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



                                                        S. Hrg. 109-791
 
                  PROSPECTS FOR THE ECONOMIC EXPANSION

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

                                HEARING

                               before the

                        JOINT ECONOMIC COMMITTEE
                     CONGRESS OF THE UNITED STATES

                       ONE HUNDRED NINTH CONGRESS

                             SECOND SESSION

                               __________

                             JUNE 27, 2006

                               __________

          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 E. 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, a U.S. Senator 
  from Rhode Island..............................................     2

                               Witnesses

Statement of Dr. Edward P. Lazear, Member, Council of Economic 
  Advisers.......................................................     3
Statement of Dr. Mickey D. Levy, Chief Economist, Bank of America    30
Statement of Dr. Brad Setser, Director, Global Research, Roubini 
  Global Economics; and Research Associate, Global Economic 
  Governance Center..............................................    35

                       Submissions for the Record

Prepared statement of Representative Jim Saxton, Chairman........    46
Prepared statement of Senator Jack Reed, Ranking Minority........    47
Prepared statement of Dr. Edward P. Lazear, Member, Council of 
  Economic Advisers..............................................    49
Editorial, The Wall Street Journal, entitled, ``America at Work''    58
Chart, entitled, ``Effects on After-Tax Income of Tax Cuts Passed 
  Since 2001''...................................................    60
Chart, The New York Times, entitled, ``The Rich Get Richer, 
  Again''........................................................    61
Prepared statement of Dr. Mickey D. Levy, Chief Economist, Bank 
  of
  America........................................................    62
Prepared statement of Dr. Brad Setser, Director, Global Research, 
  Roubini Global Economics; and Research Associate, Global 
  Economic Governance Center.....................................    74


                  PROSPECTS FOR THE ECONOMIC EXPANSION

                              ----------                              


                         TUESDAY, JUNE 27, 2006

             Congress of the United States,
                          Joint Economic Committee,
                                                     Washington, DC
    The Committee met, pursuant to notice, at 10 a.m., in room 
2118, Rayburn House Office Building, the Honorable Jim Saxton, 
Chairman of the Committee, presiding.
    Representatives present: Representatives Saxton, Paul, 
Ryan, Brady, Maloney, Hinchey, Sanchez and Cummings.
    Senators present: Senators Bennett, Reed and Sarbanes.
    Staff present: Chris Frenze, Robert Keleher, Brian 
Higginbotham, Colleen Healy, Ari Evans, Jeff Schlagenhauf, Chad 
Stone, Daniel Dowler, and Matt Homer.

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

    Chairman Saxton. Good morning.
    It is a pleasure to welcome Chairman Lazear of the 
President's Council of Economic Advisers before the Joint 
Economic Committee this morning. Thank you for being with us.
    The Council of Economic Advisers and the Joint Economic 
Committee share a common history, and we value the good 
relationship that we have had over many years. I would also 
like to welcome the members of the second panel, Dr. Mickey 
Levy, and Dr. Brad Setser this morning.
    Thank you also for being here.
    The U.S. economy has grown at a healthy pace in recent 
years, according to official data. The U.S. economy advanced 
4.2 percent in 2004 and 3.5 percent in 2005.
    The pick-up in economic growth since 2003 is largely due to 
the rebound in investment including equipment and software 
spending.
    A combination of accommodative monetary policy and 
investment tax incentives enacted in 2003 helped to boost 
investment and improve economic growth in recent years.
    Since August of 2003, 5.3 million new jobs have been 
created and the unemployment rate has fallen to 4.6 percent. As 
the Fed noted in a policy report last February, the U.S. 
delivered a solid performance in 2005.
    In the first quarter of 2006, the economy expanded at a 
blistering pace of 5.3 percent. This performance is all the 
more remarkable considering the impact of high oil prices and a 
tightening of monetary policy by the Federal Reserve.
    Although there is some weakness in the real estate sector, 
it appears as though a soft landing is the most likely outcome. 
The overall economy has proven to be quite resilient.
    Very recent data suggests that the U.S. economy is no 
longer growing at an unsustainable rate in excess of 5 percent 
but advancing at a more moderate rate of about 3 percent.
    According to the Blue Chip consensus of economic 
forecasters, this trend will continue through most of the next 
six quarters.
    The Fed has stated that the U.S. economy should continue to 
perform well in 2006 and 2007. A variety of forecasts suggest 
that the economic growth for 2006 will be about 3.5 percent and 
that the economic expansion will continue into 2007.
    At this time, I would like to ask the Ranking Member, 
Senator Reed, if he has comments that he would like to make.
    [The prepared statement of Chairman Saxton appears in the 
Submissions for the Record on page 46.]

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

    Senator Reed. Thank you very much, Mr. Chairman.
    Let me also welcome Chairman Lazear to his first hearing, 
and I, too, am pleased that Dr. Levy and Dr. Setser will be 
participating in the second panel.
    The latest Administration forecast, which is in line with 
the consensus of other forecasters, is for economic growth to 
continue at a more moderate pace than we have seen recently. Of 
course, there are risks to that forecast; high energy prices 
and cooling housing markets might slow consumer spending more 
sharply than forecasters are predicting. And our trade deficit 
and dependence on foreign lenders have reached alarming 
proportions.
    The Federal Reserve has to decide how to deal with these 
risks while preserving its credibility on inflation. If the Fed 
makes the wrong choice, the economic recovery could end before 
it has begun for many American families. That brings me to the 
core of my concern about the economy and the Administration's 
policies. As much as the President would like to say that his 
policies are benefiting all Americans, the fact is that we have 
gone through the most prolonged job slump in many decades. Real 
wages are not just lagging behind productivity growth. They are 
stagnating.
    And economic inequality is increasing. While workers are 
waiting to see the benefits of this economic recovery show up 
in their paychecks, American families are experiencing 
widespread economic insecurity in the face of soaring energy 
prices, rising health care costs, declining health insurance 
and pension coverage, and rising costs for a college education 
for their children.
    The President's tax cuts have not been the answer. They 
were poorly designed to stimulate broadly shared prosperity and 
produced a legacy of large budget deficits that leave us 
increasingly hampered in our ability to deal with the host of 
challenges we face. Moreover, 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 
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 stop accepting our IOUs. 
We had a current account deficit of nearly $800 billion last 
year. And our international financial debt continues to mount.
    I hope 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 
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.
    Most experts believe that the budget deficits we need to 
worry about are the long-term structural deficits resulting 
from the President's tax cuts, not cyclical deficits resulting 
from a temporary decline in economic activity. So I'll be 
interested in Chairman Lazear's explanation of just how we can 
grow our way out of deficits as he recently wrote in the 
Washington Post.
    I am also curious about Dr. Lazear's recent statement in 
the Wall Street Journal that the President's tax cuts have made 
the Tax Code more progressive, which narrows the difference in 
take-home earnings. In fact, the President's tax cuts have 
widened the gap in take-home earnings. According to the non-
partisan Tax Policy Center, the tax cuts passed since 2001 have 
raised the after-tax income of the top 1 percent of Americans 
by 5 percent while raising the after-tax income of the bottom 
60 percent of Americans by just 2 percent.
    Chairman Lazear rightly points out that policies must 
increase the opportunities of all workers to acquire skills and 
training, but this view doesn't square with the President's 
budget, which includes cuts to elementary and secondary 
education, student aid and loan assistance for higher education 
and job training for displaced workers.
    I look forward to Chairman Lazear's testimony.
    Thank you, Mr. Chairman.
    [The prepared statement of Senator Reed appears in the 
Submissions for the Record on page 47.]
    Chairman Saxton. Dr. Lazear, the floor is yours, sir.

STATEMENT OF DR. EDWARD P. LAZEAR, MEMBER, COUNCIL OF ECONOMIC 
                            ADVISERS

    Dr. Lazear. Chairman Saxton, Ranking Member Reed, thank you 
for giving me the opportunity to speak to you today on the 
prospects for economic expansion. The American economy is 
strong. Even as world growth outside the United States has 
strengthened, the U.S. has maintained leadership in economic 
growth. The economic outlook remains positive as well.
    Let me begin with the current picture of the economy.
    Chairman Saxton. Would you mind pulling the microphone a 
little closer?
    Dr. Lazear. Let me begin with the current picture of the 
economy and the Administration's forecast for the next couple 
of years. First, real growth of gross domestic product (GDP) 
was at 3.2 percent over the four quarters of 2005, and it is 
forecast to be at 3.6 percent this year and 3.3 percent the 
following year.
    We expect rates of inflation of about 3 percent and even 
lower going forward from this point. These expectations are 
consistent with market data and with the consensus of private 
forecasts.
    Job growth has been strong over the past couple of years. 
The economy has been producing about 2 million jobs per year 
for a total of 5.3 million jobs since August 2003. That trend 
is expected to continue with some slight modification in 2006 
and 2007.
    Our monthly estimates of employment growth for 2006 and 
2007 are 156,000 and 140,000 respectively. The unemployment 
rate which was 5.1 percent in 2005 is forecast to average about 
4.7 percent in 2006 and 4.8 percent in 2007. In short, the 
economy continues to grow, inflation expectations are moderate, 
and the labor market is strong.
    There have been some concerns in the past couple of months 
that the economy may be slowing. It is better described as 
likely moderating from very good growth to good growth. The 
first quarter of 2006 enjoyed GDP growth at annual rate of 5.3 
percent. While we do not expect growth rates to continue at 
that level throughout the remainder of the year, we do expect 
that they will be sufficiently high to cause the real GDP 
growth over the four quarters of 2006 to be in the neighborhood 
of 3.5 percent as mentioned earlier.
    We lead the industrialized countries in economic growth, 
and we have very good fundamentals for continued economic 
expansion. These fundamentals include a flexible labor market, 
few impediments to business formation, high levels of 
investment in skills and human capital, strong property rights, 
well-developed and sophisticated capital markets, low taxes and 
an entrepreneurial spirit. Americans' pioneering attitudes and 
openness to new ideas and people have been instrumental in 
growing this economy.
    Although the economic situation is favorable, there are 
always risks to continued economic growth. The one that has 
received the most attention recently is the housing market. 
Partly as a result of higher interest rates, the housing market 
has not expanded at the same rapid rates as it has in the 
recent past. Most notably, housing starts have fallen by about 
13 percent since January of this year. But that decline is best 
understood when put in historical perspective. Over the past 45 
years, the average for housing starts has been about 1.5 
million units per year with a high point actually coming in the 
early 1970s. Right now, with housing starts at 1.957 million 
for May, they are currently above the level of housing starts 
throughout the 1990s.
    While some specific housing markets have seen price 
declines, in most markets the movement has been limited or 
slightly up. The recent nationwide price increases in the range 
of 1 to 14 percent are neither sustainable nor necessarily 
desirable. Offsetting the moderation in residential 
construction has been expansion in commercial real estate and 
other business investment.
    These latter two components signal strong confidence in the 
economy and its ability to expand further. Recent moderation in 
consumer spending has been offset by higher growth in exports. 
During the last year, consumer spending accounted for about 72 
percent of GDP growth which is down a fair amount considering 
its importance to GDP growth during the previous 3 years. 
Exports and business-fixed investments, on the other hand, rose 
to account for 50 percent of GDP growth in contrast to the 
earlier 3 years during which they actually subtracted to GDP 
growth.
    The most noticeable change in the economy since last summer 
has been a significant increase in the price of gasoline and 
oil products.
    Since last May, the price of crude oil is up more than 40 
percent and, nationally, the price of gasoline at the pump is 
35 percent higher. Higher energy prices crimp family and 
business budgets, but thus far, the economy has once again 
exhibited resiliency. Although higher energy prices have played 
a role in boosting inflation over the past year to 4.2 percent, 
the rate of core inflation was only 2.4 percent, up slightly 
from the 2.2 percent core inflation rate over the year-earlier 
period.
    These figures are from the consumer price index, the CPI, 
and other measures show even less inflation. Moreover, energy 
prices are expected to moderate. The futures price for West 
Texas Intermediate crude oil delivered 1 year from now is about 
$73 a barrel. At today's prices, that would mean an increase of 
about 3 percent over the next year. Gasoline futures are 
actually down relative to current prices, so the market is 
predicting lower gasoline prices in December than are currently 
prevailing.
    Consistent with the improved outlook on energy prices, the 
consensus of professional forecasters is that overall inflation 
will be a moderate 2.3 percent in 2007 (Q4 over Q4).
    Productivity growth is helping to keep inflation pressures 
moderate. It also helps the make the United States 
internationally competitive and leads to high standards of 
living. Productivity growth, how much workers produce per hour, 
has been remarkably strong over the past 10 years at an average 
annual growth rate of 2.9 percent. Over the past 5 years, it 
has been at an annual rate of 3.3 percent. This is the fastest 
5-year growth period in nearly 40 years.
    Productivity growth in the United States has been 
impressing economists for another reason. It is the highest 
level of any major industrial economy, and it is growing 
faster, too.
    While there are no direct ways for policymakers to increase 
productivity, as I will discuss later, there are a number of 
steps we can undertake to help.
    Mr. Chairman, you asked me to comment on the issue of 
global imbalances.
    The United States is running a current account deficit on 
an annualized basis of about $800 billion or 6.4 percent of 
GDP. Many observers look at this number with concern. I would 
like to make a few comments with respect to the issue of the 
current account deficit.
    First, let me point out that on the other side of the 
current account deficit is the capital account surplus.
    Second, I would like to point out that historical records 
suggest that countries can be in current account deficits or 
surplus situations for very long periods of time.
    More important, there is no clear correlation between a 
country's surplus or deficit position and economic growth. 
Given the lack of obvious correlation, should we still be 
concerned about large current account deficits? I believe the 
answer is that we should. We must constantly monitor our 
international situation for the reason that abrupt changes 
could create problems for the U.S. economy. In particular, a 
rapid decline in the U.S. current account deficit would 
correspondingly imply a rapid decline in the U.S. capital 
account surplus. Were this to happen, there could be 
significant adverse consequences to the U.S. economy and the 
rest of the world. We do not anticipate abrupt changes like 
this occurring, but we do not ignore the possibility.
    Most importantly, we must make sure that we maintain the 
kind of investment climate that allows foreign individuals and 
institutions to remain confident in our economy and its ability 
to grow and pay returns to investments that they are making.
    We should also consider the causes of and potential 
remedies to our current saving dearth in the United States. 
Major progress could be made by removing impediments to saving 
that are incorporated in our current tax structure and also by 
continuing to bring down the Federal budget deficit.
    This brings me to issues that are perhaps more directly 
relevant to the Congress. Mainly, what can we do specifically 
to ensure that we grow at high rates and encourage additional 
economic growth? First, we must make sure that our marginal tax 
rates stay low. The most important way to encourage growth in 
the economy is to maintain high rates of returns to investments 
both in physical and human capital.
    In order to allow for high rates of investment in physical 
capital, business taxes and returns to capital investments 
through dividends, capital gains and other payments must not be 
taxed at high rates. Raising the level of capital per worker 
makes workers more productive and leads to higher wages in the 
long run. Congress's recent action with the President to extend 
the capital gains and dividend tax cuts are very positive moves 
in this direction.
    Second, the death tax affects saving behavior. The 
President has expressed his desire to see the complete 
elimination of the death tax, and we believe a such a policy 
would be favorable to create a climate that is positive for 
saving.
    Third, we must ensure that we do not discourage investment 
in human capital. The most important source of capital in the 
economy is the capital embodied in people through their skills. 
To make sure that individuals have incentives to invest in 
skills by going to college, graduate school or vocational 
schools to obtain other forms of skills on the job, it is 
necessary to keep tax rates on wage income low.
    If individuals see that the returns to investment in their 
skills will only be dissipated through high tax rates on 
moderate- to high-wage earners, the incentives to invest in 
human capital will be dampened.
    Fourth, we must remain open to foreign investment. As I 
mentioned earlier, foreign investment has been an important 
source of capital for the United States. Approximately 1 in 20 
workers is employed in a foreign-owned firm, and about 45 
billion workers are employed by firms that engage in 
significant amounts of international trade.
    As such, we must make sure that we keep pushing for freer 
trade, especially in the area of services, which has become a 
larger and larger part of our economy.
    Fifth, the President has outlined a competitiveness 
initiative to make sure Americans have the skills to compete in 
the modern world. We must continue to push for reform in K 
through 12 education, which has been the weakest component in 
our human capital investment structure.
    Fortunately, our colleges and graduate schools are the best 
in the world. We export education by training large numbers of 
foreign students in our American colleges and universities, and 
it is good for us to continue to do that. But we must also make 
sure that those U.S. individuals who do not necessarily go on 
to college also get the skills that are important for them to 
compete in a modern American economy.
    As such, keeping students in high school, reducing our 
drop-out rates and ensuring that the education quality that is 
provided to all of our young citizens is high will be important 
not only in the near future but as we move into the later years 
of the 21st century. The President's efforts over the past 
several years to improve education with the No Child Left 
Behind Act and community college initiative will help.
    Furthermore, we must also strengthen our human capital 
infrastructure by working to raise the skill levels of American 
workers and by increasing opportunities for education and 
training. As part of the competitiveness initiative, the 
President has proposed Career Advancement Accounts that workers 
could use to obtain the education and training they need to 
compete in a global economy.
    Career Advancement Accounts are self-managed accounts that 
encourage future workers to gain the skills necessary to 
successfully enter, navigate and advance in the 21st century 
labor market.
    In conclusion, our economy is currently very strong, and it 
should continue to grow and remain strong because our 
fundamentals are positive. There are a number of issues 
policymakers need to address, including some that I have not 
mentioned here this morning, but ultimately, we must ensure 
that we do everything possible to keep productivity growing. 
Growing productivity is the key to wage growth and to rising 
standards of living. It is also a key picture of our 
international competitiveness.
    Productivity grows as a result of the investment in 
physical and human capital. And physical and human capital are 
amplified when incentives remain strong. This means that we 
must keep tax rates low, keep openness to investment and 
foreign trade, and keep our economy and labor markets flexible. 
The President's initiatives for low taxes and his focus on the 
improvements of the skills of all Americans are the right moves 
for the U.S. economy.
    Again, thank you for the opportunity to discuss these 
issues with you. I would be happy to answer any questions that 
you may have.
    [The prepared statement of Dr. Lazear appears in the 
Submissions for the Record on page 49.]
    Chairman Saxton. Dr. Lazear, thank you very much for a very 
comprehensive statement.
    In a statement last February, the Federal Reserve stated 
that the economy had performed well in 2005 and was expected to 
continue to perform well in 2006.
    Also on June 10th, the Blue Chip forecast was issued which 
essentially said the same thing, projecting that economic 
growth would be around 2.8, 2.9, 3 percent.
    Is this consistent with what the Administration's forecast 
is going forward?
    Dr. Lazear. Thank you, Mr. Chairman.
    Yes, it is consistent. We recently engaged in an exercise 
that we go through a couple of times a year. It is called the 
troika process, and it involves three agencies: the Council of 
Economic Advisers, the Office of Management and Budget and U.S. 
Treasury. And the consensus from the group was that economic 
progress is strong and that it will continue to be strong over 
the next couple of years. In fact, we recently revised upward 
our estimate of the growth in the economy based on first 
quarter numbers. So we were initially projecting 3.4 percent 
growth for this year and actually revised up to 3.6 percent as 
a result of the very strong Q1.
    That is also being reflected in the labor market. We are 
seeing high employment growth during the first quarter. We also 
saw creation of jobs at about the same rate that we had seen 
through the previous 2 years, which is a very high rate.
    Initial claims on unemployment insurance continue to be at 
low rates, so all of these are indications of a strong labor 
market, and we anticipate that will continue into the future.
    Chairman Saxton. Thank you.
    In your statement, you listed four items that you think are 
important in terms of keeping the economy in robust shape. 
Three of the four included or focused on low tax rates. The 
first was that marginal tax rates stay low; the second was, the 
estate tax stay in a position where it will positively affect 
savings; the third was that incentives to invest in human 
capital should be kept in place, again referring to low 
marginal tax rates in order to incentivize people to increase 
their personal skills with a goal toward increasing their 
income.
    I don't mean to speak for him, but in his opening 
statement, Senator Reed questioned how the Administration's 
policy relative to taxes could be sustainable in as much as we 
have to worry about revenue.
    Would you address that further for the Committee, please?
    Dr. Lazear. Sure. Obviously, we are concerned about 
revenue. The President stated that his goal was to cut the 
budget deficit in half by 2009. As you know, revenues have been 
coming in at rates that have been above the projected levels 
both last year and during the early parts of this year. So 
things are actually looking much better than we anticipated in 
terms of revenue growth. In large part this reflects the fact 
that the economy has been very strong and when we have a strong 
economy with strong GDP levels and strong growth, that tends to 
reflect the tax revenues as well. So the budget deficit is 
currently moving in the right direction and moving in that 
right direction at a very hurried pace and at a much more rapid 
pace than we expected. And this is true despite the fact that 
we were able to cut taxes and give more money to the American 
taxpayer and put that money in their pockets rather than 
directly in the hands of the Government. So we view these as 
all being positive developments.
    I have also looked at the effect of tax cuts on economic 
growth. I have reviewed the literature, and this literature is 
broadly based. Much of it comes from academia, and it is 
written by individuals who are on both sides of the political 
spectrum. The general consensus is that the tax cuts have been 
effective in bringing about changes that we were anticipating 
in 2003 in particular. The dividends in capital gains taxes 
have resulted in higher levels of investment and higher levels 
of economic growth. So we view those as all very positive 
developments and very positive aspects of the policies that 
were implemented a few years back.
    Chairman Saxton. I remember sitting here during 2002 and 
hearing the Administration criticized because job growth was 
rather anemic. Then the tax changes that occurred in early 2003 
seemed to have a positive effect on investment and the economic 
growth that followed the investment. Would you care to comment 
on that?
    Dr. Lazear. Yes, what we saw after 2003 was that the tax 
cuts had an immediate effect on investment and on GDP growth. 
What was a bit slower to develop were movements in the labor 
market. So what happened initially was, we had very high rates 
of productivity growth; GDP went up; productivity went up, but 
we were able to obtain these higher levels of productivity and 
output without hiring more workers.
    That worked for a while. We were able to get more out of 
fewer for a while but eventually, the economy needed additional 
workers and we saw job growth start to take off a couple of 
years ago.
    As you mentioned in your opening statement, Chairman 
Saxton, we have seen job growth of over 5 million jobs over the 
past couple of years, and that trend continues. So we think 
that what we saw earlier has now generalized to other aspects 
of the economy.
    I should also mention that one of the developments that I 
view as being quite healthy is that the expansion that was 
fueled earlier by housing and by consumption now seems to be 
generalizing to other sectors of the economy, particularly 
exports and business investment.
    I view that as a healthy development because it means that 
the economic situation is more robust and perhaps less fragile 
than it would have been a year or 2 ago. So I am actually 
encouraged by the fact that these developments have occurred 
and that we are seeing generalization of the kind of economic 
activity that was very strong in the earlier couple of years to 
other sectors of the economy that now seem to be important in 
growing to us.
    Chairman Saxton. Thank you.
    Let me just finish up with one question that I find quite 
interesting. Because the investment climate has been more 
favorable in the U.S. than in many other countries, the United 
States has enjoyed a net inflow of foreign-direct investment 
particularly in the last few years. These net inflows are 
recorded as surpluses in the U.S. financial account.
    Given the rules of international accounting surpluses and 
the U.S. financial account inevitably produced deficits in the 
U.S. current account, should U.S. current accounts be seen as a 
sign of relative strength in the U.S. economy compared to the 
many other economies in the rest of the world rather than a 
problem?
    Dr. Lazear. Right now, our deficit in the current account 
is about $800 billion, but as you correctly point out, you 
don't get to enjoy consumption of these goods without having 
something else go on on the other side.
    Foreign suppliers are not willing to simply give us their 
goods for free. And what they are doing is, they are giving us 
their goods because they find the United States perhaps the 
most attractive place in which to invest.
    As a result, foreign investment in the United States has 
been very high. And we have benefited from that foreign 
investment in large part through growth not only in investment 
activity but in growth of our output and employment as well.
    So part of the--part of the story, and we always like to 
point out at the Council of Economic Advisers that an important 
part of the story whenever we talk about current account 
deficits, is that that means that we are getting funds from 
abroad, and that is we get those funds from abroad because 
individuals abroad see this place, this country, as the most 
attractive environment to invest in.
    Again, I would return to what I said earlier. I believe 
that is because of the fundamentals of the American economy. We 
have flexible labor markets. We have relatively low tax rates. 
We have a climate of entrepreneurship. All of those factors are 
favorable to economic growth and economic investment, and they 
have enabled not only American citizens but also foreigners to 
invest in ours and enjoy the gains from our productivity.
    Chairman Saxton. Thank you.
    Senator Reed.
    Senator Reed. Thank you very much, Mr. Chairman.
    Let us go to the issue which I think is important, this 
notion of revenues versus tax cuts. You have looked at the 
literature. But there is recent economic analysis by the Joint 
Committee on Taxation, the Congressional Budget Office and the 
Congressional Research Service, which all find that deficit-
financed tax cuts reduce long-term economic growth because of 
the increase in governmental deficits and the resulting decline 
in national saving. There is something to be said, and it was 
true several years ago when we were running a huge surplus, 
which is a thing of the past, that tax cuts could have a 
stimulative effect, and they would not adversely affect the 
bottom line. But we are literally borrowing money to make tax 
cuts, and according to these reports, it will, in the long-
term, affect our growth in a negative way. What is your 
comment?
    Dr. Lazear. Well, I certainly agree with you that running 
long-term budget deficits is a problem, and I think the 
President shares that view. We don't want to see deficits 
persist for long periods of time. It is not only not good for 
economic growth, but it is not good for consumption. It is good 
for displacing other kinds of investments. There are many 
angles to it, and I don't think anybody favors having sizable 
budget deficits.
    To my mind, the question is, what do we do about deficit 
situations? As you know, center deficits are caused by a number 
of different factors. The deficit that we face today to some 
extent at least was caused by unanticipated events, wars, 
natural disasters, of which we have had our share. And those 
kinds of factors do contribute to a deficit situation.
    The issue, when you are hit with factors like that, is, 
what is the optimal way to finance those expenditures over 
time? No one would argue that you want to finance the 
expenditures on hurricanes or wars out of current consumption 
to finance all of it out of current consumption. Almost any 
reasonable economist would argue that we have to smooth that 
financing over time.
    The issue I think that we confront there is whether we are 
financing it at the appropriate level at the appropriate speed 
and whether we are doing it at appropriate--in an appropriate 
fashion.
    That is a tough question, to be honest with you, because 
people will have different views on that politically.
    My way of looking at this is to rely on market estimates, 
and what I mean by that is that when we run a very high 
deficit, if we are running a deficit that is too high and one 
that is too high for economic growth, we see two things 
happening. First, we crowd out business investments. In fact, 
that hasn't been happening in recent years. Business investment 
has been strong during the first quarter. Business investment 
is up about 13 percent.
    The second thing that I would look at, and I think the 
thing that probably most economists would look at, is what has 
it done to interest rates? When we see that the Government is 
borrowing at very high rates, that tends to drive up interest 
rates because it means that the demand for funds is high for 
any given supply of funds available.
    Again, we haven't seen higher interest rates. In fact, 
interest rates right now, even though they have gone up over 
the past couple of years, are quite low by historical 
standards.
    So we are looking at a situation where long-term interest 
rates are down at about 5.1 percent. All of those factors seem 
to be consistent with the markets saying that we are probably 
doing a good job in financing our current expenditures.
    Senator Reed.  What has all of this done to the national 
saving rate, and how important it is to have a national saving 
rate that is positive?
    Dr. Lazear. Again, I certainly agree with your pointing out 
that the national saving rate is low. In fact, it has been 
negative. Not just low. And that is a concern. I would like to 
see saving get much higher in the future. I think we need to 
save more for the future of our country.
    I focused in my earlier statement on tax cuts. I think that 
is probably the best way to get at this. We can't make 
individuals save. The question I think that you are aiming at 
is whether Government saving or Government consumption is 
driving out--crowding out--private saving, and again, if that 
were the case, we would see the evidence in terms of higher 
interest rates.
    So my view of this is that, if we look at the markets, if 
we look at financial markets, we are not seeing a lot of 
evidence that private savings has been crowded out by action by 
the Government.
    That being said----
    Senator Reed. We are not showing a lot of private savings.
    Dr. Lazear. Certainly not seeing private saving. But I 
would say, we are not seeing private savings declining because 
of Government action.
    If it were the case that the Government were crowding out 
investments, other kinds of activities, we would worry about 
that, and we would see that reflected in financial markets. We 
don't tend to see that.
    The one thing that I think is a concern that you point out 
is that this issue of private saving and the private saving 
rate having been low is not one that is recent. It has been 
true for a long period of time, although I admit it is lower 
now than it has been in the past. But we are a very low-saving 
country, and the question is, why is that the case?
    Now some people believe that part of that is a statistical 
artifact; in part, a reflection of the fact that we are not 
counting savings in the appropriate fashion. For example, if we 
took into account the very large capital gains that we see in 
the housing market and in the stock market, and we look at the 
change in individuals' wealth, most individuals would think, 
gee, I am saving a lot because I have a house now that I bought 
at $200,000 that is now worth $400,000. I have saved $200,000 
during that period.
    It doesn't show up in the difference between current income 
and current consumption, but most individuals would think of 
this as saving. And so that is another way to look at it, and 
many economists believe that is the appropriate way to look at 
it.
    Senator Reed. You and the Administration have been talking 
about not only the rising tide but one that has been fairly 
shared. But when you point to the data, it is all aggregate 
data on productivity or average income rather than looking at 
median wages or median income to get a better picture of how 
the wealth is being shared.
    And when you look at some of these median numbers, it looks 
as though many workers are being left behind even though 
productivity is growing, and that the distribution of the 
benefits is skewed to the upper income rather than lower 
income. Is that accurate?
    Dr. Lazear. I would say that part of it is accurate. It has 
certainly been true that over the past 25 years, there has been 
an increased dispersion between the incomes of the top and the 
incomes of the bottom or even the median.
    Most of the growth that has taken place in wages in the 
economy over the 25 years has been among those individuals who 
have had the highest level of skills. This is, I think, 
something that is fundamental to our economy, and in some 
sense, it is a good thing. And what I mean by it is a good 
thing is that it reflects high rates of return to investment in 
human capital. We like that part of it. It is a good thing. 
Some people invest in skills, and those skills have high 
payoffs.
    What we don't like is the fact that some people in the 
society have been left behind and have not been able to invest 
in those skills and enjoy the benefits that are associated with 
these investments in level--in high levels of human capital. 
And that is an issue, and it is an issue that concerns me, and 
I believe it is an issue that concerns the President as well.
    One of the first things that he did, as you know, when he 
came into office was to institute No Child Left Behind. That is 
a step to move in that direction. Obviously, it is not the 
entire solution to that problem. But my view is that the only 
way to solve the problem of bringing up the bottom is through 
higher investment and skills to those individuals. And by the 
way, I would argue that that is generally the consensus among 
labor economists. I recently did a call with a large number of 
labor economists, many of whom were members of the Clinton 
administration, and we have basically all come to the same 
conclusion, which is that the reason for increased inequality 
is not something that has to do with the policies of any 
particular administration, Democrat or Republican, but rather 
reflects a long-term trend in differences in human capital. So 
my view is that we need to address those differences, and I 
think that is a very--I think you have focused on a very 
important issue and one that is certainly close to my heart.
    Senator Reed. I just want to make a final point, which is 
that the data suggest that if you look at median earnings and 
median family income, there is a great deal of stagnation, and 
it goes, I think, to the point you have made several times if 
there is not an incentive in your paycheck to upgrade your 
skills, then it won't happen. And what we are seeing for the 
vast majority of Americans is that this economy is not 
producing the kind of gains in their paychecks that we saw in 
the past and that we hope to see again. I think that is a huge 
problem.
    Dr. Lazear. That is the part of your statement that I--that 
I don't fully subscribe to. Let me tell you why. While I think 
your facts are correct--I certainly don't dispute that--I would 
interpret it slightly differently. The person who is the median 
worker 5 years ago is not the median worker today. So if you 
look, for example, at the median worker in 1994, and you ask, 
where is that worker today--let us take the group of workers 
between 25 and 34, because they are going to be moving up the 
distribution the most, so this in one sense, one extreme, those 
individuals enjoyed a 52 percent wage growth from 1994 to 2004. 
So it is not that the median worker is being left behind. It is 
that, as the economy changes, in its composition in large part, 
bringing in new immigrants, the person who is the median worker 
is a different individual. That having been said, again, I 
don't dispute I think what is your basic point and your basic 
point is we need to provide opportunity for all individuals and 
for individuals at the bottom as well as for individuals at the 
top. And I certainly subscribe to that. So whether we differ on 
how to interpret median income or not, I think I would say, I 
am on the same page as you are on that.
    Senator Reed. Thank you, Mr. Chairman.
    Chairman Saxton. Thank you very much.
    Senator Bennett.
    Senator Bennett. Thank you, Mr. Chairman. And thank you 
Chairman Lazear for your being here and for the cogent way in 
which you are responding to some of these issues. Let us go a 
little farther down the road that Senator Reed started us on.
    The productivity growth: You indicated productivity went 
up, and wages lagged. And then the job growth took off as we 
couldn't handle it with these more productive workers. But 
isn't it normal that productivity growth, particularly 
following recession, will always lead wage growth and job 
growth? Isn't that a normal pattern that we have seen for a 
generation or more?
    Dr. Lazear. Indeed, it is. It tends to be the case that 
when we have a turnaround in the economy, when we have a 
recession followed by an economic recovery productive period at 
first, and then employment fix-up later and then finally wages 
tend to pick up. The same thing was true by the way during the 
1990s, so if we look at the recession that occurred in the 
early part of the 1990s and we ask, what happened, then in fact 
what happened was productivity took off, and it took a while 
for wages to catch up. In fact, some of my colleagues who 
served in my capacity and as members of the Council of Economic 
Advisers during President Clinton's administration were also 
concerned about some of these same issues, kept thinking if 
productivity is growing, why aren't wages growing, and then in 
the late 1990s, we saw wages did start to grow and grew at 
fairly strong paces.
    If you look at the numbers for Q1 of 2006, we saw some very 
strong wage growth during that period. We saw wage growth of 
5.3 percent, and I am talking about hourly wages. The picture 
is even better I would say for wages if we take into account 
not just wages but total compensation.
    Senator Bennett. That was going to be my next question.
    Go ahead. Let us talk about the entire compensation package 
and not just what shows up on the W2 form.
    Dr. Lazear. One of the things that has happened over the 
past 5 years is that, while hourly wages have gone up but not 
gone up by as much as we might have hoped, compensation has 
increased at about double the rate of hourly wage growth; in 
fact, by some measures, more than that.
    So we are looking at compensation that was up by about 2 
percent since 2001.
    Much of that reflects compensation that takes the form of 
benefits. Some of it is health benefits. Health benefits are 
good when they improve the health of our workers. We don't view 
that as a bad thing. If workers take some of their compensation 
in the form of more health insurance, we would like to see that 
occur.
    So that is not a bad thing. And we do expect that those 
trends will tend to--tend to slow down a bit in the future as 
health costs tend to get under control, and we hope they will 
get under control.
    But we also would expect then that at the same time wages 
will increase to make up for some of these differences in 
increases in benefits.
    Senator Bennett. Having been an employer, I know that, when 
you look in terms of your labor costs, you don't look at the W2 
number. You have to figure in all of the other costs connected 
with the job, so that your employee has to return value to the 
firm sufficient to cover the entire package of compensation 
rather than just the amount that shows up in the wages. So I 
have had the feeling that some of the rhetoric around this 
issue has focused entirely on the W2 and not recognized that 
the entire package which the employer has to pay has in fact 
gone up rather substantially.
    Taking the entire package--I think this is what I heard you 
say, but I want to just emphasize it and nail it down--taking 
the entire package, the amount that an employer has to pay for 
labor or the flip side of it, the amount of benefit that the 
employee gets, has in fact been going up fairly substantially--
in the period since the recovery. Now, is that a fair summary 
of where you are?
    Dr. Lazear. It is a fair summary. Obviously, we always--we 
would prefer more growth to less growth. It certainly is the 
case that if we take compensation into account, compensation 
has grown at a much more rapid rate than hourly earnings. So as 
we move into the future, my expectation is that compensation, 
total compensation, which as you point out is what is relevant 
from an employer's point of view, is the cost side, it is also 
relevant from an employees' point of view, because when we take 
wages, wages are only one component of earnings. Pension 
benefits, vacation benefits, health benefits, which are the 
major components of compensation that don't show up in wages, 
are also important parts of an individual's well-being, and we 
want to make sure that those continue to grow as well. So I 
agree with you. I think we have to take the entire package into 
account.
    Senator Bennett. There was a time in my career when pension 
benefits struck me as being completely worthless. The older I 
get, the more valuable they become. Thank you.
    Dr. Lazear. Thank you, sir.
    Chairman Saxton. Thank you, Senator Bennett.
    Mrs. Maloney.
    Representative Maloney. Thank you and welcome.
    You testified that the deficit relative to the GDP is 3.6 
percent this year.
    Dr. Lazear. Deficit relative to GDP, you are talking about 
for 2005 I think.
    Representative Maloney. Yes.
    Senator Bennett. I would think it is 2.6.
    Dr. Lazear. I think that is right. I want to check the 
number just to make sure. Why don't you continue, and I can 
listen to you while I am checking?
    Representative Maloney. My question really pertains to 
long-term sustainability of economic growth with the deficit. 
Most economists believe that, 5 to 10 years out, the deficit 
will grow definitely, entitlements are going to grow and now, 
how can we sustain this with the revenue loss from the tax cuts 
and the growth and entitlements and the growth in the deficit? 
You have a structural problem that has long range challenges 
for the country.
    So how do you propose to sustain economic growth with the 
structural deficit and expenses that are now part of our 
system?
    Dr. Lazear. Well, I think that you----
    Chairman Saxton. If I can interrupt. My sharp staff behind 
me here has given me this the actual percentage of GDP. GDP 
that the deficit represents is actually 2.6 percent.
    Dr. Lazear. It sounded off. I think the 3.6 number that I 
cited was the projected growth for next year for GDP, but 
anyway, we have got our numbers straight, and I certainly 
understand.
    Representative Maloney. The point is not the 2.6 now, which 
is not a problem. The problem is the sustainability of--with 
the structure of deficit, lost revenue and entitlements and 
built-in spending with Social Security, with the baby boomers 
and the challenge that we face there.
    Dr. Lazear. I agree with you, and in fact, I would say I 
would paint an even bleaker picture than you pointed out if we 
don't get things under control because we estimate that if we 
go forward into 2030 on the level of benefits projected right 
now and entitlements projected right now, we will have about 60 
percent of our GDP devoted to the Federal budget, and that is 
clearly not sustainable, nor would any country tolerate levels 
of taxation that would support 60 percent of GDP going to that 
part of society.
    Representative Maloney. And another challenge is wages not 
growing for most workers. So where will spending come from if 
wages are not growing? Where is the boost for the economy?
    Dr. Lazear. I would disagree with your point that wages are 
not growing. Again, I would go back to the numbers that I just 
cited for Senator Reed which is that, if you look at the 
typical worker----
    Representative Maloney. We are talking about money put into 
the economy from their wages. Their wages, their take-home pay 
is not growing. Maybe they have more vacation time, but their 
take-home pay is not growing.
    Dr. Lazear. I even mean take-home pay. Let me go back to 
the number that I cited before. If we look at the median worker 
between 25 and 34 years old in 1994, we compare with that 
worker 10 years later. We ask, by how much did that typical 
worker's wages grow? It is 52 percent. So although the median 
is not growing, that doesn't mean that typical workers' wages 
are not growing. So those individuals do see wage increases 
over their careers.
    Now, I thought----
    Representative Maloney. Many people, many Americans feel 
with the high cost of gas and with the high cost of housing--
and the housing market is cooling--that their wages are not 
growing. I just want to ask one question. You were talking 
earlier about the deficit, and you talked about 9/11 and 
Hurricane Katrina and the war. Hopefully the war will be over 
soon. The President announced he is withdrawing troops. I hope 
he will. But you talked about
9/11 and Katrina for the budget deficit. And I would say that 
9/11 and Katrina are a very small, a little of the deficit 
compared to revenue and other items and with the large revenue 
that is lost from the tax cuts, and I would like to ask you 
just, at a basic level, do you agree that tax cuts cause a drop 
in the Federal revenue?
    Dr. Lazear. There is no doubt in any mind the tax cuts 
cause a drop in the Federal revenue initially. That is 
certainly true. What tax cuts are able to do, though, is to 
help grow the economy. Now----
    Representative Maloney. I would agree that some tax cuts 
help grow the economy. But when you have deep structural tax 
cuts that take out a large amount of revenue for the 
Government, you have a structural problem. Alan Greenspan 
testified before us in the seat that you are sitting in, it is 
very rare and very few economists believe that you can cut 
taxes and you will get the same amount of revenues, and he says 
it is very--you will get some back, but it is very small, and 
it is not a large part of the economy. So what I am basically 
concerned about is the sustainability of our economic growth 
with the large deficits, the trade deficits, the growing built-
in challenges with Social Security for aging baby boomers and 
so forth, and a major revenue source cut out of the budget. And 
I would add that everybody talks about the earmarks, but the 
Republican majority has really hurt the budget with removing 
the caps and not continuing the program of pay-as-you-go, the 
Democrats----
    Chairman Saxton. The gentlelady's time has expired.
    Representative Maloney. May I get his answer?
    Chairman Saxton. You can get his answer, but we have to 
stop the question.
    Representative Maloney. On PAYGO, it is a program where you 
do not spend money that you do not have, and that program has 
been removed, and that has also added to the----
    Chairman Saxton. The gentlelady's time has expired.
    The Chairman would like you to answer the gentlelady's 
question, please.
    Dr. Lazear. I certainly agree with Chairman Greenspan's 
earlier statement that tax cuts result in an initial decline in 
revenue. The issue I think that you are addressing is what 
happens over time. And you made the point that----
    Representative Maloney. His statement was over time. Over 
time.
    Dr. Lazear. I was going to address that. Bear with me. I 
will get to you. I will get to it.
    And I certainly would not claim that tax cuts pay for 
themselves nor do I think that is necessary. My view of tax 
cuts is not to cut taxes so that they pay for themselves but 
rather to cut taxes so that the economy grows and so that it 
has fewer distortions in it. I am more concerned about economic 
growth in the private sector than I am about the size of the 
public sector. I would rather not see the public sector grow. I 
would rather see a more controlled public sector, but my focus 
is on, as an economist, is on making sure that we create the 
kinds of economic conditions that are favorable to economic 
growth in the private sector.
    In terms of sustainability, again, I certainly agree with 
you. I think that it is extremely important to make sure that 
we deal with deficits and that we deal with the expenditure 
side as well as the tax side. I am concerned that, as we 
project forward, we have not done a good job in thinking about 
expenditures. I actually think the President would also agree 
with you; he is concerned about entitlements, Social Security, 
Medicare, Medicaid and the programs that are going to eat up a 
very large part of our budget into the future.
    So I don't think we have much of a disagreement there.
    The one point where I would perhaps want to take a slight 
issue with something that you said is that the tax cuts have 
not been helpful or will not be helpful in the long run. In 
looking at the economy, and there, I say, numbers speak louder 
than words. If we look at the history since 2003, it is very 
difficult to argue with the evidence that we see there, that 
the growth in the economy has been very strong; the growth in 
the labor market has been very strong; growth in investment has 
been very strong. So I think we have a slight difference of 
opinion there.
    Chairman Saxton. Thank you very much.
    The gentlelady's time has expired.
    Mr. Brady, it is your time, sir.
    Representative Brady. Thank you, Mr. Chairman.
    What was the increase in Federal revenues last year. Do you 
recall?
    Dr. Lazear. The increase in Federal revenues, I believe, 
was 9 percent, was the number. Yes, I believe it is 9 percent.
    Representative Brady. This year it is projected to be 
double digit?
    Dr. Lazear. 13 percent.
    Representative Brady. So just following up that point, the 
tax relief that helps spur the economy to create 2 million jobs 
every year has actually resulted in close to a 10 percent 
increase in Federal revenues last year, and a projected 13 
percent increase this year.
    Dr. Lazear. Well, revenues are certainly up. I guess the 
way I would like to put the point is that I view the tax cuts 
as having helped increase the rate of growth in the economy.
    I also view a growing economy as consistent with generating 
more Federal revenues. So the additional Federal revenues that 
we see are attributable in large part to the growth of the 
economy, some of which I think can be attributed to the tax 
cuts that were initiated primarily in 2003. I would say those 
are the ones that were most important in stimulating economic 
growth.
    Representative Brady. I think at the time, I know with the 
triple hit of the 9/11 attacks, which cost almost 2 million 
jobs, the recession that we were in and then the collapse of 
the dot-coms, at that point, we were at a critical point in the 
economy and needed to boost spending in a number of areas. I 
think the tax relief helped produce, as you pointed out, the 
Federal revenues that we are receiving today.
    You pointed out a key issue on the trade balance, that our 
account deficit is really related not to just what we buy and 
what we sell but how much we consume, what type of investments 
we are seeing as a Nation compared to the rest of the world.
    One of the keys in our trade balance is related to both our 
consuming as a Nation and selling our exports as a Nation.
    Representative Brady. One of the keys is finding, not only 
new markets for American business services which our free trade 
agreements are producing, but also spurring more consumption by 
other nations. As you look at the world from China to Europe to 
Africa to Central America, to South America, do you forecast 
increased consumption and stronger economies outside the United 
States? What impact could that have on our economic growth?
    Dr. Lazear. Yes. That is a very important point in that 
when we will look forward, and we think about where we are, we 
have to remember that we are only 5 percent of the world's 
population, and of course, since we have a very large and very 
rich economy relative to the rest of the world, we are much 
greater right now in terms of our economic importance.
    But as we look forward, that situation is going to change. 
If you have countries like China and India growing at very 
rapid rates and they account for over, well over a couple 
billion people, we know that they are going to be an important 
component in the entire picture. And we have to make sure that 
we have access to their markets and that we are able to trade 
with them.
    Fortunately, the rest of the world actually is doing quite 
well right now. Not only are the developing countries like 
China and India growing at very rapid paces, but Europe is now 
fighting its way back, Japan, after having a very troubled 
decade, is doing recently well with growth rates around 3 
percent right now.
    All of those factors contribute to a situation that will 
help our economy as we trade and export and also import from 
those individuals and from those countries as well. So I think 
the picture looks quite good, and actually looks better than it 
did a few years ago in large part because the world is a 
healthier place than it was.
    Representative Brady. So from your perspective does America 
isolating ourselves from the global market increase our 
economic growth, or does our engagement in the global market, 
especially in prying open new markets, encourage our economic 
growth?
    Dr. Lazear. I think there is little doubt about this, and 
this is one you often you hear economists saying on the one 
hand, on the other hand. This is one in which there is no other 
hand. Virtually, the entire economics community believes that 
trade is beneficial to an economy.
    And increased trade improves economic growth.
    So we are very much in favor of making sure that we 
maintain openness in terms of trade, the Doha round, which is 
currently being negotiated, is one that we are hopeful will 
conclude in some positive achievements, the bilateral 
agreements we have been engaging in over the past few years, I 
think, have been helpful in opening up the world. We are a very 
productive nation. We are actually a low unit cost nation. So 
despite the fact that our wages are high relative to the rest 
of the world, we are not a high cost country because we are so 
productive. So our costs are actually relatively low as 
compared with those countries with whom we trade.
    All of those developments mean we can compete and we can 
compete successfully when we have openness to other markets. 
And we are certainly pushing in that direction. And we believe 
that is a very important component of growth as we look forward 
to the 21st century.
    Chairman Saxton. Thank you, Mr. Brady. The gentleman from 
New York, Mr. Hinchey.
    Representative Hinchey. Good morning, Mr. Chairman, and 
welcome. As you pointed out in your testimony, we have seen 
significant amounts of productivity growth and substantial 
increases in the profitability of corporations, the 
corporations' bottom lines, as well as in the pay of corporate 
executives, which has reached extraordinarily high levels, 
record levels. We have even seen some growth in the economy but 
the growth in the economy itself has been rather modest, 2.6 
percent or so, which is really odd in the face of the fact that 
we have experienced record amounts of economic stimulation.
    We have had record low interest rates, which have been the 
primary reason why the housing bubble sustained the economy and 
prevented us from going into a deep recession. And we have seen 
huge amounts of public spending which have created very, very 
large debts.
    And given the fact that the interest rates are now going 
up, how much longer do you think that we can sustain even the 
productivity growth and the corporate profits, let alone the 
modest amount of economic growth that we have experienced?
    Dr. Lazear. Rising interest rates have certainly had an 
effect on various sectors. You pointed out housing in your 
question, and I think that housing is one of the areas in which 
we have seen the most significant change. The picture in the 
housing market is a little bit uncertain. And what I mean by 
uncertain is that when we look at these numbers--and I look at 
these numbers almost daily--we see some numbers declining, for 
example, housing starts have declined by 13 percent since the 
beginning of the year. But then, we were surprised yesterday by 
the number that showed that new home sales were up by 4.6 
percent last month.
    So we have things moving in different directions there, and 
it looks like the housing market is slowing, I would say, and 
slowing a bit, but not slowing by as much as we had perhaps 
anticipated or even feared.
    The other side to that, sir, that I would point out is that 
while the housing market has declined, so we are talking about 
residential construction declining, we are seeing a lot of 
strength in commercial real estate. And so what we have lost in 
housing real estate we are seeing picked up in commercial.
    The other component of the economy that has been very 
strong is business fixed investment which has also picked up. 
So that, coupled with growth in exports, indicates to me that 
what we saw initially as being focused on consumption and 
housing and I think that was your concern you were worried 
about sort of the fragility in some sense of that those 
sectors----
    Representative Hinchey. My concern is sustaining what 
little economic growth we have actually experienced in the face 
of the fact that interest rates are going up, somewhat, the 
housing market is closing down, and you are facing a growing 
disparity in income among people in the economy.
    Most of the benefits, the economic benefits, have flown to 
people in the upper income brackets. But if you look at, for 
example, the effect on the income of the median American 
family, when you adjust that for inflation, their income has 
dropped off by more than $1,600 over the course of the last 5 
years. As a result of that, we are beginning to see a decline 
in demand, and this is essentially a demand-based economy.
    If you don't have demand, it doesn't matter how much supply 
you have. In fact, if you have too much supply and lessening 
demand, you are going to be facing a situation of deflation, 
which some people have raised as a potential problem for the 
future, and I would be interested to hear what you have to say 
about that.
    But the fact is that what we have--all of these 
allegations, the so-called economic growth and prosperity and 
rosy pictures that have been painted--are not reflected in the 
experiences of the average American family.
    The income of the average American family is declining. The 
number of people without health insurance is now up over 45 
million, and the number of people in poverty in the last 5 
years has gone up by 4.5 million people.
    So we are seeing people at the lower income level and the 
middle income level being seriously economically depressed, 
while everyone in the Administration is painting a very rosy 
picture about the economy.
    It doesn't make any sense to me.
    Dr. Lazear. You have covered a lot of territory in your 
question. Let me see if I can address a few of your points.
    The first one that you made and you have made it twice now 
was that there was little economic growth, and I guess I don't 
share that view.
    Representative Hinchey. It is 2.6 percent average.
    Dr. Lazear. Let me read to you the numbers, specifically 
real GDP growth was 4 percent in 2003, 3.8 percent in 2004, 3.2 
percent in 2005, 5.3 percent of in Q1 of 2006. I don't know 
where you got 2.6 percent out of that, maybe you are looking at 
a different period.
    Representative Hinchey. The Bureau of Labor Statistics has 
provided that.
    Dr. Lazear. We look at these numbers, and I am quite 
confident of these numbers, so I would stand by my numbers. I 
believe my numbers on this.
    The growth rate in the economy has been very high. I don't 
think there is any dispute about that.
    The issue I thought that you were coming to in the second 
half of your question was one that I did address earlier, it 
was this issue of wage growth and how the average individual 
was enjoying the gains in the society.
    And as I pointed out, I do believe that we have seen growth 
in compensation, which it was greater than the growth in wages, 
albeit, perhaps not what we would like, we would like to see 
higher growth in wages, I agree with you on that. I certainly 
would like to see higher growth in wages. I believe it is 
coming again.
    If I cite the Q1 figures, we did see very strong wage 
growth in Q1, and we hope it will continue. These tend to 
reflect lags that one sees after a turnaround in the economy.
    Whether we will be right, whether the over-95 percent wage 
growth that we saw in Q1 will be sustained into the future, we 
don't know. But we certainly hope that it will be. And I would 
join you in cheering those efforts. But I think that what we 
have done and what we believe is that a growing economy and 
growing productivity is the best way to make sure that there is 
wage growth. If you look at this over the long run and it is 
not even a very long run, there is almost a 1-to-1 relation 
between wage growth and productivity growth. So for every 1 
percent you get in productive growth you get in wages.
    During some periods you will see a lag, as I pointed out in 
the mid-1990s, we saw a lag, and in the early 2000s, we saw a 
lag as well. But we do seem to see somewhat of a catch up right 
now and I hope it will continue.
    Chairman Saxton. I thank the gentleman. On housing, it 
seems to me that the low rates of interest that we saw in the 
past years created a great incentive on the demand side. The 
housing sector benefited greatly during those periods of time, 
but to the point where we saw an increase in prices that made 
it somewhat difficult for the average guy on the street to 
afford housing. Can you just comment on that and see, where do 
you see that going?
    Dr. Lazear. Well, last year, we have seen increase in 
housing prices in the range of 14 percent. And housing price 
increases at that level, I do not believe are sustainable into 
the distant future.
    In fact, if I felt that there was certainty that housing 
prices would increase at 14 percent, I think that is all I 
would be investing in right now. I think all of us would do 
that. We wouldn't need to worry about anything else.
    So I think that seeing rates of growth at that level are 
first, not sustainable, and second, as you point out, not even 
necessarily desirable, because what that does is it changes the 
prices of housing so that the persons in older age groups are 
receiving capital gains relative to those in younger age 
groups, those outside the housing market who have to buy into 
the housing market suffer some capital losses as a result of 
that and it is not clear to me at all that that is a healthy 
development for the economy.
    So some leveling off of housing prices that we might be 
seeing this year, at least to my mind, does not signal any kind 
of disaster scenario. In fact, it is probably a move in the 
direction of a more sustainable path.
    Chairman Saxton. Thank you.
    Senator Sarbanes.
    Senator Sarbanes. Mr. Lazear, as you are well aware, the 
way it works here you have a certain amount of time when you 
are recognized to ask questions and get your answers. Now if 
you give long answers, we don't get to ask many questions.
    In fact, if you give a long enough answer, you can get one 
question and then, dance off the stage and then of course, 
Chairman Saxton will gavel me down as I try to put another 
question to you, frustrated by encountering these long answers.
    So I will try to give relatively short questions and 
hopefully get relatively short answers and maybe we can move 
along here, and then I won't come into conflict with the 
chairman, as I try to put yet another question to you.
    An article in last Sunday's New York Times illustrated what 
has been happening in income distribution over the last 25 to 
30 years.
    [The New York Times chart, entitled, ``The Rich Get Richer, 
Again,'' appears in the Submissions for the Record on page 61.]
    Now what it shows is that the distribution of income has 
become about as unequal as it was in the 1920s. We had 
incredible growth in the post-World War II period for better 
than a quarter of a century. But we have seen in recent years 
this concentration with respect to the share of income, so that 
the top one-tenth of 1 percent is now getting 7 percent, and 
the top 1 percent gets 16 percent, and the top 10 percent get 
43 percent.
    Does this trend concern you? I don't need a long answer. If 
it concerns you, I would like to know, if it doesn't concern 
you, say so.
    Dr. Lazear. It does concern me.
    Senator Sarbanes. Now, traditionally economists have called 
our income tax system progressive because taxes rise as per 
share of income, the higher up you go in the income scale and 
that, of course, narrows the difference in after-tax income 
compared to before-tax income.
    But do you agree with that observation as a general 
proposition?
    Dr. Lazear. It depends on the actual tax structure. 
Sometimes a tax structure can be made more progressive 
sometimes less progressive. You would have to be a bit more 
specific.
    Senator Sarbanes. I do indeed want to be specific. In your 
op-ed piece in The Wall Street Journal on May 8th, you said, 
and I am now quoting you, the President's tax cuts have made 
the Tax Code more progressive, which also narrows the 
difference in take home earnings.
    [The Wall Street Journal editorial, entitled, ``America at 
Work,'' appears in the Submissions for the Record on page 58.]
    Now the Tax Policy Center, which, of course, has economists 
across the political spectrum, has found just the opposite, 
that the net effect of the tax changes since 2001, has been to 
raise the after-tax income of the top 1 percent of the 
population by 5 percent, and raise the income of the bottom 60 
percent of the population by only 2 percent.
    And that is illustrated in this chart, this is, the effects 
on after-tax income of the tax cuts. And it shows the top 1 
percent up 5 percent, the bottom 60 percent, in other words, 
more than half the population, three-fifths of it, up 2 
percent.
    [The bar chart, entitled, ``Effects on After-Tax Income of 
Tax Cuts Passed Since 2001,'' appears in the Submissions for 
the Record on page 60.]
    What is your evidence for the statement in The Wall Street 
Journal that tax changes since 2001 have narrow differences in 
after-tax income?
    Dr. Lazear.  I am going to have to give you a slightly 
longer answer, but I will try to keep it short so you get to 
ask another question. I will speak quickly. When we look at the 
tax cuts, first, I want to point out that there have been a 
variety of changes in the Tax Code, some of which move in the 
direction of progressivity, some of which move in the opposite 
direction. Remember that associated with the tax cuts during 
this Administration have been reductions in tax rates from 15 
to 10 percent, increase in child care credits, reduction in 
marriage penalties and some changes in the EITC as well. Those 
tend to work in the direction of progressivity.
    On the opposite side of that we have seen changes in the 
capital gains tax which tend to work against progressivity.
    So the issue is really an empirical question. I don't think 
one can answer that ex ante.
    Senator Sarbanes. This is empirical evidence that the 
Policy Center has done----
    Dr. Lazear.  And I saw your numbers. I have looked at those 
numbers carefully, and I have also investigated this quite 
thoroughly. We believe that the tax cuts that the President 
instituted were progressive in the following sense. If we look 
at those tax cuts estimated for 2006, take those right now, and 
ask, what would the effect of those tax cuts be on individuals 
in, say, the lowest 50 percent of the income distribution, we 
estimate that with the tax cuts, they pay 15 percent fewer, 
lower taxes than they would without the tax cuts.
    Additionally, if we look at the proportion of individuals 
who pay no taxes at all, before the tax cuts individuals who 
earn $32,000 paid no taxes. After the tax cuts individuals who 
pay, I am sorry, who earn less than $42,000, pay no taxes. So 
to my mind that is a move in the direction of progressivity.
    Senator Sarbanes. I am not challenging that some of the tax 
cuts contributed to progressivity.
    But if you put them all together and look at the estimates 
that the Tax Policy Center has made, I think these are rather 
spectacular findings here. In any event, Mr. Chairman, I think 
my time is up, as I understand it.
    Chairman Saxton. Yeah it was up about a minute ago.
    Senator Sarbanes. Let me ask this final question, Chairman 
Lazear.
    I am always interested in the struggle to maintain 
professionalism of people who come into say the Council of 
Economic Advisers or other positions from private life, and 
then they are confronted with the political demands to, in 
effect, be spokesman for an administration policy. It happens 
in all administrations, an administration policy which is often 
arrived at largely on political grounds.
    And I am just curious. Are you encountering that struggle 
now as chairman of the CEA?
    Dr. Lazear. No, sir, I am not.
    Senator Sarbanes. All right. That is all I want to know.
    Chairman Saxton. Thank you. Before we go to the gentlelady 
let me ask this question as a follow-up to Senator Sarbanes' 
question, which I thought was a good one. When we look at the 
percentage of taxpayers, Senator Sarbanes talked about the top 
1 percent and the bottom 60 percent. I would like to talk about 
the top 1 percent and the bottom 50 percent. My numbers are 
that the top 1 percent of the wage earners in this country pay 
34 percent of the taxes, while the bottom 50 percent of the 
wage earners pay just 3.5 percent of personal income taxes.
    And I am wondering how you could give the same percentage 
of tax cuts to the bottom 50 percent, given the fact that they 
pay just 3.5 percent of the taxes, as you would the top 1 
percent? It would be a difficult chore, it would seem to me.
    Dr. Lazear. Indeed it would. And that is why the numbers 
that were cited earlier are not compelling in my mind. It is 
virtually impossible to think about tax cuts that would win by 
that particular standard.
    The reason is this: If you think about people at the bottom 
who are paying a small proportion of the total taxes, suppose 
you eliminated all of their taxes and you change the taxes for 
the very top individuals by 1 percent. Well, obviously, if 
those are the individuals who are paying all the taxes in 
absolute terms, they are going to get a bigger tax cut. On the 
other hand, most people would believe that eliminating entire, 
the entire amount of taxes for individuals at the bottom, and a 
small fraction of taxes at the top would be a move toward 
progressivity, but it would fail on that test. It would succeed 
on other tests. That is why these questions become somewhat 
more difficult, somewhat more complicated, and do require a bit 
of, what I would say, more study before jumping to particular 
conclusions and that was what we were trying to point out with 
the numbers that we gave, and I think your numbers reinforce 
that point.
    Senator Sarbanes. Are you asserting that the percentage 
cuts given to the bottom 60 percent were equal to the 
percentage cuts given to the top 1 percent?
    Dr. Lazear. No, the percentage cuts, I am sorry, sir, the 
percentage cuts given to the bottom, when we look at the 
overall picture, just talking, again, about your--the statistic 
that you used, which is take all of the tax cuts combined, 
capital gains, dividend tax cuts, take the EITC, add those all 
up and then ask what proportion of the tax burden is borne by 
low income individuals versus high income individuals, low 
income individuals----
    Senator Sarbanes. It wasn't a percent of the tax burden, it 
was after-tax income----
    Chairman Saxton. I would like to thank the gentleman for 
his----
    Senator Sarbanes. [Continuing.] inequality.
    Chairman Saxton. I would like to thank you for your input. 
We are about 8 minutes past your time so, Ms. Sanchez, the 
floor is yours.
    Senator Sarbanes. I was prompted to ask since you asked a 
question----
    Chairman Saxton. Thank you.
    Senator Sarbanes. I thought we ought to keep the record 
straight. It is important to do that.
    Representative Sanchez. Thank you, Mr. Chairman. And Mr. 
Chairman, thank you for being before us today. I have a couple 
of questions that I have been following in the last year, since 
I have been on this Committee, one with respect to housing and 
one with respect to why hasn't Wall Street slapped Washington 
for the deficit spending that is going on, and their inability 
to--our ability to structure ourselves into what I think is a 
big hole coming out of Wall Street, and I am incredibly 
interested in why the markets haven't sent a message to us yet.
    In talking to Chairman Greenspan, I think it was the last 
question that was asked before he left, by me and the Congress, 
one of the reasons that he gave us was, you know I asked him, 
why hasn't Wall Street gone after us on this?
    And he suggested that one of the reasons, one of the major 
reasons was that productivity at the high end had increased, 
even though the cost for productivity had not, that the influx 
of people from the former Soviet Union, and India and China, 
high end engineering, mathematics, et cetera, that we were now 
using was depressing the wages or keeping the wages down at the 
high end of these type of people.
    I have noted that high--that the graduating class out in 
universities in the United States actually is in high demand, 
and the salaries are going up this year for the first time in a 
long time of people coming out of there, given that less than 
20 percent of the people in the United States carry at least a 
BA, I am thinking of them as a higher productivity class, if 
you will.
    So my question to you is, does it, I was talking to a 
colleague last night, and she told me that her daughter, who is 
a second-year law student is making more per week than we do as 
lawmakers per week. So, obviously, salaries are going up for 
people who are getting the education out there.
    Does this trouble you, given that Chairman Greenspan said 
this is all about to collapse on us, and he viewed that 
increases in this level of people were going to begin and bring 
down the productivity of the United States? Does this concern 
you?
    Dr. Lazear. No, I actually view it as a positive 
development that the return to investment in education is high.
    What does concern me, though, again, is that I would, I 
think we need to focus on making sure that all Americans enjoy 
the ability, the opportunity to take advantage of these high 
returns. It is a good thing when our productivity is high, when 
our investment in skills pay off, when our investment in any 
kind of capital, physical or human, pay off. And that trend, by 
the way, has been going on for a long period of time. So I 
don't view it has particularly problematic. I don't see any 
robustness issue there which I think is what you were getting 
at in your question, is this going to collapse? There doesn't 
seem to be any tendency at all at least in the historic data to 
suggest that it will.
    Representative Sanchez. So you believe that if increases in 
the higher end, the high productivity that Chairman Greenspan 
at least had alluded to, that the increase in wages which if 
nothing else comes out, drops down the productivity, that this 
will not be a problem and the capital market will not see this 
as a problem for the United States, inflation in other words at 
the higher end? Again, we are talking about the top 10 percent 
here getting higher wages where the lower end is stuck, we 
can't even get a minimum wage through the Congress in over 9 
years.
    Dr. Lazear. I believe it actually works the other way, that 
it is not so much that wages will cause productivity to 
collapse, but rather wages are a reflection of productivity. So 
in large part, the reason that our individuals are wage earners 
at the top of the distribution, top of the skill distribution, 
are doing so well is because their productivity is very high, 
they are contributing a lot to the economy.
    Representative Sanchez. Thank you, I want to get to my 
second question. I will add that unfortunately, this President 
and this Congress in raising the cost of the interest cost to 
student loans and in cutting moneys really to education are 
really not investing in education, as the rest of us would like 
to see, given your comment about productivity.
    Back to this housing issue, you know, I talked to Greenspan 
and also, of course, to the new chairman of the Fed now, when 
he was in your position before, and coming from California and 
having seen the type of market that we have had, my question is 
to the issue of interest rates increasing, and probably for the 
foreseeable future, seeing them go up even more and the fact 
that in order for people to get into homes, they took out ARMs 
and, you know, quite frankly things that as an investment 
banker that, I just, scream about, 50-year, I think the No. 1 
loan out there in California right now is a 40-year, 1 percent 
negative amortization loan or 50-year loan, with 0 percent, I 
mean just things are incredibly crazy, I think. With this 
slowdown, and I know that you talked yesterday about the 
housing sales and the new housing sales having gone up but even 
developers, I watch this all day long, are very interested in 
this issue because Orange County is developer haven, that is 
what we export to the rest of the world is new development in 
particular.
    Even all of the heads of Lennar and other companies said 
this surprised them, and they also said that cancellations are 
not noted in these housing sales. And then they said that their 
cancellation rates are about 30 percent right now. In other 
words, the new housing, that this home sales that supposedly 
went up yesterday, you could begin to discount by at least 30 
percent, because it said their cancellation rates were hitting 
that high at this point in this quarter. So they said, it is 
definitely slowing down. Almost every major developer said this 
yesterday.
    So my question to you is, are you worried? And what should 
Congress do, as a policy to these ARMs that are coming due, a 
quarter of them due in this next year across the Nation, people 
not having equity, because as we have seen the new housing 
starts and the lack of sales are actually beginning to show, 
and the developers are admitting to, will push down, I believe, 
even further the sales of existing homes.
    Are you worried about these nontraditional or 
nonconservative financing methods, and what they are going to 
do with respect to foreclosure and lack of equity? And what do 
you really see? Are you tracking this? And what do you think 
the impact will be to the overall economy nationally, and what 
do you think, what do you, I think, Congress can or should do 
about anticipating this?
    Dr. Lazear. Thank you. Again you, too, have touched a large 
number of areas. Let me try to answer in a comprehensive 
fashion.
    Specifically, let me talk about the ARMs that you refer to.
    In fact, we do watch these, and it is a concern for us as 
well as for you.
    What one worries about, of course, is that as interest 
rates go up, one is concerned that individuals then have higher 
household payments. At the same time, if they can't make those 
payments, increases in interest rates could involve capital 
losses in their housing prices, and then they could be in 
trouble, and I think that is the concern that you have.
    We looked at that actually very carefully, because we too 
were concerned about that.
    What we are finding is at least to this point, there is no 
evidence of that happening, in fact, net household worth is up 
and bankruptcy rates have been down and down considerably. One 
of the good pieces of news in our economy among many but one of 
the ones that we focused on in the household level is that 
bankruptcy rates are running at about less than half of where 
they were in the late 1990s. So part of that, you asked what 
Congress could do is, I think, part of that is I think a result 
of some of the action you took about a year ago to reform some 
of the bankruptcy laws, but what we are seeing is real declines 
in bankruptcies right now.
    And, again, I think that reflects increases in net worth, 
in large part coming not only from the housing market, which, 
by the way, is still going up, it is still not--it hasn't 
declined. It is still going positive, but also from equity 
markets as well.
    So it is a concern. It is one that we monitor. It is one 
that we continue to look at, and we will continue to look at 
it, I think you know I am also a Californian, although from the 
north, but I share your views. I have seen markets like this 
have booms and busts and it is one that we are on to.
    Representative Sanchez. Let me just end, Mr. Chairman, if 
you will, by saying that, you know, as somebody who also 
invests in the stock market, I would say that the equity 
markets, at least from my statements, and I follow 
straightforward market investment portfolio, not individual 
stocks, has declined over a thousand points as I recall it has 
had a little bit of a rally in the last few days, so equities 
have actually come down, I believe, over the span of this year. 
And my realtors, who were in from Orange County, said that 
definitely there is a slowdown, pricing houses, may be a little 
up or at the same level, but the number of homes up for sale 
the length of the homes up for sale and people actually taking 
their homes off for sale, because they can't find buyers is 
continuing to increase, and the fact that 25 percent of the 
ARMs or, you know, people are going to have to redo their loans 
this coming year, I think is a real vital should be a vital 
concern to many of us, especially those who have seen heavy 
movements in the markets or robust economy because of housing 
sales.
    Representative Brady. [Presiding.] Thank you. Gentleman 
from Texas, Mr. Paul.
    Representative Paul. Thank you very much, Mr. Chairman. 
Good morning. I have a question dealing with inflation. I see 
on page 3 you talk a little bit about inflation, expressing a 
little bit of concern, but I don't think a whole lot.
    And yet, the Fed seems to be a lot more concerned about 
inflation right now.
    Even this week, there is the anticipation that they have so 
much concern that some in the market believe that the interest 
rates might even be raised a half a point rather than just a 
quarter point. So they evidently are very fearful and that is 
generally what the whole talk is in the financial community. 
But I am a little bit bewildered by the way we handle 
inflation.
    Generally speaking, Treasury, or the Fed, or the Council of 
Economic Advisers, in talking about inflation, they never talk 
about the depreciation of money. They always talk about some 
external force that causes prices to go up. For instance, you 
suggest a significant increase in the price of gasoline and oil 
prices will push up inflation, of course, some of us see that 
as a consequence of inflation. There was a famous economist 
once who taught that inflation was always a monetary 
phenomenon. And yet we essentially never talk about it.
    So here there is, this concedes there is a concern about 
inflation, and typically, and this has been the way it has been 
for decades now, and I think this is the Keynesian influence in 
our system.
    And therefore, they make the assumption that prices go up 
because there are too much of a healthy economy and we have to 
turn the economy off, because the economy is booming too much.
    So what do they do? They suggest we raise interest rates to 
turn off the growth. Of course, raising interest rates has a 
price effect too. That can be so-called inflationary as far as 
pushing up prices.
    And besides, it challenges the whole notion that if you 
have a free market and it is productive and going well, 
productivity is the best thing in the world to drive prices 
down. So we have, you know, one section of the market is rather 
unfettered, it is in the area of TVs and computers. And you 
don't have an inflation, price inflation there, prices keep 
going down. And so here we are, we refuse to think about it as 
a monetary phenomenon, then we get too much growth and we say 
too much growth is bad. We have to turn the growth off to crash 
the prices or bring the prices down. And at the same time, not 
recognize the fact that it is the depreciation of money that 
really counts.
    And I am just wondering whether you have an opinion of 
this, why is there this almost refusal to deal with the 
depression of money because if that is, if the economists are 
correct that point all the blame at monetary depreciation and 
we refuse to deal with it, we can forget about a healthy 
economy and your job becomes much worse. How can you adjust for 
it? How can an economic adviser give advice to cause a healthy 
economy if the basic flaw is in monetary policy?
    Dr. Lazear. Thank you.
    Well, I would say first just commenting on your sort of 
general theme of your question, which is that I seem to show 
less concern about inflation than the Fed does, at least in 
public statements. I guess I would say that I am, part of that 
is because I have confidence in the Fed.
    So I don't have to worry about inflation because Ben and 
his partners are doing that right now for us. And I think we 
will do a good job and we will be successful in controlling it.
    But my views are not based on personal knowledge of the Fed 
or its board, but rather on the market. I think if we look at 
the market indicators, the market also seems to believe 
inflation is under control or will be under control.
    For example, if you look at things like our forecast or 
look at the Tip spread, which is an estimate of what the market 
believes about inflation, Bloomberg estimates, all of these are 
in the same range, they are all about 2\1/2\ percent going 
forward.
    So those numbers obviously take into account Fed policy. 
But I think that the economy and the forecasters are all pretty 
much singing the same song. I think the most important point 
you made is one I would strongly agree with, and that is the 
best way to control inflation--and what we are talking about in 
terms of inflation is increases in real prices, prices of goods 
going up relative to our earning power. That is what we really 
worry about.
    And you mentioned that the best way to control that is 
through increases in productivity. And I certainly subscribe to 
that philosophy as well. I think that the most effective 
control against inflation, the most effective guard is to make 
sure productivity stays high. We have done that in the past few 
years, productivity growth has been very strong. And I see it 
continuing into the near future.
    As a result, we have not experienced very high levels of 
inflation, even with gas prices going up and maybe we don't 
want to call it inflation, because as you point out, most of us 
think of inflation as a monetary phenomenon, at least where I 
went to school, that is how we think of it, but still the fact 
that prices are going up is a concern obviously to consumers.
    They haven't gone up very much, except for gasoline and oil 
prices, prices have not gone up very much, quarter prices have 
been contained, and I think, in large part, because of the 
productivity gains to which you alluded.
    Representative Paul. May I have one quick follow-up? If 
this is true, raising interest rates may well diminish the 
product for productivity increase, wouldn't this be true?
    Dr. Lazear. When interest rates are raised, it does have an 
effect on the economy. As Ms. Sanchez pointed out earlier, we 
are already seeing this in the housing market, there is no 
doubt the housing market has slowed at least relative to its 
past. The question that one has to address is whether we are 
willing to tolerate some slowing in the economy in order to 
keep what would be viewed as a monetary reason for inflation 
under control. We have full confidence that the Fed is looking 
at those issues and making the appropriate tradeoffs in doing 
that. As I said, I have confidence in them in large part, 
because I know the individuals involved. They are very sensible 
and very thoughtful people. They have all the data available to 
them that I have available to me. And I think they will do the 
appropriate and responsible thing.
    Representative Brady. Chairman, thank you for your services 
leading the Council of Economic Advisers and taking time to 
enlighten us today about future prospects to the economy. Thank 
you very much.
    Dr. Lazear.  Thank you, sir.
    Representative Brady. The Committee welcomes for its second 
panel two distinguished Members, Dr. Mickey Levy, chief 
economist for the Bank of America, and Dr. Brad Setser, senior 
economist and director of Global Research for the Roubini 
Global Economics Group out of New York.
    Representative Brady. Gentlemen thank you for joining us 
today, Dr. Levy why don't we begin with you.

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

    Dr. Levy. Thank you very much for inviting me to express my 
views to you about the economy. In addition to giving you a 
brief economic overview, I would like to identify several risks 
facing the economy and also discuss why global imbalances are 
so large, and what the implications are. I see some narrowing 
of imbalances coming our way.
    Now, without being redundant with Mr. Lazear, the economy 
is really fundamentally sound and, it is important to keep in 
mind that the U.S. has the highest potential growth of all 
industrialized nations. To put it in perspective, we have $11 
trillion economy, so 3\1/2\ percent growth means economic 
output or national income is about $375 billion higher than 
last year and, it is spread, around and the reason why the U.S. 
economy has high potential is because we have generally pro-
growth economic policies and it is very important to keep it 
that way.
    Going through the economy, everything has been quite 
healthy, particularly productivity, and I would note that, in 
some sectors, productivity is much higher than the statistics 
suggest.
    The soft spot that was alluded to in the previous testimony 
is while wages have been rising, they have not kept pace with 
productivity gains. And the rise in energy prices has tempered 
the rise in real compensation. When we think about the 
culprits, it is not just higher costs and nonwage costs to 
corporations, it is also international competition.
    And this is going to continue. We see low cost producers 
overseas. It is very difficult to identify the independent 
impact of this, but it seems to me it is putting higher demands 
on high skilled workers and somewhat lesser demands on lower 
skilled workers. And that is just a fact going forward. It is 
more severe in Europe.
    The right way to address this is not to address the 
symptoms of the problem, but rather to increase education and 
skill levels.
    Now, as for my outlook, I am looking for continued economic 
expansion but at a moderating pace. As a consequence of the 
higher interest rates, the higher energy prices, and the impact 
of the higher interest rates on mortgage refinancing, a natural 
consequence, and actually a welcome consequence of the Fed's 
rate hikes, will be some moderation in consumption of the rate 
of economic growth.
    But even with those factors, consumption will continue to 
grow. And if you look at the key factors that have historically 
driven consumer spending, real or inflation-adjusted disposable 
personal income is still growing, even though it has been 
suppressed by higher energy prices. And should energy prices 
stabilize here, real disposable personal income growth will 
accelerate.
    Also while real interest rates have gone up a little bit, 
they still remain low, particularly in after-tax terms. And 
household net worth, that is, stocks bonds and real estate, net 
of all household debt, is at an all-time high, and of the 
nearly $50 trillion in total net worth, less than 30 percent is 
real estate. And so, even if real estate falls by more then I 
think, it will not affect the consumer that much. It will slow 
things down, but not lead to a decline.
    With regard to housing activity, I expect, looking forward, 
further flatness, perhaps modest declines in housing activity 
and prices, but not large declines.
    Once again when we look at the factors underlying what has 
historically driven housing, they are all generally positive.
    Employment is rising and the unemployment rate is 4.6 
percent, and personal incomes on average are rising, and real 
after-tax interest rates are low.
    Toss in the demographics, and in my view, it is adjustment 
process. While I agree that the recent pace of price 
appreciation in housing is unsustainable, the adjustment 
process suggests that a flattening out and maybe a modest 
decline, but not much more.
    Capital spending is very strong, reflecting record-breaking 
profits, cash flows, low real costs of capital, and other 
positive factors. Exports are very strong reflecting global 
economies that are quite strong. So if you were to look at the 
destination of U.S. exports and what we are exporting, the 
outlook is very, very favorable.
    The trade deficit is widening, but a key point I am going 
to emphasize here is the deficit is widening because the U.S. 
is strong. Imports are higher and rising more rapidly than 
exports. Forty percent of all U.S. imported goods are 
industrial supplies and capital goods, even excluding petroleum 
and automobiles. That is because the U.S. is growing faster 
than nearly every other industrialized nation--not just 
consumption but investments--imports are rising rapidly and a 
hefty portion of that rise in imports that is generating the 
trade deficit is for business production and expansion and 
associated with job creation.
    The largest risk to the economy--and we shouldn't 
understate these--involve three sources. The first risk is if 
the Fed were to inadvertently hike rates too much, causing a 
slump in aggregate demand. In response to several questions 
about the housing markets and consumer debt, as long as the 
economy continues to grow at a healthy enough pace, in the 
aggregate, we can withstand higher interest rates. But if the 
Fed raises rates too much, which creates a slump in aggregate 
demand, which leads to a slowdown in employment and wages--this 
is the biggest risk to the economy and to housing.
    The second risk is protectionism that significantly raises 
the cost of production or otherwise jars international trade 
and capital flows and/or elicits retaliatory measures. In this 
world of large global imbalances, barriers to trade and capital 
are dangerous and have to be avoided.
    And the third potential risk is a dramatic or undisciplined 
decline in the dollar. I am not anticipating one.
    Inflation has risen. It has risen due to excess demand. In 
the last couple years, nominal spending growth in the economy 
has been about 6\3/4\ percent, which is well above common 
estimates of potential, about 3\1/2\. Consequently, inflation 
has accelerated and core inflation, even excluding food and 
energy, has risen above 2 percent. The Fed has told us it wants 
to keep core inflation at 2 percent. And so it will hike rates.
    And here is the difficulty for the Fed. It doesn't want to 
cause a slump. It has looked at its past history at times when 
it is has orchestrated a soft landing and times when it has 
tightened too much. It doesn't want to do the latter. But the 
difficulty is there is no single measure of monetary thrust 
they can rely on. And in addition, monetary policy works with a 
lag. But with the markets testing the Fed's inflation fighting 
credibility, here is a good analogy: Let's say you told your 
kids it is 9 o'clock bedtime. And it is 9:15 and then 9:30 and 
you look in and they are still watching TV and it looks like 
they are getting more wound up than closing down shop.
    What do you do?
    The Fed is going to hike rates further. And I am looking 
for a 5\3/4\ percent funds rate by year end. I do not think 
that would unhinge the economy.
    With regard to the trade deficits and the current account 
deficits in the global context of large global imbalances, if 
all countries had approximately the same rates of economic 
growth and investment and saving, imbalances would be very 
minor.
    But that is not the case.
    The U.S. has been growing significantly faster than every 
other large industrialized nation since 1990 except for Canada. 
And not just consumption has been growing faster but 
investments have been growing faster. So there is a tremendous 
demand for capital. At the same time, our rate of saving has 
been too low.
    In the 1990s, during the investment boom, the rate of 
national saving was fairly high. The decline in the rate of 
personal saving was offset by the Government moving from 
deficit to cash-flow surplus. But so far this decade, the rate 
of personal saving has stayed so low, and we have budget 
deficits. And so the U.S. has insufficient savings relative to 
high investment.
    Now, in Japan, where the economy has languished up to until 
a couple of years ago, it had a very weak domestic demand, flat 
consumption, weak investment and excess saving. Ditto Germany. 
While China is poor in GDP per capita terms, and has strong 
growth, it has an extraordinarily high rate of personal saving, 
over 40 percent, by their official statistics.
    The reason why it is so high is they don't have a social 
safety net or any retirement programs.
    So those countries have excess saving relative to 
investment and they export their capital to the United States.
    I understand the current account deficit is extremely high. 
I am not concerned at all about the U.S. trade deficit, because 
it reflects relative strength. What we have to ask is, what are 
we doing with the imported capital? What is the rate of return 
on it? Are we putting it toward investment that creates future 
jobs? Or are we using it for current consumption?
    I am concerned about the current account, not because I 
think there is going to be a collapse in the economy, and not 
because there is going to be a sharp decline in the dollar, but 
I think we have to address the factors underlying it.
    When you think about the current account deficit in the 
United States, you should also think about the current account 
surpluses in Japan and China and look at the factors underlying 
them. I would like to make several points: One, the large 
imbalances are largely a reflection of the U.S. strength, and 
its low rate of saving; second, in equilibrium, don't expect 
the trade and current accounts to be in balance unless every 
country has approximately the same rate of economic growth, 
same rate of investment and same rate of saving. Do not expect 
an ultimate day of reckoning where the dollar plummets or the 
U.S. economy collapses.
    I have had the pleasure of sitting down with the top global 
portfolio managers in Asia who manage nearly $2 trillion. I 
walk away from those meetings with the clear impression that 
they are absolutely economically rational in holding a very 
large portion of their portfolio in U.S. dollar-denominated 
assets.
    If you think about it, the U.S. has the fastest growth and 
the most credible policymakers, a credible central bank, the 
highest interest rates in market and in inflation-adjusted 
terms. They are investing in the U.S. for the right reasons. 
Don't expect any sell-off and do not expect a sharp decline in 
the dollar.
    That is just not how portfolio managers work.
    In order to think the dollar will fall sharply, you would 
have to think those portfolio managers are irrational 
economically.
    I think there are factors in place that will begin to 
narrow global imbalances.
    Think about the following.
    In the last couple years, Japan's domestic demand has 
picked up. That means its consumers after a dozen years of flat 
to declining consumption are starting to consume more.
    Japan enjoys record breaking profitability, and that is 
generating higher investment. Its domestic demand is picking 
up, which is going to boost its demand for capital. At the same 
time, their rate of personal saving is coming down as 
confidence builds.
    Dr. Levy. Their excess saving is starting to shrink, and 
they will become smaller exporters of capital to the U.S. and 
around the world.
    Ditto Germany. We are finally starting to see a pick-up in 
the German economy largely due to lower German tax receipts and 
spending as a percentage of GDP. European economies are picking 
up and, once again, you are going to see a pick-up in domestic 
demand. Germany's current account surpluses will come down.
    Finally, China. In the U.S., consumption is nearly 70 
percent of GDP. In Europe, it is about 58 percent. In China, it 
is 42. That is going to increase. As the Chinese citizens start 
to spend more of their disposable income, the excess of 
national savings relative to investment will shrink, and there 
will be less sources of capital available to the U.S.
    From the U.S. perspective, the Fed's rate hikes and higher 
real interest rates are beginning to slow down domestic demand, 
and we are seeing that in housing and we are going to see it in 
consumption. We are going to see a slowdown. So the demand for 
capital is going to come down a little bit. At the same time, 
the excess capital from around the world is going to shrink a 
little bit.
    This is going to serve to begin to narrow the current 
account imbalance. It will not eliminate it, because if we 
consider the sources of insufficient saving in the U.S., the 
primary source is the budget deficit (that is, the Government's 
``dissaving''). This has to be addressed. You can't just go 
through this exercise by ``arithmetically'' closing the budget 
gap as if it was a deficit bean-counting game. You have to 
think about policies that both reduce the imbalance, increase 
the rate of national savings, and, at the same time, are pro-
growth. In my mind, in most people's minds, this requires 
addressing the entitlement programs and the retirement 
programs. I think once you do that, it is going to provide you 
a lot of flexibility to address a lot of other budget needs.
    If you look at the total Government budget imbalance, not 
just the cash-flow deficit now, but the long-run imbalance 
based on rational estimates of the unfunded liabilities of 
Social Security retirement, Medicare, Medicaid, and divide that 
by GDP and take the present values, the numbers are scary and 
very large: perhaps up to 6 percent of GDP. In the long run, 
raising taxes to close that gap in an arithmetic way could 
cripple the economy and you end up further away from your 
objective, and hurt exactly the people you are trying to help.
    And so once again, I think addressing the entitlement 
programs is not just a direct way of increasing the rate of 
national saving, but it is also an indirect way to provide you 
a lot of flexibility to reallocate national resources in a way 
that helps current citizens and future citizens. And I will 
stop right there.
    Representative Brady. Dr. Levy, thank you very much.
    [The prepared statement of Dr. Levy appears in the 
Submissions for the Record on page 62.]
    Representative Brady. Dr. Setser.

         STATEMENT OF DR. BRAD SETSER, DIRECTOR, GLOBAL
  RESEARCH, ROUBINI GLOBAL ECONOMICS; AND RESEARCH ASSOCIATE, 
               GLOBAL ECONOMIC GOVERNANCE CENTER

    Dr. Setser. I too would like to thank Members of the 
Committee for inviting me to testify here today.
    I am going to focus my remarks on the one risk to the 
outlook. That is the United States' very large current account 
deficit. The current account deficit in the fourth quarter of 
2005 reached about 7 percent of U.S. GDP, about $900 billion. 
It fell slightly in the first quarter, but I think most people 
believe that it is likely to remain at least at $900 billion 
and perhaps widen during the remaining course of this year.
    Current account deficits of 7 percent of GDP in an advanced 
economy like the United States cannot be directly compared to 
those of major emerging market economies, but it is still worth 
noting that a 7 percent of GDP current account deficit is equal 
to that Mexico ran in 1994 and 1995 on the eve of its crisis. 
The U.S. deficit is quite large. It is also unprecedented for a 
major advanced economy to be running deficits of this size.
    In my view, these large deficits pose two risks to the 
outlook. The first risk is the financing necessary to sustain 
deficits of this kind, financing that by and large, despite 
what some people have argued, continues to come from official 
sources, will not continue to be available. If that financing 
should dry up, there would be a sharp adjustment to the dollar, 
perhaps a sharp rise in interest rates, and a major change in 
both the pace of growth and in the composition of growth. 
Sectors such as the housing sector which have benefited from 
low-income rates would contract and the export side would 
benefit. However, if the adjustment is too abrupt, the sectors 
which are contracting would contract faster than the sectors 
which are expanding. You cannot create an export industry 
overnight.
    I think the second risk is that the possibility that there 
may not be any adjustment. The U.S. deficits will not only 
remain at the current size but perhaps expand. Those deficits 
have to be financed by taking on additional debt. That debt is 
a claim on our future income. And looking ahead right now, the 
net claims on the U.S. are around--net foreign claims are 
around 25 percent of GDP. That is certainly going to double in 
any gradual adjustment scenario. It could more than double if 
an adjustment does not start soon. That implies that the United 
States' population isn't just going to be paying for its own 
retirees, but will also be contributing to the retirement 
income of our creditors in Japan, our creditors in China, and 
our creditors in Russia and other oil-exporting states.
    These two risks interrelate. If the deficit continues to 
expand and the policies needed to reduce the deficit not be put 
in place, the risks of a disorderly adjustment go up. That is, 
the bigger the deficit, the bigger the risk that the adjustment 
process will not be benign, gradual and so forth, but rather 
sharp, disruptive, and painful.
    Before outlining the specific policies that I believe 
should be put in place to address the United States current 
account deficit, I want to make three analytical points.
    First, the U.S. current account deficit has increased not 
because of a rise in investment but, rather, because of a 
substantial fall in savings. That was most noticeable in the 
years between 2000 and 2003 when net Government savings fell 
substantially. Recently, the budget deficit has trended 
somewhat down, improving Government savings but household 
savings have fallen.
    It is true that investment has picked up somewhat since 
2003. But that rise in investment has been overwhelmingly 
concentrated in residential housing and residential real 
estate. There has been, more recently, a bit of a pick-up in 
business investment. However, that increase needs to be put 
into context. Current rates of investment are still well below 
the levels of the 1990s. I would also note, neither residential 
real estate nor investment in commercial real estate seems like 
an obvious source for the future export revenues that will be 
needed to pay our external debt.
    Second analytical point. These deficits have not been 
financed because the United States is an attractive location 
for equity investment. Net equity flows into the United States 
have been substantially negative for most of the past 5 years. 
The exception is last year, 2005, I think most analysts believe 
those flows were influenced heavily by the Homeland Investment 
Act. Certainly in the first quarter the pattern of net equity 
outflows from the United States reappeared.
    There has been a substantial rise in the amount of U.S. 
debt that foreigners have been buying, I would argue that rise 
has not come exclusively because U.S. debt is attractive to 
private individual investors but, rather, because foreign 
central banks and, increasingly, oil investment funds. Official 
creditors have been providing very large funds of financing to 
the United States.
    Recorded flows from official creditors fell in 2005. But I 
share the judgment of the former chairman of the Council of 
Economic Advisers, Martin Feldstein, that the U.S. data 
significantly understates official flows in the United States. 
Specifically, it does not capture a major fraction of the flows 
from China and is failing to capture any of the flows from the 
Gulf States.
    Third point. In order to keep the current account deficit 
at around 7 percent of GDP, the trade deficit has to fall. The 
current account deficit is the sum of the trade deficit, the 
transfers deficit, and balance on investment income. Over the 
past few years, the interest rate that the U.S. has to pay on 
its external debt fell substantially. It was above 6 percent in 
2000. It fell to around 3 percent in around 2003 and 2004.
    As we all know, interest rates are rising. That means the 
interest that we will be paying on our external debt is soon 
going to rise, and rise significantly. As a result, because of 
those increasing net interest payments in order to keep the 
current account deficit just at its current elevated level, the 
trade deficit needs to begin to fall. I don't see the necessary 
steps either here or abroad for that to happen.
    The president of the New York Federal Reserve Bank, Tim 
Geithner, observed that private markets will eventually force 
the United States to adjust, even if policy changes that would 
support that adjustment are not put into place. However, he has 
also noted that the risk of disruptive adjustments are higher 
in the adjustment process is not supported by appropriate 
policies.
    Here in the United States the most direct, most 
significant, and best way we can increase our national savings 
is to reduce our fiscal deficit. Academic work suggests a $1 
reduction in the fiscal deficit will lead to a roughly 50 cent 
increase in national savings--or up to a 50 cent reduction in 
the current account deficit. We could also take measures to 
produce or demand for foreign oil, something that Menzie Chinn 
of the University of Wisconsin has highlighted. Those measures 
directly reduce the volume of oil that we need to import, and 
also would have impact on global market prices.
    What policies are needed outside of the United States? I 
would put an emphasis on three:
    First, China and other Asian countries need to allow their 
exchange rates to appreciate. Their exchange rates are being 
held down by their central banks intervening heavily in the 
foreign exchange markets.
    China needs to do more than just adjust its exchange rates. 
It also needs to put in place policy steps that would lead its 
low rate of household consumption to rise. I would note that 
China's savings rate is rising this year and that its current 
account surplus is also rising. That is, necessary policies to 
change haven't yet been put in place and haven't yet put into 
effect.
    Second, more emphasis should be placed on the role of oil-
exporting countries. I don't think Saudi Arabia and the other 
Gulf States should be pegging to the dollar. That means that 
their currency's external purchasing power has fallen even as 
their oil revenues have surged. They need to find more creative 
ways to inject some of their huge oil windfall into their 
economy rather than lending it back to the United States.
    Now I put more emphasis on the role of emerging policies 
and less on that which is needed in Europe and Japan because 
the increase in the U.S. current account deficit has been 
associated with the rise in the surplus of European economies. 
But there is little doubt that the willingness of Europe and 
Japan to accept further appreciation of their currencies and 
base their future growth on current demand will be critical to 
sustain an orderly adjustment process.
    The United States is undoubtedly an important market for 
many of these countries and everyone has a stake in an orderly 
rather than disorderly process. But we in the United States, in 
my judgment, should not base our policies on an expectation 
that other countries will provide us the financing we need, no 
matter what we do.
    The majority of economists believe that the odds favor an 
orderly adjustment process. I certainly hope they are right. I 
would also note that this process is yet to begin. It should 
begin soon if the odds of an orderly adjustment are to be as 
high as the majority think.
    Former Treasury Secretary Larry Summers has reminded us 
recently that just because large deficits have been financed 
relatively easily in the past doesn't mean they will be in the 
future. Here in the U.S. we rarely pay attention to the 
developments in financial markets in places like Iceland, New 
Zealand or Turkey. But all their currencies have fallen sharply 
this year, and interest rates in all of these markets are up. 
Large and growing current account deficits in each of these 
countries helped trigger these market concerns.
    This turmoil should provide us with a warning. Experience 
teaches us it is better to adjust our policies when markets are 
calm, not wait until markets demand change. Thank you very 
much.
    [The prepared statement of Dr. Setser appears in the 
Submissions for the Record on page 74.]
    Representative Brady. Thank you.
    Dr. Levy, in your statement you note, and I think it is 
important, 40 percent of imported goods flowing in the U.S. is 
comprised of capital goods in industrial supplies. In other 
words, these are not goods that my family is buying to consume. 
These are goods that a business is purchasing to produce 
something else here in the United States.
    Won't these types of imports facilitate increased U.S. 
production? Shouldn't they be viewed as favorable, rather than 
an item that is being purchased for and imported for 
consumption?
    Dr. Levy. Yes, sir. They are. Absolutely positive. The 
reason why I included those statistics is to dispel the myth 
that it is just the profligate consumer that is generating 
excess import growth; that it is evenly balanced between the 
consumer and business expansion. And once again, if you look at 
the record, the U.S. has been growing persistently faster than 
nearly every other industrial nation, and that is why imports 
are growing rapidly.
    So the issue is, let us say we want to address the trade 
deficit. How do you do it? Well, presumably we want to do it in 
a way that increases growth and increases standards of living 
rather than a way that hurts the economy and hurts those 
citizens that we want to help.
    We need to look at the composition of the imbalances, get a 
clear understanding of why the imbalances have occurred, and 
then think rationally of what policies can be put in place that 
both sustain strong economic growth and reduce the imbalances.
    Representative Brady. Thank you.
    Dr. Setser, over the past 25 years--and I am not an 
economist--but the current account deficit tends to mirror the 
U.S. economy. The stronger our American economy, the stronger 
the accounts deficit is. The larger it is, the weaker our 
economy, the smaller it is. And you make the point today that 
foreign countries are not investing in the United States 
because we are a strong economy, a good place to invest. What 
are the reasons for investing--for the foreign investment in 
the United States? If we are not a strong economy, why are they 
investing?
    Dr. Setser. I want to clarify my remarks. My point was that 
equity investment from foreigners has been quite low recently, 
unlike in the late 1990s. There have been substantial inflows 
into U.S. debt markets. Foreigners do find our bonds 
attractive. I think that is for several reasons. One, as Dr. 
Levy has noted, that some U.S. interest rates are somewhat 
higher than those of other advanced industrial countries. I 
don't think that those interest rates differentials alone, 
though, are sufficient to generate $800 or $900 billion in net 
inflow into our debt markets from private individuals and 
private market players alone.
    And I think if you look closely at the data, a significant 
fraction of those votes aren't coming from private individuals; 
they are coming from foreign central banks and from oil 
investment funds. Why do foreign central banks buy U.S. 
dollars? Well, in part, they are buying U.S. dollars in order 
to keep the value of their currencies down in the face of trade 
surpluses and net capital flows into their own economy. They 
take those dollars in and they have to invest them somewhere. 
Until now, the majority of those funds have found their way 
back to the United States.
    Some have characterized this relationship as vendor 
financing. Countries want to export to the United States and 
lend us the money we need in order to buy their goods.
    The oil investment funds have just had a huge influx of 
cash. Obviously with oil at 70, there is a lot of money 
sloshing around the Gulf, sloshing around Russia, sloshing 
around any place that has oil. Their revenues have gone up far 
faster than their capacity to spend that money. They haven't 
been very creative about finding ways to inject that money into 
their economy. The cash is building up faster than they can 
find ways to spend it. And they are lending it back to us. That 
may not last forever.
    Representative Brady. Thank you.
    Congressman Hinchey, do you have a question?
    Representative Hinchey. Thank you, Mr. Chairman.
    First of all, I want to thank both of you for your very 
thoughtful and articulate testimony. It was interesting to 
listen to both of you.
    I want to insert something in the Record to make it clear 
about the general economy. Contrary to what we may have got the 
impression of as a result of the last testimony, the average 
annual growth rate over the last 5 years has been 2.6 percent. 
The Chairman left out growth rates of 1.2 and 1.6. And after 
you adjust for inflation, compensation of employees' wages plus 
benefits has grown at just 1.6 percent, which is half of the 
growth in productivity. And after adjusting for inflation, the 
income of the typical household has declined by more than 
$1,600.
    So I would like to ask you to comment on that situation. I 
mean, we are confronting a problem in this economy where the 
income of the median family, middle-income people, is going 
down. It has been dropping off more severely as you get further 
down the income scale.
    But it is impacting middle-income people very severely, and 
that, I think, is going to have a major impact on the economy.
    Also, I would be interested if you have any thoughts on the 
impact of the alternative minimum tax on median income, and how 
that is affecting the economic situation that we are 
confronting. We are debating now a major reduction in the 
estate tax, but this Congress is paying no attention whatsoever 
to the aspect of Federal taxation which is impacting most 
severely the middle-income part of our economy.
    Dr. Levy. Let me tackle those questions. Firstly, your 2.6 
percent includes the 2 years of very soft growth that brings 
down your average. But if you look over a 10-year period or 20-
year period, the average economy has been growing about 3.4 
percent.
    Over the last 5 years it is 2.6 percent.
    Dr. Levy. I agree with you.
    I think the key point with regard to the median household 
is the No. 1 factor we all have to strive for is sustained 
economic expansion. All the policies in the world are not going 
to help that middle-income household if the economy slumps. So 
it is healthy economic growth that is absolutely required, and 
that requires healthy economic policies. And we have had 
healthy economic policies the last couple of years in 
particular. We are now in this transition where the Federal 
Reserve has been taking away the monetary accommodation and it 
should slow things down, but we have to recognize that stable 
inflation is the best foundation for sustained economic 
expansion and job creation.
    Now with regard to wages, I have been disappointed that 
wages have not kept pace with labor productivity gains. There 
are reasons for this. One is the higher nonwage costs.
    The other is higher energy prices which clearly push up 
headline inflation, and we can't do anything about that. We 
have to hope energy prices stabilize so real wages rise.
    Another factor is international competition. As I noted in 
my testimony, it is very hard to isolate the impact of 
international competition on wages, but my hunch is the higher 
supply of low-wage workers around the world is increasing the 
global supply of low-wage workers and putting downward demand 
on low-wage workers here.
    Meanwhile, there is high demand for high-skilled workers. 
This is one of the factors that we have to deal with because it 
is not going to go away. And I would say the absolute best way 
to deal with it is pro-growth policies that help the people 
that you really want to help: build education and skills. 
Trying to address the symptoms, like raising the minimum wage, 
would absolutely hurt exactly the people you are trying to 
help, because it makes them less competitive in a global world 
where the costs and the price of tradable goods are falling.
    So there is no question we have a major dilemma, and it is 
not going to go away, and we have to address it in a fair and 
efficient way.
    Finally, with regard to the AMT, put it close to the top of 
your priority list because it is affecting people in a way it 
wasn't designed. The AMT is going to become more and more 
onerous; not just the tax burden, but going through the 
calculation of how you consume, how you invest: Everything is 
being affected by the AMT.
    Representative Brady. Thank you, Dr. Levy.
    Congressman Hinchey, I would point out that the mitigation 
of the AMT was included in the President's tax relief bill he 
just signed a few weeks ago and has been a part of all of the 
major tax relief measures in the last 5 years.
    Mr. Paul----
    Representative Hinchey. Could we hear Mr. Setser's response 
to my question?
    Representative Brady. Yes.
    Dr. Setser. I too think that the priority that was placed 
on reducing the estate tax relative to the--or limiting the 
estate tax--relative to the priority that has been given to 
addressing other national needs and other potential reforms in 
the tax system has been misplaced.
    I certainly agree with Dr. Levy that an economic slump is 
unlikely to be good for the median or average worker. But the 
problem has been that the economic expansion that we have seen 
over the past few years hasn't been very good to the median or 
average worker either, for many of the reasons that he 
outlined.
    I think the policy response that has been adopted by the 
Congress and the Administration has tended to augment rather 
than to help the situation. Specifically, the priority that has 
been placed on steps like reducing the estate tax, steps like 
reducing the capital gains tax, steps like reducing the 
dividends tax all have come at a time when global competition 
has been placing downward pressure on the wages of relatively 
low-skilled workers and increasing the returns on capital. So 
at a time when international markets are moving in one 
direction, increasing inequalities within our society, we have 
made policy changes at the Government level that have continued 
to add to those inequalities. I think that is a problem.
    Representative Brady. Thank you. Mr. Paul.
    Representative Paul. Thank you, Mr. Chairman.
    It seems to me that the two of you have a slightly 
different interpretation of amount of concern we should have 
for the current account deficit. I wanted to get just a quick 
clarification if I could from Dr. Levy. Your argument is that 
these funds aren't just going to consumption, that it 
represents some business expansion and business investment when 
it comes to the purchase of mortgage securities. Is that 
considered consumption or is that considered a business 
investment in our calculation?
    Dr. Levy. Doesn't matter. Capital is fungible.
    Representative Paul. You are arguing that a lot of these 
funds are going into business, and Dr. Setser is arguing the 
other case.
    Dr. Levy. Here is my point. Let us say an Asian central 
bank that has excess savings buys U.S. mortgage-backed 
securities. Well, that frees up funds for investment in 
whatever, including business investment or construction or 
residential housing or consumption.
    Representative Paul. Let me follow up with Dr. Setser 
because his statements are rather emphatic that the current 
account deficit has risen largely because of the fall in 
savings and a rise in residential investment, not because of a 
surge in business investment, arguing the case that it is not 
business investments we are borrowing a lot of money from 
overseas for consumption.
    Now following that, he mentions that this is not an 
economic decision by individual investors. This is not a 
private market participation. This comes from central banks, 
which I think muddies the water. And I just wonder if there is 
any reason to think that central bankers--you know, in their 
planning that is what central bankers are; they are planners 
domestically to centrally--run the economy. Why wouldn't 
central bankers get together and say, look, tit for tat; you 
buy our securities and we will keep the consumption going.
    And because there is this fantastic trust in the dollar, a 
remnant of the Bretton Woods Agreement that it is still a 
reserved currency, it seems to me like we could be working 
toward a dollar bubble. I know Dr. Levy says don't worry about 
it. But I think there is room for concern about the setup that 
we have, and the dollar being so unique that this is why the 
deficit's going to--maybe it will--you suggest there are two 
problems: One, it will correct; and two, it will continue to do 
it. Let us say the psychology is so powerful and the dollar is 
so strong and our military stays strong and we have success 
overseas and there is no reason to doubt our preeminence in 
economics because we can continue our economic power through 
borrowing, what if we continue this until we get a 10 or 12 
percent current account deficit? Doesn't this just mean that 
someday we have to be prepared for some serious adjustments?
    Dr. Setser. Certainly if the U.S. account deficit were to 
rise to 10 percent of U.S. GDP, which is where it will be in 3 
or 4 years if we don't or our markets don't demand--if we don't 
implement corrective policies or the markets don't demand that 
we do--that's the track we are on. The deficit has been growing 
at a pace that would imply 10 percent of GDP current account 
deficits by 2010. So I think your concerns are well placed.
    I think that it is important when talking about the dollar 
to differentiate between the exchange rate between the dollar 
and euro, which is largely determined by market forces and the 
exchange rate between the dollar and, say, the Chinese 
currency, which is not set by market forces. It is set by the 
intervention of the Chinese central bank and the amount of 
intervention that China has to do in order to maintain it has 
been growing.
    At some point--I don't know when that point will be--I 
think it is likely that China will conclude that there are 
better ways of spending their money than subsidizing American 
consumption, and that the domestic monetary consequences of 
this very rapid reserve growth will become such that there will 
be a reevaluation inside China of this policy choice.
    Now that reevaluation hasn't come yet. It may not come next 
year, it may not come the year after; but at some point it will 
come. The People's Bank of China in my judgment is unlikely to 
extend an infinite credit line to the United States, which 
implies at some point something will change.
    I think it is also important to recognize that right now a 
very large amount of the central bank financing from the United 
States is coming from a set of countries which are not 
necessarily either democracies nor necessarily our allies: 
China, Russia, many countries in the Middle East.
    Finally, I do disagree with Dr. Levy's argument that we are 
currently largely taking on external debt to finance a surge in 
investment, including a surge in business investment.
    Unambiguously, business investment today is lower than it 
was in the 1990s. Unambiguously, residential investment today 
is higher than it was in this 1990s. Unambiguously, household 
savings today is lower than it was in the 1990s. Unambiguously, 
the Government deficit today is bigger than it was in this 
1990s. On all of those measures, the overall characterization 
that we are taking on more external debt not to finance a surge 
in business investment relative to the 1990s is accurate.
    Dr. Levy. Let me respond. There is no question the rate of 
business growth is lower than the 1990s. In the 1990s we said 
it was way, way too high and we were worried about it. Business 
investments so far this expansion is growing double digit. That 
is very, very healthy. And I like what I see in terms of the 
allocation.
    I think it is a misuse of the term to imply that the 
Chinese are going to get tired of subsidizing the U.S.
    Nations that have excess savings relative to investments 
have to do something with it. They allocate their resources to 
generate the highest risk-adjusted expected rate of return.
    As long as the U.S. continues to have healthy economic 
fundamentals and healthy economic policies, it will continue to 
not have problems attracting foreign capital.
    But once again, I think it is critically important to look 
underneath the imbalances. But why are they there? Once again, 
if we had economic growth along the lines of Europe, less than 
2 percent, with unemployment rate twice what we have; or, if in 
the last 15 years we had 1 percent economic growth like Japan, 
with declining investment, then we wouldn't have such a large 
trade deficit. But the fact that there are imbalances, we all 
benefit from international trade and international capital. And 
not only does the U.S. benefit because we are able to import 
capital and put it to work not just for consumption but for 
business expansion, but nations that have excess savings are 
able, through international capital flows, to put their capital 
to work.
    So globally the saving in the world seeks investment 
opportunities.
    There is no question but that when the U.S. runs a current 
account deficit. It implies that we are exchanging current 
consumption and investment for claims on future U.S. income. 
That is OK as the returns on our imported capital are higher 
than the cost of financing it. And therein lies the rub.
    The Government deficit spending for consumption-oriented 
activity does not add to future productive capacity, yet it 
does reduce the rate of national savings and that is one area 
we need to address.
    And I think there is this other area where, Brad, I think 
we totally agree, and that is in response to the more than 
doubling of energy prices in the last couple of years. You 
suggest consumers have maintained their rate of consumption 
growth, which has lowered the rate of personal saving and 
lowers the rate of national saving. That capital has flowed to 
OPEC producers (oil transactions all transacted in dollars) and 
a lot of it flows back into the U.S. This rise in oil prices 
has clearly been something that 4 or 5 years ago none of us 
anticipated, and has clearly increased the current account. We 
have to hope that energy prices stabilize and come down; and if 
they do, that should contribute to a higher rate of personal 
savings in the U.S. and higher rate of national savings. If, on 
the other hand, energy prices go up significantly from here, 
now that monetary policy is more neutral than accommodative, 
then the economic impact could be negative and it could keep 
our rate of personal savings in the negative territory.
    Representative Brady. I want to thank the panelists for 
being here, the Members as well. And this meeting is adjourned.
    [Whereupon, at 12:50 p.m., the Committee was adjourned.]


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