannot comment on the specifics of the President's 
proposal because it is rather complex and there are pluses and 
there are minuses, and I probably would be better off if I just 
stayed with that for the moment.
    But we should keep looking for policies which, one, enhance 
savings and enhance flexibility. I think there has been too 
much in the way of trying to do short-term stimuluses and they 
work in the short run, but then they fade out. And I think we 
spend more time than I think is productive in figuring out how 
to get the economy to move in a certain way in the very short 
run, rather than focus on the long-term. And if we do that, I 
suspect the short-term will largely take care of itself.
    Senator Dole. Thank you.
    Chairman Shelby. Senator Bayh.
    Senator Bayh. Thank you to both Chairmen.
    Mr. Chairman, I have four questions. So, I am going to try 
to march through these relatively succinctly.
    The first is about the proposal and the double taxation of 
dividends. I understand the argument in favor of it. It is that 
it will promote more flexibility in the economy, increase 
productivity growth, and thereby, better prepare us for the 
advent of the retirement of the baby-boom generation.
    As you know, there are many things that affect productivity 
growth. I remember well in my previous capacity as Governor, 
your giving an address to the Governors Association about the 
effect of job training and education on productivity growth. 
There are other things, such as investment in research and 
development. There are other parts of the tax code that could 
be altered that would stimulate productivity gains.
    Why is this the best proposal of all the possible avenues 
to promote productivity growth? And is there a comparative 
analysis that we can rely on in making this policy decision?
    Chairman Greenspan. Senator, I do not know the answer to 
that question. I do know that eliminating the double taxation 
of dividends is a positive force for just the reasons you gave.
    I cannot say to you that I know that say using the same 
amount of resources, if you want to put it that way, it is the 
best because nobody has come up with a proposal which strikes 
me as better. I do not deny that one could.
    Senator Bayh. Unfortunately, that is the choice that we 
face.
    My second question is about the effect of tax cuts on 
revenues. A couple of years ago, the tax cut that was enacted 
into law was advanced as a way to reduce the burgeoning size of 
the surplus by reducing the amount of revenue coming into the 
Federal Treasury.
    Today, an acceleration of those same tax cuts is being 
urged upon us. I understand not by you because you have 
questions about the need for a stimulus at this point. But as a 
way to stimulate the economy, to grow revenue, and thereby deal 
with the budget surplus.
    How do you reconcile these arguments coming from the same 
people? How can the same policy both increase and decrease 
revenues?
    Chairman Greenspan. As you say, you are not addressing that 
question to me.
    [Laughter.]
    Senator Bayh. Well, someone needs to answer it because it 
is being pressed upon us, and it seems to me to be internally 
inconsistent. But I will go on to my third question.
    You mentioned a combination of weak demand plus continuing 
productivity gains has led to a soft job market. All of us want 
the productivity gains to continue. In your opinion, what level 
of growth is necessary to create jobs in a climate where robust 
productivity gains continue?
    Chairman Greenspan. It is a strictly arithmetical 
calculation because, basically, jobs or, more exactly, hours of 
input, plus the change in productivity, is what gives you the 
GDP.
    What we had for a good part of last year was a largely 
unex-
ploited capability of a manufacturing and distribution system 
and service system, which basically had not been pressed 
through the latter part of the 1990's to be as efficient as it 
could.
    Remember, back in the latter part of the 1990's, the real 
issue was to try to expand markets, expand sales, and expand 
profitability as a consequence. And little relative effort was 
employed in making sure that the costs involved in producing 
those expanding outputs were as efficient as they could be.
    When we came into the early 2000's, where sales became very 
sluggish, American business turned to that unexploited source 
of potential productivity and created a remarkable run-up in 
output per hour.
    So long as that unexploited base is there, then it is 
possible for business to continuously increase output with very 
little increase in employment.
    Now, I do not know where the point turns. At some point, 
that availability of unexploited short-term capability to 
increase productivity will have been exhausted, and then to 
keep up with demand which is coming in, presumably, you have to 
start reemploying lots of people. And I do not know where that 
is, but it will happen, and presumably, sooner rather than 
later.
    Senator Bayh. And the more that we can do to increase 
demand and grow GDP, the sooner that day would arrive.
    Chairman Greenspan. Oh, certainly. For every percentage 
point increase in the GDP growth rate, holding productivity 
growth unchanged, is the same percentage----
    Senator Bayh. I promise, Chairman Shelby, this will be 
quick, Mr. Chairman. So let me just cut to the bottom line of 
my fourth question.
    I have only been around this town for 4 years. But I think 
a healthy level of skepticism is in order when it comes to the 
Federal Government's ability to constrain--take the difficult 
steps neces-
sary to constrain the budget deficit. Ordinarily, the thing 
grows until it can be denied no longer, a crisis is imminent, 
then something is done.
    Having said that, I want to ask you about the double 
taxation again. Assuming for the sake of argument, that these 
deficits are going to persist for a while, does the benefit of 
flexibility and productivity generated by ending the double 
taxation of dividends outweigh the exacerbation of the deficit 
that it may cause?
    Chairman Greenspan. Well, I presume that it will not cause 
an exacerbation because I would couple my consideration of this 
with the restoration of the PAYGO rules. So, I look at that as 
a joint recommendation.
    Senator Bayh. Thank you, Mr. Chairman. It is one that 
hopefully we can implement.
    Mr. Chairman, thank you.
    Chairman Shelby. Thank you.
    Senator Miller.
    Senator Miller. Mr. Chairman, thank you for your wisdom and 
also, as I note the clock, thank you for your patience this 
morning.
    My first question is one that I am bringing from Young 
Harris, Georgia. I was sitting around a coffee table in this 
rural Georgia restaurant. We were discussing the President's 
economic program and his plan, and the fact that it suggests 
that the deficit is going to rise. And the way that it was put 
to me was, does the growth in the deficit pose a greater or 
lesser danger than the prospect of slower economic growth?
    I told them that I did not know the answer, but that I 
would ask Chairman Greenspan, which impressed them and let me 
get out of that restaurant.
    [Laughter.]
    Senator Sarbanes. Give the Chairman the name of the 
restaurant so he can go down there and visit it himself.
    [Laughter.]
    Senator Miller. Mary Anne's.
    Chairman Shelby. Mary Anne's.
    [Laughter.]
    Chairman Greenspan. The basic approach to economic analysis 
and programming that is associated with it is, in my judgment, 
to try to formulate a budget policy which is stable, meaning 
that it does not create pressures on private finance which 
eliminates the underlying growth pattern in the economy.
    So, I would presume that we can have a fairly rapidly 
growing economy with a balanced budget or even a surplus, and 
that the presumption that deficits somehow would increase the 
GDP--the more deficit, the greater the GDP--is a short-term 
view which I do not believe continues in the longer run.
    I think we have to focus on maintaining maximum economic 
growth, but simultaneously recognize that a necessary condition 
to do that is that deficits have to be contained or, at the 
extreme, that the ratio of debt to the public as a percent of 
the GDP, remains stable.
    Senator Miller. Thank you. I will try to paraphrase that 
next Saturday.
    [Laughter.]
    This also is a question that comes from personal 
experience. I am sitting here between two former governors. I 
do not know about them, but from time to time, I get to 
thinking that maybe it would be better to be back in the 
Statehouse. Except right now, it is not too good back in the 
Statehouse.
    My question to you is, do you think that Congress should 
address in any way the budget shortfalls that the States are 
having? And if so, what would be your approach?
    Chairman Greenspan. This is a difficult question largely 
because the source of the problem in many of the States, as you 
know, Senator, has been that with the fairly substantial surge 
in revenues that the States had in many cases, and it is hard 
to know how many, permanent programs for expenditures were 
financed.
    And to a large extent, because the tax rate on capital 
gains and options and the like are--or I should say the tax 
rate on capital gains in the States are pretty much equivalent 
to the regular income tax rate since the adjusted gross income 
from the Federal returns is what is used for the income tax 
where it is applicable for the States, we saw a very big surge 
in Federal revenues, but for some States, because the tax rates 
are relatively high, they saw an even greater surge.
    So that you have to weigh the fact that some of the States 
overexpended and should and will and are appropriately pulling 
back, and others did not. And the question is, how does the 
Congress or the Federal Government appropriately handle that 
without essentially treating those who were not sufficiently 
conservative to contain their funds from those who are less 
conservative? In other words, how does one make a program which 
is fair to everybody?
    I have no objection obviously to having Federal funds go to 
the States. We have been doing that for decades. But I must 
admit that I do have some problems--how would one in all 
fairness create a program which did not essentially benefit 
those who are the least conservative in their programs relative 
to those who were more conservative? If that can be done, then 
I think that there are obvious arguments in favor of it.
    Senator Miller. Thank you, sir.
    Chairman Shelby. Senator Carper.
    Senator Carper. Mr. Chairman, again thanks for all of your 
time and insights today.
    I want to follow up on Governor Miller's and Governor 
Bayh's questions with one that also relates to the States.
    We have heard from the States repeatedly over the last year 
or two that, particularly for those whose tax systems 
piggybacked on the Federal system, that when we make reductions 
here, then there is an effect on them as well, reducing their 
revenue base.
    With the latest proposal from the Administration, and which 
I think in theory, the double taxation of dividends make sense. 
It is logical.
    I, like you, would say, if we are going to do that thing in 
the context of maybe a broader tax reform, that it be deficit-
neutral and that we do it on the corporate side rather than on 
the approach that the Administration seems to be taking.
    But I am hearing from some of my old governor friends that 
they are concerned about the cost of issuing tax-exempt debt 
and how that might be affected, if we approach the taxation of 
dividends as the Administration has proposed.
    Any thoughts as to how we could minimize the effect of the 
impact on the States by taking a different course?
    Chairman Greenspan. Senator, you are referring to the issue 
that municipal finance, the interest rates that are involved 
would be affected by essentially creating a whole new segment 
of demand for untaxable issues, so to speak.
    Senator Carper. Yes, sir.
    Chairman Greenspan. This is a half-full, half-empty glass 
problem because the double taxation of dividends is a subsidy 
to the municipalities in the sense that it gives them less 
competition and, hence, better financing capability.
    If you look at it that way, then the question is you are 
eliminating a subsidy. If you look at it the other way, you are 
taking away a subsidy which is deserved. And I do not have a 
clue how to answer that question.
    Senator Carper. All right. Let us try another one. I am 
going to quote you here in your written testimony, which says:

    The intensification of geopolitical risks makes discerning 
the economic path ahead especially difficult. If these 
uncertainties diminish considerably in the near term, we should 
be able to tell far better whether we are dealing with the 
business sector and an economy poised to grow more rapidly--our 
more probable expectation--or one that is still laboring under 
persisting strains and imbalances that have been misidentified 
as transitory.

    And then, skipping down a couple of lines, you say:

    If instead, contrary to our expectations, we find that, 
despite the removal of the Iraq-related uncertainties, 
constraints to expansion remain, various initiatives for 
conventional monetary and fiscal stimulus will doubtless move 
higher on the policy agenda.

    There is a couple of different ways a person could read 
this.
    My own view is that the greatest impediment to economic 
growth in this country is the uncertainties, a lot of them 
outside of our country. But I alluded to some of those earlier.
    Are you saying here that before we use the other arrows in 
our monetary arrow-holder----
    Senator Miller. Quiver.
    Senator Carper. Quiver--out of our monetary quiver, or out 
of our fiscal quiver, that we should first try to deal with 
some of these uncertainties. And once we have dealt with those, 
then let us see what we further need to do on the monetary side 
or the fiscal side. Is that what you are saying?
    Chairman Greenspan. Yes, Senator.
    Senator Carper. On the monetary side, what could that 
include?
    Chairman Greenspan. The usual monetary policy initiatives.
    Senator Carper. Well, you have done a lot. And there are 
some on this Committee who have been rather critical of your 
stewardship on monetary policy. I am certainly not among them. 
But what further can we do? You have taken the Federal funds 
rate down. You have loosened up the money supply. What further 
is there to do?
    Chairman Greenspan. Well, the general position of the 
Federal Open Market Committee at this particular stage is that 
we are holding at the 1\1/4\ percent Federal funds rate and 
view the outlook as the balance of risks essentially balanced 
on both the upside and the downside.
    One of the reasons is the large uncertainties with respect 
to the geopolitical risks. As I said several times this 
morning, our judgement, as best as we can make it, is that 
there seems to be a fairly significant, almost inexorable, 
endeavor on the part of the economy to move forward, but it is 
being held back by these set of forces.
    And if that is the correct interpretation, and we are 
viewing it correctly, then we will find that, at least in my 
judgment, the issue of the discussion of stimulus will probably 
just go away. Because of the fact we are apt to know the 
resolution of that within a period which doesn't stretch out 
indefinitely into the future, I have concluded, as I have 
indicated previously here, that we are probably more sensible 
to wait to see what happens before we embark upon a number of 
programs which may in fact from a stimulus point of view, not 
be necessary.
    Remember that I am in support of the President's program on 
the elimination of the double taxation of dividends, not for 
short-term stimulus purposes. I think that it is a very 
sensible long-term program.
    Senator Carper. Thank you.
    Chairman Shelby. Senator Corzine.
    Senator Corzine. Thank you, Mr. Chairman.
    Chairman Greenspan, I want to be precise if I can. You said 
that you support President Bush's proposal, which I just heard 
you say, about the dividend exclusion. But I also heard you 
say, only if it were implemented in a revenue-neutral world. 
Does that mean, to be clear, would you oppose the Bush tax plan 
if it were not offset with regard to the dividend exclusion?
    Chairman Greenspan. I would just allow my remarks to stand 
as I have stated them.
    Senator Corzine. You do believe it should be revenue-
neutral?
    Chairman Greenspan. I do believe it should be revenue-
neutral.
    Senator Corzine. I presume that, if we cannot put that 
together, the conclusion is clear.
    Let me say, in light of changed conditions that we have 
talked about, Senator Dodd asked a question about making 
permanent the 2001 tax cuts. And I thought I heard that in 
light of changed conditions, you believed in triggers, sunsets, 
and reviews, those policies in light of those changed 
circumstances. Did I hear that as it related to the 2001, 
making permanent the 2001 tax cuts?
    Chairman Greenspan. Yes. I went further. I thought I said 
that I did not believe that there can be in this changed fiscal 
environment, with so much in the way of commitments to the 
longer term, which are entitlements, that there can be such a 
concept as an unchangeable program on either the revenue or the 
expenditure side.
    Senator Corzine. Thank you.
    Following up on some of the questions that the Governors 
talked about, is a $70 to $90 billion cumulative budget deficit 
at the State levels, maybe larger if you include some of the 
local government levels, a drag on economic activity, 
regardless of what we do here, if that is what takes place, 
cutting in expenditures or raising taxes, 18\1/2\ percent in 
the city of New York or property taxes?
    Chairman Greenspan. Senator, as you know, it relates solely 
to the general funds of the States and does not affect really 
the localities or other parts of the State budgets that are 
involved. So those numbers are really quite large. But they are 
variable. And our ability to forecast them has not been 
particularly good.
    But, having said that, to the extent that taxes are raised 
in order to close those gaps, I would assume that it is 
restrictive of economic activity in the locality.
    Senator Corzine. Thank you.
    I just wanted to make sure that I heard you say deficits 
impact long-term interest rates, in your view, and have an 
impact then on the investment function over a period of time.
    Chairman Greenspan. You heard me correctly, sir.
    Senator Corzine. Okay. Then I would just ask, is there any 
time--you have a wealth of knowledge on this--in economic 
history that you know of a period in time when we are at war, 
where we have serious programmatic demands with regard to 
homeland security and protecting the American people and our 
national security needs, that you have seen a series of tax 
cuts in the judgment of Congress, is the right way to proceed 
fiscally?
    Chairman Greenspan. Well, Senator, that is a factual 
question which it is either true or it is false. And I presume 
that we can find that out.
    There is one point in this discussion, however, that I 
think we should at least put on the table. It is that the ratio 
of defense expenditures to the GDP is still quite low and 
indeed, as recently as a couple of years ago, it was at the 
lowest level since before World War II.
    So, we do have a low base from which we are functioning. 
And one would presume that there is some give there.
    Now that does not respond specifically to your question 
with respect to whether tax cuts are appropriate or not 
appropriate. But it is relevant to the general impact of what 
the size of potential demands, at least for the military, would 
be relative to the overall economy.
    Senator Corzine. I would understand that. But it does have 
an ultimate budget impact on the bottom line of whether we are 
running deficits and national savings is being impacted by the 
fact of the role of Government, whether it is for national 
security or whether it is for domestic policy.
    Chairman Greenspan. That is certainly the case. But in the 
context of raising it with the issue of being in periods of war 
or in periods of military stress, those periods, you will find 
the ratio of 
defense expenditures-to-GDP was considerably higher than it is 
today.
    Senator Corzine. You talked about flexibility in the 
economy and then were complimentary of Sarbanes-Oxley.
    I would presume that there are times when you believe that 
the role of Government in our society is a positive element. 
Some people might call that rigidity and the imposition of 
rigidities with 
respect to flexibility. So that there is some minimum level of 
participation that I would suspect that you are supportive of 
with regard to the SEC and other elements.
    Chairman Greenspan. I think that I have a very rigid view 
toward the Constitution of the United States. I do not wish to 
imply, Senator, that I believe that flexibility goes into our 
laws or any of the other things which affect business 
decisionmaking and business activity and corporate governance.
    Clearly, you cannot run a flexible, capitalist, ``creative 
destruction'' type of economy unless you have a rule of law 
which is clear, unequivocal, and definitive. And in that 
regard, that is not flexible. In other words, flexible law may 
very well lead to rigid economics.
    Senator Corzine. Thank you.
    Chairman Shelby. Senator Stabenow.

              COMMENTS OF SENATOR DEBBIE STABENOW

    Senator Stabenow. Thank you, Mr. Chairman. And Chairman 
Greenspan, welcome back to the Committee.
    One more follow-up regarding State budget deficits because 
we know that across the country now, the vast majority of the 
States are in serious deficits or gaps in their funding.
    The National Council of State Legislatures says in the 
coming year, over $68 billion will be there in terms of 
shortfalls.
    From a macroeconomic view, can you speak to the effect 
again in terms of large fiscal shortfalls and the macroeconomic 
effect to the country?
    Chairman Greenspan. Well, Senator, because, I gather, with 
the exception of Vermont, every State has a requirement that 
the budget be balanced within the State, the actions that are 
going to be taken by the States in order to meet their internal 
statutes or constitutions are going to be taken well before the 
Congress can decide to move significant funds for the current 
year.
    Those adjustments are going to be taken. And one must 
presume, although I do not know this, that it will effectively 
restore balance into the States well before any funding could 
be made available to the States.
    If that is the case, then you have to be careful in 
thinking about this issue because unless taxes which are raised 
which would have a macroeconomic negative effect, are then 
presumed to be lowered again as Federal funds come in, which 
strikes me as questionable policy, then I think you have to 
recognize that because the timing of when the fiscal years end 
in the States tends to be different than our fiscal year in the 
Federal Government, you have a very tricky problem, in that if 
the States have to take actions in order to close their budget 
deficits in this fiscal year before any Federal funds could 
conceivably be forthcoming, and in that process, they actually 
close the gap for all subsequent years, then the issue of 
making Federal funds available to help the States over this 
particular problem tends to be moot.
    And I do not know what the answer to that is. You have to, 
I suspect, argue that even if they were to impose taxes or cut 
programs in order to maintain their constitutional required 
balance, that there are still problems for the current fiscal 
year which could be assisted by Federal funds.
    In that event, as I indicated to Senator Miller, you could 
make the argument that one could go forward with programs, but 
it is next year's concerns that should be of interest to you, 
not the current ones, because it is already too late to address 
those issues in most States, as I understand it.
    Senator Stabenow. I appreciate that. I know that in 
Michigan, that is certainly the case, although they are 
projected for 2004 additional either spending that will be 
eliminated from the economy in the State, or some other 
combinations in terms of--certainly, States are looking at 
raising taxes, taking spending out of the economy, and so on. I 
would suspect that this is going to be a few years of a 
challenge for the States.
    If you might talk one more time about the deficit.
    Senator Bayh, Senator Snowe, and I and others have been, 
since 2001, talking about a trigger and put forward both in 
committee and on the floor the idea of both addressing an 
economic trigger that dealt with tax and spending programs so 
that we would not be going back into debt.
    Two years ago, we were talking about tremendous surpluses 
and whether or not we should go back into debt. Now, we are 
talking about how big the deficit will be, dramatically 
different just in 2 years. It is astounding the shift that we 
have seen. But I know you have spoken in support of the idea of 
some kind of a trigger that relates to the deficit.
    And also, before the Committee back in February 2001, when 
we talked about that, you had said: ``If there were a trigger 
which were built into both tax and spending programs, to the 
extent that they were phased, it ensures that we achieve what I 
think should be the first priority--namely, to eliminate the 
debt.''
    I would ask both if you continue to support the idea of a 
trigger to bring us into balance, but also, do you still 
believe that eliminating the debt should be our first priority?
    Chairman Greenspan. With the revenues where they are, or 
more exactly the tax base, where it currently is, that is no 
longer feasible as a realistic priority.
    I was raising it in the context of when we were getting 
significantly higher individual income tax receipts as a 
consequence of a very high flow of cash which the Congressional 
Budget Office was projecting would maintain us in a very high 
surplus level for quite a while.
    If we could eliminate the debt in a practical way which was 
conceivable at that point, I would certainly be in favor of it. 
But having lost the base and, indeed, largely because of the 
sharp decline in the stock market, a very substantial amount of 
revenues have been pulled out of the system, it is not a 
credible policy which we can embark upon without very 
substantially altering revenues and spending in a way which I 
do not think the Congress would even remotely consider.
    So it was a practical consideration back then. Regrettably, 
that is gone without it being achieved.
    Senator Stabenow. It is extremely regrettable. And when we 
look at the slowing of the economy, the issues of terrorism and 
the war certainly have to be taken into account. But I would 
argue that, unfortunately, a majority was self-inflicted by 
decisions that were made by the Congress.
    Just one other quick question if I might, Mr. Chairman, 
that is a totally separate track.
    Chairman Greenspan, I know that the Federal Reserve is 
exempted from the appropriations process. I would like to talk 
about the SEC, just one question.
    I know that you are allowed to use whatever funds are 
collected. There are reasons for that in terms of insulating 
you from political pressure, being able to make long-term 
decisions, being able to make decisions independently, and so 
on, all of which makes sense to me.
    I am wondering if you believe that the SEC, which is one of 
the only major regulators that goes through the appropriations 
process, might be better served and if investors and Americans 
would be better served if in fact the SEC funding process was, 
as your funding process is, exempt from the annual 
appropriations process.
    I wonder if you have any thoughts on that.
    Chairman Greenspan. I have no specific thoughts on that 
general proposal, Senator. But I have always argued that it has 
been our experience that the levels of the salaries in the SEC 
are probably too low, especially for their lawyers, to attract 
the quality of people in general which they need to maintain 
the type of surveillance which is required.
    They have some extraordinary lawyers in the SEC whom I 
suspect could be making double to three times what they are 
making in the private sector.
    Senator Stabenow. Don't tell them that, would you?
    Chairman Greenspan. No, they are smart enough to know that.
    Senator Stabenow. I agree.
    Chairman Greenspan. But they consider working at the SEC a 
sufficiently interesting job to consider that the foregone 
income is more than matched than the job appreciation that one 
has from doing that work.
    Senator Stabenow. Thank you.
    Chairman Shelby. Chairman Greenspan, I am going to try to 
be quick. I have a lot of questions for the record, such as the 
President's budget, projected deficits, tax reform, personal 
savings--some of these things have been touched on. Dividend 
proposals have been touched on. Condition of the banking 
industry, the economy's resilience, and so forth.
    But we will do those for the record. I will try to be real 
fast and try to wind this up. I know you have a place to go and 
you need to get there.
    Would you elaborate quickly on the types of decisions 
regarding our tax structure that would increase economic 
flexibility as well as the long-run growth potential that the 
changes would create?
    Chairman Greenspan. Senator, the first thing I would do 
would be to broaden the question to overall fiscal policy.
    Chairman Shelby. Okay.
    Chairman Greenspan. As I indicated earlier, I think we are 
now involved in the type of process which is really quite 
different from anything we had in the past. It is essentially 
the fact that we are dealing with long-term entitlements or 
taxes which do not go through annual appropriations or annual 
evaluations by the Congress, and as a consequence of that, can 
very readily add up to a drain on the resources of the economy, 
which is not the intention of the Congress.
    So, I think that the process really needs to be thoroughly 
reviewed to make it consonant with the fact of our long-term 
commitments. And that would be involved with accrual 
accounting, which I discuss at length in my prepared remarks. 
It has to do with the triggers and various other mechanisms to 
enable a phase-in of programs which will go off-track 
inevitably, so that they do not create instabilities in the 
fiscal system.
    We must be sure that the Federal Government does not 
impinge on the private sector's capability of creating goods 
and services and expanding the standard of living of the 
American people, and that requires that it not drain the 
savings resources of the private sector, which it does when it 
is running a deficit.
    Chairman Shelby. Last, would you comment on the effect of 
the strengthened Euro versus the dollar on the U.S. economy? 
What is the future of that?
    Chairman Greenspan. Well, unfortunately, I am not capable 
of answering that because, as I think I may have said to you 
previously in hearings, that we have an agreement with the 
Treasury that the exchange rate is discussed only by the 
Secretary of the Treasury and by no one else in the 
Administration.
    Chairman Shelby. We will have Secretary Snow up here as 
soon as Senator Sarbanes and I can.
    Chairman Greenspan. I would suggest that you raise that 
question with him and you will get a sensible answer.
    Chairman Shelby. Senator Sarbanes.
    Senator Sarbanes. Mr. Chairman, I just have one question 
that I want to ask Chairman Greenspan.
    Just last year, you testified before the JEC, and I quote 
you:

    It is difficult to predict how long global investors will 
continue to place their funds disproportionately in U.S. 
assets. The current account is a measure of the increase in net 
claims, primarily debt claims that foreigners have on our 
assets. As the stock of such claims grows, an ever larger flow 
of interest payments must be provided to the foreign suppliers 
of this capital.
    Countries that have gone down this path invariably have run 
into trouble, and so would we.

    And in your monetary policy report, you point out that we 
are already borrowing $500 billion a year from a broad, a 
record 5 percent of our GDP. I have been concerned about this 
issue, as you know from some of our exchanges, for a very long 
time. This is the net international position of the U.S. as a 
percent of GDP.
    A little over 20 years ago, we were positive, 12.9 percent 
of GDP. Now, we are negative, just shy of 23 percent of GDP. 
And if we had 5 percent this next year because of the continued 
borrowing, we would be down to 28 percent of GDP. Is it really 
realistic to expect that these big increases in our Federal 
deficit can be offset even more by foreign borrowing? What kind 
of hole are we digging ourselves into here?
    Chairman Greenspan. Senator, I think I probably said at the 
JEC testimony, to which you are alluding, and in years previous 
when this issue came up, that that trend cannot continue. 
Something will make it change.
    What is basically causing it is the fact that we have a 
propensity to import goods and services relative to our GDP 
which is by far higher than our trading partners'. So in the 
context of everybody in the world growing at the same rate, we 
would continually increase our imports faster than anybody else 
and create a large and increasing trade deficit, which of 
course is at the root of this particular problem.
    We know that at some point, the system cannot go on 
because, as you point out in one of the balance sheets in the 
way our economy functions is, of necessity, that there are 
relationships between the Government deficit, domestic 
investment, and domestic savings which are all tied together. 
And they cannot go off in different directions without 
affecting each other.
    I presumed 5 years ago that it would be resolved at some 
point. I have been presuming the same thing every year for 5 
years. Fortunately, we have not had a major problem with 
respect to this 
because the productivity in the United States has been very 
impressive and the rates of return on our assets have attracted 
a considerable amount of investment.
    There are a numbers of ways in which this adjustment could 
occur. One, which we hope is the case, is a gradual adjustment 
process which is essentially incremental and we restore balance 
without economic disruption.
    There are other scenarios in which there are disruptions. I 
do not know of any useful way--I know of no way that I find 
persuasive that enables us to look at this particular process 
and be able to forecast when the adjustment is going to occur. 
But far more importantly, how it is going to occur. And that it 
will occur I think is inevitable.
    Chairman Shelby. Any other questions?
    [No response.]
    Mr. Chairman, picking up on this, on the current account, 
how much of that is attributable, our deficiency in the current 
account, to the importation of oil?
    You can furnish that for the record.
    Chairman Greenspan. It is an issue, but it is not the 
critical issue.
    Chairman Shelby. It is not the only issue, is it?
    Chairman Greenspan. No. We import much more oil per dollar 
of GDP than others. But in and of itself, even without the oil, 
that problem still exists.
    Chairman Shelby. It would exist, but it wouldn't be 
exacerbated. Is that true?
    Chairman Greenspan. Obviously, we are increasing an ever-
increasing proportion of our domestic consumption of oil, we 
are importing an increasing proportion, and that clearly has no 
offsets.
    Chairman Shelby. Mr. Chairman, thank you for your 
appearance. Thank you for your patience and your answers.
    The hearing is adjourned.
    [Whereupon, at 12:45 p.m., the hearing was adjourned.]
    [Prepared statements, response to written questions, and 
additional material supplied for the record follow:]
              PREPARED STATEMENT OF SENATOR ELIZABETH DOLE
    Thank you, Mr. Chairman. I want to thank you for holding this 
hearing, and I join you in welcoming Federal Reserve Chairman Greenspan 
today for his Semi-Annual Monetary Policy Report. Chairman Greenspan, 
over the years the economy has benefited greatly from your leadership 
at the Federal Reserve. In these uncertain times, experience and 
steadiness at the helm of the central bank are particularly important. 
We are grateful for your continued service.
    In recent months, we have witnessed some mixed messages from our 
economic indicators. I was pleased to see that last month unemployment 
fell three-tenths of a percent from December and that home sales and 
residential construction remain at high levels. However, at the same 
time, rising energy costs place a strain on the economy and adverse 
weather has harmed agricultural production.
    The Federal Reserves' January Current Market Conditions Report 
quoted a Charlotte, North Carolina, contact which summed up conditions 
in commercial real estate sector as ``slow to partly cloudy.''
    With these issues in mind, my colleagues and I look forward to your 
thoughts on the current state of the economy and its potential. In 
addition, I hope we have the benefit of your views regarding the 
President's tax package and its ability to stimulate the economy. I 
know you agree that tax stimulus is a necessary component of economic 
recovery, and I look forward to hearing your thoughts on this.
    While all of us agree that the American economy needs a push in the 
right direction there is some disagreement among my colleagues on the 
best way to achieve this goal. I hope in the months ahead we can work 
together to take the necessary steps in the right direction. Your 
report today will help us focus on the fundamentals as we move forward.
    Chairman Greenspan, I look forward to working with you and the 
Federal 
Reserve in the years to come to achieve sustainable long-term growth.
    Thank you, Mr. Chairman.
                               ----------
             PREPARED STATEMENT OF SENATOR PAUL S. SARBANES
    I am pleased to welcome Chairman Greenspan before the Committee on 
Banking, Housing, and Urban Affairs this morning to testify on the 
Federal Reserve's Semi-Annual Monetary Policy Report to Congress.
    Yesterday, a statement signed by over 450 economists, including 10 
Nobel Prize winners, was released. At the outset of today's hearing I 
think it would be worthwhile to read parts of that statement because it 
helps to frame the economic issues that will be under discussion this 
morning:

          Economic growth, although positive, has not been sufficient 
        to generate jobs and prevent unemployment from rising. In fact, 
        there are now more than two million fewer private sector jobs 
        than at the start of the current recession. Overcapacity, 
        corporate scandals, and uncertainty have and will continue to 
        weigh down the economy.
          The tax cut plan proposed by President Bush is not the answer 
        to these problems. Regardless of how one views the specifics of 
        the Bush plan, there is wide agreement that its purpose is a 
        permanent change in the tax structure and not the creation of 
        jobs and growth in the near-term. The permanent dividend tax 
        cut, in particular, is not credible as a short-term 
        stimulus. As tax reform, the dividend tax cut is misdirected in 
        that it targets individuals rather than corporations, is overly 
        complex, and could be, but is not, part of a revenue-neutral 
        tax reform effort.

          Passing these tax cuts will worsen the long-term budget 
        outlook, adding to the Nation's projected chronic deficits.

    When President Bush came into office in January 2001, the Federal 
Government had a projected 10-year surplus of $5.6 trillion. In fact, 
Chairman Greenspan, you testified before the Senate in favor of the tax 
cut proposed by the President at that time on the grounds that the 
Government was paying off its debt too fast. You argued that a tax cut 
was needed to ``smooth the glide path,'' I believe that was the phrase 
you used, so that the Government debt would not be paid off too quickly 
and put the Government in the position of acquiring private assets.
    That is not the problem we confront today. If the President's 
program were enacted into law, the budget projection for the same 10-
year period would be a $2.1 trillion deficit. That is a $7.7 trillion 
reversal. That does not include the costs of a possible war with Iraq. 
It also does not include tax changes such as the reform of the 
alternative minimum tax and the extension of tax provisions currently 
scheduled to sunset which have traditionally been extended. That 
projection may well be overly optimistic.
    By any measure, we are in the process of transforming the fiscal 
position of the United States from one of fiscal surplus to one of 
large fiscal deficits. Given the scale of the deficits that would be 
created by the President's plan, fundamental questions are raised about 
the impact of deficits on interest rates, investment, growth, and jobs 
in our economy.
    The Administration is downplaying the impact of budget deficits, 
arguing the deficits that will result from their program are not that 
large relative to the economy, and that their size will be reduced by 
the economic activity that will result from the enactment of its 
proposed tax cuts. Some people who now support these tax cuts, and 
discount the significance of the budget deficits they would produce, 
previously supported an amendment to the Constitution requiring a 
balanced budget. Particularly in the face of the uncertain demands on 
public resources imposed by the war on terrorism, homeland defense, 
difficulties with North Korea, and a possible war with Iraq, I believe 
the President's proposals are reckless and irresponsible.
    Giving away our economic strength with the kind of irresponsible 
tax cuts proposed by the President would not only deny us the public 
resources we will need to meet future challenges, but also it would put 
upward pressure on long-term interest rates that would reduce economic 
growth and impose greater hardship on middle and working class 
Americans.
    I look forward to reviewing these issues with Chairman Greenspan 
this morning.
                               ----------
               PREPARED STATEMENT OF SENATOR TIM JOHNSON
    Chairman Shelby and Ranking Member Sarbanes, thank you for 
convening today's hearing to examine the monetary policy of the United 
States. We are privileged to have before us Chairman Alan Greenspan, 
and I welcome him here today to the Senate Banking Committee.
    Today, as we gather to hear about the state of America's economy, 
we face a grim picture. It is sobering to note that, just 2 years ago, 
Chairman Greenspan cautioned this Committee about the dangers of paying 
down the national debt too quickly. Now just a short time later, we 
face a $304 billion deficit this year alone, and a deficit of more than 
$2 trillion over the next 10 years.
    In 2001, I voted to support President Bush's $1.3 trillion tax cut. 
While I wish that package had been less skewed to the richest 
Americans, I agree with Chairman Greenspan, who has often warned that 
the Government should not accumulate 
taxpayer dollars. At the time I voted for tax relief, this country 
faced historically high surpluses of $5.6 trillion for fiscal years 
2002-2011, and I committed myself to returning surplus funds to the 
taxpayers. I did so, however, on the condition that President Bush 
himself reiterated during his State of the Union address: ``We will not 
pass along our problems to other Congresses, other Presidents, other 
generations.''
    It is difficult to believe that our circumstances have changed so 
dramatically since President Bush took office 2 short years ago. And it 
is even more difficult to believe that President Bush appears 
determined to do exactly the opposite of what he pledged not to: Pass 
along our actions to the next generation.
    Frankly, I am appalled at the President's recklessness in proposing 
a massive tax cut targeted for the rich while so many of our Nation's 
basic needs go unmet. I simply cannot understand the impulse to plunge 
our Nation into even more staggering deficits in order to indulge the 
desire for massive tax relief for the rich. All this, Mr. Chairman, 
while denying that we leave the next generation to pay for this folly.
    I believe that any stimulus plan must meet three simple conditions: 
(1) it should give tax relief to working American families who need it 
and who will spend it; (2) it should give tax relief now, while the 
economy is weak; and (3) it should not saddle our children and 
grandchildren with additional debt. President Bush's plan does not meet 
these conditions. Instead, President Bush uses his plan as an excuse 
not to provide real stimulus, like drought relief that is so 
desperately needed in States like South Dakota.
    Chairman Greenspan has long been respected for his wise counsel on 
the damaging impact of deficits. It is now conventional wisdom that 
deficits cause high interest rates, and that, as Mr. Greenspan 
testified back in 2001, ``a declining level of Federal debt is 
desirable because it holds down long-term real interest rates, thereby 
lowering the cost of capital and elevating private investment.'' We 
need only look at the incredible appreciation in the Nation's housing 
market to see the real benefits that low interest rates have had on our 
economy.
    Back in 2001, when we were faced with record surpluses, I think 
that we all recognized the value of Chairman Greenspan's suggestion 
that the President's tax cut include so-called ``triggers'' to revisit 
the revenue side if the projected budget surpluses did not materialize. 
He recognized that political pressure tends to make hard decisions even 
harder.
    Today, it is my hope that Chairman Greenspan can resist the strong 
pressure to allow politics to color his testimony. We have all read 
articles decrying the last election cycle as one of the most vicious in 
history, with ads attacking our colleagues' patriotism, their judgment, 
their motives. For the sake of our Nation and its fiscal health, we 
must not let that ugliness infect our current deliberations. Chairman 
Greenspan, your legacy deserves to reflect the brilliance of your 
career to this point. And so it all comes down to this: Will you be 
remembered for maintaining your opposition to reckless deficit 
spending? Or will you abandon that legacy by succumbing to enormous 
political pressure to justify the President's tax proposal.
    I look forward to your testimony.
                               ----------
                  PREPARED STATEMENT OF ALAN GREENSPAN
       Chairman, Board of Governors of the Federal Reserve System
                           February 11, 2003
    Mr. Chairman and Members of the Committee, I am pleased this 
morning to present the Federal Reserve's Semi-Annual Monetary Policy 
Report to the Congress. I will begin by reviewing the state of the U.S. 
economy and the conduct of monetary policy and then turn to some key 
issues related to the Federal budget.
    When I testified before this committee last July, I noted that, 
while the growth of economic activity over the first half of the year 
had been spurred importantly by a swing from rapid inventory drawdown 
to modest inventory accumulation, that source of impetus would surely 
wind down in subsequent quarters, as it did. We at the Federal Reserve 
recognized that a strengthening of final sales was an essential element 
of putting the expansion on a firm and sustainable track. To support 
such a strengthening, monetary policy was set to continue its 
accommodative stance.
    In the event, final sales continued to grow only modestly, and 
business outlays remained soft. Concerns about corporate governance, 
which intensified for a time, were compounded over the late summer and 
into the fall by growing geopolitical tensions. In particular, worries 
about the situation in Iraq contributed to an appreciable increase in 
oil prices. These uncertainties, coupled with ongoing concerns 
surrounding macroeconomic prospects, heightened investors' perception 
of risk and, perhaps, their aversion to such risk. Equity prices 
weakened further, the expected volatility of equity prices rose to 
unusually high levels, spreads on corporate debt and credit default 
swaps deteriorated, and liquidity in corporate debt markets declined. 
The economic data and the anecdotal information suggested that firms 
were tightly limiting hiring and capital spending and keeping an 
unusually short leash on inventories. With capital markets inhospitable 
and commercial banks firming terms and standards on business loans, 
corporations relied to an unusual extent on a drawdown of their liquid 
assets rather than on borrowing to fund their limited expenditures.
    By early November, conditions in financial markets had firmed 
somewhat on reports of improved corporate profitability. But on 
November 6, with economic performance remaining subpar, the Federal 
Open Market Committee chose to ease the stance of monetary policy, 
reducing the Federal funds rate 50 basis points, to 1\1/4\ percent. We 
viewed that action as insurance against the possibility that the still 
widespread weakness would become entrenched. With inflation 
expectations well contained, this additional monetary stimulus seemed 
to offer worthwhile insurance against the threat of persistent economic 
weakness and unwelcome substantial declines in inflation from already 
low levels.
    In the weeks that followed, financial market conditions continued 
to improve, but only haltingly. The additional monetary stimulus and 
the absence of further revelations of major corporate wrongdoing seemed 
to provide some reassurance to investors. Equity prices rose, 
volatility declined, risk spreads narrowed, and market 
liquidity increased, albeit not to levels that might be associated with 
robust economic conditions. At the same time, mounting concerns about 
geopolitical risks and energy supplies, amplified by the turmoil in 
Venezuela, were mirrored by the worrisome surge in oil prices, 
continued skittishness in financial markets, and substantial 
uncertainty among businesses about the outlook.
    Partly as a result, growth of economic activity slowed markedly 
late in the summer and in the fourth quarter, continuing the choppy 
pattern that prevailed over the past year. According to the advance 
estimate, real GDP expanded at an annual rate of only \3/4\ percent 
last quarter after surging 4 percent in the third quarter. Much of that 
deceleration reflected a falloff in the production of motor vehicles 
from the near-record level that had been reached in the third quarter 
when low financing rates and other incentive programs sparked a jump in 
sales. The slowing in aggregate output also reflected aggressive 
attempts by businesses more generally to ensure that inventories 
remained under control. Thus far, those efforts have proven successful 
in that business inventories, with only a few exceptions, have stayed 
lean--a circumstance that should help support production this year. 
Indeed, after dropping back a bit in the fall, manufacturing activity 
turned up in December, and reports from purchasing managers suggest 
that improvement has continued into this year. Excluding both the 
swings in auto and truck production and the fluctuations in nonmotor-
vehicle inventories, economic activity has been moving up in a 
considerably smoother fashion than has overall real GDP: Final sales 
excluding motor vehicles are estimated to have risen at a 2\1/4\ 
percent annual rate in the fourth quarter after a similar 1\3/4\ 
percent advance in the previous quarter and an average of 2 percent in 
the first half.
    Thus, apart from these quarterly fluctuations, the economy has 
largely extended the broad patterns of performance that were evident at 
the time of my July testimony. Most notably, output has continued to 
expand, but only modestly. As previously, overall growth has 
simultaneously been supported by relatively strong spending by 
households and weighed down by weak expenditures by businesses. 
Importantly, the favorable underlying trends in productivity have 
continued; despite little change last quarter, output per hour in the 
nonfarm business sector rose 3\3/4\ percent over the four quarters of 
2002, an impressive gain for a period of generally lackluster economic 
performance. One consequence of the combination of sluggish output 
growth and rapid productivity gains has been that the labor market has 
remained quite soft. Employment turned down in the final months of last 
year, and the unemployment rate moved up, but the report for January 
was somewhat more encouraging.
    Another consequence of the strong performance of productivity has 
been its support of household incomes despite the softness of labor 
markets. Those gains in 
income, combined with very low interest rates and reduced taxes, have 
permitted relatively robust advances in residential construction and 
household expenditures. Indeed, residential construction activity has 
moved up steadily over the year. And 
despite the large swings in sales, the underlying demand for motor 
vehicles appears to have been well maintained. Other consumer outlays, 
financed partly by the large extraction of built-up equity in homes, 
have continued to trend up. Most equity extraction--reflecting the 
realized capital gains on home sales--usually occurs as a consequence 
of house turnover. But during the past year, an almost equal amount 
reflected the debt-financed cash-outs associated with an unprecedented 
surge in mortgage refinancings. Such refinancing activity is bound to 
contract at some point, as average interest rates on outstanding home 
mortgages converge to interest rates on new mortgages. However, fixed 
mortgage rates remain extraordinarily low, and applications for 
refinancing are not far off their peaks. Simply processing the backlog 
of earlier applications will take some time, and this factor alone 
suggests that refinancing originations and cash-outs will be 
significant at least through the early part of this year.
    To be sure, the mortgage debt of homeowners relative to their 
income is high by historical norms. But as a consequence of low 
interest rates, the servicing requirement for the mortgage debt of 
homeowners relative to the corresponding disposable income of that 
group is well below the high levels of the early 1990's. Moreover, 
owing to continued large gains in residential real estate values, 
equity in homes has continued to rise despite sizable debt-financed 
extractions. Adding in the fixed costs associated with other financial 
obligations, such as rental payments of tenants, consumer installment 
credit, and auto leases, the total servicing costs faced by households 
relative to their incomes are below previous peaks and do not appear to 
be a significant cause for concern at this time.
    While household spending has been reasonably vigorous, we have yet 
to see convincing signs of a rebound in business outlays. After having 
fallen sharply over the preceding 2 years, new orders for capital 
equipment stabilized and, for some categories, turned up in nominal 
terms in 2002. Investment in equipment and software is estimated to 
have risen at a 5 percent rate in real terms in the fourth quarter and 
a subpar 3 percent over the four quarters of the year.
    However, the emergence of a sustained and broad-based pickup in 
capital spending will almost surely require the resumption of 
substantial gains in corporate 
profits. Profit margins apparently did improve a bit last year, aided 
importantly by the strong growth in labor productivity.
    Of course, the path of capital investment will depend not only on 
market conditions and the prospects for profits and cashflow but also 
on the resolution of the uncertainties surrounding the business 
outlook. Indeed, the heightening of geopolitical tensions has only 
added to the marked uncertainties that have piled up over the past 3 
years, creating formidable barriers to new investment and thus to a 
resumption of vigorous expansion of overall economic activity.
    The intensification of geopolitical risks makes discerning the 
economic path ahead especially difficult. If these uncertainties 
diminish considerably in the near term, we should be able to tell far 
better whether we are dealing with a business sector and an economy 
poised to grow more rapidly--our more probable expectation-- or one 
that is still laboring under persisting strains and imbalances that 
have been misidentified as transitory. Certainly, financial conditions 
would not seem to impose a significant hurdle to a turnaround in 
business spending. Yields on risk-free Treasury securities have fallen, 
risk spreads are narrower on corporate bonds, premiums on credit 
default swaps have retraced most of their summer spike, and liquidity 
conditions have improved in capital markets. These factors, if 
maintained, should eventually facilitate more-vigorous corporate 
outlays.
    If instead, contrary to our expectations, we find that, despite the 
removal of the Iraq-related uncertainties, constraints to expansion 
remain, various initiatives for conventional monetary and fiscal 
stimulus will doubtless move higher on the policy agenda. But as part 
of that process, the experience of recent years may be instructive. As 
I have testified before this Committee in the past, the most 
significant lesson to be learned from recent American economic history 
is arguably the importance of structural flexibility and the resilience 
to economic shocks that it imparts.
    I do not claim to be able to judge the relative importance of 
conventional stimulus and increased economic flexibility to our ability 
to weather the shocks of the past few years. But the improved 
flexibility of our economy, no doubt, has played a key role. That 
increased flexibility has been in part the result of the ongoing 
success in liberalizing global trade, a quarter-century of bipartisan 
deregulation that has significantly reduced rigidities in our markets 
for energy, transportation, communication, and financial services, and, 
of course, the dramatic gains in information technology that have 
markedly enhanced the ability of businesses to address festering 
economic imbalances before they inflict significant damage. This 
improved ability has been facilitated further by the increasing 
willingness of our workers to embrace innovation more generally.
    It is reasonable to surmise that, not only have such measures 
contributed significantly to the long-term growth potential of the 
economy this past decade, they also have enhanced its short-term 
resistance to recession. That said, we have too little history to 
measure the extent to which increasing flexibility has boosted the 
economy's potential and helped damp cyclical fluctuations in activity.
    Even so, the benefits appear sufficiently large that we should be 
placing special emphasis on searching for policies that will engender 
still greater economic flexibility and dismantling policies that 
contribute to unnecessary rigidity. The more flexible an economy, the 
greater its ability to self-correct in response to inevitable, often 
unanticipated, disturbances, thus reducing the size and consequences of 
cyclical imbalances. Enhanced flexibility has the advantage of 
adjustments being automatic and not having to rest on the initiatives 
of policymakers, which often come too late or are based on highly 
uncertain forecasts.
    Policies intended to improve the flexibility of the economy seem to 
fall outside the sphere of traditional monetary and fiscal policy. But 
decisions on the structure of the tax system and spending programs 
surely influence flexibility and thus can have major consequences for 
both the cyclical performance and long-run growth potential of our 
economy. Accordingly, in view of the major budget issues now 
confronting the Congress and their potential implications for the 
economy, I thought it appropriate to devote some of my remarks today to 
fiscal policy. In that regard, I will not be emphasizing specific 
spending or revenue programs. Rather, my focus will be on the goals and 
process determining the budget and on the importance, despite our 
increasing national security requirements, of regaining discipline in 
that process. These views are my own and are not necessarily shared by 
my colleagues at the Federal Reserve.
                                 * * *
    One notable feature of the budget landscape over the past half 
century has been the limited movement in the ratio of unified budget 
outlays-to-nominal GDP. Over the past 5 years, that ratio has averaged 
a bit less than 19 percent, about where it was in the 1960's before it 
moved up during the 1970's and 1980's. But that pattern of relative 
stability over the longer term has masked a pronounced rise in the 
share of spending committed to retirement, medical, and other 
entitlement programs. Conversely, the share of spending that is subject 
to the annual appropriations process, and thus that comes under regular 
review by the Congress, has been shrinking. Such so-called 
discretionary spending has fallen from two-thirds of total outlays in 
the 1960's to one-third last year, with defense outlays accounting for 
almost all of the decline.
    The increase in the share of expenditures that is more or less on 
automatic pilot has complicated the task of making fiscal policy by 
effectively necessitating an extension of the budget horizon. The 
Presidents' budgets through the 1960's and into the 1970's mainly 
provided information for the upcoming fiscal year. The legislation in 
1974 that established a new budget process and that created the 
Congressional Budget Office required that organization to provide 5-
year budget projections. And by the mid-1990's, CBO's projection 
horizon had been pushed out to 10 years. These longer time periods and 
the associated budget projections, even granted their imprecision, are 
useful steps toward allowing the Congress to balance budget priorities 
sensibly in the context of a cash-based accounting system.\1\ But more 
can be done to clarify those priorities and thereby enhance the 
discipline on the fiscal process.
---------------------------------------------------------------------------
    \1\ Unfortunately, they are incomplete steps because even a 10-year 
horizon ends just as the baby-boom generation is beginning to retire 
and the huge pressures on Social Security and especially Medicare are 
about to show through.
---------------------------------------------------------------------------
    A general difficulty concerns the very nature of the unified 
budget. As a cash accounting system, it was adopted in 1968 to provide 
a comprehensive measure of the funds that move in and out of Federal 
coffers. With a few modifications, it correctly measures the direct 
effect of Federal transactions on national saving. But a cash 
accounting system is not designed to track new commitments and their 
translation into future spending and borrowing. For budgets that are 
largely discretionary, changes in forward commitments do not enter 
significantly into budget deliberations, and hence the surplus or 
deficit in the unified budget is a reasonably accurate indicator of the 
stance of fiscal policy and its effect on saving. But as longer-term 
commitments have come to dominate tax and spending decisions, such cash 
accounting has been rendered progressively less meaningful as the 
principal indicator of the state of our fiscal affairs.
    An accrual-based accounting system geared to the longer horizon 
could be constructed with a reasonable amount of additional effort. In 
fact, many of the inputs on the outlay side are already available. 
However, estimates of revenue accruals are not well developed. These 
include deferred taxes on retirement accounts that are taxable on 
withdrawal, accrued taxes on unrealized capital gains, and corporate 
tax accruals. An accrual system would allow us to keep better track of 
the Government's overall accrued obligations and deferred assets. 
Future benefit obligations and taxes would be recognized as they are 
incurred rather than when they are paid out by the Government.\2\
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    \2\ In particular, a full set of accrual accounts would give the 
Congress, for the first time in usable form, an aggregate tabulation of 
Federal commitments under current law, with various schedules of the 
translation of those commitments into receipts and cash payouts.
---------------------------------------------------------------------------
    Currently, accrued outlays very likely are much greater than those 
calculated under the cash-based approach. Under full accrual 
accounting, the Social Security program would be showing a substantial 
deficit this year, rather than the surplus measured under our current 
cash accounting regimen.\3\ Indeed, under most reasonable sets of 
actuarial assumptions, for Social Security benefits alone past accruals 
cumulate to a liability that amounts to many trillions of dollars. For 
the Government as a whole, such liabilities are still growing.
---------------------------------------------------------------------------
    \3\ However, accrued outlays should exhibit far less deterioration 
than the unified budget outlays when the baby boomers retire because 
the appreciable rise in benefits that is projected to cause spending to 
balloon after 2010 will have been accrued in earlier years.
---------------------------------------------------------------------------
    Estimating the liabilities implicit in Social Security is 
relatively straightforward because that program has many of the 
characteristics of a private defined-benefit retirement program. 
Projections of Medicare outlays, however, are far more uncertain even 
though the rise in the beneficiary populations is expected to be 
similar. The likelihood of continued dramatic innovations in medical 
technology and procedures combined with largely inelastic demand and a 
subsidized third-party payment system engenders virtually open-ended 
potential Federal outlays unless constrained by law.\4\ Liabilities for 
Medicare are probably about the same order of magnitude as those for 
Social Security, and as is the case for Social Security, the date is 
rapidly approaching when those liabilities will be converted into cash 
outlays.
---------------------------------------------------------------------------
    \4\ Constraining these outlays by any mechanism other than prices 
will involve some form of rationing--an approach that in the past has 
not been popular in the United States.
---------------------------------------------------------------------------
    Accrual-based accounts would lay out more clearly the true costs 
and benefits of changes to various taxes and outlay programs and 
facilitate the development of a broad budget strategy. In doing so, 
these accounts should help shift the national dialogue and consensus 
toward a more realistic view of the limits of our national resources as 
we approach the next decade and focus attention on the necessity to 
make difficult choices from among programs that, on a stand-alone 
basis, appear very attractive.
    Because the baby boomers have not yet started to retire in force 
and accordingly the ratio of retirees to workers is still relatively 
low, we are in the midst of a demographic lull. But short of an 
outsized acceleration of productivity to well beyond the average pace 
of the past 7 years or a major expansion of immigration, the aging of 
the population now in train will end this state of relative budget 
tranquility in about a decade's time. It would be wise to address this 
significant pending adjustment sooner rather than later. As the 
President's just-released budget put it, ``The longer the delay in 
enacting reforms, the greater the danger, and the more drastic the 
remedies will have to be.'' \5\
---------------------------------------------------------------------------
    \5\ Office of Management and Budget, Budget of the United States 
Government, fiscal year 2004, Washington, DC: U.S. Government Printing 
Office, p.32.
---------------------------------------------------------------------------
    Accrual-based revenue and outlay projections, tied to a credible 
set of economic assumptions, tax rates, and programmatic spend-out 
rates, can provide important evidence on the long-term sustainability 
of the overall budget and economic regimes under alternative 
scenarios.\6\ Of course, those projections, useful as they might prove 
to be, would still be subject to enormous uncertainty. The ability of 
economists to assess the effects of tax and spending programs is 
hindered by an incomplete understanding of the forces influencing the 
economy.
---------------------------------------------------------------------------
    \6\ In general, fiscal systems are presumed stable if the ratio of 
debt in the hands of the public-to-nominal GDP (a proxy for the revenue 
base) is itself stable. A rapidly rising ratio of debt-to-GDP, for 
example, implies an ever-increasing and possibly accelerating ratio of 
interest payments to the revenue base. Conversely, once debt has fallen 
to zero, budget surpluses generally require the accumulation of private 
assets, an undesirable policy in the judgment of many.
---------------------------------------------------------------------------
    It is not surprising, therefore, that much controversy over basic 
questions surrounds the current debate over budget policy. Do budget 
deficits and debt significantly affect interest rates and, hence, 
economic activity? With political constraints on the size of acceptable 
deficits, do tax cuts ultimately restrain spending increases, and do 
spending increases limit tax cuts? To what extent do tax increases 
inhibit investment and economic growth or, by raising national saving, 
have the opposite effect? And to what extent does Government spending 
raise the growth of GDP, or is its effect offset by a crowding out of 
private spending?
    Substantial efforts are being made to develop analytical tools 
that, one hopes, will enable us to answer such questions with greater 
precision than we can now. Much progress has been made in ascertaining 
the effects of certain policies, but many of the more critical 
questions remain in dispute.
    However, there should be little disagreement about the need to 
reestablish budget discipline. The events of September 11 have placed 
demands on our budgetary resources that were unanticipated a few years 
ago. In addition, with defense outlays having fallen in recent years to 
their smallest share of GDP since before World War II, the restraint on 
overall spending from the downtrend in military outlays has surely run 
its course--and likely would have done so even without the tragedy of 
September 11.
    The CBO and the Office of Management and Budget recently released 
updated budget projections that are sobering. These projections, in 
conjunction with the looming demographic pressures, underscore the 
urgency of extending the budget 
enforcement rules. To be sure, in the end, it is policy, not process, 
that counts. But the statutory limits on discretionary spending and the 
so-called PAYGO rules, which were promulgated in the Budget Enforcement 
Act of 1990 and were backed by a sixty-vote point of order in the 
Senate, served as useful tools for controlling deficits through much of 
the 1990's. These rules expired in the House last September and have 
been partly extended in the Senate only through mid-April.
    The Budget Enforcement Act was intended to address the problem of 
huge unified deficits and was enacted in the context of a major effort 
to bring the budget under control. In 1990, the possibility that 
surpluses might emerge within the decade seemed remote indeed. When 
they unexpectedly arrived, the problem that the 
budget control measures were designed to address seemed to have been 
solved. Fiscal discipline became a less pressing priority and was 
increasingly abandoned.
    To make the budget process more effective, some have suggested 
amending the budget rules to increase their robustness against the 
designation of certain spending items as ``emergency'' and hence not 
subject to the caps. Others have proposed mechanisms, such as statutory 
triggers and sunsets on legislation, that would allow the Congress to 
make mid-course corrections more easily if budget projections go off-
track--as they invariably will. These ideas are helpful and they could 
strengthen the basic structure established a decade ago. But, more 
important, a budget framework along the lines of the one that provided 
significant and effective discipline in the past needs, in my judgment, 
to be reinstated without delay.
    I am concerned that, should the enforcement mechanisms governing 
the budget process not be restored, the resulting lack of clear 
direction and constructive goals would allow the inbuilt political bias 
in favor of growing budget deficits to again 
become entrenched. We are all too aware that Government spending 
programs and tax preferences can be easy to initiate or to expand but 
extraordinarily difficult to trim or to shut down once constituencies 
develop that have a stake in maintaining the status quo.
    In Congress's review of the mechanisms governing the budget 
process, you may want to reconsider whether the statutory limit on the 
public debt is a useful device. As a matter of arithmetic, the debt 
ceiling is either redundant or inconsistent with the paths of revenues 
and outlays you specify when you legislate a budget.
    In addition, a technical correction in the procedure used to tie 
indexed benefits and individual income tax brackets to changes in ``the 
cost of living'' as required by law is long overdue. As you may be 
aware, the Bureau of Labor Statistics has recently introduced a new 
price index--the so-called chained CPI. The new index is based on the 
same underlying data as is the official CPI, but it combines the 
individual prices in a way that better measures changes in the cost of 
living. In particular, the chained CPI captures more fully than does 
the official CPI the way that consumers alter the mix of their 
expenditures in response to changes in relative prices. Because it 
appears to offer a more accurate measure of the true cost of 
living--the statutory intent--the chained CPI would be a more suitable 
series for the indexation of Federal programs. Had such indexing been 
in place during the past decade, the fiscal 2002 deficit would have 
been $40 billion smaller, all else being equal.
    At the present time, there seems to be a large and growing 
constituency for holding down the deficit, but I sense less appetite to 
do what is required to achieve that outcome. Reestablishing budget 
balance will require discipline on both revenue and spending actions, 
but restraint on spending may prove the more difficult. Tax cuts are 
limited by the need for the Federal Government to fund a basic level of 
services--for example, national defense. No such binding limits 
constrain spending. If spending growth were to outpace nominal GDP, 
maintaining budget balance would necessitate progressively higher tax 
rates that would eventually inhibit the growth in the revenue base on 
which those rates are imposed. Deficits, possibly ever widening, would 
be the inevitable outcome.
    Faster economic growth, doubtless, would make deficits far easier 
to contain. But faster economic growth alone is not likely to be the 
full solution to currently projected long-term deficits. To be sure, 
underlying productivity has accelerated considerably in recent years. 
Nevertheless, to assume that productivity can continue to 
accelerate to rates well above the current underlying pace would be a 
stretch, even for our very dynamic economy.\7\ So, short of a major 
increase in immigration, economic growth cannot be safely counted upon 
to eliminate deficits and the difficult choices that will be required 
to restore fiscal discipline.
---------------------------------------------------------------------------
    \7\ In fact, we will need some further acceleration of productivity 
just to offset the inevitable decline in net labor force, and 
associated overall economic, growth as the baby boomers retire.
---------------------------------------------------------------------------
    By the same token, in setting budget priorities and policies, 
attention must be paid to the attendant consequences for the real 
economy. Achieving budget balance, for example, through actions that 
hinder economic growth is scarcely a measure of success. We need to 
develop policies that increase the real resources that will be 
available to meet our longer-run needs. The greater the resources 
available--that is, the greater the output of goods and services 
produced by our economy--the easier will be providing real benefits to 
retirees in coming decades without unduly restraining the consumption 
of workers.
                                 * * *
    These are challenging times for all policymakers. Considerable 
uncertainties surround the economic outlook, especially in the period 
immediately ahead. But the economy has shown remarkable resilience in 
the face of a succession of substantial blows. Critical to our Nation's 
performance over the past few years has been the flexibility exhibited 
by our market-driven economy and its ability to generate substantial 
increases in productivity. Going forward, these same characteristics, 
in concert with sound economic policies, should help to foster a return 
to vigorous growth of the U.S. economy to the benefit of all our 
citizens.

        RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY 
                      FROM ALAN GREENSPAN

Q.1. I would like to start off with a very broad question 
involving our tax structure. I am a strong proponent of a 
simplified tax structure which would eliminate the 
inefficiencies of our current system and end the waste of the 
vast resources currently dedicated to taking advantage of all 
of the complexities.
    What three words would you use to describe our current 
system? What would be the benefits of moving to a more 
straightforward structure? What aspects of our current tax 
structure would be in the ``most in need of reform'' winners?

A.1. I believe that our current tax system is overly complex, 
burdensome, and inefficient. It creates larger disincentives 
for work, saving, and investment than need be to raise the 
revenue required to finance Government operations. Moreover, 
the complexity leads to a substantial commitment of resources 
on the part of the private sector for the sole purpose of 
complying with the tax code. The Nation would be well served by 
moving to a more straightforward structure that would engender 
greater economic flexibility and efficiency and lower the 
compliance burden. A successful round of tax reform, 
particularly with regard to the taxation of capital income, 
could significantly improve the working of our economy. As I 
stated in my recent appearance before the Committee, I believe 
any such tax reform should be implemented in a budget-neutral 
manner.

Q.2.a. The President's budget proposes an end to the double 
taxation of corporate dividends by granting tax relief to 
individual shareholders. I support this proposal and the 
President's proposal to increase expensing for small 
businesses. What would you anticipate would be the effect of 
these proposals on investment and job growth?

A.2.a. A full analysis of the macroeconomic impact of the 
proposals is exceptionally complicated because the relevant 
conceptual issues touch on unsettled questions at the heart of 
public finance and corporate finance. That said, as I pointed 
out during my testimony, I support elimination of the double 
taxation of dividends because it is good long-term policy that 
reduces distortions and adds to the flexibility of the economy 
in responding to shocks that otherwise might result in 
recession. While I do not support elimination of double 
taxation because of short-term stimulus, it likely would 
provide some near-term boost to the economy. This is primarily 
because the plan would likely boost the level of stock prices 
that, in turn, would generate a positive wealth effect; there 
also could be some small income effects owing to short-run 
multiplier effects on aggregate demand.

Q.2.b. Won't this proposal give corporations better incentives 
as they decide whether to issue debt or equity to run their 
operations?

A.2.b. If enacted as proposed, the President's plan would 
eliminate the double tax on corporate dividends and those 
capital gains derived from undistributed after-tax profits 
(``deemed'' dividends). This would eliminate shareholder taxes 
on corporate equity income and thus mitigate the current tax-
induced distortion that favors debt financing relative to 
equity financing. Lower taxes on corporate dividends and 
capital gains would boost the incentive to issue equity, both 
to finance new investment and to pay down existing debt, 
resulting in a decline in corporate debt-equity ratios. As a 
positive byproduct, the diminution of the reliance on debt 
would tend to reduce the fragility of the financial system in 
the face of adverse shocks.

Q.2.c. Some have argued that it would be preferable to allow 
corporations to expense dividends akin to the treatment of 
interest. Does it matter how we do it? And if it does, what 
incentives/disincentives and costs/benefits are created based 
on the two approaches?

A.2.c. I would prefer that the elimination of the double 
taxation of dividends be done at the corporate level, although 
in the long run, it probably would not matter greatly which 
approach is taken. I would note a couple of differences, 
however, between the two approaches you outline. First, if the 
plan were implemented on the corporate side, the revenue loss 
likely would be larger, because about half of dividends are 
received by tax-exempt equity holders at the personal level. 
Second, the increase in share prices may be larger: When 
implemented on the corporate side, the stream of dividend 
payments plausibly would rise essentially immediately and, 
thus, make stocks more attractive even to tax-exempt holders.

Q.3.a. The President's budget projects deficits through 2008. 
Some have expressed concern about the magnitude of these 
deficits. However, on a percentage basis, the deficits are a 
smaller percentage of GDP than those we experienced in the 
1980's. (For example, the projected $308 billion deficit for 
2003 represents 2.8 percent of GDP while the 1992 deficit was 
4.7 percent of GDP.) Given current economic conditions and 
uncertainty concerning world affairs, how important is it to 
maintain fiscal discipline and where is it most important to 
seek this discipline?

A.3.a. Current economic and fiscal circumstances make the 
maintenance of fiscal discipline highly important. The recently 
updated budget projections from CBO and the Office of 
Management and Budget show that projections of the budget 
balance have deteriorated sharply over the past 2 years 
reflecting, in part, the demands that our response to the 
events of September 11 has placed on our budgetary resources, 
as well as the effects on tax revenues of the cyclical downturn 
and stock market decline. This return to budget deficits has 
occurred at a time when lower deficits and declining Federal 
debt levels would help the country prepare for the fiscal 
pressures that will accompany the rapidly approaching 
retirement of the baby-boom generation.
    My preferred approach to attaining fiscal discipline would 
be to reinstate budget rules--perhaps a version of the recently 
expired PAYGO rules and discretionary spending caps. Such an 
approach would leave the Congress and the Administration free 
to act on high-priority initiatives and respond to 
unanticipated demands as long as their effect on the deficit 
were offset elsewhere in the budget. In addition, I have 
frequently stated that improvement in the budget balance 
realized through spending restraint would generally be 
preferable to improvements based on tax increases.

Q.3.b. At what point do you believe we should be concerned 
about Government deficits ``crowding out'' private borrowing?

A.3.b. The tendency for increases in the deficit to crowd out 
private borrowing does not begin at a particular point. In 
general, increases in the deficit result in higher long-term 
interest rates which, in turn, discourage private borrowing. 
However, if we let deficits become too large there is the 
additional concern that the fiscal system will become 
unsustainable; that is, higher-debt service outlays engendered 
by growing debt may result in a cycle of ever-higher debt-
service outlays and deficits relative to GDP. Such instability 
would not occur as long as deficits do not result in a rising 
debt-to-GDP ratio. The path of the debt-to-GDP ratio currently 
being projected by CBO and the Office of Management and Budget 
for the next several years is about flat; that is, the deficits 
do not yet pose a significant instability concern. But as we go 
beyond the turn of the decade, a very significant acceleration 
in payments to beneficiaries of both Social Security and 
Medicare will hit the budget and, in the absence of other 
budget adjustments, produce deficit-to-GDP ratios that would 
not be consistent with long-run fiscal sustainability.

Q.4. The threat of war against Iraq leaves consumers and 
businesses feeling very uncertain about the economic outlook. I 
want to ask you about an article from last week's Wall Street 
Journal. According to this article, since WWII, wartime 
spending has become a smaller part of the economy and produces 
fewer economic gains. In short, the article makes the case that 
the United States cannot expect an economic boost from war-
related spending since the economy has grown so large relative 
to the spending. Given that is the case, should we be arguing 
that the threat of war represents a significant factor in the 
cooldown or lag in the economy? What other factors might be at 
work that are not receiving attention?

A.4. It is certainly the case that defense spending represents 
a smaller share of our GDP than it did in the 1950's and 
1960's; that is also true for the share of defense output in 
manufacturing production. However, I would still expect the 
incremental increases in defense spending over previously 
budgeted levels to boost the level of real activity, at least 
in the short to intermediate term. Part of that effect is 
likely to occur right away. However, the boost to production 
from the replacement of spent munitions and equipment would 
likely extend over several years. That was the pattern we saw 
after the 1991 Gulf War.
    In more recent months, geopolitical concerns have been 
among a number of factors inhibiting business hiring and 
capital spending. There is considerable anecdotal evidence that 
business remain in a wait-and-see mode when it comes to dealing 
with geopolitical risks. These same concerns likely have 
weighed on consumer confidence in recent months. As I noted in 
my testimony, if these uncertainties diminish considerably in 
the near term, we should be able to determine whether we are 
dealing with an economy poised to grow more rapidly or one that 
is still laboring to rectify lingering imbalances.

Q.5. Economists have long lamented the low savings rate of 
Americans. The President's budget includes sweeping proposals 
aimed at raising the amount of money Americans save. I believe 
that increasing savings is critical yet I am concerned that we 
may not be able to go as far as the President suggests. If the 
Congress chose to address this issue, how would you recommend 
that we provide greater incentives for individual saving?

A.5. I agree that raising our Nation's saving rate should be an 
important long-term priority. Saving frees up resources from 
current use and thereby makes those resources available for 
investment in new plants and equipment. Indeed, about half of 
the growth in labor productivity in the United States over long 
periods can be attributed to capital investment. The more 
saving our economy generates, the greater our productivity and 
prosperity.
    Raising personal saving--the saving done by households--can 
be an important element of raising national saving--the saving 
done by the country as a whole. However, it is only one 
element. National saving is the sum of personal saving, saving 
by businesses (that is, retained earnings), and the saving of 
governments (that is, budget surpluses less budget deficits). 
Of the various savings concepts, it is national saving that is 
most important for determining our future national standard of 
living. Thus, it is critical that any effort to raise personal 
saving be judged in terms of its efficacy in raising national 
saving.

Q.6. The Fed's most recent Senior Loan Officer Survey of Bank 
Lending Practices (January 2003) reported that banks continued 
to tighten lending standards and terms for commercial and 
industrial (C&I) loans over the past 3 months in fractions 
similar to those reported in the October survey. In particular, 
the percentage of domestic banks that reported worsening 
industry-specific problems were a reason for tightening rose 
substantially from 39 percent in October to 66 percent in 
January. What is the nature of industry-specific problems? Do 
you see any particular types of businesses having difficulty 
getting credit? On the other hand, few banks reported that they 
had tightened any terms on credit card loans or other consumer 
loans. Should we have any concerns about too much credit in 
this area?

A.6. The survey did not ask respondents to comment on 
particular industries that were experiencing problems. The few 
banks that volunteered such information most commonly cited the 
energy industry, with the telecommunications and airlines 
industries also being mentioned.
     The growth of consumer credit slowed sharply last year, to 
3.3 percent, down from 6.9 percent in 2001. Part of this 
slowdown owes to a substantial volume of debt consolidation 
facilitated by a wave of ``cash out'' refinancing of mortgage 
debt in an environment of unusually low mortgage rates. Indeed, 
the growth of mortgage debt was sufficiently strong to raise 
the growth of overall household debt, the sum of consumer 
credit and residential mortgages, in 2002. Even so, as I 
mentioned in my testimony, adding in the fixed costs associated 
with other financial obligations, such as rental payments of 
tenants, consumer installment credit, and auto leases, the 
total servicing costs faced by households relative to their 
incomes are below previous peaks and do not appear to be a 
significant cause for concern at this time. Recent declines in 
delinquency rates on total household debt suggest that this 
sector remains healthy overall.

Q.7. Last week, we saw American Insurance Group (AIG) increase 
its reserves by $3.5 billion--a result of unexpected costs from 
corporate claims over injury lawsuits, corporate mismanagement, 
improper financial transactions, and medical malpractice. AIG 
has a significant amount of capital and isn't in financial 
danger. Can we expect to see similar increases in reserves for 
other companies and what does this mean for the insurance 
industry's condition as a whole? How much of what we are seeing 
is due to price competition among insurers versus potential 
flaws in our tort liability system?

A.7. As you know, the Federal Reserve does not have direct 
supervisory or regulatory responsibility for the insurance 
industry. In its role as umbrella supervisor of financial 
holding companies, and for internal purposes, the Federal 
Reserve tracks broader insurance industry developments, 
particularly in view of the industry's role in providing credit 
to the economy. The Federal Reserve monitors 
insurance industry developments using publicly available 
information. Our response is limited to comments on the 
property and casualty sector of the insurance industry in view 
of your reference to adverse reserve developments in that 
sector.
    Based on the publicly available sources, it appears that 
further adverse reserve developments for a number of property 
and casualty insurance companies may occur. It is our 
understanding that a large proportion of the recent additional 
claims reserving for the industry as a whole is associated with 
business booked in the late 1990's when pricing was 
particularly competitive and that additional reserving may be 
anticipated. The increased reserving 
appears to be largely related to losses in commercial coverage, 

including coverage for product liability, workers' 
compensation, general liability, financial guarantees, and 
directors and officers insurance. We also understand that 
additional reserving by a number of companies is associated 
with commercial coverages under general liability dating back 
to the 1970's and before, particularly for asbestos-related 
claims. (AIG reports that its exposure to asbestos claims is 
minimal and attributed none of its increased reserves noted 
above to asbestos exposure.)
    In addition to continued underwriting losses, other factors 
may continue to affect the condition of the property and 
casualty insurance industry, including declining interest 
earned on investment portfolios and write-downs for bond 
impairments. For many years prior to 2000, property and 
casualty insurance companies relied on their investment 
portfolio results to offset underwriting losses. Declines in 
corporate credit quality and equity prices in recent years have 
reversed that trend, which has put significant pressure on 
insurance companies to price their products to cover expected 
losses and recover prior losses. The industry now appears to be 
benefiting from significantly stronger demand for insurance 
products and increased insurance premium rates across virtually 
all business lines, and may benefit in the future from the 
heightened focus on underwriting standards.
    On balance, the industry continues to face significant 
challenges. Despite the adverse effect of recent developments 
on earnings and capital, capital levels appear strong by 
historical standards.
    The Federal Reserve does not have the data to determine the 
extent to which the reserve developments may have been 
attributable to adverse judgments by juries. Press reports 
suggest that the adverse reserve developments may be 
attributed, in large part, to unsustainable, aggressive pricing 
during the late 1990's, but we do not have the data to indicate 
the extent to which the reserving is attributable to 
competitive pricing.

Q.8. Although the banking industry continues to earn record 
profits, credit-quality problems continue to be a concern in 
commercial and industrial (C&I) loan portfolios at large banks. 
The industry's noncurrent rate on C&I loans increased from 2.87 
to 3.01 percent during the quarter, the first time since the 
first quarter of 1993 that it has been above 3 percent. Will we 
see banks continue to add to loan loss reserves when the fourth 
quarter data is released? Will credit quality problems continue 
into 2003 or can we expect to see an improvement?

A.8. Bank data for the fourth quarter of 2002 show that both 
net charge-offs and nonperforming assets declined moderately 
from the previous quarter, providing some indication that 
credit quality overall has begun to improve. Broadly speaking, 
the key contributing factors to the credit quality problems 
experienced in the past 2 years--a period of recession and weak 
economic growth, structural problems experienced by certain 
specific industrial sectors (e.g. telecommunications) and the 
revelation of improper 
corporate governance practices at certain firms--appear to have 

receded in significance. These preliminary indications of 
improvement should be interpreted with caution. Many bankers 
have expressed considerable uncertainty about the prospects for 
significant improvement in credit quality before the middle of 
2003.
    Consistent with this general outlook, banks bolstered their 
reserves in the fourth quarter by about $1.5 billion, so that 
reserve coverage of nonaccrual loans improved to 1.63 times, an 
increase in the multiple of 0.06 from September 2002. For the 
full year, a net increase in reserves of $3.2 billion was not 
sufficient to offset more rapid growth in nonaccrual loans, so 
that reserve coverage of these loans declined by 0.11 times 
from year-end 2001.
    The noncurrent ratio for C&I loans cited in the question 
provides one useful indicator of the severity of credit 
problems at banks. In the current period, this indicator has 
been strongly influenced by lower C&I loans outstanding that 
were attributable to cyclically weak business loan demand, as 
well as by increases in noncurrent loans. A broader measure of 
credit quality, the noncurrent rate for all loans, reached only 
1.45 percent of loans at year-end 2002, well below the 
comparable figure of 3.06 percent in 1992. This result is 
consistent with the broader view that the current credit cycle 
has been much more manageable for banks than that of a decade 
ago. The most significant area of difference is in commercial 
real estate lending. In 1992, the noncurrent rate for all real 
estate loans was 3.88 percent while the same rate for 
construction loans reached a remarkable 14.01 percent; these 
ratios were far lower in 2002, at 0.89 percent and 0.98 
percent, respectively. A number of factors contributed to the 
unusually large magnitude of the 1992 figures, including the 
poor lending practices and the significant weakness of 
commercial real estate as an economic sector at that time.

Q.9. When you appeared before the Committee last July, I asked 
a question about productivity. I would like to revisit that 
issue again today. Last year, productivity in both the business 
and nonfarm business sectors rose 4.7 percent--the fastest pace 
since 1950 and more than four times the 1.1 percent gain posted 
in 2001. What are your views regarding this significant gain? 
What could be done to attempt to duplicate gains of this 
magnitude or greater? Do you think that this significant 
increase provides any indication as to the future direction of 
the economy?

A.9. The impressive performance of productivity recently 
appears to support the view that the step-up in the pace of 
structural productivity growth that occurred in the latter part 
of the 1990's has not, as yet, faltered. Indeed, the high 
growth of productivity during the past year merely extends 
recent experience. Since the mid-1990's, output per hour has 
been growing at an annual rate of 2\1/2\ percent, on average, 
compared with a rate of roughly 1\1/2\ percent during the 
preceding two decades.
    Arguably, the pickup in productivity growth since 1995 
reflects largely the ongoing incorporation of innovations in 
computing and communications technologies into the capital 
stock and business practices. In addition to the rapid pace of 
technical progress, deregulation and other policies to promote 
the flexibility of the economy have almost surely contributed 
to the spread and adoption of innovations that have, in turn, 
boosted the growth of productivity. Furthermore, the more 
flexible is an economy, the greater is its ability at any given 
point in time to be producing close to its productive 
potential.
    Looking forward, the transition to the higher permanent 
level of productivity associated with previous innovations is 
likely not yet completed. The chances of prolonging the period 
of rapid innovation, doubtless, will be enhanced by maintaining 
and extending conditions that contribute to flexibility and by 
dismantling policies that contribute to unnecessary rigidity.
    However, history does raise some warning flags concerning 
the length of time that productivity growth remains elevated. 
Gains in productivity remained quite rapid for years after the 
innovations that followed the surge in inventions a century 
ago. But in other episodes, the period of elevated growth of 
productivity was shorter. Regrettably, examples are too few to 
generalize. Hence, policymakers have no substitute for 
continued close surveillance of the evolution of productivity 
during this current period of significant innovation.

Q.10. I would like to quote from remarks given by Chairman Alan 
Greenspan at Lancaster House, in London, September 25, 2002:

    The development of our paradigms of containing risk has 
emphasized, and will, of necessity, continue to emphasize 
dispersion of risk to those willing, and presumably able, to 
bear it. If risk is properly dispersed, shocks to the overall 
economic system will be better absorbed and less likely to 
create cascading failures that could threaten financial 
stability.
    The broad success of that paradigm seemed to be most 
evident in the United States over the past 2\1/2\ years. 
Despite the draining impact of a loss of $8 trillion of stock 
market wealth, a sharp contraction in capital investment and, 
of course, the tragic events of September 11, 2001, our economy 
held firm. Importantly, despite significant losses, no major 
U.S. financial institution was driven to default. Similar 
observations pertain to much of the rest of the world but to a 
somewhat lesser 
extent than to the United States.

    In light of these circumstances and observations, plus a 
significant tax-cutting proposal by our President of an overall 
estimated $674 billion dollars, and the likelihood of impending 
war against Iraq, what are your thoughts about the U.S. 
economy's resilience for the upcoming year?

A.10. The ability of our economy to weather the many shocks 
inflicted on it since the spring of 2000 attests to our market 
system's remarkable resilience. As I have noted previously, 
that characteristic is far more evident today than two or three 
decades ago. There may be numerous causes of this increased 
resilience. Among them, ongoing efforts to liberalize global 
trade have added flexibility to many aspects of our economy 
over time. Furthermore, a quarter-century of bipartisan 
deregulation has significantly reduced inflexibilities in our 
markets for energy, transportation, communication, and 
financial services. And, of course, the dramatic gains in 
information technology have markedly improved the ability of 
businesses to address festering economic imbalances before they 
inflict significant damage. This improved ability has been 
further facilitated by the increasing willingness of our 
workers to embrace innovation more generally. Looking forward, 
the enhanced flexibility should continue to allow the economy 
to withstand the potentially destabilizing effects of 
additional negative shocks.

Q.11. I share the Chairman's view regarding the need to keep in 
place mechanisms that control spending in the budget process. I 
am particularly intrigued by the ideas relating to limits on 
the ability to have emergency or supplemental spending. It 
seems that these types of measures are a significant loophole 
in the system. Would you recommend that there be some type of 
automatic offset for these types of bills? Would you suggest 
that a super-majority (60 votes or more) be required to waive 
such a rule?

A.11. I recommend that Congress reinstate discretionary 
spending caps and PAYGO rules because those procedures have 
provided clear direction and constructive goals capable of 
offsetting in-built political biases in favor of budget 
deficits. To remain effective over time, a budgetary control 
mechanism must be stringent enough to exert real budgetary 
restraint and yet be sufficiently flexible to remain relevant 
in the face of ``shocks'' such as wars, recession, or 
unforeseen surpluses. Given the recent breakdown of budget 
controls in the face of emerging surpluses, I agree that 
closing spending loopholes in a way that better balances 
flexibility and overall restraint would be desirable. That 
said, how to best accomplish such adjustments must be left with 
Congress, which has the expertise needed to evaluate how 
possibly subtle changes in the budget process might affect 
budget decisions.

Q.12. Your testimony makes clear that our current cash-based 
budget may present a misleading picture of actual Federal 
Government commitments. I agree with you a better system is 
needed so that we can get a handle on Federal spending. How 
would we transition to such a system and over what time period? 
Should we also be looking at a capital budget system for 
certain types of programs which reflect infrastructure 
building?

A.12. As I stated in my testimony, an accrual-based accounting 
system could be constructed with a reasonable amount of effort. 
Moreover, at least a set of rough estimates of an accrual-based 
budget probably could be developed relatively quickly. Although 
there appear to be no major conceptual hurdles blocking 
preparation of more refined estimates, it would not be hard to 
imagine--given the vast scope and complexity of the 
Government's operations--that significant operational questions 
might arise. All of those questions should be resolvable within 
a relatively short time-frame. Based on present information, I 
would recommend that accrual-based budgetary information be 
developed as a supplement to--not substitute for--the current, 
largely cash-based, unified budget. If that same view is 
adopted by the Congress, the transition to production of 
accrual-based estimates presumably could proceed on a 
reasonably expedited basis.
    The capital-budgeting concept has some merit for the 
Government because it can provide useful information about the 
way the Government's activities are affecting overall saving 
and investment. However, such information is already provided 
in the Analytical Perspectives volume of the budget. Moreover, 
implementing a separate capital expenditures category within 
the budget that, presumably, would be subject to different 
rules than the operating budget would likely be problematic. In 
particular, I am concerned that the classification of spending 
as between current expenditures versus capital expenditures 
could be susceptible to manipulation.
    I would also note that there is a fundamental difference 
between the application of capital budgeting in the private and 
Government sectors. In the private sector, separate accounts 
for capital expenditures can be justified because capital 
investments are expected to yield financial returns that are 
applied to interest charges and to liquidate the liability side 
of the capital accounts as the assets 
depreciate. Government investments generally are not expected 
to yield comparable financial returns.

         RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED 
                      FROM ALAN GREENSPAN

Q.1. Over the past couple of years we have seen an increasing 
number of credit unions drop their Federal insurance and opt 
for private insurance. From a safety and soundness perspective, 
is this something that we should be concerned with at this 
time?

A.1. The banking and thrift industries have had unfortunate 
experience with alternative deposit insurance systems, most 
recently during the 1980's in Ohio and Maryland. Participation 
in such systems can appear attractive to financial 
institutions, particularly if that participation is viewed as 
reducing the scope and cost of Federal regulatory oversight. In 
the final analysis, these alternative systems did not provide 
adequate oversight of the participating institutions and proved 
to be insufficiently funded or diversified to withstand 
significant failures. The result was mass depositor withdrawals 
from, and ultimately the failure of, other similarly-insured 
institutions.
    Credit unions have no immunity to these risks, as 
demonstrated in the collapse of the Rhode Island Share and 
Deposit Indemnity Corporation in 1991. The NCUA has been vocal 
in expressing its concern, on a number of occasions, about the 
potential problems 
associated with credit unions opting for private deposit 
insurance, including undue relaxation of their field-of-
membership rules and insufficient oversight of the financial 
condition of these institutions. The history of alternative 
deposit-insurance systems suggests that such concern is well-
founded.

Q.2. What impact do you anticipate from regulatory relief 
legislation that allows interest on business checking accounts 
to have on monetary policy and on the economy as a whole? How 
would it specifically impact small businesses?

A.2. Permitting interest to be paid on business checking 
accounts would help to improve the efficiency of our banking 
industry and provide important benefits for the business 
customers of banks. A more efficient banking industry would 
strengthen the overall economy by reducing the level of 
resources needed to provide a given level of banking services. 
In addition, interest on business checking could be beneficial 
for the implementation of monetary policy in the future if it 
were combined with the authorization of interest on balances 
held at Federal Reserve Banks.
    Currently, the prohibitions against interest on demand 
deposits and on required reserve balances give banks incentives 
to establish programs to sweep the demand deposits of larger 
business firms into instruments that can earn interest and that 
are not subject to reserve requirements. Banks also set up 
complicated compensating balance programs that pay implicit 
interest through credits for the use of their services by 
larger firms. If interest could be paid on demand deposits and 
on the reserves that must be held against them, there would be 
no need for such programs, and the resources devoted to them 
could be redirected to activities that are genuinely productive 
for the economy as a whole.
    Sweep programs have the potential to undermine the 
implementation of monetary policy under current operating 
procedures. The Federal Open Market Committee determines a 
target for the Federal funds rate, which the Open Market Desk 
at the Federal Reserve Bank of New York tries to achieve by 
adjusting the aggregate supply of reserves through open market 
operations. To realize the desired Federal funds rate, the Desk 
needs to have a predictable demand for reserves so it knows the 
level of reserves to supply. A predictable demand is provided 
by balances held at Reserve Banks to meet reserve requirements 
and contractual clearing requirements. If these balances were 
to drop too low, the demand for reserves would be less 
predictable and the Desk would find it more difficult to 
achieve the targeted level of the Federal funds rate. Interest 
payments on balances at Reserve Banks, along with interest 
payments on business checking accounts, would remove incentives 
for reserve-avoidance activities, thereby helping to ensure 
that the balances held at Reserve Banks remain at a 
satisfactory level for the continued effective implementation 
of monetary policy.
    While households have been able to earn interest on their 
checking accounts since the early 1980's, and larger 
businesses, at some cost, have earned implicit interest through 
sweep programs and compensating balance arrangements, small 
businesses continue to be disadvantaged by the unnecessary 
prohibition against interest on demand deposits. The checking 
accounts of small firms are often not sizable enough to justify 
the complicated compensating balance arrangements or the type 
of sweep programs mentioned above. Therefore, many small firms 
earn no interest on the funds they keep in demand deposit 
accounts.

Q.3. What is your position on whether Industrial Loan Companies 
should be able to offer interest bearing corporate checking 
accounts? Do you believe they should be subject to the same 
regulatory treatment with regards to interest on their 
accounts?

A.3. Currently, Federal law prohibits commercial firms from 
owning and operating insured banks and establishes a prudential 
framework of supervision that protects the safety and soundness 
of banks controlled by corporate owners and thereby protects 
the taxpayer. When Congress closed the nonbank bank loophole in 
1987, it granted corporate owners of industrial loan companies 
(ILC's) chartered in a limited number of States an exception 
from the rules that apply to all other corporate owners of 
banks. The exception was subject to the condition that the ILC 
either refrain from offering demand deposits withdrawable by 
check or remain below $100 million in assets. At that time, 
ILC's were for the most part small local institutions that did 
not offer checking accounts and consequently were 
distinguishable from full service insured banks. In recent 
years, the insured deposits in a number of ILC's have grown 
into the multiple billions of dollars and ILC's have been 
acquired by a number of large corporations.
    The Board opposes allowing ILC's that currently cannot 
offer 
demand deposits to offer their functional equivalent: Business 
checking accounts. If this were allowed, ILC's would become the 
functional equivalent of full service insured banks. This would 
turn the limited exception for ILC's into a significant 
competitive advantage for corporate owners of ILC's, such as 
large retail and commercial firms, by allowing them to avoid 
the rules that apply to all other corporate owners of full 
service insured banks. Unlike bank holding companies, corporate 
owners of ILC's would be able to have commercial affiliations 
and avoid the prudential framework the Congress has deemed 
essential for the enhancement of financial stability and the 
protection of the taxpayer. Indeed, in the Gramm-Leach-Bliley 
Act (GLB Act), the Congress rejected efforts to allow 
commercial entities to acquire insured depository institutions 
and closed the unitary thrift loophole.
    This is not a technical matter, nor a simple matter of 
fairness that affects only a small number of grandfathered 
companies. There is no restriction that prevents grandfathered 
States from chartering new ILC's for corporations seeking 
banks, as they have continued to do since 1987. Moreover, 
competitive pressures could encourage existing bank holding 
companies seeking commercial 
affiliations or to avoid prudential supervision to relocate 
their insured banks to grandfathered States that charter ILC's 
to take advantage of the ILC loophole. Consequently, taking 
this step would alter the structure of banking in the United 
States and be contrary to two important national policies that 
Congress reaffirmed recently in the GLB Act: One prohibiting 
the mixing of banking and commerce, and the other establishing 
a Federal prudential framework to assure that companies that 
own insured banks operate in a safe and sound manner.

       RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING 
                      FROM ALAN GREENSPAN

Q.1. Should the tensions in the Middle East and/or Venezuela 
continue, are you worried about the effect of long-term high 
energy prices on our economy?

A.1. Because the United States is a major net importer of crude 
oil, higher crude oil prices exert a restraining influence on 
the growth of aggregate demand by a reduction in the purchasing 
power of consumers. In addition, higher crude oil prices raise 
business costs, and with many companies unable to pass on these 
cost increases to their customers, the growth of corporate 
profits slows; this, in turn, restrains business investment. 
Obviously, the higher crude oil prices go and the longer these 
high prices persist, the larger the negative economic 
consequences.

Q.2. We all know what the housing boom has done for this 
economy, especially over the last year. Do you see the housing 
market being able to sustain this growth?

A.2. Last year was truly extraordinary in terms of the 
construction and sale of residential properties. Near-record-
low mortgage rates helped to push up home sales to a record 6.4 
million unit pace. However, unless mortgage interest rates fall 
by the same extent as last year, housing construction is likely 
to contribute less to economic growth in the period ahead.

Q.3. On Thursday, the Joint Tax Committee will release a report 
on the Enron mess that I understand may ``name names'' of those 
institutions that aided Enron in trying to evade taxes. Will 
you be taking a look at this report to see if it affects 
institutions under the Federal Reserve's regulatory 
jurisdiction?

A.3. Federal Reserve staff are continuing to evaluate financial 

organizations' participation in the types of structured finance 
activities that have recently raised significant legal and 
accounting questions. These efforts include analysis of 
individual transactions, as well as evaluation of the policies 
and the processes employed by financial organizations to ensure 
that they are in compliance with all laws and regulations. In 
addition to the information developed by our own examination 
efforts, our staff intend to fully consider information 
developed by other regulatory agencies, law enforcement 
offices, Congressional committees, bankruptcy proceedings, and 
others. Staff have recently received copies of the Joint 
Committee's report and are in the process of reviewing it.

Q.4. Last year, I asked you about your views on OTC energy and 
metals trading, and you responded very favorably to the values 
that commodity trading brings to the energy industry. Has 
anything occurred in the last year to change your support for 
the OTC markets?

A.4. I continue to believe that OTC derivatives, including 
energy derivatives, are important tools for managing price 
risks. During the last year, there have been a string of 
revelations and accusations regarding the trading practices of 
Enron and some other firms during the California energy crisis. 
However, it is difficult to determine on the basis of publicly 
available information whether the practices in question 
constituted fraud or market manipulation or what the scale of 
any such illegal activity was. What does seem clear is that 
most of the practices that are being questioned were made 
possible by a flawed implementation of deregulation of energy 
markets. Fraud and manipulation undermine the integrity of 
markets and must be effectively deterred. But, thus far, I have 
seen no compelling evidence that it cannot be deterred 
effectively through a combination of market discipline and 
effective exercise of existing regulatory authority.

        RESPONSE TO WRITTEN QUESTIONS OF SENATOR MILLER 
                      FROM ALAN GREENSPAN

Q.1. Morgan Stanley Dean Witter Chief Economist Richard Berner 
said on January 10 in The Washington Post, ``Federal budget 
deficits do tend to raise long-term interest rates, making it 
more expensive for businesses to borrow and invest. But he 
added as long as economic growth is slow, the private sector's 
demand for investment money will stay low. Only when the 
economy significantly heats up would the competition between 
the Federal Government and private companies for lenders 
significantly boost interest rates.'' What do you see the 
overall economy doing over the next 6 months and do you agree 
with Mr. Berner's statement?

A.1. As discussed in the Monetary Policy Report, the members of 
the Federal Open Market Committee at the time of my testimony 
believed the most likely outcome for the economy this year was 
that the economic fundamentals would support a strengthening of 
economic growth. Of course, considerable uncertainty attends 
this view owing to geopolitical concerns. There is no question 
that long-term interest rates are affected by rising deficits, 
and that this tends to have a negative effect on capital 
formation. In particular, econometric evidence suggests that 
when investors see the projected long-run budget outlook 
worsening, bond rates rise today in anticipation of tighter 
credit market conditions down the road.

Q.2. Mr. Chairman, the housing sector has been one of the 
strongest performers in our economy. What impact do you see on 
the housing sector if deficits increase and interest rates 
start to rise? Are we threatening one of our strongest 
performers?

A.2. Should mortgage interest rates rise, it is entirely 
possible that new and existing home sales would decline. It is 
worth bearing in mind, however, that any sustained increase in 
rates presumably would occur only in the context of a more 
vigorous upturn in the pace of business activity, suggesting 
that the net effect on housing activity might be relatively 
limited.

Q.3. Do you see deflation as a threat in the near term?

A.3. Central bankers have long believed that price stability is 
conducive to achieving maximum sustainable growth. 
Historically, debilitating risk premiums have tended to rise 
with both expected 
inflation and deflation, and they have been minimized during 
conditions of approximate price stability. At present, the 
United States is nowhere close to sliding into a pernicious 
deflation. Indeed, both market and survey measures of inflation 
expectations have remained relatively stable over the past 
year, suggesting that there are no widespread concerns about 
deflation developing in the period ahead. But a major objective 
of the recent heightened scrutiny of the issue is to ensure 
that any latent deflationary pressures are addressed well 
before they become a problem.

Q.4. Mr. Chairman, last year you and I had the opportunity to 
discuss OTC energy derivatives. A bill has again been 
introduced this Congress that would reverse the legal certainty 
provisions for OTC energy derivatives achieved in the Commodity 
Futures Modernization Act in 2000. My concern is that 
significant regulatory uncertainty would be created for these 
products if the bill passes. Have you seen anything recently 
that would change your views on the California energy crisis 
and whether energy derivatives trading contributed either to 
the California energy crisis or to Enron's bankruptcy?

A.4. I have not seen anything that demonstrates clearly that 
energy derivatives trading contributed significantly to the 
California energy crisis. The root cause of the crisis was a 
flawed implementation of the deregulation of energy markets. To 
be sure, some traders may have used energy derivatives to 
profit from the flaws in the regulatory structure. But it 
remains unclear to what extent these trading strategies added 
to the strains and the imbalances inherent in the regulatory 
system. Likewise, although Enron was a leading dealer in energy 
derivatives, derivatives were not the root cause of its 
failure. Rather, it failed because its board of directors and 
its auditors allowed it to publish financial statements that 
distorted its true financial condition and allowed it to become 
excessively leveraged. More intensive regulation of derivatives 
would not have prevented the California energy crisis or the 
failure of Enron. Furthermore, as you recognize, some of the 
proposals for more intensive regulation would have the 
unintended consequence of reintroducing legal uncertainty 
regarding contract enforceability.

        RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO 
                      FROM ALAN GREENSPAN

Q.1. During a recent hearing of this Committee, it was 
suggested that some financial institutions may be illegally 
tying the availability or price of credit to investment banking 
services. What are your views concerning the adequacy of 
existing laws and regulation in this area and are you aware of 
any convincing evidence that illegal tying occurs? What steps 
is the Federal Reserve taking to ensure that commercial banking 
companies do not engage in illegal antitying activities?

A.1. Banks are subject to a variety of laws that prohibit them 
from tying products and services in a manner that harms 
customers or lessens competition. Section 106 of the Bank 
Holding Company Act Amendments of 1970, prohibits a bank from 
extending credit or varying the terms of credit on the 
condition that a customer purchase another product or service 
from the bank or its affiliates, with certain exceptions. Banks 
are also subject to the antitying provisions of the Federal 
antitrust laws, which prohibit a company with market power in 
one product from using that market power to require a customer 
to purchase a second product.
    In addition, to the extent that this conduct involves a 
bank reducing the price of credit to benefit an affiliate's 
investment banking business, it may violate Section 23B of the 
Federal Reserve Act, which requires that transactions involving 
a bank and its affiliate be on market terms. Finally, in 
certain circumstances, this practice may, by reducing the 
bank's income for the benefit of an affiliate, be an unsafe and 
unsound banking practice.
    The Board's examination procedures and practices include 
supervisory efforts to ensure compliance with Section 106, 
other banking statutes and safe and sound banking practices. 
For example, the Board's Supervision Manuals governing Bank 
Holding Company and State Member Bank Examinations provide for 
compliance reviews of a bank holding company and State member 
bank that 
include evaluation by examiners of the institution's program 
for compliance with Section 106. The Board and the other 
Federal banking agencies have also issued guidance directing 
banks and bank holding companies to implement and maintain 
appropriate systems and controls to promote compliance with the 
antitying provisions. That guidance addressed the need for 
specific policies and procedures addressing tying prohibitions, 
training materials and programs that provide examples of 
prohibited practices and sensitize employees to the concerns 
raised by tying, compliance systems, and management involvement 
in reviewing training, audit, and compliance programs related 
to tying. See, e.g., FRB Bank Holding Company Supervision 
Manual Sec. 3500.0; OCC Insurance Activities Handbook, Federal 
Prohibitions on Tying (June 2002); OCC Bulletin 95-20 (April 
14, 1995).
    In addition to examining for compliance with this agency 
guidance, the Board investigates allegations of illegal tying 
and initiates appropriate actions to remedy any violations of 
the antitying provisions that are found. Currently, the Board, 
in conjunction with the Office of the Comptroller of the 
Currency, is conducting a special targeted review of compliance 
with the antitying provisions in light of reports described in 
the press. This review includes a review of the antitying 
training and compliance programs, marketing programs, training 
materials and adequacy of internal audits for compliance with 
the bank's internal policies and procedures at several of the 
country's largest banks. These efforts are ongoing, and we have 
not yet completed our evaluation of the information we have 
gathered thus far. If the Board finds banks offering credit on 
an impermissible basis, we will take appropriate supervisory 
action to assure compliance with the law and to terminate 
unsafe and unsound banking practices.
    To date, the agencies have not found that commercial banks 
are manipulating the pricing of credit to build investment 
banking market share. Clearly, banking organizations that have 
credit relationships with customers hope to sell them the 
bank's full range of products and services. As you know, 
banking organizations are permitted to package certain services 
because some tying arrangements are permissible under statutory 
and regulatory exceptions and some customers may request that 
the bank package services. In both cases, interested customers 
have the choice of whether to enter into these arrangements.

Q.2. Derivatives are complex instruments used by institutional 
investors. As I understand it, derivatives are actually 
utilized in our markets to allocate risk better to those areas 
or those entities that can handle it, and it is a stabilizing 
force in the markets. Do you agree with that?

A.2. Derivatives allow price risks to be transferred to those 
most willing to assume and manage those risks. Provided that 
those assuming the risks manage them effectively, such risk 
transfers stabilize markets and contribute to economic growth. 
Notwithstanding certain high-profile instances of 
mismanagement, derivatives have been an important factor 
supporting growth of the U.S. economy in recent years.

Q.3. As you know, last year we had proposals in the Senate that 
would amend the CFMA (Commodity Futures Modernization Act). Do 
you see any need to revisit the CFMA at this time?

A.3. No. Some may argue that the CFTC needs additional 
authority to deter fraud and manipulation in the trading of OTC 
energy derivatives. While some apparently were tempted to 
engage in such market abuses by flaws in the way energy markets 
were deregulated by the States, the scale and significance of 
such practices 
remains unclear. Furthermore, it is not clear that such 
practices cannot be effectively deterred by a combination of 
market discipline and exercise of existing regulatory 
authority. We need to be mindful of the danger of unintended 
consequences of new legislation, 
including the reintroduction of legal uncertainty regarding the 
enforceability of contracts.

Q.4. What existing reporting and disclosure is made for 
derivatives transactions?

A.4. Firms that file financial statements with the SEC are 
required to make certain public disclosures related to 
derivatives transactions. Under generally accepted accounting 
principles (GAAP) in the United States, all derivatives must be 
measured at fair value and recognized on the balance sheet as 
either assets or liabilities. Also, a firm must disclose its 
objectives for entering into derivatives transactions, the 
context needed to understand the objectives, and its strategies 
for achieving the objectives. In addition, the SEC requires 
firms to describe their accounting policies for derivatives and 
to provide the quantitative and qualitative information about 
market risk exposures, including exposures due to derivatives 
transactions.
    Banks are subject to additional public reporting 
requirements for derivatives transactions. Regulatory reports 
for banks and bank holding companies require a breakdown of 
derivatives transactions by risk factor (interest rate, foreign 
exchange, equity, commodity, credit) by type (futures, 
forwards, options), and by purpose (trading or nontrading). 
Moreover, the Federal Reserve has encouraged large banks to 
disclose additional information on market risk exposures in the 
trading account (exposures arising from derivatives and other 
trading instruments), such as value-at-risk on an aggregate 
basis and value-at-risk by risk factor.

       RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES 
                      FROM ALAN GREENSPAN

Q.1. Chairman Greenspan, at the hearing you stated that, 
``There was a good deal of concern, as you know, about this 
housing bubble. But our evaluation of the data and the outlook 
suggests that, while obviously, there are potential problems, 
they are not serious ones that need to be addressed in any 
material way as far as we can judge.'' Can you please elaborate 
on these potential problems and the process that led you to 
your conclusion that they are not serious enough to be 
addressed in any material way?

A.1. The house price increases over the past 2 years have been 
described by some analysts as possibly symptomatic of an 
emerging housing bubble, not unlike the stock market bubble 
whose bursting has produced considerable distress in recent 
years. Existing home prices (as measured by the repeat-sales 
index) rose by 7 percent during 2002, and by a third during the 
past 4 years. Such a pace cannot reasonably be expected to be 
maintained. And recently, price increases have slowed.
    It is, of course, possible for home prices to fall as they 
did in a couple of quarters in 1990. But any analogy to stock 
market pricing behavior and bubbles is a rather large stretch. 
First, to sell a home, one almost invariably must move out and 
in the process confront substantial transaction costs in the 
form of brokerage fees and taxes. These transaction costs 
greatly discourage the type of buying and selling frenzy that 
often characterizes bubbles in financial markets.
    Second, there is no national housing market in the United 
States. Local conditions dominate, even though mortgage 
interest rates are similar throughout the country. Home prices 
in Portland, Maine, do not arbitrage those in Portland, Oregon. 
Thus, any bubbles that might emerge would tend to be local, not 
national, in scope.
    Third, there is little indication of a supply overhang in 
newly constructed homes. The level of overall new home 
construction, including manufactured homes, appears to be well 
supported by steady household formation and not dependent on 
high and variable replacement needs or second-home demand. 
Census Bureau data suggest that one-third to one-half of new 
household formations in recent years result directly from 
immigration.
    After their very substantial run-up in recent years, home 
prices could recede. A sharp decline, the consequences of a 
bursting bubble, however, seems most unlikely. Nonetheless, 
even modestly declining home prices would reduce the level of 
unrealized capital gains and presumably dampen the pace of home 
equity extraction. Home mortgage cash-outs and home equity loan 
expansion would likely decline in the face of declining home 
prices. However, the 5-year-old home building and mortgage 
finance boom is less likely to be defused by declining home 
prices than by rising mortgage interest rates.
    Should rates rise, it is entirely possible that new and 
existing home sales would decline. However, it is worth bearing 
in mind that any sustained increase in rates presumably would 
occur only in the context of a more vigorous upturn in the pace 
of business activity, suggesting that the net effect on housing 
activity might be relatively limited.

Q.2. In the Administration's proposed budget they have 
decreased their projections for the cost of bank failures in 
fiscal year 2004 by 70 percent (from $6.4 billion to $1.9 
billion). Do you agree with the Administration's changed 
projection? Comparing the economic en-
vironment for banking institutions, going forward from this 
year compared to last year, would you expect the likelihood for 
aggregate bank failures to have increased, decreased, or 
remained the same?

A.2. Bank failures have been relatively few in recent years, 
and only 10 banks and one thrift failed in 2002. Based upon 
current conditions, there are no indications that failures 
should be expected to rise significantly in the near future. 
Despite recent increases in problem loans and charge-offs, the 
number and size of problem banks remains small relative to the 
banking industry. The FDIC reported that at year-end 2002 there 
were 136 problem institutions (for example, those receiving a 
CAMEL composite rating of ``4'' or ``5,'' made up of 116 banks 
and 20 thrifts), with combined assets of approximately $39 
billion. These figures are significantly higher than just a few 
years ago, but nonetheless represent a relatively minor share 
of the industry. Moreover, the industry once again reported 
robust earnings for the year 2002 and remains strongly 
capitalized. The prospect of improved economic conditions, 
together with preliminary indications that problem loans have 
begun to decline, suggest that credit quality pressures on the 
banking industry may be expected to subside in the coming 
years. Barring unforeseen developments, it would be reasonable 
to expect that the number of bank failures in the next 2 years 
would remain low, perhaps even lower than were experienced in 
2002.
    Neither figure cited in the question as projected costs of 
bank failures could readily be located in the Administration's 
budget documents, so that it is not possible to comment on them 
specifically. As a general observation, both figures seem very 
high. The total costs to the deposit insurance funds from bank 
failures have been below $1 billion every year since 1992, even 
if losses to both the Bank Insurance Fund and Savings 
Association Insurance Fund are included. Estimated losses for 
2002 came to roughly $630 million. Given the current number and 
size of problem banks and the general state of the banking 
industry, and barring significant unforeseen events, it would 
seem reasonable to expect annual losses to be well below even 
the $1.9 billion figure in the next 2 years.








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