[Joint House and Senate Hearing, 109 Congress]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 109-392 

                          THE ECONOMIC OUTLOOK

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

                                HEARING

                               BEFORE THE

                        JOINT ECONOMIC COMMITTEE

                     CONGRESS OF THE UNITED STATES

                       ONE HUNDRED NINTH CONGRESS

                             FIRST SESSION

                               __________

                            OCTOBER 20, 2005

                               __________

          Printed for the use of the Joint Economic Committee








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                        JOINT ECONOMIC COMMITTEE


    [Created pursuant to Sec. 5(a) of Public Law 304, 79th Congress]


HOUSE OF REPRESENTATIVES             SENATE
Jim Saxton, New Jersey, Chairman     Robert F. Bennett, Utah, Vice 
Paul Ryan, Wisconsin                     Chairman
Phil English, Pennsylvania           Sam Brownback, Kansas
Ron Paul, Texas                      John Sununu, New Hampshire
Kevin Brady, Texas                   Jim DeMint, South Carolina
Thaddeus G. McCotter, Michigan       Jeff Sessions, Alabama
Carolyn B. Maloney, New York         John Cornyn, Texas
Maurice D. Hinchey, New York         Jack Reed, Rhode Island
Loretta Sanchez, California          Edward M. Kennedy, Massachusetts
Elijah E. Cummings, Maryland         Paul S. Sarbanes, Maryland
                                     Jeff Bingaman, New Mexico



               Christopher J. Frenze, Executive Director
                  Chad Stone, Minority Staff Director
















                            C O N T E N T S

                              ----------                              


                      Opening Statement of Members


Statement of Hon. Jim Saxton, Chairman, a U.S. Representative 
  from New Jersey................................................     1
Statement of Hon. Jack Reed, Ranking Minority Member, a U.S. 
  Senator from Rhode Island......................................     2

                               Witnesses

Statement of Hon. Ben Bernanke, Chairman, Council of Economic 
  Advisers, Washington, DC.......................................     4
Statement of Dr. Mickey D. Levy, Chief Economist, Bank of 
  America, New York, NY..........................................    23
Statement of Dr. David F. Seiders, Chief Economist, National 
  Association of Home Builders, Washington, DC...................    26
Statement of Dr. Brad Setser, Senior Economist and Director of 
  Global Research, Roubini Global Economics, LLC, New York, NY...    28

                       Submissions for the Record

Prepared statement of Representative Jim Saxton, Chairman........    37
    Civilian Unemployment Rate Chart.............................    38
    International Unemployment Chart.............................    39
    Core PCE Inflation Chart.....................................    40
    Personal Consumption Expenditures (PCE) Chart................    41
    Economic Effects of Inflation Targeting, Study...............    42
Prepared statement of Senator Jack Reed, Ranking Minority Member.    49
Chart submitted by Representative Carolyn B. Maloney showing the 
  growing trend of inequality between the ``haves'' and the 
  ``have-nots''..................................................    51
Prepared statement of Hon. Ben Bernanke, Chairman, Council of 
  Economic Advisers, Washington, DC..............................    52
Prepared statement of Dr. Mickey D. Levy, Chief Economist, Bank 
  of America, New York, NY.......................................    55
Prepared statement of Dr. David F. Seiders, Chief Economist, 
  National Association of Home Builders, Washington, DC..........    60
Prepared statement of Dr. Brad Setser, Senior Economist and 
  Director of Global Research, Roubini Global Economics, LLC, New 
  York, NY.......................................................    67
























 
                          THE ECONOMIC OUTLOOK

                              ----------                              


                       THURSDAY, OCTOBER 20, 2005

             Congress of the United States,
                          Joint Economic Committee,
                                                     Washington, DC
    The Committee met, pursuant to notice, at 10 a.m., in room 
311, Cannon House Office Building, the Honorable Jim Saxton, 
Chairman of the Committee, presiding.
    Representatives Present: Saxton, Ryan, English, Paul, 
Maloney, Hinchey, and Sanchez.
    Senators present: Bennett and Reed.
    Staff present: Chris Frenze, Robert Keleher, Brian 
Higginbotham, Colleen Healy, John Kachtik, Suzanne Stewart, 
Jeff Schlagenhauf, Emily Gigena, Chad Stone, Matt Salomon, Nan 
Gibson, and Daphne Federing.

    OPENING STATEMENT OF HON. JIM SAXTON, CHAIRMAN, A U.S. 
                 REPRESENTATIVE FROM NEW JERSEY

    Representative Saxton. Good morning. I am pleased to have 
the opportunity to welcome Chairman Bernanke and the members of 
our second panel as well before the Joint Economic Committee 
this morning.
    The Committee values its long history of cooperation with 
the Council of Economic Advisers. The testimony today will 
provide a solid foundation for understanding the forces that 
are shaping current economic conditions, as well as the 
economic outlook.
    The recent hurricanes have caused a tragic loss of life and 
property on the Gulf Coast and also have had temporary effects 
on the U.S. economy as a whole. One reason for this national 
impact is that a significant portion of U.S. oil and gas 
production is concentrated in the Gulf, and much of it is still 
damaged. Thus, it is reasonable to expect that the economic 
impact of the hurricanes will slow GDP growth during the second 
half of 2005.
    In 2006, as recovery efforts proceed, many economists 
expect growth to be a bit higher than previously forecast. 
Despite the hurricane damage, a broad array of standard 
economic data indicates that the economic expansion has built 
up a strong momentum. The U.S. economy grew at 4 percent during 
2004 and advanced at a rate of about 3.5 percent in the first 
half of 2005. A rebound in business investment has played an 
important role in explaining the pickup of the economy since 
2003. Equipment and software investment has been strong over 
this period.
    The improvement in economic growth is reflected in other 
economic figures as well. For example, since May of 2003, 
business payrolls have increased by 4.2 million jobs. The 
unemployment rate stands at 5.1 percent. Consumer spending 
continues to grow. Home ownership has hit record highs. 
Household net worth is also at a record level, and productivity 
growth continues at a healthy pace.
    Long-run inflation pressures appear to be contained, and 
that is good news. Long-term interest rates, including mortgage 
rates, are still relatively low, in spite of the fact that the 
Fed has increased short-term rates. It is clear that the Fed 
remains poised to keep inflation under control.
    In summary, overall economic conditions remain positive. 
The U.S. economy has displayed remarkable flexibility and 
resilience in dealing with many shocks.
    It is clear that monetary policy and tax incentives for 
investment have made important contributions to the improvement 
of the economy in recent years. Recently released minutes from 
the Federal Reserve suggest that the central bank expects this 
economic strength to continue. The Administration forecast for 
economic growth in 2006 is compatible with those of the Blue 
Chip consensus and Federal Reserve.
    With growth expected to exceed 3 percent next year, the 
current economic situation is solid, and the outlook remains 
favorable.
    At this time, we will go to Ranking Member Senator Reed for 
his opening statement.
    [The prepared statement of Representative Saxton appears in 
the Submissions for the Record on page 37.]

OPENING STATEMENT OF HON. JACK REED, RANKING MINORITY MEMBER, A 
                 U.S. SENATOR FROM RHODE ISLAND

    Senator Reed. Thank you very much, Mr. Chairman.
    I want to welcome Chairman Bernanke to the hearing today. I 
hope he will give us some important insights into current 
economic conditions and the President's policies and the 
direction of these policies.
    I am also pleased that we will have a second panel of 
witnesses to provide additional perspectives on the current 
economic conditions and outlook.
    Like many Americans, my concerns about the economic outlook 
and the Administration's stewardship of the economy have grown 
in the wake of Hurricane Katrina and Hurricane Rita and the new 
hurricane in the Gulf. Economic insecurity for workers is 
widespread as energy prices are soaring. Employer-provided 
health insurance coverage is falling, private pensions are in 
jeopardy, and American workers are still waiting to see the 
benefits of the economic recovery reflected in their paychecks.
    President Bush's tax cuts were poorly designed to stimulate 
broadly shared prosperity, and it produced a legacy of large 
budget deficits that leaves us increasingly hampered in our 
ability to deal with the host of challenges that we face. The 
devastating impact of Hurricanes Rita and Katrina will put 
short-term strains on the Federal budget, strains that would be 
fairly easy to absorb if our budget and economic policies were 
sound, but they are not.
    The President's goals of making his tax cuts permanent and 
cutting the deficit in half are simply incompatible. Large and 
persistent budget deficits have also contributed to an ever-
widening trade deficit that forces us to borrow vast amounts 
from abroad and puts us at risk of a major financial collapse 
if foreign lenders suddenly stop accepting our IOUs. The trade 
deficit of $59 billion in August is close to the record for a 
single month of more than $60 billion set in February.
    The broader current account deficit, which measures how 
much we are borrowing from the rest of the world, is running at 
a record annual rate of nearly $800 billion, or well over 6 
percent of GDP. I will be interested in the Chairman's views on 
whether the budget deficit and trade deficit are dangerous 
imbalances that pose a risk to the economic outlook. I am also 
pleased that we will be able to hear Dr. Setser's views, which 
may be somewhat different.
    I hope that we would all agree that raising our future 
standard of living and preparing adequately for the retirement 
of the baby boom generation require that we have a high level 
of investment and that a high fraction of that investment be 
financed by our own national savings, not by foreign borrowing. 
We followed such prosperity enhancing policies under President 
Clinton, but that legacy of fiscal discipline has been 
squandered under President Bush.
    Sound policies are clearly important for the long run, but 
I am also deeply concerned about what continues to be a 
disappointing economic recovery for the typical American 
worker. Strong productivity gains have turned up in the bottom 
line for the shareholders, but not in the paychecks of workers. 
The typical worker's earnings are not keeping up with their 
rising living expenses, and both earnings and economic 
inequality are increasing.
    It is certainly hard to take seriously the President's 
rhetoric about wanting to lift families out of poverty when he 
has refused to support an increase in the minimum wage and has 
lifted the Davis-Bacon Act, thereby legitimizing subpar wages 
for workers rebuilding the communities in the hurricane-
stricken gulf coast region.
    Even though home heating costs are expected to skyrocket 
this winter, President Bush said he will not request additional 
funds for the Low Income Home Energy Assistance Program known 
as LIHEAP. Together with my colleagues, Senators Snowe and 
Collins, we have been trying to reverse that by providing 
additional funds, and I hope we succeed, but I think the 
Administration should be supportive, not antagonistic to that 
approach.
    I look forward to your testimony, Chairman Bernanke, about 
the economic outlook; and thank you again, Mr. Chairman, for 
this hearing.
    [The prepared statement of Senator Reed appears in the 
Submissions for the Record on page 49.]
    Representative Saxton. Thank you.
    Thank you for being with us this morning, Dr. Bernanke. Let 
me just say, for purposes of introduction, Dr. Bernanke was 
sworn in June of 2005 as chairman of the President's Council of 
Economic Advisers. Prior to his appointment to the Council, Dr. 
Bernanke served as a member of the Board of Governors of the 
Federal Reserve.
    We are pleased to have you here today.
    I might also note, as a New Jerseyan, that Dr. Bernanke has 
served as professor of economic and public affairs at Princeton 
University.
    Dr. Bernanke.

 STATEMENT OF HON. BEN BERNANKE, CHAIRMAN, COUNCIL OF ECONOMIC 
                    ADVISERS, WASHINGTON, DC

    Dr. Bernanke. Thank you.
    Chairman Saxton, Vice Chairman Bennett, Ranking Member Reed 
and Members of the Committee, thank you for the opportunity to 
testify before the Joint Economic Committee. We appreciate the 
long-standing and mutually beneficial relationship between the 
Committee and the Council of Economic Advisers. My remarks 
today will focus on the current state of the economy, but of 
course, such an overview would be incomplete without an eye to 
the human and economic impacts of Hurricanes Katrina and Rita 
in the U.S. Gulf Coast.
    While it has been nearly two months since Hurricane Katrina 
made landfall, its devastation will have a protracted impact on 
the Gulf region. As you know, Hurricane Katrina wreaked 
unprecedented losses on the people of Louisiana, Mississippi, 
and the Alabama coasts. Katrina took many lives, destroyed 
communities and shook a vital portion of our nation and our 
economy. The Gulf region was then hit by Hurricane Rita, which 
did significant damage, but in most areas less than was feared.
    In response to the disasters, the President has directed 
all agencies of the Federal Government to devote their maximum 
effort to helping the victims of the hurricanes and to begin 
the process of cleaning up and rebuilding the region. The 
President has also proposed a series of measures to restore the 
Gulf's communities and economy.
    One of the greatest assets we have in rebuilding after a 
hurricane is the overall strength of the national economy. The 
resiliency of the economy--the product of flexible labor 
markets, a culture of entrepreneurship, liquid and efficient 
capital markets and intense market competition--is helping it 
to absorb the shocks to energy and transportation from the 
hurricanes. The ability of our economy to grow and create jobs 
will act as a lifeline to the regions and people most affected. 
Thus, these recent events make it all the more important that 
we keep the fundamentals of the national economy strong and 
continue to promote economic policies that will encourage 
growth and job creation.
    When thinking about where the economy is now and where it 
is heading, it is useful to keep in mind just how far the U.S. 
economy has come in recent years. The economy's resilience was 
put to severe test in the past 5 years, even prior to Katrina. 
A remarkable range of shocks hit the U.S. economy, beginning 
with a sharp decline in stock prices in 2000 and the recession 
that followed in 2001. The economy was further buffeted by the 
terrorist attacks of September 11, 2001, and the subsequent 
geopolitical uncertainty. Business and investor confidence was 
shaken by a series of corporate scandals in 2002. By early 
2003, uncertainty about economic prospects was pervasive and 
the economy appeared to be sputtering.
    Yet, in the face of all these shocks, together with new 
challenges such as the recent sharp rise in energy prices, the 
American economy has rebounded strongly. Policy actions taken 
by the President and the Congress were important in getting the 
economy back on track. Notably, beginning with the President's 
2001 tax cuts, multiple rounds of tax relief increased 
disposable income for all taxpayers, supporting consumer 
confidence and spending, while increasing incentives for work 
and entrepreneurship. Additional tax legislation passed in 2002 
and 2003 provided incentives for businesses to expand their 
capital investments and reduce the cost of capital by lowering 
tax rates on dividends and capital gains.
    Together with appropriate monetary policies, these policy 
actions helped spur economic growth in both the short run and 
the long run. Today, the U.S. economy is in the midst of a 
strong and sustainable economic expansion. Over the past four 
quarters real GDP has grown at a 3.6 percent rate and over the 
past eight quarters real growth has been at a 4.1 percent 
annual rate.
    Prior to Katrina, the near-term forecast of both CEA and 
private-sector economists had called for continued solid 
growth. The destruction wrought by Katrina and Rita may reduce 
growth somewhat in the short run, but the longer-term growth 
trajectory remains in place. I will return to economic 
prospects in a moment.
    An important reason for the recovery has been improved 
business confidence. To an extent unusual in the post-War 
period, the slowdown at the beginning of this decade was 
business-led rather than consumer-led. Home building and 
purchases of consumer durables did not decline as they 
typically do in a cyclical downturn. Instead, the primary 
source of weakness was the reluctance of businesses to hire and 
to invest. Supported by appropriate fiscal and monetary 
policies and by the economy's innate strengths, business 
confidence has risen markedly in the past few years. The 
effects are evident in the investment and employment data. From 
its trough in the first quarter of 2003, business fixed 
investment has increased over 21 percent, with the biggest 
gains coming in equipment and software.
    Since the labor market bottomed out in May 2003, more than 
four million net new payroll jobs have been added. Currently, 
the unemployment rate stands at 5.1 percent, up from 4.9 in 
August prior to the job losses that followed Katrina.
    Although growth and GDP and jobs capture the headlines, one 
of the biggest macroeconomic stories of the past few years is 
what has been happening to productivity. Productivity growth is 
the fundamental source of improvements in living standards and 
the primary determinant of the long-run growth potential of the 
economy. Over the past four years, labor productivity in the 
non-farm business sector has grown at a 3.4 percent annual 
rate, and productivity in manufacturing has risen at a 5.7 
percent annual rate. Productivity growth has slowed recently as 
businesses have absorbed millions of new workers--a normal 
development for this stage of an economic expansion--but it 
remains--in the four quarters ending in the second quarter this 
year--at the quite respectful level of 2.2 percent and 6.3 
percent in the non-financial corporate sector. Thus, on each of 
the three key indicators of the real economy--GDP growth, job 
creation, and productivity growth--the United States in recent 
years has the best record of any major industrial economy and 
by a fairly wide margin.
    Finally, while there has been a notable rise in overall 
inflation this year, prices on nonenergy products have 
continued to increase at moderate rates. In particular, soaring 
energy prices have played the largest role in boosting the 
overall consumer price index to an increase of 4.7 percent in 
the past year, up from a 2.5 increase over the year-earlier 
period.
    In contrast, core consumer prices--as measured by the 
consumer price index, excluding volatile food and energy 
prices--rose only 2 percent the past 12 months, unchanged from 
the year-earlier pace. Long-term expectations also remain low 
and stable, based on measures of inflation compensation derived 
from inflation-indexed Treasury securities.
    To be clear, the focus on core inflation by no means 
implies the rise in energy prices is inconsequential. Sharply 
higher energy costs place a heavy burden on household budgets 
and increase firms' costs of production. I will discuss the 
energy situation in more detail in a moment. However, the 
stability in core inflation and inflation expectations does 
suggest that overall inflation is likely to return to levels 
consistent with price stability in coming quarters.
    Let me turn now to the outlook. In the shorter term, the 
devastation wrought by the hurricanes has already had palpable 
effects on the national rates of job creation and output 
growth. Payroll employment declined by 35,000 in September, its 
first decline since May of 2003, and industrial production fell 
1.3 percent, its largest monthly decline in over two decades. 
Both of these declines appear to be entirely accounted for as 
the effects of the hurricanes. The Bureau of Labor Statistics 
estimates employment growth would have been roughly 200,000 in 
the absence of the hurricanes, and the Federal Reserve 
estimates that industrial production would have increased about 
.04 percent. Consumer confidence also dropped in September, 
although growth in consumer spending has continued to be solid.
    While the effects of the storm certainly reduced growth in 
the third quarter relative to what it would have been 
otherwise, most private-sector economists expect healthy growth 
for the remainder of this year and in 2006. For example, the 
Blue Chip panel of forecasters now projects growth at 3.2 
percent in the second half of 2005 and 3.3 percent growth in 
2006. Recovery and rebuilding will contribute to job creation 
and growth by the latter part of this year and in 2006.
    The economic impact of the hurricanes included significant 
damage to the country's energy infrastructure. As you know, 
Katrina shuttered a substantial portion of U.S. refining and 
pipeline capacity, which led to a spike in gasoline prices in 
the weeks after the storm. Rita caused further damage. The 
Federal Government has assisted in, among other ways, by 
lending or selling oil from the Strategic Petroleum Reserve, 
arranging for additional shipment of oil and refined products 
from abroad to the United States, and providing appropriate 
regulatory waivers to increase the flexibility of the energy 
supply chain. In part because of these efforts and a vigorous 
private-sector response, oil prices have returned to roughly 
their pre-Katrina levels. Wholesale gasoline prices have also 
retreated to the levels of mid-August, suggesting the recent 
declines in prices at the pump is likely to continue. National 
gas prices may remain elevated somewhat longer, however, 
because of lost production in the Gulf, the difficulty of 
increasing natural gas imports, and damage to plants that 
process natural gas for final use.
    Even as the energy sector continues to recover, it remains 
true that the prices of oil and natural gas have risen sharply 
in the past two years, reflecting a tight balance of supply and 
demand. High energy prices are burdening household budgets and 
raising production costs, and continued increases would at some 
point restrain economic growth. Thus far, at least, the growth 
effects of energy price increases appear relatively modest. The 
economy is much more energy efficient today than it was in the 
1970s when energy shocks contributed to sharp slowdowns.
    Well-controlled inflation and inflation expectations have 
also moderated the effects of energy price increases since 
those increases no longer set off an inflation spiral and the 
associated increases in interest rates as they did three 
decades ago. In addition, allowing prices to adjust, rather 
than rationing gasoline, is helping to minimize the overall 
impact on the economy.
    House prices have risen by nearly 25 percent over the past 
two years. Although speculative activity has increased in some 
areas, at a national level these price increases largely 
reflect strong economic fundamentals, including robust growth 
in jobs and income, low mortgage rates, steady rates of 
household formation, and factors that limit the expansion of 
housing supply in some areas.
    House prices are unlikely to continue rising at current 
rates. However, as reflected in many private-sector forecasts 
such as the Blue Chip forecast mentioned earlier, a moderate 
cooling in the housing market, should one occur, would not be 
inconsistent with the economy continuing to grow at or near its 
potential next year.
    The current account deficit presents some economic 
challenges. At 6.3 percent, the ratio of the current account 
deficit to GDP is now at its highest recorded level. Gradually 
reducing the account deficit over a period of time would be 
desirable. While the current account imbalance partly reflects 
the strong growth of the U.S. economy and its attractiveness to 
foreign investors, low U.S. national saving also contributes to 
the deficit. The United States should work to increase its 
national saving rate over time by encouraging private saving 
and by controlling federal spending to reduce the federal 
budget deficit. Our trading partners must also play a role in 
reducing imbalances by becoming less reliant on export-led 
growth and increasing domestic spending and by allowing their 
exchange rates to move flexibly as determined by the market.
    The economic challenges posed by Hurricanes Katrina and 
Rita reinforce, once again, the importance of economic policies 
that promote growth and increase the resilience of the economy. 
Energy issues, in particular, have come to the fore recently. 
The energy bill recently passed by Congress and signed by the 
President should help address the nation's energy needs in the 
longer term. As an additional step, the Administration will 
continue to work with Congress to take measures that permit 
needed increases in refinery capacity. The Administration has 
made a number of other proposals to increase economic growth, 
including proposals to reduce the economic cost of litigation, 
to increase quality and reduce costs in the health care sector, 
and to address national needs in education and job training.
    The Administration is currently engaged in several 
international negotiations, including the Doha round at the 
World Trade Organization, as well as talks with China on a 
number of matters involving trade, exchange rates and needed 
financial reforms. Liberalized trade and capital flows promote 
economic growth, and we should strive to achieve those 
objectives in the context of a gradual reduction of current 
account imbalances. It is important that we persist in these 
efforts and not retreat to economic isolationism, which would 
negatively affect the long-run growth potential of the economy.
    Fiscal discipline, always important, has become 
increasingly so in the face of the likely costs of assisting 
the victims of the hurricanes and of helping in the rebuilding. 
Before the impact of the hurricanes, strong economic growth was 
helping to reduce the budget deficit and the government 
finished fiscal year 2005 with a much lower-than-expected 
deficit.
    The President remains committed to controlling spending and 
cutting the budget deficit in half by 2009. His 2006 budget 
made numerous proposals to save more than $200 billion over the 
next 10 years from both discretionary and mandatory programs.
    In the budget resolution earlier this year, Congress laid 
plans to pass $35 billion out of the President's $70 billion in 
savings for mandatory programs over the next 5 years. Congress 
should now make good on that plan by passing at least $35 
billion in mandatory savings in reconciliation legislation.
    Further savings beyond $35 billion would be highly 
desirable. The President continues to seek a decrease in non-
security discretionary spending in fiscal year 2006 
appropriation bills, and the Administration is working on 
options for spending rescissions. The President also remains 
committed to reforms to address fiscal challenges in the longer 
term, such as Social Security.
    Finally, I note that the Tax Reform Advisory Panel, whose 
official report will go to the Secretary of the Treasury on 
November 1st, has kicked off a much-needed debate on how to 
make the Federal Tax Code simpler, fairer, and more pro-growth. 
We thank them for their hard work and look forward to reviewing 
their recommendations.
    Thank you very much for the opportunity to be here today, 
and I would be happy to take any questions.
    [The prepared statement of Dr. Bernanke appears in the 
Submissions for the Record on page 52.]
    Representative Saxton. Thank you very much, Dr. Bernanke. 
We appreciate your being here.
    Thank you.
    Let me begin with a question on business investment. As 
most of us know, in recent economic analysis a lot of credit 
has been given to business investment that has spurred economic 
growth. However, when the recovery started in the last quarter 
of 2001, business investment was not great. In fact, it was not 
good in 2002, and it didn't begin to click in until the second 
quarter of 2003.
    Coincidentally, Congress passed some tax legislation that 
was recommended by the President in 2003 which appears to have 
stimulated investment. Dr. Bernanke, do you believe that the 
tax legislation that was passed in 2003 had this effect; and, 
if so, how important do you think it was?
    Dr. Bernanke. As I agreed, it was very important. As your 
chart shows, investment was quite weak until the middle of 
2003. The President's tax proposals which were passed by 
Congress included, first, measures to reduce the cost of 
capital, including reductions in dividends and capital gains 
taxes; second, bonus depreciation provisions which increased 
the incentives for firms to make capital investment.
    Of your private nonresidential investment, there were two 
components. There are both equipment and structures. Structures 
investment has remained somewhat moderate in terms of its 
recovery, reflecting overbuilding in the late 1990s and 
relatively high vacancy rates in office buildings, for example. 
So investment in the structure side, while we expect it to 
recover, has not yet fully recovered to earlier rates. However, 
the recovery in equipment investment has been quite strong; and 
I believe that the tax measures that you mentioned were an 
important component in that recovery.
    Representative Saxton. Thank you, sir.
    Let me turn quickly to another question. I would like to 
show you another chart that shows the history of inflation 
during the past several years; and it is fairly obvious by 
looking at the chart that inflation has remained in check since 
the early 1990s.
    [The chart appears in the Submissions for the Record on 
page 40.]
    As an advocate of inflation targeting, it appears to me 
that the Fed has successfully kept the measure of inflation in 
the range, as the chart shows, between 1 and 2 percent, which 
some refer to as the Fed's, quote, comfort zone. This appears 
to be similar to informal inflation and targeting, inflation 
targeting. By keeping inflation low and in this narrow range, 
hasn't the Fed reduced risk and helped keep long-term interest 
rates lower than they would otherwise be, in spite of the fact 
the Fed has increased short-term rates in recent times?
    Dr. Bernanke. Indeed, sir, you are correct. Bringing 
inflation down has been an important accomplishment. It has 
been often noted that, since about 1986, that the U.S. economy 
has been more stable. This is referred to by economists as a 
so-called grade moderation. In my belief, one of the major 
contributors to the increased stability of the economy, the 
fact the recessions are less frequent and severe than they were 
earlier, is the fact that inflation remains low and stable.
    As you point out, inflation, core inflation has remained 
within the 1 point to 2 percent range, which I believe is 
consistent with overall price stability. Looking forward, I 
hope the Fed will continue to maintain its commitment to keep 
inflation low and stable. I believe that is the best way to 
achieve its overall objectives of economic stability, price 
stability and low interest rates, as you point out.
    Representative Saxton. Thank you.
    Senator Reed.
    Senator Reed. Thank you very much, Mr. Chairman. Thank you, 
Chairman Bernanke.
    Much has happened since the President's tax cuts were first 
advocated or passed here--9/11, huge costs for homeland 
security, the war in Iraq--which has consumed over $200 
billion. In fact, I think one of your predecessors, NEC 
Director Lindsey, accurately predicted that, much to the 
chagrin of the Administration.
    We have hurricanes that we are going to spend billions of 
dollars in the Gulf, and yet the President seems to still be 
solely stuck on permanent tax cuts. Some people suggest that he 
is not paying attention to the reality of what has been 
happening in the last several years about the expenditures that 
we just can't avoid and the need, as you also suggested, to 
balance the budget, bring down the deficit. So what is more 
important, reducing the deficit or continued tax cuts?
    Dr. Bernanke. Thank you.
    First, as you point out, a good bit of the costs that have 
occurred are related to security expenditures, the global war 
on terror; second, the disasters in the Gulf. I think most 
economists would agree that, to the extent that deficit 
spending is appropriate for large expenditures of this type, 
using deficit spending as a partial way of funding it is not an 
unreasonable approach.
    With respect to taxes, it is my belief, and I think many 
economists would agree, that low marginal tax rates are 
supportive of economic growth, particularly in the long run, 
and that keeping them low, therefore, is an important priority. 
The question one would ask is, ``Before we begin raising taxes, 
have we really satisfied ourselves that we have reduced 
government spending as much as possible and that the existing 
programs that we are funding meet rigorous cost-benefit 
tests?'' I would submit that we would want to look very hard at 
government spending, make sure it is controlled before we raise 
taxes, which, in turn, would have negative impacts on the 
economy.
    Looking in the future, first in the near term, I do believe 
the President will be successful in his promise to bring the 
deficit down half by 2009. If that is accomplished, then, as a 
share of GDP, it will be significantly lower than the long-term 
average.
    Looking further out, we face very substantial increased 
costs in terms of entitlement programs. I would submit that 
there is simply no way that tax increases could ever cover the 
projected costs of those entitlement programs because they, on 
current plans, over the next few decades will rise, will 
increase government spending by 50 percent or more. Therefore, 
both in the short run as we look at current government programs 
and in the long run at entitlement programs, we need to think 
how hard we are going to maintain discipline in fiscal 
spending.
    Senator Reed. We have gone from a surplus in the Clinton 
administration, when tax policies seemed to be not adversely 
affecting the economy, to a situation now where we have no 
surplus, we have deficits, cumulative deficits going forward 
many years, a position of economic weakness rather than 
strength. Everyone is sympathetic about programs that don't 
seem to be working efficiently, but we are talking about 
cutting deeply into programs that are necessary for many 
Americans: those entitlement programs, et cetera. As we 
approach the baby boom generation, we seem to have squandered 
the flexibility and strength which we had several years ago 
with a surplus.
    Again, in the short run, what is more important, to deal 
with this deficit or to have permanent tax cuts?
    Dr. Bernanke. With respect to the arrival of deficits in 
the early part of this decade, I believe that the tax revenues 
that were received in the late 1990s were well above normal 
levels and I think I attribute that to the stock boom and the 
unsustainable state of the economy in the late 1990s. The 
deficits that arose early this decade primarily, in my opinion, 
arose because of the decline in the stock market, the end of 
the Internet bubble and then, on the spending side, from the 
increased costs of the War on Terror in particular.
    So I think----
    Senator Reed. Well, I have just 30 seconds. Can you give us 
your estimate of how much we will be spending on homeland 
security and the war in Iraq over the next 5 years? Because I 
presume you would not want to cut those funds.
    Dr. Bernanke. I think efficiency should be applied 
throughout the budget. Wherever we can find savings, it is 
important to do so. I do not know, however, what the spending 
will be on those items you are referring to.
    Senator Reed. So you would urge us to look closely at the 
military budget, Iraq, everything.
    Dr. Bernanke. I think the cost-benefit analysis should be 
applied wherever it is appropriate. However, the President has 
set forward proposals for savings that would double, for 
example, the current proposed savings under the budget 
resolution. So there certainly are many proposals that have 
been put forth by the White House, and I think we should look 
throughout the entire budget and see where we can find programs 
that are not providing value for money.
    Senator Reed. Thank you.
    Representative Saxton. Thank you very much, Senator Reed.
    We are going now to Senator Bennett.
    Senator Bennett. Thank you, Mr. Chairman.
    The longer I sit on this Committee, the more I realize the 
debate just keeps being recycled. I remember the first time I 
came to the JEC as the Committee's very junior, very green, 
newest Member. One of your predecessors, Dr. Tyson, was the 
witness and her comment was, ``Compared to other industrial 
nations in the world, we are seriously undertaxed; and this 
Administration is going to fix that.''
    Now, with the benefit of a dozen years of hindsight, 
looking back at the U.S. economic position vis-a-vis that of 
other industrialized nations, to pick a few--Germany, France, 
Japan, Great Britain--would you say that our tax policies have 
been more conducive to growth than theirs and that the level of 
taxation, which in my opinion should be measured as a 
percentage of GDP rather than in numbers of tax rates and tax 
brackets, but the amount, whatever the method, by which the 
Government takes money out of the economy relative to the GDP 
is the number that I think makes the most sense. Do you think 
our present band of GDP tax revenues is too high or too low 
compared to other industrialized nations, their rate of growth? 
Just get into this whole question of the American economy and 
tax policy and growth vis-a-vis other countries.
    Dr. Bernanke. Thank you, Senator.
    There have been three important long-term trends in tax 
policy in the United States. They encompass both Democratic and 
Republican administrations.
    Since President Kennedy, there has been generally declines 
in the marginal tax rates both at the highest level, but 
throughout the distribution. My view, and I think that this has 
become broadly accepted, is that lower marginal tax rates 
improve incentives for work and promote growth. The differences 
in marginal tax rates here and abroad, I think, account for a 
significant part of the difference in U.S. economic performance 
in terms of growth and productivity relative to other 
countries.
    The other two trends are, first, that the share of taxes, 
the share of GDP collected in taxes has not in fact changed 
very much despite the declines in marginal tax rates, 
suggesting that growth and other measures have been sufficient 
to keep revenues strong.
    The ultimate way to determine the appropriate level of 
revenue collection--I think, again, the first place to look is 
to ask the question, what does the Government need to spend; we 
need to look at spending programs in terms of whether they are 
providing value for money.
    So my approach is to think first about government spending. 
It is, in fact, the share of GDP that goes to government 
spending which is the true measure of the burden of the 
government on the national economy, and that is where we have 
to make sure that we are getting full value for money.
    Let me just add that although I think the U.S. tax system 
on the whole has been positive in terms of promoting growth, 
investment, entrepreneurship, and productivity, relative to 
other industrial countries, there is still a lot of improvement 
that can be had in the U.S. Tax Code. The President's tax panel 
is reporting and the objectives of tax reform would be to make 
the system simpler--it is incredibly complex--to make it more 
fair and to increase still further its tendency to increase and 
support economic growth. I think there is progress that can be 
made, but this bipartisan consensus over 40 years of reducing 
tax rates and improving incentives I think has paid off in 
terms of U.S. economic performance.
    Senator Bennett. Let me just comment, my reaction to the 
Mack-Breaux Commission is that I am sorry they weren't more 
bold. The present tax system is a disaster in terms of 
simplicity and efficiency, and we continue to nibble around the 
edges as we have done ever since we created the tax in the 
1930s. I would have preferred something much more dramatic than 
they have proposed. I would endorse the direction they are 
proposing, but I would like to move in another direction. Thank 
you very much.
    Chairman Saxton has given us a chart that shows the 
relative unemployment in various countries. Maybe we are not 
doing so badly when we compare American unemployment with some 
of that of the other industrial nations. Thank you.
    [The chart appears in the Submissions for the Record on 
page 39.]
    Representative Saxton. Chairman Bernanke, if I may refer to 
the chart to my right, your left. The unemployment rate in the 
so-called Euro zone is shown on this chart to be about 8.6 
percent; in Canada, 6.7 percent; and here in the United States 
at 5.1 percent. Your comments relative to and Senator Bennett's 
comments relative to the tax situation I suspect you would 
agree has something to do with this in various economies.
    Dr. Bernanke. Yes, sir. In addition, another dimension of 
this labor market performance is job creation where over the 
past two or three years total job creation in the United States 
is greater than that of Germany and Japan and the UK combined. 
Our tax system makes a constructive contribution to this 
performance. In addition, we have flexible and diverse labor 
markets which also can adapt to shocks and have allowed us 
remarkably to deal with high energy prices, hurricanes and many 
other shocks to the economy and still continue to have growth 
and job creation.
    Representative Saxton. Thank you, sir.
    Mrs. Maloney.
    Representative Maloney. Thank you very much and welcome. 
Congratulations on your appointment.
    You testified that productivity growth is absolutely 
fundamental to the improvement of the standard of living for 
Americans and for our long-term growth, but in order to have 
productivity we have to have jobs.
    At a recent forum that we had, Professor Blinder testified 
and said some interesting and, for me, some rather disturbing 
things about outsourcing for the future of this country. He 
argued that we can expect a dramatic increase in the amount of 
outsourcing because there is a huge educated population in 
China, India and other countries, and any job that can be 
remotely subject to outsourcing or can be done in another 
country, he says is in jeopardy. He predicts that outsourcing 
will be an incredible drain on American jobs in the future. I 
would like to hear your comments on what he has put forward, 
and does the Administration have policies that would address 
the fact that a huge number of American jobs may be at risk in 
the future.
    Dr. Bernanke. Thank you.
    First of all, we certainly don't want to see any American 
lose their job. If someone loses a job, we hope to have ways of 
helping them retrain and relocate as needed to find good new 
work. We want to support American workers in every way that we 
can.
    There is certainly some outsourcing in terms of purchases 
of services abroad. There is also insourcing. For example, the 
United States, although we have a very large overall current 
account deficit, we have a surplus on services. Americans 
provide financial, educational, tourism, and other services to 
people the world over. So it is a source of prosperity in 
markets for us as well.
    In addition, we benefit from foreign direct investment. 
Many Americans are employed by foreign companies with plants in 
the United States, for example, in the automobile industry. So 
trade is a two-way street. I think it is important to protect 
Americans who lose their jobs or whose jobs come under pressure 
from international trade, but I think we need to be careful not 
to embrace economic isolationism.
    With respect to overall jobs, I dispute the conclusion that 
either trade or even current account deficits destroy jobs. As 
was just shown on the diagram, the unemployment rate here is 
lower than Germany, which has a larger current account surplus, 
lower than Japan or other countries which have large current 
account surpluses. The job creation is better here. I believe 
that the U.S. economy will prosper in an international global 
economy and that jobs will be created, as many as needed, to 
employ all those who want to work.
    Representative Maloney. So, you do not see outsourcing as a 
challenge to American jobs. How much do you believe the United 
States will have to borrow from the rest of the world this year 
to support our swollen trade deficit? Some people have said it 
will be as much as 600, 700, 800 billion dollars. What is your 
estimate?
    Dr. Bernanke. As I mentioned in my testimony, the current 
account deficit is currently 6.3 percent of GDP, so that would 
be roughly the amount of foreign acquisition of U.S. assets 
associated with the current account deficit. I agree that we 
need to bring the current account deficit down, and I believe 
we can do so over a period of time. Doing so requires more 
savings of the United States, including a reduction in the U.S. 
budget deficit.
    Representative Maloney. That is roughly $800 billion. What 
would happen, Professor, if the rest of the world decided that 
it was too risky to hold this large amount of our debt? Would 
we see a collapse of the dollar, high interest rates, and 
possibly an international crisis if countries decided not to 
continue holding our debt?
    Dr. Bernanke. I don't anticipate any such development. U.S. 
bonds are well regarded as safe and liquid investments. They 
are the primary source of international reserves.
    Representative Maloney. Finally, what are your comments on 
the growing trend of inequality between the haves and have-nots 
that has been displayed? We have a chart. This also was a theme 
at our hearing with Professor Blinder, and I believe that 
leaders on both sides of the aisle are concerned about this 
trend. It is not good for our country, it is not good for our 
people, and what policies does the Administration have to 
address this growing trend of inequality between the haves and 
have-nots?
    [The chart appears in the Submissions for the Record on 
page 51.]
    Dr. Bernanke. Ma'am, that is a very complex question. I 
won't have time to answer in full detail. But I would point to 
one trend which is over the last 25 years or so the returns to 
education have risen. Therefore, people who are more educated, 
have college degrees or advanced degrees, the differential in 
their earnings to those who have high school or less has 
increased. This is reflective of the change in our economy 
toward a more technologically dynamic economy, one where higher 
skills are valued.
    The fact that we have become more technologically dynamic 
is a positive thing, but the increased inequality and earnings 
associated with this is a concern. I think certainly one 
approach is to try and spread the benefits of education, skills 
and training more broadly to make sure everyone is equipped to 
deal with the demands of our current economy.
    Representative Saxton. Thank you very much.
    Mr. Paul.
    Representative Paul. Thank you, Mr. Chairman.
    On page 8, you talk about the current account deficit which 
you expressed concern about and you discussed, as well as 
expressing concern about spending and deficits. You talked 
about a $35 billion cut, which to me seems like a drop in the 
bucket and will turn out to be irrelevant. We can't even get it 
passed here. It is over 5 years, and the national debt is going 
up nearly $600 billion a year. I don't think we are addressing 
the real problem, and the real problem is the Government is out 
of control and spending is out of control.
    But I think some of the problems you discuss here are 
probably related to monetary policy, and we never seem to 
connect the two. Yet in a speech a few years ago, I thought you 
did make a connection, and I want to just quote from that 2002 
speech.
    He says, ``We conclude that under a paper money system, a 
determined Government can always generate higher spending and 
hence positive inflation. While there are some who are less 
enthusiastic about paper money than that, I don't see inflation 
ever as a positive because it caused some of these problems 
that we are concerned about.'' But also increased spending 
naturally is going to lower savings. You would like to see 
higher savings. So we have a system of money where free market 
people supposedly have total monopoly control of the money 
supply and interest rates so we manipulate interest rates down 
to 2 percent on savings and then we want people to save. These 
are artificially low interest rates. So people on fixed incomes 
aren't going to save. There is really no incentive. Then we tax 
them on the interest they earn.
    To me, that is reflection of a very flawed monetary policy, 
and it does confirm Nixon's contention in 1971 that we are all 
Keynesians now, and we are resorting to the liquidation of debt 
through the debasement of currency, and it also invites concern 
about deflation which you have had concern about. But, since 
1971, we have had a 1,300 percent increase in the money supply 
and we have the privilege of being the reserve currency of the 
world, so we are encouraged to spend.
    But I think it is so unfair. It is not, as far as I am 
concerned, good economics, and it is unfair to the people who 
want to save. Then we get concerned about savings and then we 
create a monetary system that does increase spending not only 
in the private sector, but in the Government sector. As long as 
the Fed is there waiting ready to monetize anything we spend 
on, I think we are going to continue guns and butter, endless 
war spending, endless domestic spending.
    So I would like to suggest why can't we make a better 
connection to monetary policy, and I think you would be the 
expert on this that might be able to do that, and how can we 
justify this as being a fair system to the elderly who would 
like to earn a decent interest on their savings?
    Dr. Bernanke. Related back to an earlier question from Mr. 
Saxton, I think the best thing the Federal Reserve can do to 
avoid the problems you are referring to and make sure people 
get a fair return on their savings is to keep inflation low and 
stable. That has been the objective, and success has been 
increased over a period of time. You keep inflation low and 
stable. Then the cost of living for the retirees, for example, 
doesn't go up as fast. The real returns to savings are not 
eroded by inflation.
    So I think the appropriate approach is to focus on keeping 
inflation in the medium term low and stable. I believe that 
supports the Fed's other objectives of low interest rates and 
stable employment growth. So that would be the central part of 
my prescription for making monetary policy constructive in 
terms of economic growth and stability.
    Representative Paul. But for the elderly, the cost of 
living is not 2 percent, so I think it is a fiction to tell the 
people there is no inflation. If most of their money is being 
spent on medical care and on energy and keeping their house 
warm, these people are having an inflation rate of 10, 12 or 15 
percent and we deny this. So at the same time the Government 
says there is no inflation, therefore it is justified to have 
low interest rates. My contention is, why should we assume that 
we know what the interest rates ought to be? Why as free market 
people do we not resort to the marketplace to determine 
interest rates?
    Dr. Bernanke. There have been many proposals along those 
lines, and some of them are quite interesting. Under our 
current system, the central bank has been required by Congress 
to manage the monetary system, and I think the best way to do 
that in a stable manner is again, to focus on making sure that 
we have price stability.
    You point out correctly we do have inflation now. We have 
4.7 percent inflation in the last year. The biggest contributor 
to that is higher energy prices, which in turn depends on a 
variety of factors, including the supply and demand for energy 
around the world. That is a real phenomenon, one that is 
affecting people's budgets. It is hitting a lot of people, a 
lot of firms. There is no question that is a negative influence 
on our economy.
    Representative Saxton. Thank you very much. The gentleman's 
time has expired.
    Mr. Hinchey.
    Representative Hinchey. Thank you very much, Mr. Chairman.
    Chairman Bernanke, it is nice to see you, and thank you for 
being here.
    We are talking about economic growth; and it strikes me 
that growth, somewhat like beauty, is in the eye of the 
beholder. Looking at the chart over here on unemployment rates, 
I think that those figures in many respects do not reflect 
aspects of our culture that, if they were taken into 
consideration, would cause some dramatic differences in the 
levels of those charts.
    For example, we have two million people in prison in the 
United States, more than in any other country in the world, 
with the possible exception of China. We don't know how many 
they have, but if that were reflected in that chart number it 
would go up considerably.
    We have the highest level of homeless people of any 
advanced industrial country in the world. If that number were 
considered in there, the unemployment rate would go up 
substantially.
    There are a great number of people who have dropped out of 
the economy. That number of people is not reflected in that 
chart over there as well.
    So you have a situation where we are not just facing up to 
the truth. We are not addressing the real needs of people in 
this country, and one of the ways that we are avoiding that is 
pretending that the situation is rosy, rosy where for a lot of 
people it really isn't. One of the reasons why we have had the 
kind of growth that you described in your testimony over the 
last several years is that we have experienced an extraordinary 
amount of economic stimulation, both fiscal and monetary; and 
the fiscal stimulation, of course, has resulted in huge budget 
deficits, in fact, record budget deficits for the last 3 years 
and a record and growing national debt.
    The question arises, I think, in the minds of anyone 
looking at this objectively, how much longer can we sustain 
that kind of so-called economic stimulation, which is the 
source of whatever growth we are experiencing? And, of course, 
going back to the idea of the inequality of that growth, we are 
seeing more and more inequality in this country.
    The tax cuts that were passed by this Congress have had 
extraordinary economic benefits for the wealthiest people in 
America, but, at the same time, they are causing economic 
hardship for millions and millions of other people. We have 37 
million people in America now living below poverty. That is an 
increase of more than one million in the last couple of years. 
We have 45 million people now without health insurance, most of 
them working people making incomes of above $50,000 a year. 
Nevertheless, 45 million Americans are without health 
insurance. That number has gone up by nearly 8 million in the 
last 5 years.
    So the inequality that we are experiencing is very, very 
dramatic. Anyone sitting here at this table or as a member of 
the President's Council of Economic Advisers pretending that 
everything is just fine in America, that everybody is 
benefiting from this growth in the economy isn't really being 
honest about the situation.
    What is it that we ought to be doing to address the real 
economic needs of the average America?
    With another example, the median income of the average 
American family has been flat for the last 5 years. They are 
experiencing no growth whatsoever. That is the first time that 
that has happened in recorded history in our nation. So, what 
can we do, what can this Congress do and what can you recommend 
as the sole member of the President's Council of Economic 
Advisers that we can do to address the real needs of the real 
people of America?
    Dr. Bernanke. Thank you. That was a very lengthy question.
    First of all, with respect to the labor market, it is true 
that the unemployment rate is calculated relative to the labor 
force, and that in turn depends on how many people are actively 
seeking work and would include, for example, prisoners. If you 
look at other measures of the labor force, the share of the 
total population that is working or the number of jobs that are 
created, both of those also suggest a very strong labor force, 
so I don't think incarceration rates, for example, are the 
issue here.
    Also, in terms of sustainability, ultimately what allows us 
to continue to grow is the rate of productivity growth. As I 
mentioned in my testimony, we have had remarkable productivity 
growth going back to the mid-1990s.
    Representative Hinchey. That productivity growth is not 
being shared equitably. We have lost 3 million manufacturing 
jobs in the last several years here in this country. The kind 
of growth that you are talking about is not being shared 
equitably. If we are going to put up a chart reflecting the 
unemployment rates between Europe and another country that I 
can't see or another place that I can't see and the United 
States, we need to take into consideration the cultural aspects 
of those countries. The things that you are talking about are 
not reflected there. The number of people that are in the 
employment arena in Europe is reflected in those numbers.
    Representative Saxton. I am sorry, but the gentleman's time 
has expired.
    Representative Hinchey. They are not reflected here in this 
chart.
    Representative Saxton. Let me just remind everybody, we 
have this room for just 2 hours. We started right on time. We 
are now 55 minutes into the first hour, and we haven't finished 
the first round of questions. So we are going to go to Mr. 
Ryan.
    Representative Ryan. I will try to keep under the 5 
minutes.
    First, I want to make a clarification and ask a quick 
question. I think it was Senator Reed who talked about the tax 
cuts, how they supposedly balloon the deficits and how we 
should not extend these tax cuts. Mr. English and I serve on 
the Ways and Means Committee that wrote that tax cut, so I 
looked up the spreadsheet from the Joint Committee on Taxation 
that we used in 2003 to estimate what they would cost.
    In 2003, our official scorekeeper estimated that in the 
next year, 2004, the individual income tax cuts would cost this 
country $106 billion in revenue loss and that the corporate tax 
revenue loss would cost us $35 billion. So, we thought in 2003 
individual receipts would go down by $106 billion. What 
happened? They went up 14 percent. We thought corporate 
receipts would go down, because of the tax cuts, $35 billion. 
What happened, they went up 33.4 percent. In total, in light of 
our scorekeeping, our estimate, we thought that in 2004 we 
would lose $148 billion in revenues from those tax cuts. We 
thought we would increase the budget deficit by $148 billion. 
What actually ended up happening in 2004 was revenues went up 
$116 billion.
    Look at what is happening in 2005. In 2005, so far this 
year, individual income tax receipts are up 15 percent and 
corporate income tax receipts are up 47 percent. We have had 
the largest year-to-year increase in revenues in this country 
since 1981 and, in particular, in our budget deficit in the 
first quarter of this year, we have the largest drop, an 
unprecedented first quarter drop of $94 billion. The budget 
deficit is now down $94 billion pre-Katrina, and we are 
preparing a package to pay for that one as well.
    So, I think it is very important as we talk about tax 
policy and what to do in the future, and what not to do in the 
future, not look at estimates that were done a few years ago 
that we already know for a fact are not only incorrect, but are 
way off. Let's look at reality, and let's look at actual 
performance, and let's look at the fact that these tax cuts not 
only help produce jobs and economic growth, lower the 
retirement or lower the unemployment rates, but these tax cuts 
actually increased revenue to the Federal Government, which is 
helping us get this budget deficit down. So it is a very 
important dose of reality.
    Here is my quick question. Two important tax cuts expire in 
2008, dividends and capital gains; they are off the track with 
respect to the rest of the tax cuts which expire in 2010.
    I want your opinion, Dr. Bernanke, on how the economy views 
this; how do the markets look at this? I am very concerned that 
the longer we delay in extending those two provisions that 
expire in 2008, the more it will produce more uncertainty in 
the capital markets, will make capital less attractive in the 
United States and more attractive in foreign countries, will 
depress our savings rate even more, and would be harmful to our 
economy. But that is just my own personal concern. Could you 
address what the economic ramifications, in your opinion, are 
of not extending the capital gains and dividend tax cuts; and 
are we hurting ourselves with respect to the economy by 
delaying extending those cuts? Is it wrong to wait until the 
last minute to extend those cuts, and should we do this now or 
should we not be concerned about that?
    Dr. Bernanke. Thank you. First of all, I agree about your 
comments about 2005, that tax receipts have been about $100 
billion more than expected, and the deficit correspondingly 
lower.
    With respect to taxes on capital gains and dividends, the 
President, as you know, is in strong support of continuing 
those tax measures. I do think that uncertainty and delay, 
although sequel, would be costly in the sense that investors 
would not know exactly what to anticipate in making their 
decisions. So there is, I think, some validity to that concern.
    Representative Ryan. So we will forego economic growth that 
we would have otherwise been able to achieve in this economy if 
we delay in extending those two provisions from 2008 to, say, 
2010 or permanently.
    Dr. Bernanke. There will be an increase in uncertainty and 
there may be some effect on growth, yes.
    Representative Ryan. Thank you.
    Representative Saxton. Thank you.
    Ms. Sanchez.
    Representative Sanchez. Thank you, Mr. Chairman. And I have 
to tell you that as a trained economist, I feel like I am in--
and I am used to sitting in a room with lots of economists and 
everybody having different opinions--but I really feel like I 
am in the twilight zone here. It is just amazing to hear some 
of the things that are being said here.
    I find it interesting that this Administration would pat 
itself on its back by comparing the European Union's 
unemployment to the United States', for example. Europe has 
been vigorously incorporating poor countries into its economy, 
cold war economies that were totally devastated by communism, 
and cold war workers who have had a very hard time 
accommodating to the market economy. So to compare their 
unemployment rate to the United States, I mean, I think this 
Administration has been terrible about accommodating poor 
people, about educating poor people, about bringing people who 
are underemployed or unemployed into the realm. And we see it 
basically with the differences between the gap, income gap. And 
certainly Chairman Greenspan spoke about this when he was 
before us most recently.
    I have a couple of questions. I hope I get to them. The 
first one would be, I am interested in the comments that were 
just made about the revenue levels with respect to the tax cut, 
because when I look at the numbers, I see that the revenue 
levels in the Bush administration have been actually lower as a 
share of GDP than at any time since 1959. So with increased 
spending priorities--I mean, this Administration is spending 
like crazy, it is just unbelievable--why is it better to have 
deficits than to pay for them on a pay-as-you-go basis, Mr. 
Chairman?
    Dr. Bernanke. There was a decline in tax revenues in 2001, 
I believe, which I think was justified, first of all, by the 
recession and the appropriate fiscal response to that. And in 
addition, it has been the case in the past that in a short 
period following cuts in marginal tax rates, which, as I 
mentioned, occurred under both Democratic and Republican 
administrations, there was a period of reduced tax revenues 
associated in the short run with that reduction. However, over 
a longer period, there is a tendency to return to a more normal 
level, and currently income tax revenues, for example, as a 
share of GDP, are very close to their long-run average and they 
are projected to go above the long-run average by 2009.
    Representative Sanchez. But over the time, they have been 
lower than at any time since 1959. Are you saying that all of a 
sudden, the next couple of years, we are just going to do such 
incredible things that that is not going to be true? I mean, 
given the fact that I have got two Louisiana Senators asking 
for $250 billion for Louisiana, for example, that I am sure 
most people here are going to try to put in a supplemental 
spending.
    Dr. Bernanke. Well, as I mentioned earlier, I think that 
some deficit spending is appropriate when you are facing a 
global war on terror and natural disasters. It certainly would 
not have been--a balanced budget policy in 2001 would not have 
been a constructive economic policy, in my view. I think that 
the President is going to meet his objective of reducing the 
deficit in half by 2009, and if he does so as a share of GDP, 
we will be actually well below----
    Representative Sanchez. And how do you think he is going to 
do that? I mean, I don't know where you got this figure from, 
but you just said that you thought that entitlements were going 
to be increasing by 50 percent, and I don't know over what time 
period you gave us. I mean, when I think of entitlements, I 
think of veterans health care, Social Security, disability 
benefits, a death benefit to survivors of people who have put 
into Social Security, Medicare. Are you trying to tell me that 
the President is going to cut health care to the elderly, 
retirement to the elderly, cut moneys to those who are 
disabled, cut money to orphans, cut health care to veterans, 
cut the retirement of our people who have served in the 
military? Is that what his intentions are to bring down the 
deficit, if you are looking at a 50 percent increase over this 
time period?
    Dr. Bernanke. No, ma'am. I have two different time frames 
in mind. The President's 2009 commitment obviously is over the 
next few years, and over the next few years I believe that--not 
cutting, but simply slowing the very rapid rate of growth of 
some programs will be sufficient to restore the deficit to a 
lower level.
    However, the real challenges for America are not in the 
next five years, they are over the next 20 and 30 and 40 years; 
and that is what my figures about 50 percent were referring to, 
around 2030 and 2035. If you make no changes in current 
programs such as Social Security and Medicare and Medicaid, and 
they continue to grow at recent pace, reflecting the graying of 
America, the retirement of the baby boomers and the like, there 
is going to be an enormous increase in the share of national 
resources absorbed by Government programs, much greater than we 
could conceivably cover by tax increases. We will need to 
consider how to modify those programs so that they serve their 
purposes without busting the budget.
    Representative Sanchez. It sounds to me, Mr. Chairman, like 
you are expecting the President to cut those programs----
    Representative Saxton. The time of the gentlelady has 
expired.
    Representative Sanchez. Thank you, Mr. Chairman.
    Representative Saxton. Mr. English.
    Representative English. I would like to move this debate a 
little bit, Doctor, out of the twilight zone and maybe focus on 
a couple of things where we are comparing apples to apples. You 
have been criticized, I see, for pointing out what I think is a 
useful point: that our unemployment rate in this country, 
although it is not very good in parts of my district, overall 
is significantly lower than that of many of our European 
trading partners.
    I wonder if you could briefly, maybe provide a perspective 
of comparing the growth rate within the United States--which I 
think is very much affected by our tax policy, and Chairman 
Greenspan has conceded that point up front--would you compare 
our growth rate with that of our trading partners in Europe?
    Dr. Bernanke. I don't immediately recall the recent growth 
rates in the major countries, but I am quite certain that the 
U.S. growth rate in recent years, and also over the last 
decade, for that matter, is higher by a significant margin than 
other major industrial countries such as Germany, U.K., France, 
and Japan. And job creation is significantly greater in the 
United States than in those countries.
    Representative English. And that growth rate has a direct 
bearing on our ability to grow our tax base and generate 
revenues that in turn will move us away from a deficit 
position. Has that not been the experience over the last year--
as Mr. Ryan was careful to point out--with, in effect, a 
reduction in the overall deficit picture beyond estimates of 
about $95 billion. That $95 billion drop--which I realize 
didn't take into account Katrina and some other factors--that 
was largely driven, as I understand it, by a growth in revenues 
that are directly attributable to economic growth. Am I 
mistaken on that point?
    Dr. Bernanke. No, sir, you are correct. GDP growth in the 
United States has been 4.1 percent annually over the past two 
years. I believe that tax policy had a significant role to play 
in creating that growth. Revenues have grown accordingly with 
economic growth, and indeed in 2005 they appear to be 
significantly higher than we expected, even given the amount of 
economic growth that we observed.
    Representative English. Then I think the issue here is what 
do we need to do to continue that growth path despite price 
shocks in the energy sector. And here I want to go back to Mr. 
Ryan's point with regard to current tax rates on dividends and 
long-term capital gains. I am concerned about the message we 
might send to markets if we don't move now to extend the 
current rates.
    And this week I noticed that the chief economist at 
Wachovia, John Silvia, published a research note in which he 
said, and I quote, ``Policy makers can enhance employment and 
growth by providing a stable tax environment for capital by 
extending the 15 percent tax rate.''
    Now, opportunities lost may be difficult to quantify in the 
short run, but the competitive nature of a global marketplace 
suggests that other nations will attract the capital necessary 
to improve their competitiveness and long-term employment if we 
fail to extend the current 15 percent rate.
    Now, do you think this concern is an immediate one? You 
have already testified that it would make sense for us to move 
sooner rather than later, but at what point will markets start 
to make the judgment that Congress may lack the political will 
to extend its current pro-growth policies?
    Dr. Bernanke. Well, as I indicated, I think it is important 
that we make the tax cuts permanent. The markets will have to 
make their own assessment about the probabilities and the risks 
associated with that. And I really don't have much to add on 
that side, other than the more we can assure markets that we 
continue to favor pro-growth policies and a low cost to 
capital, the better off we are going to be.
    I realize it is a very complex budget negotiation going on, 
and I want to say, in addition, that we do need to look at the 
spending side and make sure that spending is under control and 
we are eliminating programs that are not providing good value. 
Ultimately, if the spending grows beyond reasonable ranges, 
then it will be extremely difficult to maintain the low tax 
rate.
    So part of keeping taxes low is also keeping spending low, 
and I think that is equally important as we look at the budget 
process.
    Representative English. And ultimately, economic growth is 
critical to us in meeting our social needs, which the 
gentlelady from California was kind enough to catalog for us.
    I yield back the balance of my time, Mr. Chairman.
    Representative Saxton. Thank you very much, Mr. English.
    Chairman Bernanke, thank you very much for being with us 
this morning. I wish we had more time; however, we are pressed, 
and so we thank you for being here with us. And you can be sure 
that we will invite you back again.
    Dr. Bernanke. Thank you very much for having me.
    Representative Saxton. We are now going to move to our 
second panel: Dr. Mickey D. Levy, who is the Chief Economist at 
the Bank of America in New York City; Dr. David F. Seiders, 
Chief Economist, National Association of Home Builders here in 
Washington, DC; and Dr. Brad Setser, Senior Economist and 
Director of Global Research at the Roubini Global Economics in 
New York City. If you would be so kind as to take your places.
    Representative Saxton. And, Dr. Levy, when you are ready, 
sir, we would appreciate hearing from you.

   STATEMENT OF DR. MICKEY D. LEVY, CHIEF ECONOMIST, BANK OF 
                     AMERICA, NEW YORK, NY

    Dr. Levy. Yes. Mr. Chairman, and Members of the Committee, 
I am very pleased to discuss the economy and associated 
economic policies, particularly in regard to following Ben 
Bernanke's comments. I think it is extraordinarily important to 
point out the underlying fundamentals in the U.S. economy, how 
strong they are. And here I refer to the flexible and efficient 
production processes, labor markets, the low inflation, the 
relatively favorable taxes and regulatory policies, and this 
leads to the U.S. economy growing much faster than every other 
industrialized nation.
    This has been true, the United States has grown at least a 
percentage point faster than Europe every year since 1990, with 
the exception of 2002. Capital spending is multiples higher. 
And I would say U.S. potential growth is 3\1/2\ percent plus, 
to the plus side. And we have an $11 trillion economy. And so 
3\1/2\ percent growth adds an extra output of $375 billion, 
which creates jobs and the like. And I think it is incumbent 
for policymakers to maintain policies that are consistent with 
sustained healthy economic growth, not just for raising 
standards of living, but for the best environment for budget 
policymaking.
    There was sound economic growth prior to Katrina, showing 
some signs of moderation, but healthy increases in employment, 
modest increases in wages, healthy increases in personal 
income, business investment was rising, and corporate profits 
had reached an all-time high. And, I might note, exports had 
reaccelerated significantly.
    The impact of Katrina will cause a temporary--and I 
underline the word temporary--impact on employment, 
consumption, trade, and inflation. And the data we have seen 
for September, post-Katrina, suggests that the impacts are 
identifiable and local, meaning that in the rest of the Nation 
there continues to be healthy growth. And I might note that the 
healthy economic expansion and the Fed's accommodation so far 
will help absorb displaced workers, and that is already 
occurring.
    I expect in the next quarter and this quarter, and perhaps 
into early 2006, moderation in the rate of consumption growth; 
but then you are starting to see, as we speak, increased 
Government purchases, increased Government spending and fiscal 
policy multipliers are really going to kick in. And you can 
have that occur just at the same time consumption is bouncing 
back next year. So next we could have very strong economic 
growth.
    I might note here that the higher headline inflation due to 
higher energy prices is reducing real purchasing power and is 
having a temporary negative impact on real wages. I do not 
expect that to continue. I do expect sustained productivity 
gains to generate increases in wages.
    I would like to clarify two misperceptions I read about--I 
see about characteristics in the economy that are commonly 
viewed as flaws. And the first is the low rate of personal 
saving. And I would like to point out here that the rate of 
personal saving, which is close to zero, is a flow variable; it 
does not include any appreciation of stocks or bonds, it does 
not include any appreciation of real estate. Therefore, this 
rate of personal saving is so low it excludes every avenue 
through which most households save. Meanwhile, total household 
wealth, even excluding all debt, is at an all-time high. So I 
say the rate of personal saving, in an odd sense, reflects 
confidence in the U.S. economy. People, even if they feel like 
they might lose their job, they can find another one, so they 
spend their cash flow and wealth continues to rise.
    The other misperception about the economy is the trade 
deficit which is very, very large. Many people perceive that 
the high trade deficit is due to U.S. consumers, which is 
borrow to the hilt and spend their money on imported goods. But 
in fact if you look at a composition of what we import, it is 
amazing, because 40 percent of all imported goods to the United 
States are industrial materials and capital goods, even 
excluding oil and excluding autos. That is as much as total 
imports of all consumer goods.
    Now, if you look at the way the United States has 
consistently grown faster than any other industrialized nation 
and its capital spending is multiples faster, the wide trade 
deficit, the fact that we are importing more than we are 
exporting, is a natural consequence of that. And it may just 
last a long time, and it may just be sustainable. That is, if 
we had a recession, and capital spending fell and consumption 
slowed, then, sure, the trade deficit is going to come in. What 
should your objective be?
    But I would also point out so far this year, the trade 
deficit has come in, for some reason import growth is slow, the 
exports are accelerating nicely. And when I look around the 
world I see very strong economic growth in Asia, and Japan is 
really coming back to stronger growth. The Latin countries are 
doing fairly well now. All of our major trading partners, 
except for Europe, are doing poorly; so I think we can look 
forward to continued growth in exports, but the trade deficit 
is going to stay wide.
    In this regard, the extraordinarily large current account, 
it has widened. I do not perceive it is an immediate problem. 
When we think about--when we ask the question, will foreign 
central banks and foreign portfolio managers continue to buy 
dollar-denominated assets, the answer is yes; they are doing so 
because it is economically rational for them to do so. Put 
yourself in their shoes. They see stronger economic growth in 
the United States, higher interest rates, higher inflation-
adjusted interest rates, a credible central bank, credible 
policymakers, predictable policymakers. If you were in their 
shoes, you would allocate your resources to the United States. 
And I don't see any dramatic shift in global asset allocation 
that would lead to either a dramatic decline in the dollar or a 
sharp rise in interest rates.
    Having said that, the character of the current account 
deficit has changed. In the 1990s we had an investment boom and 
saving was OK, but insufficient relative to investment. Now the 
problem we have is investments bouncing back, but saving is 
low, OK. So you have insufficient saving relative to national 
investment, just like Japan has excess saving relative to 
investment, so the exports are capital here. The culprit of the 
lack of saving is not as much the low rate of personal saving 
as it is the budget deficit, and this needs to be addressed.
    And so the problem, I see, is we have this issue that, when 
I look at it, both the current trade account deficits--we 
should expect them to be wide--it is a natural consequence of 
differences.
    Let me just put it as a question. If you see such large 
differences in economic growth across nations and large 
differences in rates of saving and investment and you believe 
in international trade and capital flows, why would you ever 
expect current accounts and trade accounts to be in balance? 
You shouldn't. But we have this problem.
    Now, what is the solution? I would love to see the solution 
be the United States, Europe, and Asian policymakers sit around 
the table and say, OK, United States says we will lower our 
budget deficit by 2 percent GDP, Europe says we will lower 
taxes, reduce our burdensome regulations, increase our 
potential growth from 2 to 3, and Asia--China would come along 
and say if you do that, we will float our currency. That is a 
pro-growth solution. But the point here--the reason I am 
bringing that out is when you look at these imbalances, think 
about pro-growth solutions rather than just reducing imbalances 
just to reduce them. My expectation is that consumption growth 
in the United States will bounce back post-Katrina, but it will 
slow--it will bounce back to a more moderate level than we had. 
I mean, if you look at the average annualized growth of 
consumption, really the last 45 years it has averaged 3.6 
percent, we are not much higher than that now. I think it is 
going to bounce back to a slower rate of growth, exports are 
going to surprise to the upside, and the trade deficit will 
decline, and that imbalance will decline a bit, but we still 
have this long-run budget problem.
    And on the budget issue I would just note, trying to be as 
absolutely nonpartisan as possible, if you look at what has 
happened to the composition of spending in the budget and the 
composition of the growth in spending, in the last 3--in the 
1990s, the vast majority of the move toward budget surpluses on 
a cash flow basis was due to the decline in defense spending. 
In the last 3-4 years, both sides of the political aisle have 
voted for increase in defense spending. Neither party has come 
up with a great long-run solution for Medicaid or Medicare, 
both of which are rising fast as a share of the budget and the 
GDP, and we all know the Social Security issue.
    So basically, given the short-run intractability of the 
spending side of the budget--I am being a realist here--what 
fiscal policymakers should be addressing now is to address the 
larger budgets on an accrual basis; that is, look at the large 
entitlement and retirement programs, which is the larger source 
of the increase of the budget over the last 15 years, and have 
a rational debate and say--and ask the question, how can we put 
together programmatic changes that are fair to current 
participants, that put in place the right incentives----
    Representative Saxton. Doctor, if I may ask you to cut it--
--
    Dr. Levy [continuing.] And for the long run, just make the 
benefit structures rational. Thank you.
    [The prepared statement of Dr. Levy appears in the 
Submissions for the Record on page 55.]
    Representative Saxton. Thank you very much.
    Dr. Seiders.

      STATEMENT OF DR. DAVID F. SEIDERS, CHIEF ECONOMIST,

             NATIONAL ASSOCIATION OF HOME BUILDERS,

                         WASHINGTON, DC

    Dr. Seiders. Well, thank you, Mr. Chairman. It is genuinely 
an honor to be here today. I appreciate the opportunity to 
testify, and will certainly take any questions you may have.
    My name is David Seiders. I am Chief Economist with the 
National Association of Home Builders. My written statement 
contains detailed forecasts for the economy and the housing 
sector, on a quarterly basis, through 2007.
    Today, I would just like to concentrate on what the role of 
housing has been in the economic expansion so far, and how I 
view the evolving role of housing in the near-term outlook.
    Let me say at the beginning, that my forecasts assume that 
the current economic and housing policy structure remains very 
much intact. Housing certainly has some beneficial provisions 
in both the Tax Code and the housing finance system, and I'm 
assuming in the forecast that they are unchanged in the near 
term.
    There has been a lot of talk about imbalances here this 
morning, and you may be aware that Chairman Greenspan recently 
described the current ``housing boom,'' as he called it, as one 
of America's great economic imbalances. I certainly don't share 
that opinion, and I will tell you why as we go along.
    As you know, the housing sector has been a real pillar of 
strength for the economy, even in the recession of 2001, and 
certainly in the economic expansion since then. The housing 
production component of gross domestic product has been growing 
rapidly and delivering solid contributions to GDP growth. The 
housing stock itself produces housing services that are 
consumed by households, a big piece of consumer spending in the 
GDP accounts that also has been showing solid growth.
    When housing is moving well in terms of sales and 
production, we are pulling other industries with us, like 
furniture and appliances and those sorts of things. And as 
Chairman Greenspan has been talking a lot about recently, the 
strong house price appreciation that we have seen in recent 
years has created huge capital gains and equity benefits for 
America's homeowners, about 70 percent of all households. And 
that equity generation has supported a lot of consumer 
spending. When you add all this up, we estimate, I think 
conservatively, that housing has been accounting for at least a 
full percentage point of GDP growth in recent times. That is at 
least a quarter of the total, so it has been quite a story.
    I mentioned that this kind of performance, particularly the 
behavior of house prices, has generated widespread speculation 
that the housing ``boom'' is overdone, and that it is likely to 
``bust'' and possibly cause not only serious damage to our 
sector, the housing sector, but also to the economy overall. 
And we have been seeing a lot of analogies drawn between the 
current housing boom, if I can use the term, and the stock 
market bubble that preceded the recession of 2001. I think 
those analogies are really off base.
    My own view is that the housing market will inevitably cool 
down to some degree before long, but a destructive housing bust 
is not in the cards. Furthermore, rebuilding in the wake of 
this year's hurricane season will add to housing production for 
years to come. Everything considered, I think that the housing 
sector should transition away from being this strong GDP 
engine--fairly soon probably--but continue to play a vital role 
in the economy going forward.
    Recent housing market indicators, on balance, have been 
suggesting that the housing market may be plateauing in terms 
of the volume of sales and starts and so forth. We got some 
very strong numbers yesterday on permit issuance and housing 
starts in September, a little stronger than I expected. 
However, my surveys of builders and some other indicators 
suggest that there is kind of a flattening going on out there 
in terms of volume, certainly not yet in terms of pricing. And 
so I think that the housing market, in terms of sales and 
production, if not topping out now, is close to it.
    Going forward, my forecast does recognize emerging 
affordability issues that have been created, first of all, by 
the succession of rapid house price gains in many parts of the 
country. We are seeing that affordability factor putting a bind 
on home buying now. And we expect the affordability issue to be 
more complicated as we go ahead, as the interest rate 
structure, both short and long rates, gravitates up further; 
and that process certainly has begun.
    I am also looking for less support to the housing market 
from two special factors that probably are temporary. One is 
heavy use of what Chairman Greenspan has called ``exotic'' 
forms of adjustable-rate mortgages, including deeply discounted 
interest-only adjustable-rate loans and various structures like 
that. Certainly the financial regulators are taking a very hard 
look at that right now. I expect to see these types of loans 
recede in the market, in terms of their importance.
    The other special factor we have seen is a lot of investors 
out there, and a lot of them probably just short-term 
speculators in the housing market. As the market situation 
evolves and housing demand does fade to some degree, because of 
the affordability issue, I think we will see a lot of those 
speculators go to the sidelines as well.
    So, what does my forecast show? It says that we are going 
to see the housing numbers, in terms of home sales and housing 
starts, move off in 2006. The decline probably will be only 
about 5 percent from 2005, which will easily be a record for 
the single-family market, in particular, and also a very strong 
year for the condo market.
    In terms of pricing, we are still seeing double-digit 
increases in house values nationally, 20 percent or more in 50 
to 60 metro areas in recent times. As housing demand fades as I 
have described, and volume comes off, I think that the rate of 
appreciation in house values will recede. To what rate next 
year, I am not exactly sure. If I had to make a guess, probably 
10 to 12 percent this year, next year something like half that 
pace.
    Don't expect to be worrying about a national house price 
decline over the next couple of years. We may see some declines 
develop in some of the hottest areas where the prices have 
risen the most. But even in those areas, unless the economy 
falters, I think price declines are a low probability. One of 
the key things in those areas has been serious supply 
constraints, mainly land-use controls which prevent the 
builders from meeting the housing demand that is there. As we 
go forward, more supply will keep coming on those markets, and 
I think that the price rebalancing will be an orderly process.
    Mr. Chairman, that concludes my remarks.
    [The prepared statement of Dr. Seiders appears in the 
Submissions for the Record on page 60.]
    Representative Saxton. Thank you very much, Dr. Seiders.
    Before we go to Dr. Setser, let me just say that we have a 
series of votes currently on the House floor, and House Members 
will be scampering out to make those votes, and then we will 
try to get back for the question and answer period. In the 
meantime, Senator Bennett is going to take the Chair. Thank 
you.
    Dr. Setser.

        STATEMENT OF DR. BRAD SETSER, SENIOR ECONOMIST 
        AND DIRECTOR OF GLOBAL RESEARCH, ROUBINI GLOBAL 
                  ECONOMICS, LLC, NEW YORK, NY

    Dr. Setser. I want to thank Chairman Saxton and the Members 
of the Joint Economic Committee for the opportunity to testify 
here today.
    My remarks will focus on one particular aspect of the 
economic outlook, the payments deficit that the United States 
is running with the rest of the world. I want to make five 
points.
    First, the U.S. current account deficit has reached an 
unprecedented size for a major economy. Barring a sharp fall in 
oil prices, that deficit is likely to rise next year.
    Second, the U.S. external deficit reflects policy decisions 
both here in the United States and abroad, not simply private 
savings and investment decisions. Both the large U.S. fiscal 
deficit and the unwillingness of many economies elsewhere in 
the world to allow their currencies to appreciate against the 
dollar are contributing to this deficit.
    Third, trade deficits at nearly 6 percent of U.S. GDP are 
simply not sustainable over time.
    Fourth, large current account deficits reflect borrowing 
that is needed to finance consumption in excess of income. The 
availability of sufficient financing to sustain deficits of the 
current-size--borrowing that may reach $900 billion next year--
should not be taken for granted. Consequently, these large 
ongoing deficits will be a risk to the U.S. economic outlook 
for many years to come.
    Finally, policy actions both here and abroad can help, 
first to stabilize and then to reduce the U.S. external 
deficit. The needed policy steps by now, I think, are well 
known, but no less urgent.
    First, the U.S. current account deficit is now quite large. 
The current account deficit is, by definition, the sum of the 
trade deficit, the deficit on transfer payments--U.S. foreign 
aid, and private gifts of U.S. citizens abroad--and the balance 
on income. The income balance reflects the difference between 
what the United States earns on its foreign assets and what the 
United States must pay on its liabilities. The United States 
pays both dividends on foreign investments here in the United 
States and the interest on our rising external debt.
    In the second quarter, that balance--the balance on 
income--turned negative for the first time in some time, and 
over time the balance on investment income will contribute 
increasingly to the U.S. current account deficit.
    In 2005, I expect the current account deficit to rise to a 
bit over $800 billion. That will reflect a trade deficit that 
will increase to about $720 billion, largely on the back of 
higher oil prices, continued transfer deficits, and for the 
first time in several years, an income deficit.
    That $800 billion deficit is a significant increase from 
the $520 billion deficit of 2003 and the roughly $670 billion 
deficit of 2004. I expect the trend of wider deficits to 
continue in 2006 for three reasons:
    First, the pace of growth of non-oil imports, as has been 
noted, has been relatively subdued this year. That reflects a 
lag after very strong growth at the end of 2004. As the U.S. 
economy continues to grow, I expect some resumption in the 
growth of non-oil imports.
    Second, I expect the current strong export growth to slow. 
Why? Because the dollar has been strengthening this year, and 
that will impact the trade balance.
    I disagree somewhat with Dr. Levy in his emphasis on strong 
growth in Asia and low growth in Europe. If you look at the 
composition of U.S. export growth this year, U.S. exports to 
Europe have been growing faster than U.S. exports to the Asia 
Pacific region for the simple reason the dollar felt 
substantially against the euro in 2003 and 2004.
    Finally, the balance on investment income, the amount of 
interest that the United States has to pay on the external 
debt, is set to rise substantially. The roughly $800 billion 
that we have to borrow this year, assuming an interest rate at 
around 5 percent, translates into a $40 billion increase in our 
net payments abroad.
    Second point, this rising external deficit is a function of 
policy choices both here and abroad--policy choices that have 
reduced savings relative to investment in the United States and 
increased savings relative to investment in the rest of the 
world. The key policy decision that we in the United States 
made is to increase our structural fiscal deficit. That deficit 
went up during the recession, as Dr. Bernanke noted. It has not 
come down commensurately as the economy has recovered. As 
investment has picked up from its low levels, that has 
correspondingly widened the gap between savings and investment 
here in the United States.
    Abroad, savings and investment have evolved in different 
ways in different countries, but I think it is important to 
recognize the main counterparts to the U.S. current account 
deficit--or to the rise in the U.S. account deficit--has not 
been an increase in Europe's current account surplus. Europe's 
current account surplus, broadly speaking, has been falling. 
Japan's surplus has been rising, but the rise, roughly $60 
billion since 1997, is in no way on the same scale as the 
increase in the U.S. current account deficit. The main 
counterpart to the increase in the U.S. current account deficit 
has been the enormous increase in the surpluses that have been 
run by so-called emerging and developing economies. That 
reflects rises in savings in China and in the oil-exporting 
countries, and falls in investment in many other emerging Asian 
economies.
    The vector that has carried these surplus savings to the 
United States, by and large, has not been the private flow of 
capital; rather, it has been the unprecedented increase in the 
accumulation of hard currency reserves by emerging economies. 
The increase in true reserves, the annual increase, has gone 
from about $116 billion in 2001 to about $500 billion last 
year, and I expect around $600 billion this year just in the 
world's emerging economies.
    Third point. These deficits are not sustainable over time. 
Particularly trade deficits of this magnitude are not 
sustainable over time. Why? Because a constant trade deficit, 
according to basic external debt sustainability analysis, 
implies a rising external debt-to-GDP ratio over time, and a 
rising external debt-to-GDP ratio implies a rising current 
account deficit as the amount of interest that we have to pay 
on our external debt rises over time.
    Indeed, should the trade deficit gradually fall to roughly 
zero over the next 10 years, something that would imply 
substantial changes, the U.S. national external debt would 
still rise to about 50 percent of U.S. GDP, and at the end of 
that adjustment period the United States would still be running 
a significant current account deficit.
    Fourth, as I mentioned earlier, sustaining ongoing deficits 
of this magnitude next year requires net inflows of capital 
from abroad of between $900 billion and $1 trillion dollars; 
that implies that we have to commit some of our future income 
to pay for that inflow of debt. And broadly speaking, since we 
are relying on foreign savings to finance investment here at 
home, some of the benefits of investment here will flow to our 
foreign creditors.
    More immediately, though, the risk is that the financing 
needed to sustain these deficits won't be available at current 
relatively low interest rates. Any rise in interest rates might 
provoke a slowdown in U.S. economic activity.
    The combination of market forces and policy decisions that 
will bring about the necessary adjustment in the U.S. trade 
deficit is subject to substantial uncertainty, but there is no 
doubt that the adjustment, when it comes, implies substantial 
changes in the drivers of growth both in the United States and 
in our trading partners. Specifically, consumption growth here 
in the United States must slow, and consumption growth in our 
trading partners needs to rise.
    Recent studies by the staff of the Federal Reserve Board 
offer hope that the necessary adjustment process will be 
relatively smooth. However, caution is in order. The United 
States is in many ways operating outside the realm of 
historical experience. But I think one lesson from 
international experience is pretty clear. As a country's 
external debt grows, it becomes more, not less, important to 
maintain confidence in a country's fiscal policy choices. 
Reducing the fiscal deficit, put simply, is the best way to 
raise national savings.
    Policy changes are also necessary abroad. China, Malaysia, 
and many oil-exporting countries need to unpeg or reduce the 
degree to which they peg their currencies to the dollar. 
Spending in oil-exporting countries must rise if oil prices 
stay high, and China needs to take steps to stimulate 
consumption.
    As I have argued, the expansion of the U.S. trade deficit 
reflects mutually reinforcing policy choices. The stabilization 
and the eventual fall in the U.S. deficit will also be far 
smoother if that process is supported by appropriate policy 
changes. No doubt market forces will eventually demand 
adjustment even in the absence of policy change. But as both 
the current President of the New York Fed, Tim Geithner, and 
former Treasury Secretary Robert Rubin have emphasized, without 
supporting policies the needed market moves are bigger and the 
risk of disrupted market moves is far higher.
    Thank you.
    [The prepared statement of Dr. Setser appears in the 
Submissions for the Record on page 67.]
    Senator Bennett [Presiding.] Thank you very much. This is a 
very interesting and worthwhile panel, and it looks like 
Senator Reed and I are going to have the next 15 minutes to 
ourselves before the lease runs out and we are forced to leave 
the room.
    I would like Dr. Setser and Dr. Levy to kind of go at each 
other here, because they have slightly different views; but 
there is also a degree of agreement and common ground from 
which to have this exchange.
    Let me just make a comment before I ask the two of you to 
respond to each other. Everybody agrees that the American 
deficit has to come down; that is, the amount of borrowing by 
the government, whose percentage of GDP has to be stabilized--I 
am of the opinion that if it stays at its present level as a 
percentage of GDP that is within historic norms, then it is 
completely sustainable. However, if you look ahead at the 
demographics, it becomes abundantly clear that it cannot stay 
within its present percent of GDP without some fairly 
fundamental changes in the spending patterns. And we saw the 
peace dividend that occurred in the 1990s that brought the 
deficit down, and we all assumed we were responsible. All of us 
here in the Congress took full credit for it, and the Clinton 
administration took full credit for it, and that is the way 
politics works. But the peace dividend is a one-time dividend, 
and if we are going to bring the deficit down, we are going to 
need to have the courage to address the entitlement problem. 
And the entitlement problem is summarized by our friend Ted 
Stevens, who, when he went on the Appropriations Committee, 
said the Appropriations Committee controlled two-thirds of the 
Federal budget and one-third was mandatory spending outside of 
the purview of the appropriations process.
    Today those numbers are reversed. We have a budget of 
roughly $2\1/2\ trillion, and that portion that is subject to 
appropriations is roughly $800 billion, a third. And the 
percentages keep going in favor of the mandatory spending, to 
the detriment of discretionary spending. And the $800 billion--
$840 I think is the actual number--roughly $800 billion that 
the appropriations covers includes defense, which is roughly 
half.
    So if you take away half of the discretionary spending and 
say it is off limits because of defense, and you are going to, 
quote, ``balance the budget by Congress getting its act in 
order and holding down spending, you have a universe of $400 
billion that you have to deal with out of a $2\1/2\ trillion 
budget, unless you are willing to tackle the mandatory 
spending, the entitlement spending, which means Social 
Security, Medicare and Medicaid. And if we say those must be 
held inviolate, we will see the two-thirds that is currently 
mandatory grow to three-fourths, or to 90 percent, or 
eventually 100 percent. And if you want to talk about something 
that is unsustainable, that is a trend that is unsustainable 
and affects everything else we are talking about.
    OK. Having made that point, Dr. Setser and Dr. Levy, can 
you comment back and forth on each other, and we will try to 
hold what you say between the two of you for maybe the next 7 
minutes, and then Senator Reed can ask his for the next 7 
minutes, and we will have taken the time that is available to 
us because I don't think our House colleagues are coming back. 
Is that a fair division of time, Senator?
    Dr. Levy. Let me take a crack at it. I would note in the 
1990s, even as the cash flow government budget went from 
deficit to surplus, on an accruable basis the deficit--on an 
accrual basis, the budget was deteriorating because of the 
continued rising in the unfunded liabilities.
    It is imperative to address the long-run budget imbalance 
because if we look realistically in the short run, many aspects 
of the programs that are growing the fastest are intractable. 
So it is now important to address in a very rational, fair way 
that doesn't affect current recipients, change the policies 
that will affect the long run, grandfather them in.
    And I remember when I was working on the Hill in the late 
1970s and the Social Security projections were accurate--they 
proved to be accurate. And the issues are the same, just the 
numbers are bigger. Address them in an appropriate way.
    I would like to make two comments on the current account. 
Very frequently in my position I have to talk to portfolio 
managers that run all of the Asian central bank money. And I 
was just over there, and they are very economically rational. 
And they are seeking the highest risk-adjusted expected rates 
of return. They have no intention at all of dramatically 
altering their asset allocation.
    Second, if you think about it, in the last year with low 
interest rates, when they buy, say, a 2-year debt, we are 
borrowing at, say, 3 percent, now it is 4 percent, the issue is 
what are we doing with the imported capital? To the extent we 
are using it--and as I mentioned it in my testimony--to finance 
corporate purchases of industrial materials and capital goods, 
I guarantee you the average rate of return on that imported 
capital is higher than the cost of financing it. So once again, 
the culprit once again is the budget deficit. And not just the 
budget deficit per se, but the entitlement programs, the 
consumption-oriented ones that increase spending without adding 
to the Nation's long-run productive capacity.
    Senator Bennett. Dr. Setser.
    Dr. Setser. Well, I do think Dr. Levy and I share a common 
opinion that the best way that the pace of increase in the 
current account deficit can first be reduced and then the 
deficit can be brought down is by taking steps to increase 
national savings, and the first best way to do so is to reduce 
the fiscal deficit.
    I am not convinced, however, that the debate about 
entitlements is totally relevant here, and I say that for the 
following reason, and with complete respect for the opinions of 
the Senator.
    In my personal opinion, the trade deficit and the trends of 
the unsustainability about the trade deficit are likely to 
manifest themselves as a problem in a much shorter time frame 
than the time frame that is relevant for the debate about 
entitlements, and particularly for the debate about Social 
Security. And I would note in that context that at this current 
point in time, Social Security runs a cash flow surplus, as is 
well known, and this reduces the cash flow deficit of the rest 
of the government. So my concern would be that in the context 
of reforming our entitlements, we increase our near-term fiscal 
deficits--cash flow deficits--and increase our near-term 
borrowing. That would not increase our own national savings or 
decrease our dependence on savings from abroad.
    As I have argued, our current dependence on foreign savings 
is already quite high. And since I don't think we are talking 
about a 40-year problem or a 20-year problem, I think we are 
talking about more of a 10-year problem, so I think the time 
frames are a little bit different.
    The question about the continued availability of financing 
to sustain the U.S. current account deficit--which is much 
larger than the U.S. fiscal deficit--does hinge, as Dr. Levy 
suggested, on the portfolio decisions made by Asian central 
banks. I would also note it hinges on the portfolio decisions 
made by the Russian central bank and by the central banks of 
the major oil-exporting countries. One of the major evolutions 
that has occurred this year is that a growing share of our 
deficit is indirectly being financed by Saudi Arabia, by 
Russia, by the other countries with large oil exporters.
    I differ slightly from Dr. Levy in his assessment that it 
is rational for these countries, on an investment basis, to be 
sending and to be buying U.S. treasuries at the current rate; I 
say that for the following reason. Most forecasts for the size 
of the dollar depreciation against Asian currencies that would 
be needed to bring the trade deficit down over time, are quite 
large; therefore, even the interest rates of 4 percent or 5 
percent that these countries are getting on your dollar assets 
here, is unlikely to compensate them for the future exchange 
rate risk. So while I don't think Asian central banks are 
likely to shift their portfolio away from dollar assets, I 
think there is a risk that over time they may be less willing 
to add to their stock of dollar assets. And remember, we do 
need $800--or $900 billion every year. We get it 1 year, we 
still need it the next year. I also differ slightly in my 
assessment of the uses to which this imported savings is being 
put.
    Senator Bennett. I am sorry to interrupt you, but I would 
like Senator Reed to----
    Senator Reed. Go ahead, Doctor.
    Dr. Setser. My concern is that the external debt that we 
are taking on right now is not being, by and large, used to 
finance investment in the tradables portion of the U.S. 
economy, and external debt is ultimately a claim on our 
tradable production of goods and services. So while in the 
short run, shifting resources toward the residential housing 
sector and toward other sectors can help sustain growth, in the 
long run it is not obvious to me that improvement in our 
residential housing stock will generate the future export 
revenue needed to pay back the interest on that rising external 
debt.
    Senator Bennett. Thank you.
    Senator Reed. Thank you, Senator Bennett.
    It strikes me that we all are saying the same thing, just 
in different ways. That is that we have to increase national 
savings. There are several ways to do that. One is to reduce 
the budget deficit, or to increase household personal savings. 
And it strikes me with all the discussion particularly around 
this room about tax policy, tax policy doesn't seem to produce 
a lot of increases in personal savings.
    Do you want to comment on that, Dr. Setser?
    Dr. Setser. I tend to agree with that. I think the general 
studies suggest that tax incentives for savings have offsetting 
effects, that on one level they may increase some savings at 
the margins, but a lot of the benefits from the tax incentives 
go to people who would otherwise have saved, and so are offset 
by reductions in tax revenues, and the overall impact on 
national savings is small.
    Senator Reed. Dr. Levy, I will let you respond, too, but 
behind that question is another question. If we can't 
effectively--or don't choose to effectively stimulate household 
savings, then we are left to close the budget deficit in order 
to achieve this goal of increasing national savings and 
investment; is that----
    Dr. Levy. You want to reduce the budget deficit in any way, 
in any case, because how you spend and how you tax determines 
the allocation of national resources. And once again, what you 
want to do is effect a policy that is best for a sustained, 
healthy long-run economic growth.
    With regard to tax incentives, I respectfully disagree. I 
think they have increased saving.
    I would like to embellish on one other point, and it is an 
oddity in the following way----
    Senator Reed. Excuse me. In your testimony you indicated 
that the numbers suggest a close to zero household savings 
rate. You made some interesting points about the fact that it 
doesn't include residential real estate and stocks, et cetera, 
but I just want you to clarify now whether you are saying that 
tax policy is actually stimulating savings.
    Dr. Levy. Well, the rate of personal savings has come down 
because it is a cash flow measure and people are spending their 
cash flow because their wealth is going up. Let me juxtapose 
that with the double-digit rate of saving, personal saving in 
Germany, because people are still pessimistic about the economy 
and their prospect for jobs, where there is a 7\1/2\ percent 
rate of personal saving in Japan where there is a lot of angst.
    Let me add this oddity. In the last year oil prices have 
increased significantly. On an annualized basis, the doubling 
of oil prices has increased revenues to OPEC just in the United 
States by over $200 billion. U.S. consumers have smoothed their 
consumption pattern, that lowers their rate of saving; but 
because it is all denominated in dollars, a lot of it flows 
back into the United States and keeps the real cost of capital 
low.
    So it is very ironic, like circa 1970s recycling petro 
dollars; that is, lowering our rate of personal saving and 
widening our current account deficit. That is, the cost of 
higher energy crisis is real.
    Senator Reed. And both those things are bad in terms of 
lowering savings and----
    Dr. Levy. Yes.
    Senator Reed. Dr. Setser, do you have a final comment?
    Dr. Setser. I agree with the mechanism that Dr. Levy 
described by which the oil surplus is being recycled back on 
the United States. I think the ironic thing, in some sense, is 
that the oil surplus that these countries have comes not just 
from exporting oil to the United States, but to exporting oil 
to Asia. And one of the striking features of the current 
situation is while they are earning money from the entire 
world, it seems like a disproportionate share of their savings 
is flowing back to the United States.
    However, I wouldn't assert that is a necessary consequence 
of the fact that oil is priced in dollars. In liquid capital 
markets, it is quite easy to sell oil for a dollar and trade 
that dollar for a euro, and I think over time we shouldn't 
assume that current patterns will continue.
    Senator Reed. Well, thank you very much, gentlemen. Thank 
you, Senator Bennett.
    Senator Bennett. This has been a most worthwhile panel. 
And, Dr. Seiders, you didn't get into this macro stuff because 
you are talking about housing----
    Dr. Seiders. The House Members are probably more interested 
in that. Just kidding.
    Senator Bennett. I found your comments to be very useful.
    Let me just make one comment, back to my earlier one about 
the mandatory spending and the entitlements. Dr. Setser, the 
only reason that I pick on Social Security is that it is the 
easy one. Medicare and Medicaid are going to be much more 
difficult. And if we cannot in the Congress come together to 
solve the Social Security long-term structural problem--I agree 
with Dr. Levy, we should hold the present participants 
harmless, because I happen to be one of them; but for my 
children and grandchildren, if we can't come together to deal 
with Social Security in a bipartisan fashion, we will never, 
ever get our arms around the Medicare problem.
    Social Security is the easy one because it is simply moving 
numbers around. We know all the people, we know all the dollars 
that can be allocated. Medicare has so many other problems 
connected with it.
    So I agree with you that Social Security may not be the big 
one, but at least I want to take it on because I think it is 
the easy one.
    And thank you very much for your participation here. The 
hearing is adjourned.
    [Whereupon, at 12 p.m., the Committee was adjourned.]
                       Submissions for the Record

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

       Prepared Statement of Representative Jim Saxton, Chairman
    I am pleased to welcome Chairman Bernanke and the members of our 
second panel of witnesses before the Joint Economic Committee this 
morning. This Committee values its long history of cooperation with the 
Council of Economic Advisers. The testimony today will provide a solid 
foundation for understanding the forces that are shaping current 
economic conditions as well as the economic outlook.
    The recent hurricanes have caused a tragic loss of life and 
property on the Gulf Coast, and also have had temporary effects on the 
U.S. economy as a whole. One reason for this national impact is that a 
significant portion of U.S. oil and gas production is concentrated in 
the Gulf, and much of it is still damaged. Thus it is reasonable to 
expect that the economic impact of the hurricanes will slow GDP growth 
in the second half of 2005. In 2006, as recovery efforts proceed, many 
economists expect growth to be a bit higher than previously forecast.
    Despite the hurricane damage, a broad array of standard economic 
data indicates that the economic expansion has built up strong 
momentum. The U.S. economy grew 4 percent in 2004, and advanced at a 
rate of about 3.5 percent in the first half of 2005. A rebound in 
business investment has played an important role in explaining the 
pick-up in the economy since early 2003. Equipment and software 
investment has been strong over this period.
    The improvement in economic growth is reflected in other economic 
figures as well. Since May of 2003, business payrolls have increased by 
4.2 million jobs. The unemployment rate stands at 5.1 percent. Consumer 
spending continues to grow. Homeownership has hit record highs. 
Household net worth is also at a record level. Productivity growth 
continues at a healthy pace.
    Long run inflation pressures appear to be contained. Long-term 
interest rates, including mortgage rates, are still relatively low. It 
is clear that the Fed remains poised to keep inflation under control.
    In summary, overall economic conditions remain positive. The U.S. 
economy has displayed remarkable flexibility and resilience in dealing 
with many shocks. It is clear that monetary policy and tax incentives 
for investment have made important contributions to the improvement in 
the economy in recent years. Recently released minutes from the Federal 
Reserve suggest that the central bank expects this economic strength to 
continue.
    The Administration forecast for economic growth in 2006 is 
comparable with those of the Blue Chip consensus and the Federal 
Reserve. With growth expected to exceed 3 percent next year, the 
current economic situation is solid and the outlook remains favorable.




                Economic Effects of Inflation Targeting
    After decades of debate, the case for inflation targeting is well 
established. This paper focuses on one key ingredient of the argument 
supporting inflation targeting: The proposition that a credible 
implementation of inflation targeting will calm and stabilize various 
financial markets, anchor the price system, and limit inflation as well 
as its variability and persistence. Other competing views--i.e., (a) 
that inflation targeting has no impact on financial markets and (b) 
that inflation targeting leads to asset price bubbles and hence to 
financial market volatility--are briefly outlined.
    These alternative views are presented and briefly contrasted with 
existing empirical evidence. Some key findings include the following:
     There is little or no evidence that inflation targeting 
adversely affects financial markets.
     While not unanimous, the weight of the existing empirical 
evidence appears to support the view that inflation targeting matters 
and will work to calm and limit the variability of financial markets, 
as well as the persistence of inflation. As the empirical literature 
suggests, this will likely help to foster healthier economic growth. 
Although some research findings are consistent with competing 
hypotheses, this research has a number of problems.
    Since there is little evidence that inflation targeting has adverse 
effects on financial markets or the economy, adopting inflation 
targeting once price stability is attainted likely will make 
maintaining price stability easier. As emphasized by others, adopting 
inflation targeting will help future economic performance in that gains 
in credibility will be preserved for future Federal Reserve chairmen.
                              introduction
    The theoretical case for inflation targeting (IT) has been spelled 
out during the course of the last 15 years in a number of publications, 
including several JEC studies. The case for IT is a strong one, 
supported by a number of compelling arguments. According to proponents, 
adopting IT certainly does make a difference by improving the 
performance of the economy, the financial system, and the inflation 
rate. The arguments supporting this approach, however, will not be 
repeated here; these arguments have been amply described elsewhere. 
Instead, one component of the arguments supporting the adoption of IT 
will be reviewed and assessed.
    In particular, IT proponents contend that its adoption will help to 
calm and stabilize financial markets. More precisely, the adoption of 
credible IT will provide an anchor to the financial system and to 
financial markets. In so doing, financial markets will stabilize as 
inflation is driven from the price system. Temporary deviation of 
inflation will be ignored. This credibly reduced inflation is 
associated with less volatile financial markets, smaller risk premiums, 
and lower inflationary expectations. In this view, then, IT is 
associated with more stable financial markets.
    On the other hand, some economists contend that IT is associated 
with asset price bubbles, and thus, asset price volatility. In 
particular, as credible IT works to stabilize conventional measured 
inflation, to reduce risk premiums, and to tame economic fluctuations, 
economies experience more risk taking and more risky investment. 
Economies will also experience increased stock price volatility and 
associated asset price bubbles. According to this view, there is a kind 
of ``moral hazard'' of economic policymaking: The more stable/
predictable the economic environment, the more risk taking and risky 
investment take place. Proponents of this view point to several classic 
episodes in which asset price bubbles followed periods of price 
stability; e.g., the United States during the 1920s, as well as more 
recent episodes in Japan and the U.S. In this view, then, IT is 
associated with more volatile asset prices and financial markets, the 
opposite contention of the above, more conventional view.
    This paper briefly describes these alternative views, reviews 
relevant empirical evidence, and attempts to reconcile these seemingly 
conflicting positions.
   an unconventional view: inflation targeting (it) and asset price 
                               volatility
    Recently, a few economists have broken rank with the conventional 
view supporting IT. These economists contend that low inflation 
environments tend not to be associated with asset price stability. 
Instead, they argue that IT or low inflation environments tend to be 
associated with asset price movements and bubbles (or financial 
fragility) and asset price volatility. Fildaro, for example, states 
that:

          . . . The achievement of a low, stable inflation environment 
        has not simultaneously brought about a more stable asset price 
        environment. The record over the last decade, in fact, has 
        raised the prospect of asset price booms and busts as a 
        permanent feature of the monetary policy landscape.\1\
---------------------------------------------------------------------------
    \1\ Fildaro, Andrew, ``Monetary Policy and Asset Price Bubbles: 
Calibrating the Monetary policy tradeoffs,'' BIS Working Paper No. 155, 
June (2004), p.

---------------------------------------------------------------------------
Similarly, Borio and Lowe (2002) argue that:

          . . . financial imbalances can buildup in a low inflation 
        environment . . . while low and stable inflation promotes 
        financial stability, it also increases the likelihood that 
        excess demand pressures show up first in credit aggregates and 
        asset prices, rather than in goods and services prices . . . We 
        stress that financial imbalances can and do buildup in periods 
        of disinflation or in a low inflation environment,\2\
---------------------------------------------------------------------------
    \2\ Borio Claudio, and Philip Lowe, ``Asset Prices Financial and 
Monetary Stability: Exploring the Nexis,'' BIS Working Paper No. 114, 
(July 2002), Abstract, p. 1.

    Furthermore, in reviewing the economic environment of the past 30 
years or so, Borio and White (2004) maintain that this environment can 
be characterized as improving in price stability while at the same time 
experiencing more financial instability.\3\
---------------------------------------------------------------------------
    \3\ Borio, Claudio and William White, ``Whither Monetary and 
Financial Stability? The Implications of Evolving Policy Regimes,'' BIS 
Working Paper No. 147 (February 2004).
---------------------------------------------------------------------------
    Some endorsing this alternative view include some economists 
sympathetic to the Austrian School and several economists affiliated 
with at the Bank for International Settlements (BIS).\4\
---------------------------------------------------------------------------
    \4\ These authors, include, for example, Charles Bean, Claudio 
Borio, Philip Lowe, William White, Andrew Filadro, Andrew Crockett, and 
others.
---------------------------------------------------------------------------
    This alternative view embodies some important implications. 
Notably, proponents of this view contend that price stability or IT 
causes sharp movements in asset prices; i.e., price stability or IT is 
associated with asset price bubbles.
    According to proponents of this view, IT central banks themselves 
increasingly (but unwittingly) work to create the environment conducive 
to the formation of asset price bubbles or instabilities. Specifically, 
as modern central banks learn to control inflation and tame economic 
fluctuation, thereby stabilizing economic activity, these economies 
will experience more risk taking, more innovation, more investment and 
sometimes stronger advances in productivity. They will experience 
increased stock market volatility and associated asset price bubbles. 
Credible IT policies, therefore, stabilize conventionally measured 
price indices while at the same time create new incentives to take 
risk.
    In this view, there is a kind of ``moral hazard'' of economic 
policymaking: The more stable/predictable the economic environment, the 
more risk taking, investment, and innovation take place. In sum, low 
inflation environments are increasingly associated with financial 
imbalances and asset price volatility.
    the conventional view: inflation targeting calms and stabilizes 
                        financial market prices
    There are several theoretical explanations of how financial markets 
are affected by the existing monetary regime. In particular, different 
explanations exist as to how movements in financial market prices are 
shaped by the adoption of IT and its associated consequent price 
stabilization. One of the direct benefits of IT, for example, is the 
calming, stabilizing effect it has on financial market prices and on 
the market price system itself. In short, IT stabilizes prices and 
serves as an anchor to the price system. According to Levin et.al., for 
example:

          . . . under an inflation-targeting regime, expectations about 
        inflation, particularly at longer horizons, should be 
        ``anchored'' by the target, and thus should be less affected by 
        changes in actual inflation . . . Having inflation expectations 
        that are well anchored--that is, unresponsive to short-run 
        changes in inflation--is of significant benefit to a country's 
        economy . . . Keeping inflation expectations anchored helps to 
        keep inflation itself low and stable.\5\
---------------------------------------------------------------------------
    \5\ Jeremy Piger, ``Does Inflation Targeting Make a Difference?'', 
Monetary Trends, Federal Reserve Bank of St. Louis, April 2004, p. 1. 
See also Levin, Andrew T., Natalucci, Fabio M. and Piger, Jeremy M., 
``The Macroeconomic Effects of Inflation Targeting,'' Federal Reserve 
Bank of St. Louis Review, July/August 2004, 86 (4).

    More specifically, as inflation rates are credibly lowered and as 
stable prices eventually emerge, inflation and inflationary 
expectations will have less of a disturbing effect on price movements. 
Price reactions to both economic policy announcements and economic data 
releases will be tempered. This reduction in inflation and inflationary 
expectations will lower the variability of relative and nominal prices. 
And this reduction of inflation and inflationary expectations will also 
reduce uncertainty and thereby lower risk spreads.
    Furthermore, distorting interactions of inflation with the tax code 
will gradually be minimized. In short, the operation and working of the 
price system will be improved as adopting IT will reduce market 
volatility.
    These factors will contribute to calming and stabilizing a number 
of important markets including the short-term money market, long-term 
bond market, foreign exchange market, sensitive commodity markets, as 
well as equity markets. All of these improvements will work to better 
enable to function, improve market efficiency, and inevitably to 
improve economic growth and performance.
                indirect approaches to stabilize markets
    There are additional indirect, but important ways in which IT can 
work further to calm and stabilize movements in market prices. More 
specifically, IT necessarily involves an increase in central bank 
transparency, which can work to further stabilize markets.\6\ The 
benefits of monetary policy transparency cited in the literature 
include a reduction in both the level of and variability of inflation, 
as well as output.\7\
---------------------------------------------------------------------------
    \6\ Transparency has several dimensions. These involve explicit 
identification of policy objectives, issuing inflation reports, policy 
announcements, and testimony, i.e., providing much more information to 
the market. See for example, Seth B. Carpenter, ``Transparency and 
Monetary Policy: What Does the Literature tell policymakers?'' Working 
Paper, Board of Governors of the Federal Reserve System, April 2004. p. 
1.
    \7\ See Carpenter, op. cit., p. 1.
---------------------------------------------------------------------------
    IT, after all, involves the announcement of and explicit public 
identification of policy goals or policy rules. This involves providing 
more information to the market. Markets work better with more 
information; more specifically, they absorb new information and use it 
to form common, concentrated expectations about the future.\8\ As 
markets begin to anticipate policy changes, the initial steps of the 
monetary transmission mechanism between policy action and economic 
activity begin to work more efficiently.\9\ Policy surprises affecting 
markets become smaller and fewer in number. Central bank credibility 
begins to build and to anchor inflationary expectations, thereby 
helping to stabilize financial markets. As one proponent put it: ``the 
strength of inflation targeting, vis-a-vis other monetary regimes lies 
precisely in how transparency enhances monetary credibility and anchors 
private expectations.'' \10\
---------------------------------------------------------------------------
    \8\ See, for example, Gavin, William, ``Inflation Targeting,'' 
Business Economics, April 2004, pp. 30, 36.
    \9\ See, Charles Freedman, ``Panel Discussion: Transparency in the 
Practice of Monetary Policy,'' Review, Federal Reserve Bank of St. 
Louis, July/August, 2002, p. 155.

    \10\ Klaus Schmidt-Hebbel and Matias Tapia, ``Statement'' (2002), 
p. 11)

    In short, increased transparency changes behavior so that markets 
function better and in a more stable, predictable manner that works to 
stabilize markets.
                           empirical evidence
    In sum, alternative views as to the effects IT might have on 
financial markets suggest that, the adoption of IT could result in 
these markets becoming more volatile, less volatile, or unaffected by 
IT. Existing evidence sheds some light on validity of these alternative 
views.
    Does IT result in more Volatile Financial Markets?
    Hard empirical evidence supporting the view that IT causes 
financial market volatility appears difficult to muster. Much of the 
literature sympathetic to this view is not focused directly on such 
empirical evidence. Rather, it often deals with broader issues of 
monetary policy and the policy role played by asset price ``bubbles''. 
Borio and Lowe, for example, make such a connection:

          While low and stable inflation promotes financial stability, 
        it also increases the likelihood that excess demand pressures 
        show up first in credit aggregates and asset prices, rather 
        than in goods and services prices. Accordingly, in some 
        situations, a monetary response to credit and asset markets may 
        be appropriate to preserve both financial and monetary 
        stability.\11\
---------------------------------------------------------------------------
    \11\ Borio Claudio and Philip Loew, ``Asset Prices, Financial and 
Monetary Stability: Exploring the Nexis,'' BIS Working Paper No. 114, 
July 2002, Abstract.

    But the argument that price stability or IT itself fosters asset 
price bubbles, asset price volatility, or financial instability has 
been neither adequately nor convincingly established. And the case that 
financial imbalances develop because of stable price environments, has 
not been demonstrated; it has not been shown that price stability 
causes financial instability. In short, no direct ``hard core'' or 
formal statistical or econometric evidence supports this view. Instead, 
anecdotal compilations of ``stylized facts'' are used to assess 
historical episodes in support of the view. Additionally, only a few 
episodes appear to have the characteristics (low inflation, credit 
growth, asset price bubbles, etc) consistent with this view. Instead of 
such evidence, proponents rely on assumptions relating to the 
credibility of policymakers, investment activity, technological 
advances, or productivity gains that can serve to constrain the price 
increases of goods and services. In sum, little hard empirical evidence 
supporting the view that price stability or IT contributes to or causes 
volatile financial markets exists.
    Empirical Evidence: Does IT matter? Is IT unrelated to economic 
performance or to market volatility?
    A number of studies have examined whether the adoption of IT 
improves economic performance (as measured by movements in inflation, 
output, and/or interest rates) or affects the volatility of market 
variables. In short, they have tested to see if IT matters.
    Several researchers have addressed this question. Despite a good 
deal of effort, however, some of their empirical results have been 
mixed. As a result, this research in turn has raised a number of 
methodological questions. More specifically, in assessing these 
questions in recent years, researchers have often used a common 
methodology. The reason for this is that recently both IT and non-IT 
countries experienced improvement in economic performance as measured, 
for example, by inflation or the level of interest rates. Focusing on 
any one IT country in isolation might lead researchers to falsely 
conclude that IT caused the improvement. But non-IT countries may have 
experienced similar affects. Some researchers contend, therefore, that 
to test for the effects of IT, improvements in IT countries must be 
made relative to improvements in non-IT countries.
    Examples of research results: Implying IT doesn't matter include 
the following:
     Ammer and Freeman (1995) surveyed three IT countries, New 
Zealand, Canada, and the United Kingdom. They found that although each 
reached its inflation goal, bond yields suggested that long-term 
inflationary expectations exceeded targets as did short-term measures 
of inflationary expectations. This suggests that these countries did 
not attain the credibility necessary to properly anchor other prices 
and stabilize the price system. Moreover, there is no evidence that 
announcement of an explicit IT policy would reduce inflationary 
expectations.\12\
---------------------------------------------------------------------------
    \12\ John Ammer and Richard T. Freeman, ``Inflation Targeting in 
the 1990s. The Experiences of New Zealand, Canada, and the United 
Kingdom,'' Journal of Economies and Business, 1995, 47:165-192, pp. 
165,189.
---------------------------------------------------------------------------
     Johnson (2002) employed data from 11 countries. He adopted 
a methodology which divided up his sample into inflation targeting and 
non-inflation targeting countries. His results are mixed. Specifically, 
he found that while the level of inflationary expectations falls after 
announcing explicit inflation targets, the variability of expected 
inflation does not. In describing his results, Johnson contended that 
``inflation targets allowed a larger disinflation with smaller forecast 
errors to take place in targeting countries.'' \13\
---------------------------------------------------------------------------
    \13\ David R. Johnson, ``The Effect of Inflation Targeting on the 
Behavior of Expected Inflation: Evidence from an 11 country panel,'' 
Journal of Monetary Economies, 49 (2002) 1521-1538, p. 1537.
---------------------------------------------------------------------------
     Recent research by Ball and Sheridan (2003) is perhaps the 
most forceful example of empirical work concluding that IT does not 
matter. These authors, for example, conclude that:

          . . . on average, there is no evidence that inflation 
        targeting improves performance as measured by the behavior of 
        inflation, output, or interest rates . . . overall it appears 
        that targeting does not matter. Inflation targeting has no 
        effect on the level of long-term interest rates, contrary to 
        what one would expect if targeting reduces inflation 
        expectations . . . targeting does not affect the variability of 
        the short-term interest rates controlled by policymakers . . . 
        we find no evidence that inflation targeting improves a 
        country's economic performance.\14\
---------------------------------------------------------------------------
    \14\ Ball, Laurence and Niamh Sheridan, ``Does Inflation Targeting 
Matter?,'' Paper presented at NBER Inflation Targeting Conference, 
January 2003 (March 2003), pp. 2,3,4,29.

    In short, some research clearly concludes that IT does not matter.
                      some questions and critique
    There are, however, a number of fundamental reasons why this 
research and its conclusions are both questionable and in conflict with 
the results of other research. For example, many economists question 
the methodology employed in these studies. The selection and 
identification of ``non-IT countries,'' for example, is one of these 
issues. Several economists, analysts, and even Federal Reserve 
officials have pointed out that a number of key countries, including 
the U.S., are identified as non IT countries in the studies because 
they do not have explicit inflation targets. But many of these 
countries consistently pursued an implicit inflation targeting 
strategy. So the label may be misleading and inappropriate for several 
countries. This misspecification also applies to countries pegging 
their currencies to a currency whose central bank is following ITs; 
(i.e., some countries in Europe and Asia). These observations were made 
by, Gertler, Mankiw, Federal Reserve officials and others.\15\ These 
contentions draw into question the validity of the methodology and 
results of these empirical studies.
---------------------------------------------------------------------------
    \15\ See Gertler, Mark, ``Comments on Ball and Sheridan,'' Prepared 
for the NBER Conference on Inflation Targeting, January 2003. (June 
2003), pp 1, 3-5; Mankiw N. Gregory, (2001), ``U.S. Monetary Policy 
During the 1990's. NBER Working Paper No. 8471, Cambridge, Mass Sept 
2003; and Marvin Goodfriend, ``Inflation Targeting in the United 
States?,'' (2003) Paper prepared for the NBER Conference on Inflation 
Targeting, January 2003.
---------------------------------------------------------------------------
    Furthermore, recent IMF research surveys and delineates the many 
dimensions to and ways of classifying and categorizing IT. This 
research underscores the large number of variables that can be used to 
select and define IT. It is a reminder that there may be no easy, 
simple way of neatly identifying an IT central bank.
    Because of the multi-dimensional character of IT regimes, it is 
difficult to clearly and neatly dichotomize existing central banks into 
IT and non-IT categories. Definitions of IT, for example, should be 
adjusted to reflect the realities of ``flexible'' IT. The clean 
dichotomization maintained by theoretical researchers may not be nearly 
as clean as suggested by the authors. Consequently, the empirical 
results may not be as clean as suggested by some of the results of 
these papers.
    Additionally, several statistical or econometric issues and 
critiques were identified in much of this literature. In his comments 
on Ball and Sheridan, for example, Gertler notes that ``existing 
evidence in favor of inflation targeting is open to identification 
problems.'' \16\ Ball and Sheridan themselves assert that their 
empirical results are often not strictly comparable to the results of 
other studies because of unusual techniques that were employed.\17\
---------------------------------------------------------------------------
    \16\ Gertler, Mark, ``Comments on Ball and Sheridan,'' June 2003, 
Paper prepared for the NBER Conference on Inflation Targeting, January 
2003, p. 1.
    \17\ Ball and Sheridan, op. cit., p. 28. (The unusual technique was 
regression to the mean.)
---------------------------------------------------------------------------
    Empirical Evidence: IT is related to macroeconomic performance and 
to financial market volatility: IT does make a difference.--Despite the 
widespread practical support accorded IT in recent years, not much hard 
empirical support was found favoring IT in early, initial research.\18\ 
As time passed and more historical data has come to the fore, however, 
researchers have uncovered a number of important empirical regularities 
tending to support IT. Some of the evidence comes from single-country 
case studies suggesting that IT tends to stabilize markets. Other 
evidence is cross-section support. For example, a number of recent 
empirical studies examined the relationship between IT and 
macroeconomic performance, as well as between IT and financial market 
behavior: i.e., these studies attempted to assess whether IT matters. 
While mixed, the bulk of the new evidence indicates that IT matters; IT 
has a positive significant impact on economic and financial market 
performance.
---------------------------------------------------------------------------
    \18\ See Neumann and Von Hagen, p. 127.
---------------------------------------------------------------------------
    The following ``bullet points'' supply an abbreviated summary of 
the recent key empirical studies relevant to this topic:
     In a (1996) report to the FOMC, David Stockton surveyed 
existing literature related to price objectives for monetary 
policy.\19\ In that survey, Stockton identified several well-known 
established empirical relationships pertinent to this topic. They 
included the following:
---------------------------------------------------------------------------
    \19\ David J. Stockton, ``The Price Objective for Monetary Policy: 
An Outline of the Issues,'' A Report to the FOMC Board of Governors, 
June 1996.

          * Both cross-country and time-series evidence supports the 
        notion that inflation reduces the growth of real output (or 
        productivity).
          * Inflation is positively related to the variability of 
        relative prices.
          * Inflation is positively related to inflation uncertainty.
          * In general, relative price variability and inflation 
        uncertainty adversely affect real output.

      In his recent book Inflation Targeting (2003), Truman 
summarizes the principal conclusions of the empirical literature on 
inflation targeting.\20\ In particular, IT generally:
---------------------------------------------------------------------------
    \20\ Edwin M. Truman, Inflation Targeting in the World Economy, 
Institute for International Economics, Washington, D.C. October 2003, 
p. 72.

          * Has had a favorable effect on inflation, inflation 
        variability, inflation expectations, and the persistence of 
        inflation.
          * Has not had a negative effect on economic growth, the 
        variability of growth, or unemployment.
          * Has had mixed effects on both the level and variability of 
        real, nominal, short-term, and long-term interest rates.
          * Has had positive effects on exchange rate stability.
          * Has affected the reaction functions of the central banks 
        that have adopted the framework.\21\
---------------------------------------------------------------------------
    \21\ Ibid. p. 72. (The points outlined were taken from Truman, p. 
72.)

      For the most part, economists have established 
empirically a negative relationship between inflation uncertainty and 
---------------------------------------------------------------------------
real economic activity. Elder (2004), for example, relates that:

          Our main empirical result is that uncertainty about inflation 
        has significantly reduced real economic activity over the post-
        1982 period . . . Our findings suggest that . . . macroeconomic 
        policies that reduce volatility in the inflation process are 
        likely to contribute to greater overall growth.\22\
---------------------------------------------------------------------------
    \22\ John Elder, ``Another Perspective on the Effects of Inflation 
Uncertainty.''

     In a early study, Ammer and Freeman (AF) (1995) examined 
three IT countries. This study provided mixed results for IT. On the 
one hand, inflation did not exceed the targets and this result occurred 
without sharp increases in short-term rates. These researchers found 
that ``inflation fell by more than was predicted by the models in the 
early 1990s, an indication of the effect of the new regime.'' \23\ 
However, ``longer term interest rates suggest that none of these 
countries rapidly achieved complete long-term credibility for their 
announced long-run inflation intentions.\24\
---------------------------------------------------------------------------
    \23\ Neumann and von Hagen, op.cit., p.128.
    \24\ John Ammer and Richard T. Freeman, ``Inflation Targeting in 
the 1990's: The Experiences of New Zealand, Canada, and the United 
Kingdon,'' Journal of Economics and Business, 1995; 47: 165-192, p. 
189.
---------------------------------------------------------------------------
     Some of the earlier (pre-2000) literature was summarized 
by Neuman and von Hagen (NvH) and included the following observations:

          * Some authors find that ``IT might . . . serve to lock in 
        gains from disinflation rather than to facilitate 
        disinflation.'' \25\ After introducing IT, inflation and 
        interest rates remained below values predicted by existing 
        models.
---------------------------------------------------------------------------
    \25\ Neumann and von Hagen, op.cit., p.128.
---------------------------------------------------------------------------
          * Other authors found that the ``volatility of official 
        central bank interest rates . . . declined substantially after 
        the introduction of IT.'' \26\

    \26\ Ibid., p. 129.
---------------------------------------------------------------------------
     Neumann and von Hagen (NvH) (2002) reviewed earlier 
studies of inflation targeting episodes. They presented ``evidence on 
the performance of IT central banks.'' \27\ In particular, NvH showed 
that ``. . . IT has reduced short-term variability in central bank 
interest rates and in headline inflation . . .'' \28\ (The NvH paper) 
``suggests that IT has indeed changed central bank behavior . . .'' 
(NvH) ``looked at different types of evidence in order to validate'' 
(the claim that inflation targeting) ``is a superior concept for 
monetary policy.'' ``Taken together, the evidence confirms that IT 
matters. Adopting this policy has permitted IT countries to reduce 
inflation to low levels and to curb the volatility of inflation and 
interest rates . . .'' \29\ In discussing this paper, Mishkin reminds 
us that NvH ``produce several pieces of evidence quite favorable to 
inflation targeting.'' \30\
---------------------------------------------------------------------------
    \27\ Manfred J.M. Neumann and Jurgen Von Hagen, ``Does Inflation 
Targeting Matter?,'' Federal Reserve Bank of St. Louis, Review, July/
August 2002, p. 130.
    \28\ Ibid, p.127.
    \29\ Ibid, pp. 128, 144 (parenthesis added).
    \30\ Frederick Mishkin, ``Commentary,'' FRB St. Louis Review, July/
August, 2002, p.144.
---------------------------------------------------------------------------
     Johnson (2002) shows that inflation ``targets reduced the 
level of expected inflation in targeting countries'' \31\ . . . ``The 
evidence is very strong that the period after the announcement of 
inflation targets is associated with a large reduction in the level of 
expected inflation . . . that (significant) reduction took place in all 
5 countries with inflation targets. This is an important success of 
inflation targets.''. . . ``inflation targets allowed a larger 
disinflation with smaller forecast errors to take place in targeting 
countries.'' \32\ In sum, inflation targeting presumably favorably 
affected the bond and other markets by influencing inflationary 
expectations and reducing uncertainty premiums.
---------------------------------------------------------------------------
    \31\ David R. Johnson, ``The Effect of Inflation Targeting on the 
Behavior of Expected Inflation: Evidence from an 11 country panel.''
    \32\ Journal of Monetary Economics 49 (202), p. 1522. ibid, pp/
1537. (parenthesis added).
---------------------------------------------------------------------------
     Levin, Natalucci and Piger (LNP) (2004) find ``evidence 
that IT plays a significant role in anchoring long-term inflationary 
expectations and in reducing the . . . persistence of inflation'' \33\ 
The evidence suggests that IT practitioners can more readily delink 
their inflationary expectations from realized inflation.\34\ In short, 
IT plays a significant role in anchoring long-term inflation 
expectations and long-term interest rates themselves.\35\
---------------------------------------------------------------------------
    \33\ Andrew T. Levin, Fabio M. Natalucci, and Jeremy M. Pager, 
``The Macroeconomic Effects of Inflation Targeting,'' Federal Reserve 
Bank of St. Louis, Jan. 23, 2004. Abstract.
    \34\ Op.cit., Abstract.
    \35\ Op. cit., p.2.

          * LNP find that ``inflation targeting affects the public's 
        expectations about inflation'' . . . ``under an inflation 
        targeting regime, expectations about inflation, particularly at 
        longer horizons, should be `anchored' by the target, and thus 
        should be less affected by changes in actual inflation.'' 
        ``Keeping inflation expectations anchored helps to keep 
        inflation itself low and stable.'' \36\
---------------------------------------------------------------------------
    \36\ Jeremy Piger, ``Does Inflation Targeting Make a Difference?'' 
Monetary Trends, April, 2004.
---------------------------------------------------------------------------
          * In commenting on this paper, Uhlig (2004) . . . ``concludes 
        that these figures seem to suggest that an environment of low 
        and stable inflation helps to reduce output volatility and 
        support economic activity.'' \37\
---------------------------------------------------------------------------
    \37\ Jeremy M. Piger and Daniel L. Thornton, ``Editor's 
Introduction,'' Federal Reserve of St. Louis Review, July/August 2004, 
Volume 86, Number 4, p. 5.

     Recent empirical research at the Federal Reserve by 
Gurkaynak, Sack and Swanson (GSS) (2003) shows that the Fed could boost 
the economy by being more transparent about its long-term inflation 
objectives.\38\ GSS ``show that the long-term interest rates (of non-IT 
countries) react excessively to macroeconomic data releases and to news 
about monetary policy. This overreaction is caused by changes in the 
market's long-term inflation expectations.'' \39\
---------------------------------------------------------------------------
    \38\ See Refet S. Gurkaynak, Brian Sack, and Eric Swanson, ``The 
Excess Sensitivity of Long-Term Interest Rates, Evidence and 
Implications for Macroeconomic Models,'' Finance and Economic 
Discussion Series, Federal Reserve Board, November 17, 2003; William 
Gavin, ``Inflation Targeting, Why It Works and How to Make it Work 
Better,'' Business Economics, Vol XXXIX April, 2004, p. 32.
    \39\ See Gavin, op cit, pp. 32, 36 (parenthesis added).
---------------------------------------------------------------------------
    IT, however, works to anchor (or prevent excess volatility in) 
long-term market's. Consequently, in IT countries (like the UK), 
markets do not overreact or display over-sensitivity. The empirical 
results of the paper suggest ``that the central bank can help stabilize 
long-term forward rates and inflation expectations by credibly 
committing to an explicit inflation target.'' \40\ Commitment to an 
explicit target will help stabilize both long rates and inflation 
expectations.
---------------------------------------------------------------------------
    \40\ GSS, op.cit. p. 28.
---------------------------------------------------------------------------
     Other research conducted at the Federal Reserve also 
relates to this evidence. Carpenter (2004), for example, surveyed 
empirical studies of transparency.\41\ The summarized results are 
mixed, but suggest there is evidence of a relationship between IT and 
both transparency and lower inflation. Moreover, it is emphasized by 
several authors that there is no evidence that IT causes any harm. 
Swanson (2004) showed that increased central bank transparency acts to 
reduce financial market surprises and uncertainties. This suggests that 
IT--which is tantamount to increased transparency of policy goals--may 
aid in reducing financial market volatility and stabilizing financial 
markets.\42\
---------------------------------------------------------------------------
    \41\ Seth Carpenter, ``Transparency and Monetary Policy: What Does 
the Academic Literature Tell Policymakers?, ``Working Paper, Board of 
Governors of the Federal Reserve System, April 2004, pp. 11-13.
    \42\ Eric T. Swanson, ``Federal Reserve Transparency and Financial 
Market Forecasts of Short-Term Interest Rates,'' Working Paper, Board 
of Governors of the Federal Reserve System, February 9, 2004.
---------------------------------------------------------------------------
     Several studies establish that additional central bank 
transparency in the form of announced inflation target, works to lower 
inflation and stabilizes output. Recently Fatas, Mihov, and Rose (FMR), 
for example, found ``that both having and hitting quantitative targets 
(like IT) for monetary policy is systematically and robustly associated 
with lower inflation . . . Successfully achieving a quantitative 
monetary goal (like ITs) is also associated with less volatile 
output.'' \43\ These authors find that ``. . . countries with 
transparent targets for monetary policy achieve lower inflation.'' \44\ 
They found ``that having a quantitative de jure target for the monetary 
authority tends to lower inflation and smooth business cycles; hitting 
that target de facto has further positive effects. These effects are 
economically large, typically statistically significant and reasonably 
insensitive to perturbations in (their) econometric methodology.'' \45\
---------------------------------------------------------------------------
    \43\ Antonio Fatas, Ilian Mihov, and Andrew K. Rose, ``Quantitative 
Goals for Monetary Policy,'' NBER Working Paper No. W 10846, October 
2004, Abstract (parenthesis added.)
    \44\ Ibid, p. 1.
    \45\ Ibid. p. 21. (parenthesis added).
---------------------------------------------------------------------------
     Siklos (2004) found that ``inflation-targeting countries 
have been able to reduce the nominal interest rate to a greater extent 
than have non-inflation targeting countries . . . It is also found that 
central banks with the clearest policy objectives have a relatively 
lower nominal interest rates.'' \46\
---------------------------------------------------------------------------
    \46\ Pierre L. Siklos, ``Central Bank Behavior, The Institutional 
Framework, and Policy Regimes: Inflation Versus Non-Inflation Targeting 
Countries,'' Contemporary Economic Policy, vol 22, no. 3, July 2004, 
331-343, pp 331, 332.
---------------------------------------------------------------------------
    This abbreviated review of some of the recent literature suggests 
that overall, there is a good deal of evidence supporting the case for 
IT. This review suggests that inflation targeting does matter. More 
specifically, credible commitment to an explicit IT likely will work to 
help lower and stabilize the level and variability of inflation. This 
result occurs in part because of the reduction and stabilization of 
inflationary expectations. Hence, it will likely lower both the level 
and variability of the long bond rate. IT will anchor the price system 
and help to stabilize short-term interest rates, long-term interest 
rates, the foreign exchange and stock markets. Some research suggests 
IT also helps to dampen the business cycle and stabilize movements in 
output. Additionally there is a body of evidence indicating that 
transparency helps to stabilize markets and fosters central bank 
credibility.
                        summary and conclusions
    After decades of debate, the case for inflation targeting is well 
established. This paper focuses on one key ingredient of the argument 
supporting inflation targeting. Namely, it examines the proposition 
that a credible implementation of inflation targeting will calm and 
stabilize various financial markets, anchor the price system, and limit 
inflation, as well as its variability and persistence. Other competing 
views--i.e., (a) that inflation targeting has no impact on financial 
markets and (b) that Inflation Targeting leads to asset price bubbles 
and hence to financial market volatility--are briefly outlined.
    These alternative views are presented and briefly contrasted with 
existing empirical evidence. Some key findings include the following:
     There is little or no evidence that inflation targeting 
has adverse effects on financial markets.
     Research finding that inflation targeting does not matter 
has problems, in part related to the selection and definition of 
inflation targeting countries.
     The weight of the existing empirical evidence appears to 
support the case for inflation targeting; i.e. overall, it supports the 
view that inflation targeting matters and will work to calm and limit 
the variability of financial markets as well as the persistence of 
inflation. It will serve to anchor the price system. As the empirical 
literature suggests, this will likely foster healthier economic growth.
    There is little evidence that inflation targeting has adverse 
effects on or hurts financial markets or the economy.\47\ Accordingly, 
adopting inflation targeting once price stability is attained likely 
will make it easier to maintain.\48\ As emphasized by Gertler, ``the 
case made for adopting formal targets in the U.S. is not that this 
system would have improved past performance, but rather that it would 
help future performance by preserving gains in credibility for 
Greenspan's successor.'' \49\
---------------------------------------------------------------------------
    \47\ Ball and Sheridan, op.cit., p. 29.
    \48\ See Anthony M. Santomero, ``Monetary Policy and Inflation 
Targeting in the United States,'' Business Review, Federal Reserve Bank 
of Philadelphia, Fourth Quarter 2004, p. 1.
    \49\ Mark Gertler, ``Comments on Ball and Sheridan.'' A Paper 
presented to the NBER conference on Inflation Targeting, January 2003, 
p. 5. The point was also made by Ball and Sheridan, op. cit., p. 30
---------------------------------------------------------------------------
                                 ______
                                 
    Prepared Statement of Senator Jack Reed, Ranking Minority Member
    Thank you, Chairman Saxton. I want to welcome Chairman Bernanke, 
who I hope will give us useful insights on current economic conditions 
and where he thinks the President's policies are taking us. I am also 
pleased that we will have a second panel of witnesses to give us 
further perspectives on the economic outlook.
    Like many Americans, my concerns about the economic outlook and the 
Administration's stewardship of the economy have grown in the wake of 
Hurricane Katrina. Economic insecurity for workers is widespread as 
energy prices are soaring, employer-provided health insurance coverage 
is falling, private pensions are in jeopardy, and American workers are 
still waiting to see the benefits of the economic recovery reflected in 
their paychecks.
    President Bush's tax cuts were poorly designed to stimulate broadly 
shared prosperity and have produced a legacy of large budget deficits 
that leave us increasingly hampered in our ability to deal with the 
host of challenges we face. The devastating impact of Hurricanes 
Katrina and Rita will put short-term strains on the Federal budget--
strains that would be fairly easy to absorb if our budget and economic 
policies were sound, but they are not. The President's goals of making 
his tax cuts permanent and cutting the deficit in half are simply 
incompatible.
    Large and persistent budget deficits also have contributed to an 
ever-widening trade deficit that forces us to borrow vast amounts from 
abroad and puts us at risk of a major financial collapse if foreign 
lenders suddenly stop accepting our IOU's. The trade deficit of $59 
billion in August is close to the record for a single month of more 
than $60 billion set in February. The broader current account deficit, 
which measures how much we are borrowing from the rest of the world, is 
running at a record annual rate of nearly $800 billion, or well over 6 
percent of GDP.
    I will be interested in Chairman Bernanke's views on whether the 
budget and trade deficits are dangerous imbalances that pose a risk to 
the economic outlook. But I am also pleased that we will be able to 
hear Dr. Setser's views, which may be somewhat different.
    I hope that we would all agree that raising our future standard of 
living and preparing adequately for the retirement of the baby boom 
generation require that we have a high evel of national investment and 
that a high fraction of that investment be financed by our own national 
saving--not by foreign borrowing. We followed such prosperity-enhancing 
policies under President Clinton, but that legacy of fiscal discipline 
has been squandered under President Bush.
    Sound policies for the long run are clearly very important, but I 
am also deeply concerned about what continues to be a disappointing 
economic recovery for the typical American worker. Strong productivity 
gains have shown up in the bottom lines of shareholders but not in the 
paychecks of workers. The typical worker's earnings are not keeping up 
with their rising living expenses. And both earnings and income 
inequality are increasing.
    Instead of addressing these problems, the President's policies seem 
to be piling on. It's certainly hard to take seriously the President's 
rhetoric about wanting to lift families out of poverty when he has 
refused to support an increase in the minimum wage and he has lifted 
the Davis-Bacon Act, thereby legitimizing sub-par wages for workers 
rebuilding their communities in the hurricane-stricken Gulf Coast 
region.
    And even though home heating costs are expected to skyrocket this 
winter, President Bush has said he will not request additional funds 
for the Low Income Home Energy Assistance Program, known as LIHEAP. 
Together with Republican Senators Susan Collins and Olympia Snowe, I 
have offered an amendment to increase LIHEAP by $3.1 billion, so that 
low-income Americans won't be left out in the cold this winter. I would 
like to know if the Administration is willing to reconsider its 
position on providing additional LIHEAP funds and if not, why not?
    It seems to me that the President's compassionate words hardly 
match his Administration's actions. Now is not the time to cut funding 
for important programs such as LIHEAP and Medicaid that support working 
families and seniors, while the President continues to push for 
irresponsible tax breaks for those who are already well-off.
    I look forward to Chairman Bernanke's testimony about the economic 
outlook, and I will listen with interest to anything the Chairman and 
our witnesses can tell me that will allay my concerns about that 
outlook.




     Prepared Statement of Hon. Ben Bernanke, Chairman, Council of 
                   Economic Advisers, Washington, DC
    Chairman Saxton, Vice-Chairman Bennett, Ranking Member Reed, and 
Members of the Committee, thank you for the opportunity to testify 
before the Joint Economic Committee. We appreciate the long-standing 
and mutually beneficial relationship between the Committee and the 
Council of Economic Advisers. My remarks today will focus on the 
current state of the economy, but of course such an overview would be 
incomplete without an eye to the human and economic impacts of 
hurricanes Katrina and Rita in the U.S. Gulf Coast.
    While it has been nearly 2 months since Hurricane Katrina made 
landfall, its devastation will have a protracted impact on the Gulf 
region. As you know, Hurricane Katrina wreaked unprecedented losses on 
the people of the Louisiana, Mississippi, and Alabama coasts. Katrina 
took many lives, destroyed communities, and shook a vital portion of 
our Nation and our economy. The Gulf region was then hit by Hurricane 
Rita, which did significant damage but, in most areas, less than was 
feared. In response to the disasters, the President has directed all 
agencies of the Federal Government to devote their maximum effort to 
helping the victims of the hurricanes and to begin the process of 
cleaning up and rebuilding the region. The President has also proposed 
a series of measures to restore the Gulf's communities and economy.
    One of the greatest assets we have in rebuilding after a hurricane 
is the overall strength of the national economy. The resiliency of the 
economy--the product of flexible labor markets, a culture of 
entrepreneurship, liquid and efficient capital markets, and intense 
market competition--is helping it to absorb the shocks to energy and 
transportation from the hurricanes. The ability of our economy to grow 
and create jobs will act as a lifeline to the regions and people that 
have been most affected. Thus these recent events make it all the more 
important that we keep the fundamentals of the national economy strong 
and continue to promote economic policies that will encourage growth 
and job creation.
                         the economic expansion
    When thinking about where the economy is now and where it is 
heading, it is useful to keep in mind just how far the U.S. economy has 
come in recent years. The economy's resilience was put to severe test 
during the past 5 years, even prior to Katrina. A remarkable range of 
shocks hit the U.S. economy, beginning with the sharp decline in stock 
prices in 2000 and the recession that followed in 2001. The economy was 
further buffeted by the terrorist attacks of September 11, 2001, and 
the subsequent geopolitical uncertainty. Business and investor 
confidence was shaken by a series of corporate scandals in 2002. By 
early 2003, uncertainty about economic prospects was pervasive and the 
economy appeared to be sputtering.
    Yet, in the face of all these shocks, together with new challenges 
such as the recent sharp rise in energy prices, the American economy 
has rebounded strongly. Policy actions taken by the President and the 
Congress were important in helping to get the economy back on track. 
Notably, beginning with the President's 2001 tax cuts, multiple rounds 
of tax relief increased disposable income for all taxpayers, supporting 
consumer confidence and spending while increasing incentives for work 
and entrepreneurship. Additional tax legislation passed in 2002 and 
2003 provided incentives for businesses to expand their capital 
investments and reduced the cost of capital by lowering tax rates on 
dividends and capital gains.
    Together with appropriate monetary policies, these policy actions 
helped spur economic growth in both the short run and the long run. 
Today the U.S. economy is in the midst of a strong and sustainable 
economic expansion. Over the past four quarters real GDP has grown at a 
3.6 percent rate, and over the past eight quarters real growth has been 
at a 4.1 percent annual rate. Prior to Katrina, the near-term forecasts 
of both CEA and private-sector economists had called for continued 
solid growth. The destruction wrought by Katrina and Rita may reduce 
growth somewhat in the short run, but the longer-term growth trajectory 
remains in place. I'll return to economic prospects in a moment.
    An important reason for the recovery has been improved business 
confidence. To an extent unusual in the postwar period, the slowdown at 
the beginning of this decade was business-led rather than consumer-led. 
Homebuilding and purchases of consumer durables did not decline as they 
typically do in cyclical downturns; instead the primary source of 
weakness was the reluctance of businesses to hire and to invest. 
Supported by appropriate fiscal and monetary policies and by the 
economy's innate strengths, business confidence has risen markedly in 
the past few years. The effects are evident in the investment and 
employment data. From its trough in the first quarter of 2003, business 
fixed investment has increased over 21 percent, with the biggest gains 
coming in equipment and software. Since the labor market bottomed out 
in May 2003, more than 4 million net new payroll jobs have been added. 
Currently, the unemployment rate stands at 5.1 percent, up from 4.9 
percent in August, prior to the job losses that followed Katrina.
    Although growth in GDP and jobs capture the headlines, one of the 
biggest macroeconomic stories of the past few years is what has been 
happening to productivity. Productivity growth is the fundamental 
source of improvements in living standards and the primary determinant 
of the long-run growth potential of the economy. Over the past 4 years, 
labor productivity in the nonfarm business sector has grown at a 3.4 
percent annual rate, and productivity in manufacturing has risen at a 
5.7 percent annual rate. Productivity growth has slowed recently as 
businesses have absorbed millions of new workers--a normal development 
for this stage of an economic expansion--but it remains (in the four 
quarters ending 2005:Q2) at the quite respectable level of 2.2 percent 
(and 6.3 percent in the nonfinancial corporate sector). Thus, on each 
of three key indicators of the real economy--GDP growth, job creation, 
and productivity growth--the United States in recent years has the best 
record of any major industrial economy, and by a fairly wide margin.
    Finally, while there has been a notable rise in overall inflation 
this year, prices on nonenergy products have continued to increase at 
moderate rates. In particular, soaring energy prices have played the 
largest role in boosting the overall consumer price index to an 
increase of 4.7 percent over the past year, up from a 2.5 percent 
increase over the year-earlier period. In contrast, core consumer 
prices (as measured by the consumer price index excluding volatile food 
and energy prices) rose only 2.0 percent over the past 12 months, 
unchanged from its year-earlier pace. Long-term-inflation expectations 
also remain low and stable, based on measures of inflation compensation 
derived from inflation-indexed Treasury securities. To be clear, the 
focus on core inflation by no means implies that the rise in energy 
prices is inconsequential; sharply higher energy costs place a heavy 
burden on household budgets and increase firms' costs of production. I 
will discuss the energy situation in more detail in a moment. However, 
the stability in core inflation and inflation expectations does suggest 
that overall inflation is likely to return to levels consistent with 
price stability in coming quarters.
                          the economic outlook
    Let me turn now to the outlook. In the shorter term, the 
devastation wrought by the hurricanes has already had palpable effects 
on the national rates of job creation and output growth. Payroll 
employment declined by 35,000 in September, its first decline since May 
2003, and industrial production fell 1.3 percent, its largest monthly 
decline in over two decades. Both of these declines appear to be 
entirely accounted for as the effects of the hurricanes. The Bureau of 
Labor Statistics estimates that employment growth would have been 
roughly 200,000 in the absence of the hurricanes, and the Federal 
Reserve estimates that industrial production would have increased about 
0.4 percent. Consumer confidence also dropped in September, although 
growth in consumer spending has continued to be solid. While the 
effects of the storms certainly reduced growth in the third quarter 
relative to what it would have been otherwise, most private-sector 
economists expect healthy growth for the remainder of this year and in 
2006. For example, the Blue Chip panel of forecasters now projects 
growth at 3.2 percent in the second half of 2005 and 3.3 percent growth 
in 2006. Recovery and rebuilding will contribute to job creation and 
growth by the latter part of this year and in 2006.
    The economic impact of the hurricanes included significant damage 
to the country's energy infrastructure. As you know, Katrina shuttered 
a substantial portion of U.S. refining and pipeline capacity, which led 
to a spike in gasoline prices in the weeks after that storm. Rita 
caused further damage. The Federal Government has assisted, in among 
other ways, by lending or selling oil from the Strategic Petroleum 
Reserve, arranging for additional shipments of oil and refined products 
from abroad to the United States, and providing appropriate regulatory 
waivers to increase the flexibility of the energy supply chain. In part 
because of these efforts and a vigorous private-sector response, oil 
prices have returned to roughly their pre-Katrina levels. Wholesale 
gasoline prices have also retreated to levels of mid-August, suggesting 
that the recent decline in prices at the pump is likely to continue. 
Natural gas prices may remain elevated somewhat longer, however, 
because of lost production in the Gulf, the difficulty of increasing 
natural gas imports, and damage to plants that process natural gas for 
final use.
    Even as the energy sector continues to recover, it remains true 
that the prices of oil and natural gas have risen sharply in the past 2 
years, reflecting a tight balance of supply and demand. High energy 
prices are burdening household budgets and raising production costs, 
and continued increases would at some point restrain economic growth. 
Thus far at least, the growth effects of energy price increases appear 
relatively modest. The economy is much more energy-efficient today than 
it was in the 1970s, when energy shocks contributed to sharp slowdowns. 
Well-controlled inflation and inflation expectations have also 
moderated the effects of energy price increases, since those increases 
no longer set off an inflation spiral and the associated increases in 
interest rates, as they did three decades ago. In addition, allowing 
prices to adjust, rather than rationing gasoline, is helping to 
minimize the overall impact on the economy.
    House prices have risen by nearly 25 percent over the past 2 years. 
Although speculative activity has increased in some areas, at a 
national level these price increases largely reflect strong economic 
fundamentals, including robust growth in jobs and incomes, low mortgage 
rates, steady rates of household formation, and factors that limit the 
expansion of housing supply in some areas. House prices are unlikely to 
continue rising at current rates. However, as reflected in many 
private-sector forecasts such as the Blue Chip forecast mentioned 
earlier, a moderate cooling in the housing market, should one occur, 
would not be inconsistent with the economy continuing to grow at or 
near its potential next year.
    The current account deficit presents some economic challenges. At 
6.3 percent, the ratio of the current account deficit to GDP is now at 
its highest recorded level. Gradually reducing the current account 
deficit over a period of time would be desirable. While the current-
account imbalance partly reflects the strong growth of the U.S. economy 
and its attractiveness to foreign investors, low U.S. national saving 
also contributes to the deficit. The United States should work to 
increase its national saving rate over time, by encouraging private 
saving and by controlling Federal spending to reduce the budget 
deficit. Our trading partners must also play a role in reducing 
imbalances, by becoming less reliant on export-led growth and 
increasing domestic spending, and by allowing their exchange rates to 
move flexibly as determined by the market.
                               conclusion
    The economic challenges posed by hurricanes Katrina and Rita 
reinforce once again the importance of economic policies that promote 
growth and increase the resilience of the economy. Energy issues in 
particular have come to the fore recently. The energy bill recently 
passed by Congress and signed by the President should help address the 
Nation's energy needs in the longer term. As an additional step, the 
Administration will continue to work with Congress to take measures 
that will permit needed increases in refinery capacity. The 
Administration has made a number of other proposals to increase 
economic growth, including proposals to reduce the economic costs of 
litigation, to increase quality and reduce costs in the health-care 
sector, and to address national needs in education and job training.
    The Administration is currently engaged in several international 
negotiations, including the Doha round of the World Trade Organization, 
as well as talks with China on a number of matters involving trade, 
exchange rates, and needed financial reforms. Liberalized trade and 
capital flows promote economic growth, and we should strive to achieve 
those objectives in the context of a gradual reduction of current 
account imbalances. It is important that we persist in these efforts 
and not retreat to economic isolationism, which would negatively affect 
the long-run growth potential of the economy.
    Fiscal discipline, always important, has become increasingly so in 
the face of the likely costs of assisting the victims of the hurricanes 
and of helping in the rebuilding. Before the impact of the hurricanes, 
strong economic growth was helping to reduce the budget deficit and the 
Government finished fiscal year 2005 with a much lower-than-expected 
deficit. The President remains committed to controlling spending and 
cutting the budget deficit in half by 2009. His 2006 budget made 
numerous proposals to save more than $200 billion over the next 10 
years from both discretionary and mandatory programs. In the budget 
resolution earlier this year, Congress laid plans to pass $35 billion 
out of the President's $70 billion in savings from mandatory programs 
over the next 5 years. Congress should now make good on that plan by 
passing at least $35 billion in mandatory savings in reconciliation 
legislation. Further savings beyond $35 billion would be highly 
desirable. The President continues to seek a decrease in non-security 
discretionary spending in FY2006 appropriations bills, and the 
Administration is working on options for spending rescissions. The 
President also remains committed to reforms to address fiscal 
challenges in the longer term, such as Social Security.
    Finally, I note that the tax reform advisory panel, whose official 
report will go to the Secretary of the Treasury on November 1, has 
kicked off a much-needed debate on how to make the Federal tax code 
simpler, fairer, and more pro-growth. We thank them for their hard work 
and look forward to reviewing their recommendations.
    Thank you for the opportunity to be here today. I would be happy to 
answer your questions.
                                 ______
                                 
  Prepared Statement of Dr. Mickey D. Levy, Chief Economist, Bank of 
                         America, New York, NY
    My outlook for U.S. economic performance is upbeat, based on sound 
fundamentals that underlie high potential growth and a history of 
resilience to shocks. The negative effects of Katrina on employment, 
consumer spending, trade and inflation will be temporary, and growth 
will bounce back in 2006, aided by a significant jump in Government 
purchases. Increases in wages and personal incomes will continue to 
support consumption. Housing activity is slowing, and prices are 
beginning to recede, but it is very unlikely that average values will 
decline sharply and unhinge the economic expansion. As always, the 
economy faces risks: present concerns include higher energy prices and 
further aggressive monetary tightening, a negative shock or a global 
slump. The Federal Reserve is expected to raise rates to 4.5-4.75 
percent, but this would not be considered excessive. The probability of 
recession in 2006 is very low. Sustained long-run economic health 
requires fiscal reform involving programmatic changes to the 
Government's retirement and health care policies that are fair to 
current participants, incorporate the right incentives, and slow the 
growth of future benefits.
    (1) Solid fundamentals provide a favorable long-run outlook for 
U.S. economic growth, and the efficiency and flexibility of the economy 
and capital markets provide resilience to external shocks. Potential 
growth is 3.5+ percent.
    Long-run annualized growth has averaged 3.4 percent, and recent 
positive trends in productivity point to sustained healthy economic 
growth and rising standards of living. Favorable foundations, often 
overlooked in short-term assessments of economic conditions, include 
the efficiency and flexibility of U.S. production processes and labor 
markets, favorable tax and regulatory environment facilitating the 
entrepreneurship and business investment that support technological 
innovation, extraordinarily efficient capital markets and a well-
capitalized banking system, and low inflation and the inflation-
fighting credibility of the Federal Reserve. Following an elongated 
early expansion spurt in productivity, labor productivity gains have 
moderated but are expected to remain healthy, which combined with 
labor-force growth points to sustained economic growth over 3.5 
percent.
    Growth of U.S. GDP and capital spending has exceeded all other 
large industrialized nations, and its potential growth is higher. 
Moreover, combined with the responsiveness of economic policymakers, 
sound fundamentals provide significant resilience to external shocks. 
All recent economic expansions, including the current one that began in 
2001Q4, have experienced external shocks that potentially could have 
sidetracked performance: Latin American debt crises in the early 1980s 
and mid-1990s, the Russian default and Asian financial crisis in 1997, 
the collapse of LTCM in 1998, 9-11, and most recently, Hurricane 
Katrina. In each case, adjustment processes unfolded more quickly than 
widely anticipated and, following temporary slowdowns, economic growth 
quickly snapped back. The resilience provided by these built-in 
stabilizers and smoothed cycles have reinforced confidence in U.S. 
economic performance.
    (2) Economic growth, which was solid prior to Katrina, will 
moderate for several quarters, followed by a reacceleration to 
trendline in 2006. Risks to the outlook are slower growth as a 
consequence of tighter monetary policy and higher energy prices, or a 
negative shock or global slump.
    The economy grew at an estimated 3.8 percent annualized pace in the 
first three quarters of 2005, and displayed healthy characteristics and 
surprising vigor prior to Katrina. In particular, consumer and business 
investment spending was quite resilient to the negative impact of 
higher energy prices. This reflected several factors: energy 
consumption per unit of GDP has declined significantly in recent 
decades in response to higher energy prices, and nominal spending 
growth has exceeded 6 percent, reflecting the Federal Reserve's 
monetary accommodation, so that the higher outlays for energy have not 
significantly ``crowded out'' real spending on non energy goods and 
services. Employment gains averaged 177,000 per month, and the 
unemployment rate dipped to 4.9 percent. Wages were increasing 
modestly, contributing to healthy increases in disposable income. 
Businesses were very disciplined, and inventories were very low 
relative to sales. Corporate profits and cash-flows rose to all-time 
highs.
    Katrina generated huge declines in national wealth (by some 
estimates, up to $150 billion), caused unprecedented displacement of 
households and workers, involved large uninsured business losses, and 
impaired and disrupted oil and gas refining facilities as well as the 
port of New Orleans. Although large, these losses in wealth must be 
judged relative to the $11 trillion U.S. economy and its high growth 
potential, and household net worth of nearly $50 trillion. The loss in 
wealth has little direct impact on measured GDP, while the clean up and 
rebuilding, however financed, count as production and adds to GDP.
    As a result of Katrina, U.S. economic growth will temporarily slow 
and its composition will change. Consumption growth is projected to 
slow sharply from its estimated 3.8 percent pace over the past 4 
quarters, to approximately 1 percent annualized in Q4, followed by a 
modest rebound in 2006Q1. Business investment is unlikely to be 
significantly affected, while both imports and exports may be 
temporarily delayed, which may temporarily slow production. Aided by a 
sharp boost in Government purchases and associated ``fiscal policy 
multipliers,'' real GDP is projected to rebound significantly in the 
first half of 2006, just when the growth of private consumption is 
rebounding.
    Certainly, the economy faces risks. Domestic demand would slump in 
the second half of 2006 if the Fed inadvertently hikes rates too much 
and energy prices rise further. With the Federal funds rate at 3.75 
percent, monetary policy remains accommodative, and the inflation-
adjusted funds rate is below its long-run average. It is likely the Fed 
will raise interest rates to 4.5-4.75 percent by mid-2006, which I 
consider toward the higher end of the range of a ``neutral'' funds 
rate. Monetary tightening far beyond ``neutral'' would accentuate the 
impacts of higher energy prices. Internationally, a negative global 
shock, sharply lower global growth that generated declining U.S. 
exports, or a sharp fall in the demand for U.S. dollar-denominated 
assets that led to global financial turmoil would harm the U.S. 
economy. However, such international events are unlikely, and the risks 
of an economic downturn in 2006 remain modest.
    (3) Consumer spending growth is projected to slow significantly 
through year-end 2005 and rebound to a moderate pace in 2006, while 
business investment spending is expected to continue rising at a 
healthy pace.
    The expected temporary sharp slowdown in consumption growth in Q4 
stems from several factors: The disruptions to economic activity in the 
hurricane/flood-affected region, including the negative impact on 
consumption and provision of services (business, personal, health and 
education services, etc.); the depressing impacts of higher energy 
prices and the temporary rise in unemployment on real disposable 
personal income; and the decline in motor vehicle sales from earlier 
unsustainable incentive-driven levels. Through August, increases in 
employment and wages had more than offset the higher energy prices, 
with real disposable personal income averaging 2.3 percent year-over-
year growth in the first half of 2005. Consumer spending will find 
additional support from low real-interest rates and household net 
worth-which measures the total value of stocks, bonds and real estate 
held by households net of all household debt--that reached an all-time 
record in its last reading. Noteworthy, however, the sustained rapid 
growth of consumer spending in the face of higher energy prices has 
lowered the rate of personal saving even further.
    In the near term, the combination of temporary declines in 
employment and higher energy prices will dent real purchasing power, 
but the impact must be put into perspective: Even displaced households 
will continue to consume (shelter, food and clothing) regardless of how 
the purchases are financed, and declines in consumer activities in the 
Gulf Coast region will be partially offset by increases in other 
regions. Look for consumer spending to rebound, but to a slower pace of 
growth.
    Business investment spending is projected to continue to grow at a 
healthy pace, and is unlikely to be materially affected in the near 
term. Factors underlying investment, including product demand, 
corporate profits and cashflows, and low real costs of capital, remain 
positive. The rebuilding of structures and the reconstruction of 
damaged infrastructures in the Gulf Coast, including oil and gas 
refining facilities, will boost investment spending.
    (4) Employment has fallen modestly and the unemployment rate has 
risen in the aftermath of Katrina, but these are temporary effects, and 
labor markets remain generally healthy. Wages are rising to reflect 
sustained productivity gains, but the sharp increases in energy prices 
have temporarily suppressed real wage gains.
    Katrina's displacement of businesses and households will 
temporarily disrupt otherwise healthy labor markets. Employment fell 
modestly in September and the unemployment rate rose to 5.1 percent. A 
hallmark of the current expansion has been the slow return to health of 
the U.S. labor market, following the 2001 recession and severe equity 
market declines in 2000-2002. Business caution was unusually high and 
slow to recede, contributing to the above-trend pace of productivity 
gains. However, prior to Katrina, the pace of layoffs, measured with 
initial unemployment claims, had receded to very low levels, and 
businesses were both hiring and expanding the hours worked of existing 
employees.
    This slow cyclical rebound in employment and business caution and 
discipline will serve to mitigate the impact of Katrina on net 
payrolls. Importantly, outside the affected Gulf Coast region, economic 
conditions and business hiring have remained strong. These conditions 
provide a positive backdrop for facilitating the re-absorption into the 
workforce of many displaced workers. In addition, labor shortages and 
temporarily high wages have begun to attract workers back into the 
affected region. Following temporary weakness, employment is projected 
to resume its growth, and the unemployment rate should again recede 
below 5 percent.
    Until recently, real wages had been rising, although not as fast as 
gains in labor productivity. Rapid increases in nonwage costs, 
including employer contributions for worker health care, partially 
explain the gap. The recent sharp rise in energy prices has pushed 
headline inflation above wage gains, reducing real wages. This too is 
likely to be temporary, as the rising demand for labor lifts wages 
while headline inflation recedes.
    (5) The jump in Government spending for the Katrina cleanup and 
rebuilding and the expected fiscal policy multipliers will support 
economic growth in Q4 and boost it in 2006, but will contribute to a 
renewed spike in budget deficits.
    Prior to Katrina, rapid growth in tax receipts (a whopping 14.6 
percent in the just completed FY2005) had contributed to a faster-than-
expected decline in the budget deficit. The deficit for FY2005 fell to 
less than $320 billion or 2.6 percent of GDP, a significant reduction 
from 3.5 percent in 2003 and 3.6 percent in 2004. Fiscal responses to 
Katrina may raise the deficit by as much as 1 percent of GDP, as tax 
receipts temporarily slump and outlays surge. So far, Congress has 
authorized more than $60 billion in Katrina-related spending, and the 
total Federal fiscal response almost certainly will be higher.
    To date, the financial market reaction to Katrina and the 
anticipated fiscal response has been modest: The U.S. dollar has been 
virtually unchanged and bond yields have drifted up, reflecting both 
related and unrelated concerns. Inflationary expectations have risen, 
the underlying economy has shown strength and resilience, and markets 
fear a letdown by fiscal policymakers in the wake of the hurricanes. 
The longer-run costs are not trivial. The higher deficit will add to 
the stock of Government debt, raising net interest costs. The net costs 
to sustainable economic growth depend on a host of factors, including 
how the Government funds are spent, the returns on such spending and 
investments and how they influence private incentives, and how the 
outlays are financed--through offsetting spending reductions, tax 
increases or higher debt. All of these factors have important 
implications for the allocation of national resources. I urge fiscal 
policymakers to consider these issues in all of their dimensions, and 
encourage a rational debate about how to allocate the Government funds 
in the most economically efficient manner.
    (6) Corporate profits, which have grown to record levels, are 
projected to continue increasing through 2006, although higher energy 
prices will adversely affect profits in select industries.
    Operating profits--after-tax profits with inventory valuation and 
capital consumption allowance adjustments--have risen 9.9 percent in 
the last year and almost 59 percent cumulatively since the 2001Q4 
recession trough, modestly faster than profits gains during prior 
economic expansions. Profits have benefited from healthy growth in 
product demand, firm margins generated by modest pricing power and 
strong productivity gains that have constrained unit labor costs, low 
interest rates that have allowed businesses to restructure their 
financial balance sheets and the low U.S. dollar that has boosted 
repatriated profits from overseas activities. Higher energy prices have 
depressed profits unevenly, with outsized impacts on the airline, 
automobile and other select industries.
    I project profits to rise at a moderating pace in 2006, reflecting 
ongoing business discipline, enhanced production efficiencies and 
global demand for U.S. products. The Fed rate hikes will slow growth in 
nominal spending, which will dampen business top-line revenue growth. 
Business pricing power will be limited, but sustained productivity 
gains should largely offset upward pressures on wage compensation and 
help constrain increases in unit labor costs. Nonlabor costs may rise 
however, largely reflecting, among other influences, higher insurance 
costs.
    (7) Housing activity is expected to soften and average prices 
decline modestly, but the probability of sharp declines that would 
unhinge consumer spending and the economy is low.
    Following the unprecedented rise in residential sales, housing 
construction and home prices, the real estate market is showing signs 
of cooling. In select regions in which prices had soared, inventories 
of unsold homes have jumped up--presumably in response to the high 
prices--and the volume of sales transactions has begun to slow. In 
response to the Fed's rate hikes and flattening yield curve, there has 
been a clear shift in mortgage applications toward longer-term 
mortgages and away from short-term variable mortgages that had 
contributed to real estate price speculation.
    Clearly, the rate of real estate appreciation in recent years is 
unsustainable. A crucial issue is how and why the market will adjust, 
and whether any fall in real estate prices will harm overall economic 
performance. My assessment is that housing values will decline from 
lofty levels in select ``speculative-driven'' regions, but average 
housing prices will dip only modestly, and as long as the economy 
continues to expand at a healthy pace and inflation and bond yields 
remain reasonably low, the adjustment in housing activity and prices 
will not unduly harm the macro economy.
    Concerns that the sharp appreciation of real estate has been the 
primary factor driving consumer spending are overstated; while housing 
appreciation has contributed positively to net worth and the propensity 
to spend, real disposable income, which has continued to rise, remains 
the crucial variable underlying consumer spending. A slump in overall 
economic activity, employment and incomes would generate sharp declines 
in housing; however, a flattening in housing, including significant 
price declines in speculative markets in response to the Fed rate hikes 
and modestly higher mortgage rates, may slow the rate of consumption 
growth, but is very unlikely to unhinge the economic expansion.
    (8) Exports are projected to continue rising rapidly, reflecting 
improving global economic trends; but recently slower import growth has 
begun to narrow the trade deficit.
    Real exports, which rose very sluggishly early this expansion, but 
accelerated to a rapid 9.1 percent average annualized growth pace in 
the last 2 years, are projected to grow strongly through 2006, as 
global economic conditions continue to improve. Imports have been much 
more volatile: After declining during the 2001 recession, they have 
increased at a 7.5 percent average annual pace, faster than exports, 
and the trade deficit has widened. However, so far in 2005, import 
growth has slowed significantly to a 3.5 percent pace-contributing to a 
narrowing trade deficit.
    With the exception of economic weakness in core European nations, 
the economies of major U.S. export markets are healthy. Asia, 
destination for approximately 26 percent of U.S. exports, continues to 
grow significantly faster than the global average. Importantly, Japan, 
the world's second largest economy, is rebounding to sustainable 
healthy growth following prolonged stagnation and deflation. I expect 
Japan will grow significantly faster than consensus estimates through 
2006. China's economy shows no signs of slowing from its long-run 9+ 
percent rate of expansion. U.S. exports to China have grown 46 percent 
in the last year, reaching $39 billion, and should continue to increase 
rapidly. India's economy and trade with the U.S. are also expanding 
rapidly. Growth in Canada remains healthy, Mexico is growing on the 
coattails of the U.S. expansion, and Brazil, Argentina and Chile are 
expanding and enjoying relative stability. Europe's economic 
performance will remain uneven. Misguided tax and regulatory policies 
constrain potential growth in core European nations, while other 
European nations, including some that will be joining the European 
Union, are growing rapidly.
    The substantial widening of the U.S. net export deficit in recent 
years implies that foreign producers have supplied a growing share of 
domestic demand. Moreover, fueling concerns about the trade deficit, 
the common perception is that ``excessive consumer spending'' is the 
primary culprit of rapid import growth. In fact, nearly 40 percent of 
total U.S. imported goods are industrial supplies and capital goods 
(excluding automobiles and petroleum), which directly contribute to 
business production and expansion. The growth and composition of 
imports suggest strongly that the wide trade deficit is to some extent 
a reflection of the U.S.'s economic strength, and is not as bothersome 
as is commonly perceived.
    As long as the U.S. continues to grow faster than other industrial 
nations, and its investment growth is stronger, its trade deficit will 
tend to remain wide. However, the strength in exports and recent 
slowing in import growth, which must be interpreted cautiously, have 
reduced the trade gap. As economic growth improves in other regions of 
the world, investment in these nations will expand, and real interest 
rates will rise. Slower growth in U.S. consumption, higher household 
savings rates, a greater reliance on exports to spur domestic economic 
growth and a gradual narrowing in the U.S. trade gap are natural and 
necessary consequences of an improved balance in world economies. The 
best contribution for U.S. economic policy is to encourage the positive 
trends abroad while sustaining healthy domestic economic fundamentals.
    (9) Headline inflation has risen due to higher energy prices, but 
core measures of inflation, excluding food and energy, have remained 
low. Core inflation may rise modestly in response to Katrina, but I 
expect that any rise will be temporary, and project inflation to remain 
low in 2006.
    Following the energy price spike that accompanied Katrina, the CPI 
has now risen 4.7 percent in the past 12 months, highest since mid-1991 
and a substantial jump from 2.5 percent only a year ago. Core measures 
of inflation that exclude food and energy have drifted up very 
modestly: both the core PCE deflator and core CPI have risen 2.0 
percent in the past 12 months, ending in August and September 
respectively. Presently, the core PCE deflator is at the top end of the 
Fed's central tendency forecast of 1.75-2.0 percent through 2006. The 
Fed and most macroeconomists generally focus on core measures of 
inflation because historically, the food and energy components have 
been very volatile, and have tended to regress to their long-run 
averages, while core measures of inflation have provided the most 
reliable forecasts of future inflation.
    Core inflation may rise gently through year-end 2005 as a 
consequence of Katrina-related price increases of materials and 
commodities, but I expect that will prove to be temporary, and core 
inflation will remain relatively low in 2006. I am very impressed with 
the Fed's inflation-fighting resolve. The Fed rate hikes will slow 
nominal spending growth, which will constrain excess domestic demand 
relative to productive capacity (the Fed's central tendency forecast 
for nominal GDP is 5.25-5.5 percent for 2006, a meaningful deceleration 
from its 6.1 percent year-over-year pace). Moreover, the rapid 
expansion of the economies of low-cost producers China and India has 
lifted global productive capacity, and should continue to put downward 
pressure on the prices of traded goods. A widening array of services is 
also traded, helping to lower accompanying cost structures. These 
trends increase real output globally while constraining inflation.
    (10) The Federal Reserve's primary focus remains low inflation, and 
it will continue to hike short-term rates into 2006. Bond yields are 
projected to rise, but not as much as short-term rates, contributing to 
a flatter yield curve.
    Even though the Fed has raised its Federal funds rate target from 1 
percent to 3.75 percent, it perceives that monetary policy remains 
accommodative, and it will continue to raise rates in order to 
constrain core inflation. The Fed does not have a ``formal'' numeric 
inflation target like many central banks, but it has clearly signaled 
that low inflation is its primary goal. Beyond the typical issues of 
forecasting inflation and the economy amid uncertainty, the difficulty 
the Fed faces is that there is no reliable measure of monetary thrust 
that provides a clear, forward-looking guideline for conducting policy, 
and there are many crosscurrents in various monetary indicators. The 
``neutral'' Federal funds rate is uncertain. At present, the funds rate 
remains below its long-run average in inflation-adjusted terms, nominal 
spending growth remains too fast to be consistent with stable low long-
run inflation, and the unemployment rate is low. However, growth of the 
monetary aggregates has not provided reliable estimates of nominal 
spending; although their recent moderate growth points to slower 
nominal GDP growth, the seemingly excess liquidity in financial markets 
in recent years has not been reflected in money supply measures. The 
sharp flattening of the yield curve historically has implied monetary 
restrictiveness, but the real costs of capital remain low. The lags 
between monetary policy and economic activity always add a degree of 
difficulty to Fed decisionmaking.
    I expect that the Fed will raise rates through mid-2006, to 
approximately 4.5 to 4.75 percent. Core inflation is unlikely to recede 
appreciably, and the Fed will remain concerned about inflation in light 
of sustained economic growth, low unemployment and scattered production 
bottlenecks. Although a ``neutral'' funds rate is unobservable, my 
assessment is these anticipated rate hikes would lift rates to a level 
consistent with a neutral monetary policy, and would slow nominal 
spending and help constrain inflation. Following several years of very 
low rates and monetary stimulus, the Fed will perceive it necessary to 
hike rates to the high end of estimated range of neutrality. Rising 
world real interest rates also imply a higher equilibrium funds rate 
target.
    Bond yields, which have drifted up recently reflecting concerns 
about inflation, are projected to rise to 5 percent by mid-2006. This 
would involve a further flattening of the yield curve; I do not expect 
the Federal funds rate to rise above 10-year Treasury bond yields. Low 
core inflation and the Fed's credibility anchor bond yields. With 
inflation expectations around 2 percent, a rise to 5 percent bond yield 
would provide an ex ante 3 percent real interest rate, in line with the 
long-run average of inflation-adjusted bond yields.
    (11) The high U.S. trade deficit has resulted largely from the 
U.S.'s relative economic strength, while the unprecedented U.S. current 
account deficit reflects global differences in growth, saving and 
investment, and is not likely to be the primary source of economic 
destabilization.
    Since 1990, U.S. economic and investment growth has been 
persistently and significantly stronger than Europe, Japan and other 
industrialized nations, and its future potential growth is estimated to 
be higher. The rising U.S. trade deficit reflects and is consistent 
with its relative economic strength, as its strong domestic demand and 
investment spending support rapid growth in imports. As long as the 
U.S. maintains this growth advantage, which boosts the demand for 
imports, and the demand for U.S. dollar-denominated assets remains 
high, the trade deficit will remain large.
    In general, the large current account imbalances of many nations 
and international capital flows reflect the large difference in rates 
of economic growth, investment and saving. The unprecedented U.S. 
current account deficit--now exceeding 6 percent of GDP--reflects the 
U.S.'s insufficient saving relative to investment, other nations' 
excess saving, and the strong demand for U.S. dollar-denominated assets 
as global portfolio managers seek the highest risk-adjusted rates of 
return on investment. While U.S. investment remains strong, its large 
budget deficit and low rate of personal saving drag down national 
saving.
    In contrast, Asian nations tend to be large savers. Japan exports 
capital, as its weak investment and high saving have generated current 
account surpluses (Japan has been running a large government deficit, 
but its private sector saving has been very high, reflecting the 
prolonged deflation and long-run concerns about government finances and 
pensions). Barring a sharp change in global economic fundamentals, I do 
not expect a dramatic shift in asset allocations away from U.S. dollars 
that would generate a sharp fall in the U.S. dollar and/or rise in 
interest rates that would damage U.S. economic performance. That said, 
there are initiatives that international policymakers could agree on 
that would reduce global imbalances and boost growth at the same time. 
A coordinated package that would reduce U.S. budget deficits, institute 
pro-growth tax cuts and regulatory reforms in Europe, and involve 
agreement by select Asian nations, including China, to float their 
currencies, is such a package.
    (12) The largest risks to the medium-term U.S. economic outlook are 
excessive monetary tightening and higher energy prices or an 
unanticipated slump in global economies. The U.S. economic expansion is 
not likely to be sidetracked by large global imbalances or falling 
housing prices. Addressing the U.S.'s large Government budget 
imbalances remains crucially important to long-run economic health.
    Beyond the widely anticipated temporary economic slowdown following 
Katrina, the largest risks to U.S. macro performance in 2006 are not 
the negative ripple effects of a collapsing housing market or financial 
turmoil resulting from a dramatic withdrawal of foreign capital from 
U.S. dollar-denominated assets. Rather, my concerns center on the 
lagged impacts of significant monetary tightening coupled with 
sustained high energy prices, or some unforeseen global slump. So far, 
the economy has been very resilient to higher energy prices and Fed 
rate hikes, but consumer and business investment spending could be hurt 
by further energy price increases and rate hikes beyond the neutral 
range. The Fed's top priority should be constraining inflation, but it 
must mind its lagged policy impacts, particularly in light of leveraged 
household balance sheets. However, the low real costs of capital and 
lean business inventories provide important buffers and substantially 
reduce the probability of economic downturn.
    Although the Government's long-run budget imbalance is unlikely to 
hamper near-term economic performance, addressing future rapid growth 
in projected outlays and the Government's unfunded liabilities is 
crucially important to the Nation's long-run economic health. Delays in 
policy changes only raise future economic costs. The estimated 
difference between projected spending and taxes under current law is so 
large that raising taxes to ``close the gap'' on paper would damage 
economic performance and adversely affect the financing gap. 
Successfully achieving fiscal responsibility requires programmatic 
changes to the major entitlement programs, the sources of the recent 
and projected future spending increases, that are fair to current 
program participants, provide the right incentives, and are financially 
viable for the long run.
                                 ______
                                 
 Prepared Statement of Dr. David F. Seiders, Chief Economist, National 
              Association of Home Builders, Washington, DC
    Thank you Chairman Saxton and Members of the Joint Economic 
Committee, I appreciate the opportunity to testify before you today on 
behalf of the National Association of Home Builders (NAHB). NAHB 
represents more than 220,000 members involved in home building, 
remodeling, multifamily construction, property management, 
subcontracting, and light commercial construction. NAHB is affiliated 
with more than 800 State and local home builder associations around the 
country. Our builder members will construct approximately 80 percent of 
the more than 1.84 million new housing units projected for construction 
in 2005.
    The home building industry has been one of the strongest 
contributors to the national economy in recent years. We have had 
record years of production that have led to the highest homeownership 
rate in U.S. history--69 percent. It is in America's interest to assure 
that the home building industry maintains its leadership role in the 
economy, not only because housing and related industries account for 16 
percent of the gross national product (GDP), but most importantly 
because of the benefits of home ownership to our country.
                              introduction
    The current U.S. economic expansion began almost 4 years ago, 
payroll employment has been growing for about 2 years, and the 
unemployment rate has come down substantially in the process.
    The housing sector has been a pillar of strength throughout this 
economic expansion. The housing production component of GDP 
(residential fixed investment) has delivered major contributions to 
growth, particularly since early last year, and surging home sales and 
residential construction have pulled related components of GDP ahead as 
well--including the furniture and household equipment component of 
consumer spending. The volume of services produced by the housing stock 
and consumed by households also has been a large and growing component 
of GDP. Finally, surging house prices have generated massive amounts of 
wealth for America's homeowners, and debt-financed ``extraction'' of 
housing equity has supported spending on residential remodeling and a 
variety of consumer goods and services. Everything considered, it's 
safe to say that the housing sector has contributed at least a full 
percentage point to overall GDP growth in recent times, conservatively 
accounting for between one-fourth and one-third of the total.
    The extraordinarily strong performance of housing, including the 
large cumulative increase in house prices, has prompted widespread 
charges of an unsustainable housing boom, as well as projections of a 
bust that could wreck not only the housing market, but also the entire 
economy. Indeed, analogies have been drawn between the current housing 
market and the stock market bubble that preceded the recession of 2001.
    The housing market inevitably will cool down to some degree before 
long, but a destructive housing bust is not in the cards; furthermore, 
rebuilding in the wake of this year's hurricane season will add to 
housing production for years to come. Everything considered, the 
housing sector should transition from a strong engine of economic 
growth to a more neutral factor in the GDP growth equation, but housing 
will continue to play a vital role in U.S. economic activity going 
forward.
    It should be noted that the housing forecasts presented below 
(attachment) assume that the current U.S. housing policy structure 
remains essentially intact, with some temporary enhancements to deal 
with the extraordinary housing issues created by hurricanes Katrina and 
Rita and with maintenance of current benefits to housing in the tax 
code and the housing finance system.
                          forecast highlights
     The U.S. economy was performing quite well prior to 
hurricanes Katrina and Rita and has enough fundamental strength to 
easily weather the storms.
     The hurricanes took an immediate toll on growth of 
economic output and employment and may shift energy costs upward for an 
extended period of time. But the recovery and reconstruction process 
will soon provide enough economic stimulus to outweigh the negatives, 
thanks largely to the Federal Government response.
     The higher energy costs provoked by the hurricanes are 
putting upward pressures on headline inflation numbers, but that effect 
will diminish with time. Core inflation (excluding prices of food and 
energy) promises to accelerate modestly during the next year or so as 
labor markets tighten further and high energy prices inevitably leak 
into the core.
     The Federal Reserve tightened monetary policy another 
notch on September 20, judging that the longer-term inflationary 
implications of Katrina outweigh the short-term economic negatives. 
Additional quarter-point hikes are likely at the next three FOMC 
meetings, taking monetary policy to an approximately ``neutral'' 
position as Chairman Greenspan's term runs out at the end of January 
2006.
     Long-term interest rates have firmed up from their post-
Katrina lows as the bond markets have judged that the economy will 
weather both storms and generate an inflation issue in line with the 
Fed's concerns. Long-term rates should move up somewhat further in 
coming quarters, lessening the risk of yield curve inversion as the 
central bank raises short-term rates.
     Katrina and Rita destroyed more than 350,000 housing units 
and significantly damaged another 330,000, creating the potential for a 
huge repair and rebuilding process with major implications for 
residential remodeling, manufactured home shipments and conventional 
housing starts--both inside and outside the impacted areas.
     NAHB's housing forecasts incorporate tentative assumptions 
regarding the timing and the patterns of repair and rebuilding in the 
wake of the hurricanes. We're assuming that existing rental vacancies 
and available subsidized housing units in the Gulf region and elsewhere 
will meet some of the current need. We've also bolstered our outlook 
for residential remodeling and manufactured home shipments through 2007 
while phasing in increases in conventional housing starts (single-
family and multifamily) over an even longer period of time.
     Recent housing market indicators, on balance, suggest that 
home sales and housing starts were toying with cyclical peaks prior to 
Katrina, and surveys of builders and lenders conducted since then seem 
consistent with that judgment. However, the housing market still has a 
lot of fundamental strength and home prices still are trending upward--
at least according to most measures we have in hand.
     NAHB's housing outlook recognizes declines in housing 
affordability measures that so far have been caused by sustained rapid 
increases in house prices and that figure to be further eroded down the 
line by a persistent upshift in the interest rate structure. We're also 
anticipating less support to the single-family and condo markets from 
``exotic'' forms of adjustable-rate mortgages and from investors/
speculators that have been relying on short-term capital gains--two 
factors that undoubtedly have contributed to the recent housing boom in 
some areas.
     NAHB's housing forecast through 2007 shows a definite 
cooling down of the single-family and condo markets, with relatively 
strong performances turned in by rental housing, manufactured homes and 
remodeling--owing in part to Katrina and Rita. Everything considered, 
the housing production component of GDP (residential fixed investment) 
should soon fall out of the economic ``growth engine'' category and 
exert a slight drag on GDP growth in both 2006 and 2007.
     The anticipated fade in demand for single-family houses 
and condo units will result in some deceleration of price gains in 
2006-2007, but national average prices will not actually fall in the 
type of economic and financial market environment portrayed in our 
forecast. Prices could fall in some local markets that have experienced 
particularly strong increases in recent times, although persistent 
supply constraints in such areas should continue to support home prices 
for some time.
     Homeowner finances currently are quite healthy, despite a 
huge volume of borrowing against accumulated housing equity in recent 
years, and the Fed's Financial Obligations Ratio for homeowners still 
is in a manageable range. Furthermore, the vast majority of homeowners 
will not be disadvantaged by perspective increases in market interest 
rates and most have equity positions that could easily absorb declines 
in house values--should they occur in some local markets.
                            economic growth
    Incoming data suggest that annualized growth of real gross domestic 
product (GDP) was heading toward a robust pace of about 4.5 percent in 
the third quarter before Hurricane Katrina hit the Gulf Coast on August 
29. We estimate that Katrina took nearly a percentage point out of 
third-quarter GDP growth (dropping it to an estimated 3.6 percent) and 
that the one-two punch from Katrina and Rita will hold fourth-quarter 
growth to 3.2 percent--still a trend-like performance that displays the 
resilience of the U.S. economy to serious shocks.
    GDP growth should accelerate in the first half of 2006 as 
rebuilding activities gear up in the wake of this year's unprecedented 
hurricane damage. A bit further out, GDP growth should settle down to a 
sustainable trend pace (around 3.25 percent), reflecting minimal 
remaining slack in labor markets and maintenance of solid growth in 
labor productivity.
                             labor markets
    The employment report for September contained upward revisions to 
payroll employment for both July and August, bringing the average 
monthly gain to a robust 244,000. The preliminary estimate of net job 
losses in September came to only 35,000, much less than the consensus 
expectations, although data collection problems in the Gulf region 
definitely created a wide range of uncertainty.
    For now, the Labor Department suggests that, in the absence of 
Katrina, employment growth probably would have followed its recent 
trend (an average gain of 194,000 for the previous 12 months), meaning 
that Katrina probably subtracted around 230,000 jobs from the national 
numbers in September. It's also worth noting that strikes subtracted 
22,000 from the September payroll employment numbers, implying that, 
ex-Katrina and ex-strikes, payroll employment increased by about 
225,000--in line with the strong July-August performance.
    The labor market report for October will have to cope with 
hurricanes Katrina and Rita, both because more Katrina casualties will 
drop off payrolls and because Rita destroyed additional jobs of her 
own. However, the September-October disruption to job markets will be 
temporary, and national net job growth should regain a solid trend 
before long. Indeed, we're looking for resumption of strong payroll 
employment growth in 2006, aided by rebuilding activities, followed by 
a slowdown in 2007 as GDP growth recedes to around trend. The 
unemployment rate should sag a bit next year from the current 
hurricane-related level (5.1 percent) but then edge up a bit in 2007.
                       energy costs and inflation
    The hurricanes have seriously complicated the inflation picture, 
boosting energy prices and headline inflation in the near term and 
putting some upward pressure on core inflation down the line as energy 
prices inevitably seep into the business cost structure.
    The disruptions to energy production and transmission in the Gulf 
region caused energy prices to spike sharply after Katrina, but prices 
subsided within a few weeks as the supply situation improved. However, 
the arrival of Rita caused energy prices to surge again, particularly 
for gasoline and natural gas, and prices for these products are likely 
to remain elevated for quite a while.
    We're currently assuming that the spot price of WTI crude oil 
averages a record $65/barrel in the fourth quarter and gradually 
recedes to about $45/barrel by late 2007. We expect the retail price of 
gasoline to continue to recede gradually from the post-Katrina peak 
(above $3.00/gallon) but remain historically high across the forecast 
horizon. We also assume that persistently higher prices for natural gas 
will make their way into the prices for residential gas and electric 
service as utilities gain regulatory approval to raise their rates.
    We expect core inflation to firm up to some degree, particularly in 
2006, reflecting tight labor markets and stronger growth of hourly 
compensation, as well as some pass-through of high energy prices. Core 
consumer price inflation is likely to rise from year-over-year rates of 
slightly below 2 percent in the third quarter of this year to about 2.5 
percent by 2007. That pace may be around the upper end of the Federal 
Reserves ``comfort zone.''
                        interest rate structure
    The apparent strong forward momentum of the U.S. economy, along 
with the prospects for higher headline and core inflation, apparently 
have steeled Federal Reserve resolve to keep the inflation situation 
under control and have sent long-term rates upward.
    The Fed enacted another quarter-point increase in short-term 
interest rates at the September 20 meeting of the Federal Open Market 
Committee (FOMC), raising the Federal funds rate to 3.75 percent (the 
bank prime rate went to 6.75 percent in the process). While 
acknowledging the negative economic effects of Hurricane Katrina, the 
FOMC characterized these negatives as temporary and focused heavily on 
the evolving threats to core inflation. And while continuing to say 
that remaining monetary policy accommodation can be removed at a 
``measured'' pace, the FOMC held open the possibility of a more 
aggressive approach in the event that inflation concerns become more 
serious than expected.
    In recent weeks, various Fed spokespersons have stressed the 
evolving inflation threat, and another quarter-point rate hike at the 
next FOMC meeting on November 1 seems a foregone conclusion. 
Furthermore, we're assuming additional rate hikes at the December 13 
and January 31 meetings, as Chairman Greenspan's term runs out. We're 
assuming the 4.5 percent funds rate will be considered ``neutral'' and 
that monetary policy will hold steady for some time.
    The bond markets apparently share the Fed's perspectives on 
economic growth and inflation, and market expectations for monetary 
policy are essentially the same as ours. As a result, long-term 
interest rates have backed up considerably from their post-Katrina lows 
and the long-term home mortgage rate edged over 6.0 percent in the 
second week of October. Our forecast shows some additional increase in 
long-term rates in coming quarters, with the home mortgage rate 
reaching 6.6 percent by the fourth quarter of 2006.
                        hurricane housing damage
    According to the October 3 Red Cross ``disaster assessment'' for 
hurricanes Katrina and Rita, the two storms destroyed an estimated 
356,000 housing units, with 353,000 attributed to Katrina. This was 
more than 12 times the number destroyed in any previous natural 
disaster (or series of disasters) in the Nation's history.
    Furthermore, 146,000 units suffered ``major'' damage (not currently 
habitable), 184,000 had ``minor'' damage (could be occupied), and an 
additional 206,000 had ``extremely minor'' or ``nuisance'' damage such 
as a few missing shingles or broken windows. Four-fifths of the 
``destroyed'' housing units (uninhabitable and beyond repair) are in 
Louisiana and nearly one-fifth are in Mississippi, while Alabama and 
Texas got off quite lightly in this regard. Total damaged housing units 
(needing major, minor or extremely minor repairs) amounted to 329,000 
in Louisiana, 173,000 in Mississippi, 33,000 in Texas, and about 1,000 
in Alabama.
    The Red Cross has been trying to categorize destroyed or damaged 
homes by type of unit. Current estimates say 88 percent of destroyed 
units are single-family homes, 11 percent are apartment units and less 
than 1 percent are manufactured homes. Census Bureau numbers, on the 
other hand, show that about 15 percent of the housing stock in 
Louisiana, Mississippi, and Alabama consisted of manufactured homes in 
2000. Thus, it's likely that the Red Cross has been categorizing many 
destroyed or damaged HUD-code housing units as conventionally built 
single-family homes.
    Whatever the exact numbers, it's perfectly clear that the cleanup, 
repair and rebuilding process in the wake of Katrina and Rita will be 
immense and that the implications for residential maintenance and 
repair, spending on improvements (including replacements of major 
systems), manufactured home shipments and conventional housing starts 
are profound. The timing and composition of the process will depend 
heavily on the pattern of Government responses.
                   repair/reconstruction assumptions
    It's extremely difficult to estimate the patterns of repair and 
reconstruction of the housing stock that was destroyed or damaged by 
hurricanes Katrina and Rita. Experience with previous natural 
disasters, along with evolving patterns of Federal Government 
assistance in the wake of Katrina-Rita, have led us to the following 
working assumptions for the 9-quarter period extending through the end 
of 2007:

     $1.8 billion for outlays on residential maintenance and 
repair.
     $4.7 billion for improvements to residential structures 
(including replacements of major systems such as roofs and heating 
systems).
     38,000 manufactured home shipments (HUD-code units).
     90,000 conventional housing starts (80 percent single-
family units), including units built on existing foundations in the 
Gulf region.
                       recent housing performance
    Housing market indicators painted a fundamentally positive picture 
through the pre-Katrina period (essentially through August). Single-
family starts and permits for August held in the record range 
established during other recent months, sales of existing homes (based 
on closings) displayed a similar pattern, and ``pending'' sales of 
existing homes (based on contracts signed) actually moved up to a new 
record in August. Sales of new homes (contract basis) fell off in 
August following a record pace in July, but statistical problems 
definitely contributed to volatility in those months (hardly a new 
problem with this series).
    For the post-Katrina period, NAHB's single-family Housing Market 
Index fell by two points in September, but regained that loss in 
October, leaving the index slightly below the cyclical peak in June. 
The weekly index of applications for mortgages to buy homes (Mortgage 
Bankers Association series) was essentially flat throughout August, 
September, and early October (4-week moving average basis).
    Everything considered, it seems fair to say that single-family 
housing activity has been toying with a cyclical peak and is poised to 
show some fade before long. Measures of home-buying affordability have 
been eroding in the face of ongoing rapid increases in house prices in 
many areas, and the recent upshift in short- and long-term interest 
rates figures to take some toll as well. Furthermore, there's a good 
chance that those ``exotic'' forms of adjustable-rate mortgages are 
losing some luster under the public scrutiny of Federal financial 
regulators and the rating agencies. Finally, there's some tentative 
evidence of decline in the investor shares of purchases of single-
family homes and condo units, and this component of demand can be quite 
fragile.
                         the housing forecasts
    NAHB's forecast shows a slight decline in total housing starts in 
the fourth quarter of this year, partly because of hurricane effects in 
the Gulf region, and we expect total starts to be down moderately in 
both 2006 and 2007, despite hurricane-related additions.
    Our forecast for 2006-2007 shows a cumulative decline of 9 percent 
in single-family starts from the 2005 record. The multifamily sector is 
essentially flat in this forecast, thanks primarily to a good 
performance by the rental sector. We expect manufactured home shipments 
to pick up significantly in coming quarters, reaching 150,000 units in 
2006 before settling back toward a pre-Katrina pace. Residential 
remodeling should post solid growth (in both nominal and real terms) 
throughout the forecast period, supported by a massive amount of 
homeowner equity and swollen repair/improvement needs in the wake of 
the hurricanes.
    Everything included, the residential fixed investment component of 
GDP should soon move out of the strong ``growth engine'' category 
occupied since the 2001 recession, although the real value of RFI 
should remain within a few percentage points of the record high reached 
in the third quarter of this year.
                           homeowner finances
    Various media reports have been insisting that heavy borrowing 
against housing equity has been pushing homeowner finances to the brink 
of disaster. Indeed, Federal Reserve Chairman Alan Greenspan recently 
unveiled Fed research showing net home equity ``extraction'' of $600 
billion in 2004 (6.92 percent of disposable income), and borrowing 
against equity could be even bigger this year.
    These are staggering numbers, of course, but they don't actually 
mean that something has gone wrong. Indeed, the Fed's own national 
balance sheets show that homeowner equity grew to $10.5 trillion by 
mid-2005, up by 18 percent from a year earlier. Furthermore, the 
aggregate housing debt-to-value ratio stood at 43 percent at mid-year, 
lower than at any time in recent years.
    It's also clear that mortgage debt repayment is not placing an 
undue burden on the income of America's homeowners--partly because 
mortgage debt has been substituting for a lot of shorter-term, higher-
cost, consumer debt. Indeed, the Fed's Financial Obligations Ratio for 
homeowners was only 16.37 percent in the second quarter, compared with 
28.87 percent for renter households.
    While it's possible to find debt-strapped homeowners, the overall 
picture shows remarkably healthy homeowner finances and a housing 
equity nest egg that could withstand sizable shocks. Indeed Chairman 
Greenspan recently pointed out that ``only a small fraction of 
households across the country have loan-to-value ratios greater than 90 
percent'' and that ``the vast majority of homeowners have a sizable 
equity cushion with which to absorb a potential decline in house 
prices.'' *
---------------------------------------------------------------------------
    * Alan Greenspan, remarks on ``Mortgage Banking'' to the American 
Bankers Association Annual Convention, September 26, 2005
---------------------------------------------------------------------------
    Mr. Chairman, that concludes my remarks. Again, thank you for the 
opportunity to appear before you today. I look forward to answering any 
questions you or the Members of the Committee may have for me.




Prepared Statement of Dr. Brad Setser, Senior Economist and Director of 
      Global Research, Roubini Global Economics, LLC, New York, NY
    I want to thank Chairman Saxton and the Joint Economic Committee 
for the opportunity to testify. My remarks will focus on one particular 
aspect of the economic outlook--but a very important one--the payments 
deficit the United States is running with the rest of the world. I will 
make five key points:

     The U.S. current account deficit has reached an 
unprecedented size for a major economy. Barring a sharp fall in oil 
prices, this deficit is likely to continue to increase in the next 
year, in part because of rising interest payments on the United States 
growing external debt.
     The U.S. external deficit is a reflection of policy 
decisions, both here in the U.S. and abroad, not just private saving 
and investment decisions. Both the large U.S. fiscal deficit and the 
unwillingness of many economies to allow their currencies to appreciate 
against the dollar have contributed to the United States large deficit. 
Net private flows have not been large enough to finance the United 
States current account deficit.
     Trade deficits of nearly 6 percent of U.S. GDP are not 
sustainable over time. They imply a rapid increase in the U.S. external 
debt to GDP ratio and a growing current account deficit.
     The availability of sufficient financing to sustain 
deficits of this size at current U.S. interest rates should not be 
taken for granted. The larger the deficit, and the longer adjustment is 
delayed, the greater the associated risks.
     Policy actions, both at here and abroad, can help first to 
stabilize and then to reduce the U.S. external deficit. The needed 
policy steps are by now well known, but no less urgent. A reduction in 
the U.S. fiscal deficit would increase national savings, and thus 
reduce the United States' need to draw on the world's savings. Our 
trading partners need to show greater willingness to allow their 
currencies to appreciate and to take policy steps to encourage domestic 
consumption growth.
    The current account deficit looks likely to continue to grow in 
2006.--The current account deficit is the sum of the trade deficit, the 
balance on transfer payments, and the balance on labor and investment 
income. This deficit totaled $395 billion in the first half of the 
year, largely because of the $346 billion trade deficit. The trade 
deficit is set to widen further in the second half of the year on the 
back of higher oil prices and the disruption to U.S. oil production and 
refining created by Katrina and Rita. The current account deficit has, 
until now, largely tracked the U.S. trade deficit, but this is likely 
to change going forward. The balance on investment income turned 
negative in the second quarter, and further deterioration is to be 
expected as higher short-term rates work their way through the U.S. 
external debt stock. A surge in incoming transfer payments as European 
re-insurers make Katrina-related claims may offset some of this 
increase.
    The 2005 trade deficit is likely to approach $720 billion and, in 
conjunction with a transfers deficit of $85 billion and a negative 
income balance, push the current deficit to around $815 billion, or 
about 6.6 percent of U.S. GDP--up substantially from the $520 billion 
(4.6 percent of GDP) deficit of 2003 and the $668 billion deficit of 
2004 (5.7 percent of GDP). In dollar terms, the 2005 deficit will be 
about twice as large as the $413 billion deficit of 2000, the peak 
deficit of the .com investment boom.
    If both the U.S. and the world continue to grow at close to their 
current rates in 2006, the current account deficit is likely to 
continue to widen in 2006. The recent increase in the trade deficit has 
been driven almost exclusively higher oil prices; monthly non-oil 
imports have been roughly constant since January. Subdued non-oil 
imports combined with strong export growth to lead the non-oil trade 
deficit to fall ever so slightly in the second quarter. However, this 
improvement in the non-oil balance is likely to be difficult to sustain 
in 2006. Strong export growth in 2005 reflects the lagged impact of 
falls in dollar/euro in 2003 and 2004, plus a cyclical recovery in 
demand for civil aircraft. By 2006, the recent rise in the dollar is 
likely to begin to slow export growth. The slowdown in the growth of 
non-oil imports is therefore partially a reaction to the exceptionally 
rapid growth of these imports at the tail end of 2004. So long as the 
U.S. economy continues to grow as expected, it is reasonable to expect 
growth in non-oil imports to resume, though at a lower rate than 2004.
    The balance on investment income is likely to continue to 
deteriorate. Remember, the U.S. will take on $800 billion in new 
external debt over the course of 2005 to finance its ongoing external 
deficit. If that debt only carries an average interest rate of 5 
percent, it implies an additional $40 billion in external payments. The 
full impact of the Fed's recent tightening on short-term rates will 
also begin to manifest itself in 2006, as existing short-term debt is 
refinanced at a higher rate. The resulting 2006 current account deficit 
is likely to top $900 billion, and exceed 7 percent of GDP.
    The current account deficit essentially measures of how much we 
have to borrow from the rest of the world to support the amount we 
consume in excess of our income. It consequently is equal to the gap 
between what the U.S. saving and U.S. investment. The U.S. budget 
deficit--a drain on national savings--is likely to increase in 2006 on 
the back of Katrina. Barring a fall in investment or rise in household 
savings, so the overall gap between overall national savings and 
investment is likely to continue to widen. Put differently, savings 
imported from the rest of the world will finance an increasing share of 
domestic U.S. investment.

----------------------------------------------------------------------------------------------------------------
                                                                     2003        2004      2005 (f)    2006 (f)
----------------------------------------------------------------------------------------------------------------
Trade balance...................................................       -495        -618        -720        -780
o/w oil.........................................................       -130        -175        -241        -260
Non-oil trade balance...........................................       -365        -443        -479        -520
Transfers balance...............................................        -71         -81         -85         -90
Income balance..................................................         46          30         -10         -65
Current account.................................................       $520        $668        $815        $935
(% of GDP)......................................................     (4.7%)      (5.6%)      (6.6%)      (7.1%)
----------------------------------------------------------------------------------------------------------------

    Policy choices in the U.S. and abroad have contributed to the 
increase in the deficit.--Current account deficits of this magnitude 
are without precedent for a major economy. As Dr. Bernanke has 
emphasized, these deficits have, to date, been financed at remarkably 
low interest rates. Indeed, current U.S. interest rates seem, on their 
face, insufficient to compensate the central banks of the emerging 
market economies now financing the United States for the risk of 
further dollar depreciation. Consequently, it is interesting to review 
the forces that have led to the emergence of such a large U.S. external 
deficit.
    The U.S. current account deficit, by definition, has to be matched 
by a current account surplus in rest of the world. The fall in savings 
relative to investment in USA necessarily has been matched by a rise in 
savings relative to investment in rest of world. The U.S. external 
deficit started to widen in the late 90s, as investment in the U.S. 
surged and investment in certain Asian economies fell sharply. The U.S. 
external deficit, surprisingly, did not fall when U.S. investment fell 
sharply in 2001 and 2002, largely because changes in tax policy--along 
with an upturn in expenditure growth--turned a small structural fiscal 
surplus to a structural fiscal deficit of around 3 percent of GDP.\1\ 
Since the fiscal deficit peaked as a share of GDP in 2004, the recent 
deterioration in the U.S. current account deficit has been driven by a 
fall in household savings and a rebound in investment. This reflects a 
surge in investment in residential property, and, as Chairman Greenspan 
has emphasized, rising house prices also seem to be closely linked to 
the fall in U.S. household savings.
---------------------------------------------------------------------------
    \1\ IMF, 2005. See Table of 14 of the statistical appendix of the 
WEO. William Gale and Peter Orzag have reached a similar conclusion; 
see http://www.brookings.edu/views/articles/20050214galeorszag.pdf.
---------------------------------------------------------------------------
    Dr. Bernanke has noted that the main counterpart to the recent rise 
in the U.S. current account deficit is not found in either Japan or 
Europe.\2\ The eurozone's current account surplus fell between 1997 and 
2005.\3\ The roughly $60 billion rise in Japan's current account 
surplus between 1997 and 2005 is far too small to account for the much 
larger rise in the U.S. current account deficit. Rather, rising U.S. 
deficits have been matched by rising surpluses in emerging and 
developing economies.
---------------------------------------------------------------------------
    \2\ Ben Bernanke, ``The Global Savings Glut and the U.S. Current 
Account Deficit,'' The Homer Jones Lecture, April 14, 2005. http://
www.federalreserve.gov/boarddocs/speeches/2005/20050414/default.htm.
    \3\ The eurozone's surplus fell from $96 billion in 1997 to an 
estimated $24 billion in 2005; Japan's surplus rose from $97 billion to 
an estimated $153 billion in 2005. The surplus of the Asian NICs rose 
from $6 to $80 billion, and a $85 billion deficit in ``other emerging 
markets and developing economies'' turned into a $410 billion surplus 
in 2005. IMF data and estimates.
---------------------------------------------------------------------------
    These surpluses have different causes. Emerging Asia's surplus has 
increased since 1997, driven first by the Asian crisis and, more 
recently, by the surge in China's current account surplus. Setting 
China aside, the savings rates in most Asian emerging economies have 
been constant. Their surpluses reflect a fall in investment, which fell 
(from quite high levels) during the crisis and have yet to recover. 
China is a different story: its national savings rate has soared to 
over 50 percent of its GDP, with most of the increase occurring 
recently. It is hard to find evidence of a global savings glut, but it 
is hard to deny the presence of savings glut in China. Latin America 
has shifted from a deficit to a surplus, largely because improvements 
in the fiscal position of most Latin governments have pushed national 
savings rates up. Finally, rising oil prices have led to higher savings 
in the world's oil exporters.
    It is important to note that private capital flows have not carried 
the savings surplus of emerging economies to the U.S. Rather the large 
scale flow of capital from emerging economies to the U.S. is a function 
of policy decisions on the part of many emerging economies to resist 
pressures for currency appreciation--pressures stemming, in some cases, 
from rising current account surpluses and, in other cases, from private 
capital flows. In 2004, IMF data shows that private investors put $150 
billion more into the emerging world than they took out. Such private 
flows potentially could have financed a substantial current account 
deficit, or at least allowed emerging economies to reduce their large 
current account surpluses. However, in aggregate, these economies 
maintained current account surpluses, in some cases, quite large 
surpluses even as private flows picked up. Consequently, private flows 
to emerging economies generally have financed faster reserve growth, 
and thus have been recycled back to the U.S. and Europe.
    IMF data indicates that reserve accumulation by emerging economies 
has gone from $116 billion in 2001 to $517 billion in 2004.\4\ In 2003 
and early 2004, Japan also intervened heavily to prevent the dollar 
from depreciating against the yen. According to official U.S. data, 
central bank financing of the U.S. rose from $116 billion in 2002 to 
$278 billion in 2003 and $395 billion in 2004--and U.S. data almost 
certainly understates total dollar reserve growth, and thus foreign 
central bank's indirect role in the financing of U.S. deficits.
---------------------------------------------------------------------------
    \4\ The 2004 increase was inflated by perhaps $60 billion as a 
result of the rising dollar value of euro reserves.
---------------------------------------------------------------------------
    U.S. data shows a substantial reduction of central bank flows so 
far in 2005. This data needs to be interpreted with some caution. 
Reserve accumulation, once adjustments are made for the falling dollar 
value of euro reserves, is still running at a roughly $600 billion 
annual pace. Overall, global growth has not fallen, but the composition 
of countries adding to their reserves certainly has changed. Japan has 
stopped intervening, while reserve growth in both China and the world's 
oil exporters has picked. Almost all of Japan's increase in reserves 
showed up in the U.S. data. However, recorded Chinese purchases of U.S. 
debt in both 2004 and 2005 have equaled only about 40 percent of 
China's reserve increase. OPEC and Russia combined to run a current 
account surplus of perhaps $200 billion in the first half of 2005, 
but--at least according to U.S. data--they only purchased only $5 
billion in U.S. long-term debt (and $1.5 billion in U.S. stocks). There 
are several ways to reconcile this data: China and the oil exporters 
may account for some of the increase in ``onshore'' central bank dollar 
deposits in the second quarter; they may have added to their offshore 
dollar deposits; they may have purchased U.S. securities via 
intermediaries (inflows from the UK have been strong); or they may have 
built up their holdings of euros--driving down yields on European bonds 
and thus encouraging private capital to flow to the U.S.
    Consequently, in my view, rapid reserve growth my emerging 
economies continues to be a key reason why the U.S. has been able to 
finance its current account deficit without difficulty.
    Large trade deficits are not sustainable over time.--The current 
U.S. position differs from the U.S. position in the 1980s in two key 
ways: The underlying deficit now is substantially larger, and U.S. is 
by now a substantial net debtor. The 2005 current account deficit, 
combined with the reduced dollar value of American assets in Europe, is 
likely to lead the U.S. net external debt\5\ to increase to around 30 
percent of U.S. GDP at end of 2005.
---------------------------------------------------------------------------
    \5\ I am using net external debt as shorthand for the United States 
Net International Investment position. The international investment 
position includes U.S. equity investment abroad, and foreign equity 
investment in the U.S. Since U.S. equity (FDI and portfolio equity) 
investment abroad is worth more than foreign equity investment in the 
U.S., the negative U.S. Net International Investment position is 
entirely the product of a large negative net debt position.
---------------------------------------------------------------------------
    Basic external debt sustainability analysis implies that sustained 
trade deficits of the current level will lead to the United States net 
external debt to rise relative to GDP. Sustained trade deficits also 
imply a rising current account deficit, as the current account deficit 
includes interest payments on external debt. Stabilizing the U.S. net 
external debt-to-GDP ratio at between 50-60 percent of U.S. GDP (a 
relatively high level) requires the elimination of the trade deficit 
over the next 10 years. Even in that scenario, the U.S. current account 
deficit is likely to remain close to 3 percent of U.S. GDP. If this 
adjustment is delayed, U.S. external debt-to-GDP will stabilize at 
higher levels, net interest payments will be higher, and the U.S. could 
eventually need to run substantial trade surpluses to avoid ongoing 
increases in its external debt-to-GDP ratio.




    Relying on foreign savings to finance a substantial share of 
investment in the U.S. implies that, over time, more and more of the 
income earned on investment in the U.S. will need to be sent abroad. 
Here is one way to think about it: A Chinese company believed that the 
future income of Unocal, a U.S. oil company, was worth about $20 
billion. Financing this year's current account deficit would therefore 
require selling off the future income of 40 Unocals. Since next year's 
deficit is larger, it would require selling off the future income of 
another 50 Unocals. The U.S. has been financing its external deficits 
by selling debt not equity, but the basic principle is the same.
    International experience also suggests that deficits associated 
with fiscal deficits and low levels of national savings are of greater 
concern than deficits associated with high levels of investment. The 
recent shift in composition of investment toward residential property 
is not particularly encouraging either: Housing is not an obvious 
source of future export income.
    Short-term risks can be reduced with coordinated policy action.--
Even if the trade deficit stabilizes in 2006 and beings to fall in 
2007, the U.S. is likely to still need between $900 billion and a 
trillion in financing from the rest of the world in each of the next 2 
years. In the long-run, failing to make the adjustments needed to raise 
national savings and bring the U.S. trade deficit down over time poses 
real risks to the U.S. economy. In the short-run, though, the biggest 
risk is that market conditions will change suddenly. Should the 
market's demand for adjustment would exceed the capacity of the U.S. 
economy to adjust smoothly, U.S. growth could slow--perhaps 
significantly. The dollar would fall and interest rates would rise, and 
the drag on the economy from higher interest rates would exceed the 
stimulus to the U.S. export sector from a falling dollar. U.S. trade 
and current account deficits have built over time; we do not want to be 
forced to get rid of those deficits over night.
    The combination of market forces and policy decisions that will 
bring about the necessary adjustment in the U.S. trade deficit is 
subject to substantial uncertainty. But there is no doubt that the 
adjustment, when it comes, will require substantial changes in the 
drivers of growth, both in the U.S. and among our trading partners. In 
the U.S., consumption must grow more slowly than overall income, 
generating an increase in savings. Some sectors of the economy that 
currently are doing well may do less well, and resources will likely 
shift into the production of tradable goods and services. As former 
Treasury Assistant Secretary and long-term Director of the Federal 
Reserve's international staff, Edwin Truman has emphasized, overall 
U.S. growth could slow even during a relatively orderly adjustment 
process. Conversely, countries that until now have relied heavily on 
U.S. demand growth to spur their own economies will have to find new 
motors to propel their own growth. Just as the composition of growth 
must change here in the U.S., so too must it change abroad. After a 
period of time when U.S. imports have grown faster than U.S. exports, 
the world is likely looking at an extended period when U.S. exports 
will grow faster than U.S. imports.
    Recent studies by the staff of the Federal Reserve Board offers 
hope that the adjustment process will prove to be relatively smooth, 
and need not involve either a sharp rise in interest rates or a large 
slowdown in growth. However, caution is still in order. The U.S. is in 
many ways operating outside realm of historical experience. The U.S. 
current account deficit now is far bigger than the deficit of the 
1980s. The U.S. trade deficit is exceptionally large relative to the 
U.S. export sector. In 2004, the U.S. exported more ``debt'' than 
``goods.'' The U.S. is starting the adjustment process with very low 
long-term interest rates. The U.S. has significant assets abroad, which 
can help ease the adjustment process, but also very large gross 
external debts. Any sustained increase in U.S. interest rates could 
have a significant impact on the size of U.S. external interest 
payments. The adjustment process in the world's largest economy will 
have far larger impacts on the rest of the world than past adjustments 
in smaller economies.
    International experience certainly suggests one clear lesson: As a 
country's external debt grows, it becomes more, not less, important to 
maintain fiscal policy credibility. Reducing the U.S. fiscal deficits 
is the easiest and most certain way to bring about the needed increase 
in U.S. national savings; it is likely to prove central to maintaining 
the confidence of the United States external creditors during what 
could be a long period of adjustment. Work by the IMF and OECD suggest 
that a $1 reduction in the fiscal deficit would lead to a 40 to 50 cent 
reduction in the U.S. current account deficit.
    Just as policy changes here in the U.S. can help to increase U.S. 
savings relative to investment, policy changes in the rest of the world 
can raise their consumption growth relative to their income growth, 
raise their imports relative to their exports and reduce their savings 
relative to their investment. China, Malaysia and many oil exporting 
countries need to be willing to allow their currencies to appreciate 
against the dollar. All these countries are now running large current 
account surpluses, and countries with big surpluses cannot peg, or 
otherwise tie their currencies tightly to dollar, without impeding 
effective adjustment in the global balance of payments. If higher oil 
prices are sustained, oil exporters will need to spend more and save 
less. The low level of consumption in China relative to Chinese GDP 
suggests that there is substantial scope, with appropriate policies, 
for strong consumption growth in China to replace strong consumption 
growth in the U.S. as the driver of global demand growth. Continental 
Europe needs to direct its domestic macroeconomic policies toward 
supporting domestic demand during the adjustment process.
    The expansion of the U.S. trade deficit reflects mutually 
reinforcing policy choices, both here in the U.S. and abroad. The 
stabilization and eventual fall of the U.S. deficit will also be far 
smoother if this process is supported by appropriate policy changes. No 
doubt, market forces will eventually demand adjustment even in the 
absence of policy changes. But, as both New York Federal Reserve 
President Timothy Geithner and former Treasury Secretary Robert Rubin 
have emphasized, without supportive policies, the needed market moves 
are bigger and the risks of disruptive market moves are substantially 
higher.
---------------------------------------------------------------------------
    \6\ Includes the increase in central banks ``offshore'' dollar 
deposits reported in the international banking system. See Robert 
McCauley, ``Distinguishing global dollar reserves from official 
holdings in the United States,'' BIS Quarterly Review, September 2005. 
For more on different measures of central bank financing of the U.S., 
see Matthew Higgins and Thomas Klitgaard, ``Reserve accumulation: 
implications for global capital flows and financial markets,'' Current 
Issues in Economics and Finance, Volume 10 No. 10. Federal Reserve Bank 
of New York. September-October 2004.

                           Central bank financing of the U.S. current account deficit
----------------------------------------------------------------------------------------------------------------
                                                                       2002       2003       2004      2005 (f)
----------------------------------------------------------------------------------------------------------------
U.S. current account deficit......................................        475        520        668          815
Central bank financing (BEA data).................................        116        278        395          205
As percent of deficit.............................................        24%        53%        59%          25%
BIS estimate for increase in dollar reserves \6\..................        187        423        498            ?
As percent of U.S. deficit........................................        39%        81%        75%            ?
Memo: Global reserve increase, all currencies (Setser estimates,          285        510        640          600
 based on IMF data with adjustments for valuation changes)........
----------------------------------------------------------------------------------------------------------------


                                                                                                     

                                        Recorded Chinese Purchases of U.S. Assets v. Chinese Reserve Accumulation
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                                    Estimated
                                                                                                                                    change in
                                                                                                      Corp.             Total in    reserves
                                                                    T-bills   Treasuries   Agencies   Bonds    Foreign    U.S.      (adjusted       %
                                                                                                                          data         for
                                                                                                                                   valuation)
--------------------------------------------------------------------------------------------------------------------------------------------------------
2002.............................................................        0.2        24.1       29.3      6.1       3.5      63.1          74.5       85%
2003.............................................................        0.3        30.1       29.4      4.5       4.0      68.4           157       43%
2004.............................................................       17.3        18.9       16.4     12.1       3.0      67.4           194       34%
Jan-June 2005....................................................        2.5        17.3       11.3     13.2      14.3      48.7           137       35%
2005 f...........................................................  .........  ..........  .........  .......  ........       110           275       40%
--------------------------------------------------------------------------------------------------------------------------------------------------------
From: Derived from Prasad and Wei (2005), updated to reflect 2005 TIC data. See http://www.hbs.edu/units/bgie/seminarpdfs/Prasad%20IFC%20Supplement.pdf

  

                                  
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