[House Hearing, 110 Congress]
[From the U.S. Government Publishing Office]


 
                     STATE OF THE U.S. ECONOMY AND 
                  IMPLICATIONS FOR THE FEDERAL BUDGET 

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

                                HEARING

                               before the

                        COMMITTEE ON THE BUDGET
                        HOUSE OF REPRESENTATIVES

                       ONE HUNDRED TENTH CONGRESS

                             FIRST SESSION

                               __________

            HEARING HELD IN WASHINGTON, DC, DECEMBER 5, 2007

                               __________

                           Serial No. 110-25

                               __________

           Printed for the use of the Committee on the Budget


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                        COMMITTEE ON THE BUDGET

             JOHN M. SPRATT, Jr., South Carolina, Chairman
ROSA L. DeLAURO, Connecticut,        PAUL RYAN, Wisconsin,
CHET EDWARDS, Texas                    Ranking Minority Member
JIM COOPER, Tennessee                J. GRESHAM BARRETT, South Carolina
THOMAS H. ALLEN, Maine               JO BONNER, Alabama
ALLYSON Y. SCHWARTZ, Pennsylvania    SCOTT GARRETT, New Jersey
MARCY KAPTUR, Ohio                   MARIO DIAZ-BALART, Florida
XAVIER BECERRA, California           JEB HENSARLING, Texas
LLOYD DOGGETT, Texas                 DANIEL E. LUNGREN, California
EARL BLUMENAUER, Oregon              MICHAEL K. SIMPSON, Idaho
MARION BERRY, Arkansas               PATRICK T. McHENRY, North Carolina
ALLEN BOYD, Florida                  CONNIE MACK, Florida
JAMES P. McGOVERN, Massachusetts     K. MICHAEL CONAWAY, Texas
NIKI TSONGAS, Massachusetts          JOHN CAMPBELL, California
ROBERT E. ANDREWS, New Jersey        PATRICK J. TIBERI, Ohio
ROBERT C. ``BOBBY'' SCOTT, Virginia  JON C. PORTER, Nevada
BOB ETHERIDGE, North Carolina        RODNEY ALEXANDER, Louisiana
DARLENE HOOLEY, Oregon               ADRIAN SMITH, Nebraska
BRIAN BAIRD, Washington              [Vacancy]
DENNIS MOORE, Kansas
TIMOTHY H. BISHOP, New York
GWEN MOORE, Wisconsin

                           Professional Staff

            Thomas S. Kahn, Staff Director and Chief Counsel
                 Austin Smythe, Minority Staff Director


































                            C O N T E N T S

                                                                   Page
Hearing held in Washington, DC, December 5, 2007.................     1

Statement of:
    Hon. John M. Spratt, Jr., Chairman, House Committee on the 
      Budget.....................................................     1
    Hon. Paul Ryan, ranking minority member, House Committee on 
      the Budget.................................................     3
    Peter Orszag, Director, Congressional Budget Office..........     5
        Prepared statement of....................................     9
    Martin Feldstein, professor of economics, Harvard University.    31
        Prepared statement of....................................    32
    C. Fred Bergsten, director, Peterson Institute for 
      International Economics....................................    33
        Prepared statement of....................................    37


   STATE OF THE U.S. ECONOMY AND IMPLICATIONS FOR THE FEDERAL BUDGET

                              ----------                              


                      WEDNESDAY, DECEMBER 5, 2007

                          House of Representatives,
                                   Committee on the Budget,
                                                    Washington, DC.
    The committee met, pursuant to call, at 10:09 a.m., in room 
210, Cannon House Office Building, Hon. John Spratt [chairman 
of the committee] presiding.
    Present: Representatives Spratt, Edwards, Cooper, Schwartz, 
Becerra, Doggett, Berry, Tsongas, Scott, Etheridge, Baird, 
Bishop, Ryan, Bonner, Garrett, Diaz-Balart, Hensarling, 
Lungren, Conaway, Campbell, Tiberi and Alexander.
    Chairman Spratt. Before beginning the hearing, I would like 
to take this opportunity to welcome a new member of our staff, 
the staff director of the Republican staff, Austin Smythe. He 
is no stranger to many of us. He joins the Committee from the 
Office of Management and Budget, where he served as the 
associate director since 2001. He is also a veteran, having 
served on the Senate Budget Committee. But he will learn new 
things now that he is on the House Budget Committee, I am sure. 
We are glad to welcome him, glad to have a person of such clear 
credentials and capability on our staff. Regardless of whether 
he is a Democrat or a Republican, he is a net addition to our 
team.
    Mr. Ryan, would you care to say something? Stand up and let 
everybody----
    Mr. Ryan. I just want to introduce Austin Smythe. He is no 
stranger to the people in the budget world, the budgeteers. And 
we know he is going to bring great contributions to our side of 
the aisle. And he will be a great staff director when we are in 
the majority.
    Chairman Spratt. Austin, we look forward to working with 
you. Now I understand the Republican Conference is still going 
on. A few stalwarts broke out to come. We are glad to have you. 
And I guess your number will be increased as the hearing goes 
on.
    I am pleased to welcome to our hearing today a panel of 
very distinguished economists, here to explore with us the 
state of our economy and its implications for our budget.
    Dr. Orszag, Peter Orszag, needs no introduction. He is the 
director of the Congressional Budget Office and a highly 
respected economist. I suppose you could say his long suit is 
fiscal policy, but he has expertise that ranges across a wide 
spectrum of issues. CBO will soon be sending to us its economic 
outlook for 2008-2009, and we will be looking to CBO for 
guidance as we try to assemble a budget, the right budget for a 
shaky economy.
    Dr. Martin Feldstein is the Baker Professor of Economics at 
Harvard, and also president of the National Bureau of Economic 
Research. NBER's Business Cycle Dating Committee is the 
official arbiter in deciding what constitutes a recession. This 
is just a small swath of his many interests in the realm of 
public sector economics that range from cost-benefit analysis 
to healthcare economics to Social Security reform.
    Dr. Feldstein believes that the odds of recession are 
lengthening and that we should put in place now countercyclical 
policies that would be triggered by evidence or indications of 
an oncoming recession. Dr. Fred Bergsten has testified many 
times. He is the director of the Peterson Institute for 
International Economics and has been since its creation in 
1981. His specialty is trade and international economics, which 
makes him a valuable addition to our panel, since we want to 
know the effects a declining dollar may have on our budget, 
given our dependence in particular on foreign capital to fund 
our perennial deficits.
    We are faced with the grim impression of an economy caught 
in a confluence of adverse events, troubling events, 
unprecedented foreclosures, tightening credit, skyrocketing 
crude oil prices and a sharp decline in housing prices that 
does not seem to have bottomed out yet. I say, however, an 
impression, because it is not clear what exactly is happening.
    Just a few weeks ago, the Fed indicated it had balanced the 
risk of inflation against the risk of recession, and another 
rate cut would probably be unlikely and unnecessary. But in the 
face of worsening events apparently unforeseen, the Fed seems 
to have reconsidered, and another rate cut, another cut in the 
overnight rate seems likely on December the 11th.
    Business economists tend to be more pessimistic than the 
Fed. To cite one, David Rosenberg, who is the chief economist 
at Merrill Lynch, believes the economy faces a 60 percent 
chance of recession. Larry Summers is unable to join us today, 
but last week his column in the Financial Times said that the 
odds now favor a recession, which is a view he did not hold 
just a few months ago.
    The Bush administration still stands by its projection of 
2.7 percent growth in 2008, but they have to be careful, 
because we all know not to feed expectations of a recession for 
fear they will become self-fulfilling.
    Growth in the third quarter of this calendar year has been 
revised recently to reflect a robust annual rate, 4.9 percent, 
which I believe is the fastest growth rate in 4 years, due 
partly of course to the dollar's devaluation and our strong net 
exports. But when you look at the data now gathering and 
accumulating, it is hard to believe that this rate of growth 
can be sustained.
    Mortgage costs are rising dramatically for many Americans, 
and they will go up even more when rates are reset. Housing 
values are falling, on the other hand, sharply. Housing is one 
of the engines that drives our economy. In seasonally adjusted 
rates, home sales equaled 728,000 houses in September. That is 
the lowest level in 11 years. The median price for a home 
meanwhile dropped by 13 percent.
    So the overarching questions we face today, first, are we 
at the tipping point, headed into a recession, or just leaning 
into a slump or a slowdown? Second, is the crisis in housing 
snowballing or leveling off; is the panic in the subprime 
credit markets spilling over into other credit markets? Third, 
if we are headed into a recession, or a long slump, what should 
we do to our budget to mitigate the effects, especially in 
housing, and to stimulate the economy?
    Dr. Feldstein comes down on the side of a broadbased tax 
cut, triggered by conditions that signal or at least indicate a 
recession.
    Dr. Summers seems to support a similar position. Last week 
he told the Financial Times, ``as important as long-run deficit 
reduction is, fiscal policy needs to be on standby to provide 
immediate temporary relief through spending or tax benefits for 
low- and middle-income families if the situation worsens.'' 
Earlier this year, our committee, the Budget Committee heard 
from another panel of expert economists, which included 
Director Orszag. They stressed to us the paramount importance 
of boosting national savings, which is woefully deficient, of 
reducing deficits to ensure a stronger economy over the long 
run. Given our goals for the short- and longer-term economy, 
should the Federal Government be encouraging consumption via 
short-term stimulus, or should we instead be encouraging saving 
and long-term economic growth? Do we have to face that choice? 
And if we do face it, where do you come down?
    To address these issues and many others, let me again thank 
our panel, Dr. Orszag, Martin Feldstein and Fred Bergsten, for 
coming. We look forward to your testimony. But before turning 
to you for your testimony, let me invite the ranking member to 
make any statements he would care to make. Mr. Ryan.
    Mr. Ryan. I thank the Chairman for organizing this 
important and well-timed hearing. As you noted, Mr. Chairman, 
there are a host of legitimate concerns in the market today, 
many due to the bursting of the housing bubble. What I would 
like to do is put these recent developments in their proper 
context. First, we should not dismiss the clear economic 
successes of recent years and the still solid underlying 
fundamentals in the U.S. economy. Prudent and well-timed tax 
relief in 2001 made the recession that year one of the shortest 
in U.S. history. Further reductions in 2003, which accelerated 
those tax cuts, have led to economic benefits which we are 
still enjoying today and which, in fact, have made the economy 
more resilient than it otherwise would have been in the face of 
the current housing slump and the credit crunch.
    Let's look at the facts. This economy has enjoyed more than 
4 years of uninterrupted job gains of roughly 8.5 million new 
jobs created. Our unemployment rate stands at 4.7 percent, one 
of the lowest readings in the past 6 years. Due to this solid 
job market, the latest quarter showed American workers' real 
after-tax income grew by nearly 4 percent from a year earlier. 
The stock market is in a period of correction right now; that 
is clear. But even in the midst of the current volatility, 
equity indexes reached an all time high in October. And in 
terms of the Federal budget, the solid economic growth of the 
past few years has legally been the key factor in driving down 
the deficit, which this year fell to 1.2 percent of GDP, which 
is roughly half the level of the average of the last 40 years. 
So these are real gains that affect real people.
    But now we have a set of conditions that Dr. Feldstein 
describes as a triple threat to our economy, a credit market 
crisis, a decline in the housing prices and home building, and 
a reduction in consumer spending. Add to those a clear upside 
risk of inflation; oil prices have risen to an all time high 
recently, and the price of gold, which is a traditional pro-
cyclical indicator, recently hit a 27-year high.
    Meanwhile, to stem the combined effects of the housing 
slump and the credit crunch, the Federal Reserve has cut 
interest rates in recent months and has signaled that more 
reductions may be on the way. That in turn has led to further 
declines in the dollar, which adds even more to inflationary 
pressures by raising import prices. In this climate, sound 
monetary policy will become even more crucial to getting 
through this rough patch. But Congress also needs to recognize 
its chief role in setting the path of fiscal policy in this 
country and the important ways that that affects the economy 
and the budget for the long run. Of all times, we have less 
room for error on fiscal policy than we do today. And an easing 
monetary policy stance, coupled with proposals for a high-tax 
policy could very well lead to the worst mixture, inflation and 
slower growth, or stagflation as it was known in the late 1970s 
when a similar policy blend prevailed.
    So far the actions of this Congress are not reassuring in 
terms of setting fiscal policy for real growth. For one, 
Congress is creating a great deal of tax uncertainty. The end 
of the current tax year is less than a month away, and Congress 
has yet to pass a measure dealing with the alternative minimum 
tax or the AMT. And if Congress fails to act, more than 20 
million taxpayers will be hit with a significant tax increase 
in their tax burden and one that the Federal Government never 
even intended to impose. Meanwhile, the majorityis considering 
a number of massive tax increases, which under the guise of the 
current PAYGO system they allege are needed to pay for their 
recent spending increases. So this mix of new spending, higher 
spending and higher taxes is exactly the wrong policy mix we 
need at this time.
    There is also considerable doubt about the 2001 and 2003 
tax laws, and whether Congress and the next President will let 
these laws lapse after 2010, leading to the single largest tax 
increase in our Nation's history. At a time when credit markets 
are freezing up and some businesses are having difficulty 
attracting financing in the marketplace, Congress is gumming up 
investment and expansion plans by creating a high degree of 
uncertainty about future tax rates on business profits and 
capital income. I would like to just point to one chart, which 
I think summarizes the crossroads we are at right now with our 
fiscal policy. The one thing the majority has been certain 
about is their claim on ever higher tax revenues in the future. 
As the chart shows, over the long run, the majority's proposed 
revenue path would push the tax burden on the American economy 
to a historically unprecedented level by the end of the next 
decade. The chart shows that revenues as a share of GDP would 
reach nearly 21 percent by the end of the next decade and 
nearly 24 percent by the end of the century, compared to the 
historical 40-year average of 18.3 percent. The driving force 
behind all of these tax plans is of course the future path of 
government spending.
    This committee knows all too well that we will see 
unprecedented strains on the Federal budget in the coming 
decades as healthcare costs continue to rise rapidly and the 
baby boom generation starts to retire. Congress can choose to 
deal with these massive unfunded liabilities by chasing higher 
spending with even higher taxes which will sink the economy, 
harm our competitiveness in the international marketplace and 
guarantee an erosion of the value of the dollar; or we can work 
together to make the necessary choices today to reform our 
entitlement programs and curb this dangerous spending path.
    Addressing our long-term entitlement problems, giving 
businesses and investors and American families tax certainty 
and a low-tax environment, keeping marginal tax rates low and 
promoting capital formation, innovation and productivity is the 
best recipe for real, long-term noninflationary growth.
    And with that, Mr. Chairman, I thank you for your 
indulgence, and I look forward to this hearing.
    Chairman Spratt. Thank you, Mr. Ryan.
    And one sentence to indicate our position. It is not to 
take the tax bite out of the economy to 24 percent. We have 
passed a bill in the House that would patch the AMT's impact on 
middle-income taxpayers for at least a year, maybe longer. And 
that is our proposed policy, not one would that would take 
taxes skyrocketing.
    I want to ask unanimous consent before we begin that all 
members be allowed to submit an opening statement for the 
record. Without objection, so ordered.
    And now we will proceed with our testimony.

  STATEMENTS OF PETER ORSZAG, DIRECTOR, CONGRESSIONAL BUDGET 
    OFFICE; MARTIN FELDSTEIN, GEORGE F. BAKER PROFESSOR OF 
ECONOMICS, HARVARD UNIVERSITY, AND PRESIDENT AND CEO, NATIONAL 
 BUREAU OF ECONOMIC RESEARCH; AND C. FRED BERGSTEN, DIRECTOR, 
         PETERSON INSTITUTE FOR INTERNATIONAL ECONOMICS

    Chairman Spratt. I think the best order of testimony is, 
Dr. Orszag, to begin with you, and then go to Dr. Feldstein, 
and then let Dr. Bergsten wrap it up.
    We will then, after the testimony of all three of you, open 
the floor to questions. Once again, thank you for coming. We 
look forward to your testimony. You can summarize it. We are 
making your statements, without objection, part of the record. 
But take your time to walk through your subject matter, because 
this is extremely important.

                   STATEMENT OF PETER ORSZAG

    Mr. Orszag. Mr. Chairman, Congressman Ryan, members of the 
committee, I appreciate the opportunity to testify this 
morning.
    The economic outlook right now is particularly uncertain. 
Most backward-looking indicators suggest a relatively healthy 
economy. Despite the drop in housing construction and sales, 
economic activity has remained relatively strong, and core 
consumer price inflation remains contained. Net exports have 
risen rapidly, helping to support growth.
    The economy, however, has been buffeted by several 
important and interlinked shocks, most importantly involving 
housing, financial markets and energy prices. As a result of 
these shocks, economic activity has probably already slowed 
significantly, and the risk of recession is elevated.
    Most analysts believe that the economy will avoid a 
recession but will grow relatively slowly for several quarters. 
As table one shows, projections of economic growth for next 
year have been reduced noticeably since the summer, but they 
remain positive. That is, most analysts are projecting positive 
but sluggish economic growth.
    Let me briefly explore several of these important factors 
affecting the economic outlook in a bit more detail.
    First, the housing market has weakened significantly. By 
the end of 2005, the combination of increased mortgage rates 
and high prices for homes have reduced the affordability of 
buying a house. As a result, home sales and construction began 
to falter, and the appreciation in housing prices slowed 
substantially. By the third quarter of this year, housing 
construction was almost 25 percent below its rate in early 
2006. The direct effect of that reduction in residential 
investment has reduced annualized real GDP growth in each of 
the past six quarters by about a percentage point. House prices 
have also weakened. The national average of home prices is now 
roughly 5 percent lower than it had been at its peak.
    And as is now well known, particular concerns surround 
subprime mortgages, which are extended to borrowers who have 
low credit scores. In 2004, delinquencies on subprime 
adjustable rate mortgages, that is subprime mortgages whose 
rates are not fixed for their entire duration, started to rise 
rapidly. And as the next figure shows, by the second quarter of 
2007, almost 17 percent of subprime ARMs, or adjustable rate 
mortgages, were delinquent, up from a recent low of 10 percent 
in the second quarter of 2005.
    The problems in the subprime market are also manifesting 
themselves in the pricing of mortgage-backed securities, which 
are financial instruments whose payments of interest and 
principal are backed by the payments on an underlying pool of 
mortgages. In such mortgage-backed securities, different 
tranches are available depending upon the order in which 
investors are paid, and therefore the risks that the investors 
face. As the next chart shows, the price of the triple B 
tranche of subprime mortgage-backed securities, which is close 
to the riskiest investment grade, issued in the latter half of 
2006, which is the bottom right chart, or bottom red line 
there, has experienced a dramatic further worsening since when 
CBO last reported on this topic in September and now is 
basically paying about $0.20 on the dollar. So that red line 
there is one indication of the very severe disruption and 
deterioration in the subprime market.
    Concerns about the subprime market have translated into and 
been magnified by broader problems in financial and credit 
markets. The fundamental factors causing this broader 
disruption in financial and credit markets are a reduction in 
investors' tolerance for risk and an increased sense of 
ambiguity about exposures to assets with uncertain values. A 
reflection of this turmoil is that interest rates on riskier 
bonds, those with lower credit ratings, have increased 
significantly, as the next figure shows. Those high yield bonds 
are the bonds that are riskier and with lower credit ratings. 
And you can see the uptick that has occurred in recent months. 
It is worth noting, though, that much of the recent change 
comes after a period in which those interest rates were 
abnormally low. So part of what is going on is that the price 
of risk is returning to somewhat more normal levels after 
having been quite low during the past several years.
    Another concern involves asset-backed commercial paper, 
which represents about half of the overall commercial paper 
market. Commercial paper provides a form of short-term 
financing for banks and firms. Since the beginning of August, 
the amount of asset-backed paper that is outstanding has fallen 
by about 30 percent, and interest rates have risen sharply.
    The problems in the market for asset-backed commercial 
paper may force some firms to tap their lines of credit with 
banks as an alternative form of financing, which would then put 
unexpected pressure on the banks. Moreover, many large banks 
are committed, either explicitly or implicitly, to providing 
liquidity to entities known as structured investment vehicles, 
which are generally off of the banks' balance sheets, and allow 
the banks to earn extra income without correspondingly 
expanding their required capital.
    Should these structured investment vehicles be unable to 
continue to fund their holdings on their own through the 
commercial paper market, the banks may need to provide the 
necessary liquidity. And if the structured investment vehicles 
losses worsen, the sponsoring banks may decide to bring the 
assets and losses back onto their balance sheets, thereby 
possibly impairing other lending activities. One European bank 
has already decided to do so.
    Another factor causing concern involves oil prices. As the 
next chart shows, crude oil prices have risen by over 60 
percent this year. Most of that increase reflects underlying 
fundamentals. There has been a significant increase in demand 
for oil, especially involving nations such as China, India and 
many nations in the Middle East. And there has been a slow 
growth of worldwide supply. The combination of rapid demand 
growth and slow supply growth has been upward pressure on 
prices. Although the economy is not as sensitive to oil price 
shocks as it was in the 1970s, this recent rise in oil prices 
could hamper economic activity.
    On the brighter side, continued improvement in the Nation's 
current account deficit provides an important counterbalance to 
the weakness expected in domestic spending. After falling for 
many years--that is after the deficit expanded for many years--
net exports have now risen by over a hundred billion dollars in 
real terms since the end of 2005, and have added one and a 
third percentage points to real GDP growth in the past two 
quarters. Further depreciation of the dollar and strong 
economic activity in the rest of the world are likely to 
contribute to continued improvement in net exports. Okay.
    So that is all backward looking. Let us try to look ahead a 
little bit.
    With regard to the housing market, it seems likely that 
house prices, and consequently housing wealth, will continue to 
decline next year. For example, although it is a very imperfect 
predictor of future prices over short periods of time, the 
ratio of housing prices to rents, to rental rates, seems very 
high relative to its history, as the next chart shows. And 
indeed, if you took a literal interpretation of that chart, you 
can imagine very steep declines in housing prices that would 
result.
    Another measure which looks at an index of national prices 
and has a futures market associated with it, as the next chart 
shows, anticipates a decline in prices of about 7 percent over 
the coming year. Such housing price declines would reduce 
housing wealth and thereby constrain consumer spending and 
economic growth for several quarters. A significant amount of 
uncertainty surrounds the precise magnitude of that effect. 
CBO's analysis suggests that a reduction of housing wealth of a 
dollar will likely reduce consumer spending by somewhere 
between 2 and 7 cents.
    So to calibrate the potential impact of a hypothetical and 
assumed 16 percent decline in nominal housing prices, the next 
chart shows you what the macroeconomic impact would be for that 
range of values of how much spending falls when housing wealth 
does. The effect would be somewhere between a half and 1.5 
percentage points per year on average over the next 2 years. 
And if you added the impact of reduced residential investment, 
which is about a percentage point, the total impact would be 
somewhere between 1.5 and 2.5 percentage points per year. So 
the if the economy were otherwise growing at about 2.5 percent 
per year, it could mean that growth would be close to zero. I 
would note that it is unclear whether housing prices will 
decline as much as assumed in that scenario. And furthermore, 
in evaluating the probability of a recession, one needs to take 
into account not only this effect but also the credit market 
and financial market problems I mentioned, oil prices and, on 
the other hand, continued growth in net exports, and the fact 
that inflation remains contained and, therefore, the Federal 
Reserve has some room to adjust interest rates further.
    The bottom line is that although the combined effect of 
these various forces is an elevated risk of recession, most 
analysts currently believe that the most likely scenario 
remains sluggish, albeit positive, economic growth.
    Finally, in terms of the Federal budget, either an extended 
period of sluggish growth or a recession would cause a 
noticeable deterioration in budget outcomes. Since 1968, during 
recessions, the deficit has increased by about 1 to 3 percent 
of the economy, which translates to about $140 to $420 billion 
given the size of today's economy. Such increases in the 
deficit during periods of economic weakness in large part 
reflect the operation of the budget's so-called automatic 
stabilizers. That is, as the economy slows, tax receipts 
naturally decline, and some types of spending, for example on 
unemployment insurance and on food stamps, automatically 
increase. That combination temporarily boosts demand for goods 
and services, thereby helping to offset some of the 
macroeconomic weakness. Fiscal policy interventions that go 
beyond these automatic stabilizers in attempting to boost the 
economy during periods of economic weakness have had a mixed 
track record.
    Although there have been examples of effective 
discretionary fiscal stimulus, in several other cases, attempts 
to stimulate demand through changes in fiscal policies have 
proved to be poorly timed or designed in a relatively 
ineffective way. Policymakers considering whether to adopt 
measures beyond the budget's existing automatic stabilizers 
would need to carefully weigh the current and projected 
macroeconomic environment but also the lessons from those past 
attempts at discretionary fiscal stimulus. Thank you very much.
    [The prepared statement of Peter Orszag follows:]

             Prepared Statement of Peter Orszag, Director,
                      Congressional Budget Office

    Mr. Chairman, Congressman Ryan, and Members of the Committee, I 
appreciate the opportunity to testify this morning on the current 
economic situation.
    The economic outlook right now is particularly uncertain. Most 
backward-looking indicators suggest a relatively healthy economy: 
Despite the drop in housing construction and sales, economic activity 
has remained strong and the rate of inflation in core consumer prices 
has fallen. But the economy has been buffeted this year by several 
interlinked shocks, most importantly the turbulence in the subprime 
mortgage market, decreased confidence within the financial markets, and 
substantially higher prices for oil. Economic activity has probably 
already slowed significantly, and the risk of a recession is now 
elevated. Most analysts currently believe the economy will avoid a 
recession but will grow relatively slowly for several quarters.
    My testimony this morning covers five main topics:
     The Housing and Financial Markets. The turmoil that began 
in the subprime mortgage market and then spread to broader financial 
markets has posed substantial challenges for the economy. Housing 
activity remains quite weak, and house prices have declined in many 
areas, reducing household wealth and the outlook for consumer spending. 
Lenders' losses on mortgage-related assets and lower tolerance for risk 
have constrained the supply of credit, particularly for the riskiest 
borrowers. The problems in the housing and financial markets has 
reduced consumers' and businesses' confidence about future economic 
conditions, and presumably their willingness to spend and invest.
     Oil Markets. Crude oil prices have risen by over 60 
percent this year. Most of that increase appears to reflect underlying 
fundamentals, including rapid growth of demand (especially in China, 
India, and other developing nations) and slow growth of supply. 
Geopolitical tensions and speculative and precautionary demand have 
also exerted some influence on prices. Although the economy is not as 
sensitive to oil price shocks as it was in the 1970s, the recent rise 
in oil prices could still dampen economic growth.
     The Current Account and the Dollar. Continued improvement 
in the nation's current account balance provides an important 
counterbalance to the weakness expected in domestic spending. After 
falling for many years, net exports have risen by over $100 billion (in 
constant dollars) since the end of 2005 and have added about 1\1/3\ 
percentage points to the growth of real (inflation-adjusted) gross 
domestic product (GDP) in the past two quarters. Further depreciation 
of the dollar and strong economic activity in the rest of the world are 
likely to contribute to continued improvement in net exports.
     Consumption and Consumer Confidence. The growth of 
consumer spending has been healthy this year but is likely to weaken 
over the coming year in response to slower income growth, lower housing 
wealth, stricter standards and terms for loans, and higher oil prices. 
Especially during times in which economic conditions are shifting 
rapidly, projecting consumer spending accurately is difficult; the 
effects of many influencing factors, including housing wealth and 
consumer confidence, have a significant range of uncertainty 
surrounding them. Because consumer spending currently accounts for 70 
percent of GDP, the difficulties in projecting such spending pose 
challenges for projecting overall growth of GDP.
     The Potential for a Recession and Its Effects on the 
Federal Budget. The combined effect of those various forces is an 
elevated risk of a recession. The most likely scenario, though, remains 
slow economic growth. Few analysts currently expect an outright 
recession next year. For example, the average for the bottom 10 
forecasts included in the Blue Chip survey (which covers about 50 
private-sector forecasts) released in early November suggested 1.9 
percent growth in real GDP in 2008, and not a single forecaster 
projected negative growth. However, the next Blue Chip survey is likely 
to show further downward revisions of the forecasts. Moreover, 
recessions have often proved very difficult to foresee, or even to 
recognize in their early stages: Indeed, the apparently robust growth 
for the third quarter of this year may eventually be revised down.
    Either an extended period of sluggish growth or a recession would 
cause a noticeable deterioration in the budget deficit. Since 1968, 
during recessions, the deficit has increased by about 1 percent to 3 
percent of GDP, which translates to about $140 billion to $420 billion 
in today's economy (after the estimated effects of policy changes are 
removed). Such increases in the deficit during periods of economic 
weakness in large part reflect the operation of the budget's 
``automatic stabilizers.'' When the economy weakens, tax burdens and 
revenues tend to decline, and some types of spending (on unemployment 
insurance, for instance) tend to rise, helping to boost the demand for 
goods and services and thereby stabilize the economy.
    The Congressional Budget Office (CBO) will release an updated 
economic and budget outlook in January. This testimony, therefore, does 
not provide specific economic or budget projections.
                   the housing and financial markets
    The housing market has weakened significantly this year. Sales of 
new and existing homes have declined, and many forecasters expect 
further declines in coming months. The construction of new single-
family homes has diminished sharply. The inventory of unsold new homes 
has climbed to high levels, about 8-\1/2\ times the rate of sales in 
October, which is about twice the ratio that existed on average earlier 
in this decade. Home prices have begun to fall in many areas: According 
to the Standard & Poor's (S&P)/Case-Shiller national house price index, 
the average price has fallen by 5 percent from its peak. Many 
forecasters now believe that the national average price of a home will 
decline significantly more before the housing market stabilizes.
    The current contraction of the housing market comes after several 
years of extraordinary growth. By 2005, home sales had climbed to 
record levels. The residential construction industry boomed, and home 
prices soared in many areas of the country. Many people who had 
previously been renters became homeowners. As a result, the rate of 
home ownership, which had varied within a narrow range from the 1960s 
to the mid-1990s, increased from about 65 percent in 1995 to about 69 
percent in 2006 (see Figure 1). That rise meant that approximately 4-
\1/2\ million more families who otherwise would have been renters owned 
their homes. Investors and second-home buyers also purchased a large 
number of properties.
                    background on the housing market
    The housing boom stemmed from three main factors.
     Low Interest Rates on Mortgages. Over the past several 
years, nominal long-term rates were exceptionally low, driven by a 
benign outlook for inflation, high tolerance of risk by investors, and 
strong investment in the United States by foreigners. In addition, the 
Federal Reserve kept the federal funds rate at very low levels through 
mid-2004.\1\ Rates for 30-year conventional mortgages, which had 
averaged 7.6 percent from 1995 through 2000, dropped to 5.8 percent in 
2003 and generally remained below 6 percent until the fourth quarter of 
2005. The low rates ultimately helped feed the increase in house 
prices.
     Homebuyers' Expectations of Rapid Appreciation in House 
Prices. As the housing market began to heat up and house prices rose, 
people began to believe that prices would continue to rise. That 
expectation made housing an attractive investment opportunity, spurring 
demand and putting upward pressure on prices. Thus, for a time, the 
expectation of higher prices became a self-fulfilling prophecy that 
bore little relation to the underlying determinants of demand, such as 
demographic forces, construction costs, and the growth of household 
income.
     A Plentiful Supply of Mortgage Credit, Including the 
Expansion of Subprime Mortgage Lending. The share of subprime 
mortgages, which are extended to borrowers who have low credit scores, 
rose rapidly after 2002, constituting 21 percent of all home mortgage 
originations (in dollar terms) in 2005 and 2006. By the end of 2006, 
the outstanding value of subprime mortgages totaled more than $1 
trillion and accounted for about 13 percent of all home mortgages.
    The growth of the subprime mortgage industry was facilitated by 
changes in regulations and innovations in financial markets. 
Legislative and regulatory changes made in the 1980s lifted constraints 
on the types of institutions that could offer mortgages and the rates 
that could be charged. The development of new credit-scoring technology 
in the 1990s made it easier for lenders to evaluate and price the risks 
of subprime borrowers. The securitization of subprime mortgages 
expanded, encouraging such lending by allowing the market to spread the 
associated risks.\2\ Global investors poured large amounts of money 
into subprime investments that they judged to offer attractive risk-
adjusted returns. Indeed, the price that investors charged for taking 
on risk in the subprime mortgage market, as well as other financial 
markets, fell to abnormally low levels. Finally, the rating agencies 
appear to have miscalculated the risks of some securities backed by 
subprime loans, and they may have unduly emphasized the unusual period 
of appreciating prices.
    Many of the subprime mortgages turned out to be riskier than many 
investors expected. The problems in the market began to appear after 
2004, when delinquencies on subprime adjustable-rate mortgages (ARMs) 
started to rise unexpectedly rapidly. By the second quarter of 2007, 
almost 17 percent of subprime ARMs were delinquent, up from a recent 
low of 10 percent in the second quarter of 2005 (see Figure 2). In 
addition, the share of subprime ARMs entering foreclosure increased 
from an average of 1.5 percent in 2004 and 2005 to 3.8 percent in the 
second quarter of 2007. Although delinquencies have also risen for 
fixed-rate subprime loans, the level for those loans has been lower, 
and the increase has been slower.
    Those problems have undermined investors' confidence in the 
securities backed by subprime mortgages. Liquidity in both the primary 
and secondary markets for subprime mortgage-backed securities (MBSs) 
has declined, as some of the country's largest originators of such 
loans have experienced severe difficulties (see Box 1). In the market 
for assets collateralized by subprime mortgages, price changes have 
been dramatic. The price of the BBB tranche of subprime MBSs (close to 
the riskiest investment grade) issued in the second half of 2006 was 20 
cents on the dollar as of November 30, and the price of even the safest 
(AAA) tranche was 77 cents on the dollar--in both cases, a dramatic 
worsening from the amounts when CBO last testified on this issue in 
September (see Figure 3). Prices of tranches based on MBSs issued 
earlier, in the last half of 2005, ranged from 33 cents for the BBB 
tranche to 95 cents for the AAA tranche.
              box 1.--what are mortgage-backed securities?
          Financial institutions issue mortgage-backed securities 
        (MBSs) to investors with the payments of interest and principal 
        backed by the payments on a package of mortgages. MBSs are 
        structured by their sponsors to create multiple classes of 
        claims, or tranches, of different seniority, based on the cash 
        flows from the underlying mortgages. Investors holding 
        securities in the safest, or most senior, tranche (AAA) stand 
        first in line to receive payments from borrowers and require 
        the lowest contractual interest rate of all the tranches. 
        Investors holding the least senior securities (the equity 
        tranche) stand last in line to receive payments, after all more 
        senior claims have been paid. Hence, they are first in line to 
        absorb losses on the underlying mortgages. In return for 
        assuming that risk, holders of the equity tranche require the 
        highest contractual interest rate of all the tranches.

    Several factors seem to have contributed to the growing 
delinquencies of subprime mortgages. After mortgage rates began to move 
up in late 2005, many ARM borrowers appear to have defaulted after the 
initial period of low rates expired and their monthly payments were 
reset at significantly higher levels. Faced with prepayment penalties 
(which protected lenders from the potential churning of mortgages with 
very low initial rates), such borrowers often found it expensive to 
refinance their mortgages to avoid the increasing payments. In 
addition, some borrowers who had purchased their home with little money 
down may have seen their equity vanish as house prices began to decline 
in some areas. In the industrial Midwest, especially in Michigan, those 
problems were aggravated by the slowdown of the regional economy as the 
automotive industry retrenched.
    The underwriting standards of some originators in the subprime 
mortgage market had slipped in recent years, perhaps because they as 
well as investors were lulled by unusually low default rates while 
house prices were rising rapidly. Some made loans to borrowers who put 
little money down--and who had little to lose if they defaulted--and to 
borrowers with particularly weak credit histories. Some subprime 
lenders also required little or no documentation of borrowers' income 
and assets and established borrowers' qualification for mortgages on 
the basis of initially low teaser rates. That approach created 
opportunities for both borrowers and originators to exaggerate 
borrowers' ability to repay the loans.
             box 2.--issues in the credit markets, in brief
          The disruption in the credit markets reflects the fundamental 
        fact that in the wake of the turbulence in the subprime market, 
        investors' tolerance for risk, which was unusually high in the 
        past few years, has fallen sharply. That change has had two 
        effects: The value of risky assets has declined; and the 
        availability of credit to risky borrowers is constricted. In 
        addition, some domestic and foreign investors who in recent 
        years have invested in U.S. markets are now investing more in 
        other countries.
          Although the adjustment in asset prices has been going on 
        since August, it is not clear whether the adjustment has 
        finished, and the prices of some securities remain 
        exceptionally volatile. The prolonged period of price 
        adjustment reflects in part uncertainty about when and how the 
        problems in the subprime mortgage market will be resolved and 
        to what extent they will spill over into the broader economy.
          Decreased tolerance of risk has led to higher interest rates 
        and less availability of credit, particularly for high-risk 
        borrowers. In recent years, financial markets developed an 
        alphabet soup of new channels that allowed credit to flow to 
        risky borrowers and allowed investors to get high returns while 
        diversifying their risk. The growth of the subprime mortgage 
        market and of highly leveraged investment pools are examples of 
        those developments (see Box 3). Many of those new channels for 
        funding investments are currently largely closed. As a result, 
        the credit now being extended is flowing to a larger extent 
        through more traditional channels, such as banks.
                 box 3.--structured investment vehicles
          Structured-investment vehicles (SIVs) are entities that issue 
        commercial paper and medium-term notes and then invest the 
        funds in higher-yield, longer-maturity assets, such as asset-
        backed securities, including mortgage-backed securities and 
        collateralized debt obligations (CDOs) backed by subprime 
        mortgages. (CDOs are securities that are collateralized with a 
        range of asset-backed securities.) Fitch Ratings estimates that 
        there are $320 billion of SIVs.\1\ SIVs are usually not carried 
        on the balance sheets of the institutions creating them 
        (because the institutions do not have a legal obligation to 
        cover the SIVs' losses). As long as they remain off the balance 
        sheets, they have little or no effect on the institutions' 
        capital requirements.
          Because of the mismatch in maturity between the assets and 
        liabilities of SIVs, they periodically need to roll over their 
        debt. That ``refunding'' requires that lenders are willing to 
        take on the risks associated with a SIV's underlying portfolio. 
        However, when markets are disrupted and ascertaining the value 
        of such portfolios is difficult, refunding may be difficult or 
        impossible. In that case, the SIV will have to liquidate its 
        portfolio.
          Although some financial analysts initially believed that 
        bank-sponsored SIVs were well positioned to avoid forced 
        liquidations because their portfolios were diversified and they 
        had commitments of liquidity from their sponsoring banks, that 
        view has changed. SIVs are often required to start selling 
        their assets once their losses exceed threshold percentages of 
        their capital or if they violate liquidity provisions. Those 
        involuntary sales could then push down asset prices, which 
        could cause losses at other SIVs to exceed their capital 
        thresholds. The losses could also trigger defaults on 
        commercial paper already issued by the SIVs and further impede 
        their ability to borrow money.
          A consortium of financial institutions, prodded by the 
        Treasury, has agreed to create a new entity, the Master 
        Liquidity Enhancement Conduit (MLEC), to purchase the best of 
        the assets from SIVs as necessary. Although the MLEC may 
        mitigate refunding difficulties and help the market to 
        distinguish between good and bad assets, critics of the 
        proposal fear that the MLEC might simply postpone the 
        recognition of losses, which could delay the recovery of the 
        credit markets by reducing transparency.
          SIVs and CDOs also remain vulnerable to the failure or 
        downgrading of bond guarantors. Most of the rated securities 
        held by the CDOs carry credit enhancements in the form of 
        insurance guarantees, because the underlying securities are, on 
        average, rated BBB. Thus, those guarantees are critical to the 
        AAA ratings for the senior tranches of CDOs. Perhaps more 
        significantly, bond guarantees are also critical to a smoothly 
        functioning municipal bond market. The rating agencies have 
        placed several of the leading bond insurers (which are likely 
        to suffer significant losses and have seen their market values 
        fall between 50 percent and 75 percent from their peaks) on 
        their watch lists of institutions whose credit rating they 
        might downgrade, which suggests that those insurers might have 
        to raise more capital.

    \1\ Fitch Ratings, SIVs--Assessing Potential Exposure of Sponsor 
Banks, Special Report, November 14, 2007.
---------------------------------------------------------------------------
          The result is that some relatively risky activities, 
        including some housing investment, are not being funded. That 
        reduces total spending in the economy. Whether there will be 
        any further real effects on the economy depends on whether the 
        banks (and other financial institutions) experience capital 
        problems and have to curtail lending because of their own 
        exposure to losses on subprime mortgages and other affected 
        securities. Further reductions in asset prices could impair the 
        capital positions of some institutions and curtail their 
        ability to lend, at least until they are able to raise 
        additional new capital. The Federal Reserve and the bank 
        regulators are closely monitoring those developments.

    Those problems seemed to have stemmed from a high tolerance for 
risk on the part of investors, exacerbated by a failure to provide the 
right incentives to and oversight of originating brokers. In the 
traditional form of mortgage financing, the originator of the loan also 
holds the loan in its portfolio and therefore has a strong incentive to 
learn about the borrower's ability to make the loan payments. By 
contrast, in the securitized form of mortgage financing, the originator 
sells the mortgage to a third party and earns a fee for origination but 
receives little immediate reward for discovering relevant information 
about the borrower. As a result, originators may not have had adequate 
incentives to exercise care and discretion in their underwriting.
    The rise in defaults of subprime mortgages may also reflect the 
fact that some borrowers lacked a complete understanding of the complex 
terms of their mortgages and assumed mortgages that they would have 
trouble repaying.\3\ Defaults in areas where speculation drove home 
sales and prices may also reflect investors' inability to sell their 
properties as prices fell.
    Difficulties in the subprime mortgage market have spread to other 
mortgage markets. One is the market for jumbo mortgages, which are 
those that exceed the maximum size of a mortgage that Fannie Mae and 
Freddie Mac are eligible to purchase. That amount, which is also known 
as the conforming limit, was $417,000 in 2007. As problems in the 
market for financing subprime mortgages became more apparent, investors 
began to demand much higher premiums on jumbo mortgages. In addition, 
the terms of those jumbo loans tightened, as many lenders began to 
require larger down payments and higher credit scores. The market for 
conventional loans also has been affected. Although mortgage rates on 
conventional loans have actually declined in recent months, as they 
have benefited from a ``flight to quality,'' the Federal Reserve 
reports that commercial banks have tightened lending standards for all 
mortgage borrowers.
    Mortgage delinquencies and foreclosures will be a problem for a 
number of years as interest rates on subprime ARMs that were originated 
in recent years are reset to higher market rates. Rates have already 
been reset for some of those ARMs, but an additional 1.8 million 
subprime mortgages will have their rates reset during 2008.\4\ Those 
resets, plus additional ones in later years (most of which will occur 
before the end of 2010), could eventually add about $40 billion to 
borrowers' annual payments.\5\ Although that amount is not large 
relative to total household after-tax income of $10 trillion, many 
households will be hard pressed to make the higher payments, and some 
will become delinquent on their mortgages.
              risks to the economy from the housing market
    The turbulence in the housing market reflects the correction of an 
unsustainable growth of house prices. Although a significant adjustment 
has already occurred, the current correction in the housing market 
could continue to affect the broader economy through several main 
channels:
     Reduced investment in residential housing;
     Less spending by consumers because of their reduced 
housing wealth; and
     Contagion in mortgage and financial markets.
    Those various channels through which the problems in mortgage 
markets could spread to the broader economy make the current situation 
particularly uncertain; the potential effects involving contagion, 
along with the effects of a decline in consumers' and businesses' 
confidence (to be discussed later), are especially difficult to 
evaluate because they depend in part on how financial market 
participants, consumers, and business executives perceive the 
situation.
    Residential Housing Investment. Investment in residential housing 
bolstered the economy every quarter from 2002 to the end of 2005, at 
times contributing up to 1 percentage point to the growth of real GDP. 
By the end of 2005, though, the combination of increased mortgage rates 
and high prices for houses had reduced the affordability of buying a 
house. Home sales and construction began to falter, and the 
appreciation in housing prices subsequently slowed. By the third 
quarter of 2007, housing construction activity was almost 25 percent 
lower than it had been in early 2006, and according to the S&P/Case-
Shiller national house price index, the national average of house 
prices was 5 percent lower than it had been at its peak. The direct 
effect of the fall in residential investment reduced annualized real 
growth of GDP in each of the past six quarters by about a percentage 
point.
    The severity of the problems in mortgage markets will exacerbate 
the decline in residential investment. A few months ago, before the 
extent of the troubles in the subprime market was recognized, housing 
analysts generally anticipated a rebound in housing construction during 
2008. Now, however, they assume that increased difficulty in arranging 
financing will cause housing sales and construction to fall much 
further, perhaps delaying the recovery in the housing market until 
2009.
    Housing Wealth. The major factors influencing consumer spending are 
household income and wealth. Greater income and wealth provide 
consumers with more buying power. The amounts that consumers spend out 
of their income and wealth vary over their lifetime and vary with the 
actual and expected pace of economic activity, with interest rates, and 
with opportunities to borrow, among other things. In recent years, 
homeowners have been able to easily make use of their housing wealth by 
using home equity loans and lines of credit and by taking cash out when 
refinancing their mortgages, for example. But lower house prices 
constrain the opportunity for such cash withdrawals. The withdrawal of 
housing equity (net of mortgage fees, points, and taxes) amounted to 
$644 billion in 2005, $662 billion in 2006, and $567 billion in the 
first half of 2007.\6\
    The outlook for home prices is highly uncertain, but it seems 
likely that house prices and, consequently, housing wealth will 
continue to fall next year. The inventory of unsold homes stands at 
high levels, which will place continued downward pressure on house 
prices in many regions of the country. Moreover, the ratio of housing 
prices to rents still seems very high relative to its history (Figure 
4). To be sure, homebuyers' expectations of home prices may deviate 
from long-term fundamentals for extended periods of time, and the 
price-rental ratio may therefore not provide a reliable guide to 
potential changes in prices over relatively short periods of time.\7\
    Futures markets expect significant further declines in house 
prices. One measure, which looks at a constant-quality index of home 
prices in 10 metropolitan areas, anticipates a decline in nominal 
prices of about 7 percent over the coming year (see Figure 5).\8\ 
However, the index may not indicate what is happening to prices 
nationwide. Another measure, from Radar Logic, Incorporated, a New 
York-based real estate and data analytics firm, with coverage of 25 
metropolitan areas but with a less sophisticated adjustment for changes 
in the quality of the homes sold, projects a decline of 11 percent over 
one year and 24 percent over the next three years. Those expectations 
may also not be a reliable guide, however, because those contracts do 
not trade frequently or in large numbers and therefore may not 
represent a broad consensus of investors.
    Private forecasters differ widely in their projections of the 
decline in house prices, although all agree that there is a substantial 
decline still to come. Macroeconomic Advisers projects a 6 percent 
decline over two years, while Global Insight projects a similar decline 
over the next year. Goldman Sachs projects a 15 percent total decline 
before an upturn occurs--perhaps as much as a 30 percent decline if a 
recession occurs.
    A significant amount of uncertainty exists about the extent to 
which spending changes when wealth changes (known as the marginal 
propensity to consume out of wealth). Estimates of that parameter range 
from 2 cents to 7 cents out of a dollar of wealth.\9\ So if the value 
of a home drops by $10,000, the owner might eventually reduce his or 
her annual spending by between $200 and $700, if nothing else changes. 
Some studies find that people adjust their spending more in response to 
changes in housing wealth than to changes in other forms of wealth, 
while other studies do not reach that conclusion.
    The combined effects of lower housing wealth and the reduction in 
home construction could together be enough to push the economy toward a 
recession. In order to evaluate the size of just the wealth effect, CBO 
examined two cases (at the low end and the high end of assumptions 
about the marginal propensity to consume out of housing wealth) of the 
potential effects of a substantial decline of 16 percent in nominal 
house prices over two years. At the low end, by the third year, real 
output would be about 1 percent lower, implying that growth would fall 
by about one-half of a percentage point per year. At the high end, 
those effects would more than double; that is, growth could drop by 
about 1\1/2\ percentage points per year, on average, just from the 
wealth effect (see Figure 6).\10\ If the economy would otherwise be 
growing at something like 2\1/2\ percent per year, a response by 
consumers at the high end combined with the drop in construction 
spending could be enough to reduce growth to close to zero.
       contagion from mortgage markets to other financial markets
    Concerns about future economic activity have been magnified by the 
possibility that the problems in the subprime mortgage market could 
continue to create further problems for banks and other institutions in 
the credit markets. The possibility of such contagion upset financial 
markets earlier this year, as the market's expectation of the potential 
magnitude of problems in the subprime market worsened. Markets were 
further roiled in July and August following the failure of several 
hedge funds that had invested heavily in subprime securities, the 
knowledge that some European banks were exposed to large losses from 
similar types of hedge funds, and the arrival of other news on the 
depth of the problems in mortgage markets. The third round of turmoil, 
in November, was triggered when quarterly financial reports of banks 
and other financial institutions revealed larger-than-expected losses 
derived from the subprime mortgage market that could threaten the 
supply of credit to businesses and households. Those developments have 
led to a repricing of risk in general, which has affected valuations of 
and interest rates on a wide variety of investments: Prices of risky 
assets fell, whereas prices of Treasury securities rose, widening the 
unusually narrow risk spreads that had existed.
    Interest rates have risen on various types of business borrowing. 
One indication of the lower tolerance for risk is the change in spreads 
between interest rates on corporate bonds and the rate on 10-year 
Treasury notes. To date, interest rates on riskier bonds (those with 
lower credit ratings) have increased substantially, while rates on less 
risky bonds have fallen (see Figure 7). Much of the recent change, 
though, simply brings the spreads on risky assets back to more normal 
levels. That is, investors appear to have been underpricing risk for 
some time, and the jump in spreads on the riskiest bonds in recent 
months brings their rates up to levels that are still fairly low 
relative to those in more serious episodes when investors' aversion to 
risk was heightened, such as during the fall of 1998, when the Long-
Term Capital Management hedge fund failed, and in late 2000, after the 
last peak in the stock market.
    Serious problems have persisted in the asset-backed segment of the 
commercial paper market.\11\ Asset-backed paper (which totaled $981 
billion in August) accounts for about half of the commercial paper 
market. Since the beginning of August, though, the amount of asset-
backed paper that is outstanding has fallen by about 30 percent (see 
Figure 8). Interest rates on asset-backed paper rose sharply during the 
turmoil in financial markets in August, when holders of those 
investments became concerned about the extent of their exposure to 
subprime mortgages (see Figure 9). The underlying collateral was 
difficult to value, in part because the market for trading subprime 
loans was never liquid to begin with.\12\ Although the spreads over 
Treasury rates have since declined, they remain substantial.
    The problems in the market for asset-backed commercial paper may 
force some firms to tap their lines of credit with banks, leaving less 
bank credit available for other borrowers. Moreover, some large banks 
are committed either explicitly or implicitly to providing varying 
levels of liquidity to entities known as structured investment vehicles 
(SIVs), which have invested in a variety of asset-backed securities 
such as subprime MBSs (see Box 3). Such entities, which are off the 
banks' balance sheets, allow the banks to earn extra income without 
correspondingly expanding their capital. Should SIVs be unable to 
continue to fund their holdings through the commercial paper market, 
the banks may need to provide the necessary liquidity. If SIVs' losses 
worsen, the sponsoring banks may decide to bring the assets--and 
losses--back onto their balance sheets, possibly impairing other 
lending activities. One European bank, HSBC, has already decided to do 
so: Its SIV-sponsored assets were marked down 30 percent. The losses 
will reduce its capital, which in turn will slow the growth of its 
lending to households and businesses.
    Although some banks may be distressed, most are well capitalized 
and should be able to absorb the losses. According to the most recent 
data available, as of September 30, 2007, the book value of equity 
capital for banks whose deposits were insured by the Federal Deposit 
Insurance Corporation (FDIC) totaled more than $1.3 trillion. In 
addition, the FDIC has indicated that of the 8,560 institutions 
covered, the vast majority (8,481) are well capitalized. Those well-
capitalized banks, furthermore, hold 99.8 percent of the industry's 
assets. Only nine institutions, holding a trivial percentage of the 
industry's assets, are undercapitalized. Another 70 institutions, 
holding 0.2 percent of assets, are considered adequately capitalized.
    Still, the large size of potential losses suggests that some banks, 
abroad as well as here, will absorb losses that could impair their 
lending.\13\ On the basis of current discounts on subprime MBSs, 
expected depreciation in home prices, and past experience with 
defaults, some private-sector analysts estimate that mortgage losses 
over several years could be $300 billion to $400 billion. Because those 
losses will also be shared globally by investors, including hedge 
funds, pension funds, and other investment funds, it is unlikely that 
the banking system as a whole will be imperiled.
    Credit losses have also affected the potential lending capacity of 
Fannie Mae and Freddie Mac. Their concentration in the prime mortgage 
market serves as an insulating factor, but they hold about $230 billion 
in subprime and Alt-A mortgages.\14\ Their credit losses have lowered 
their capital cushions to just about $3 billion, on top of the $73 
billion in capital currently required to safeguard $1.6 trillion of 
balance-sheet assets and $3.3 trillion of off-balance-sheet guarantees 
of mortgage-backed securities. That modest cushion leaves little 
capacity to absorb further losses. Consequently, Freddie Mac has 
announced that it will raise $6 billion in new capital and cut its 
dividend in half. However, even if the enterprises chose not to raise 
more capital, they could continue guaranteeing MBSs as long as they 
reduced their portfolios of mortgages, because the capital requirements 
for the mortgages held on their balance sheets are about five times 
higher than the requirements for their guarantees. Because the 
enterprises' guarantees with their implicit federal backing are the 
source of lower borrowing costs in the conforming mortgage market, any 
problems that they encounter are unlikely to affect that market but 
could affect their ability to buy more subprime and Alt-A mortgages.
                    the response of monetary policy
    As the extent of the turmoil in financial markets became clear in 
August, central banks in both the United States and elsewhere took 
action to maintain liquidity. Starting on August 10, the Federal 
Reserve injected $24 billion in temporary reserves into the U.S. 
banking system, a larger-than-usual amount, by accepting greater-than-
normal amounts of mortgage-backed securities as collateral (see Figure 
10). That action included a tacit temporary suspension of targeting the 
federal funds rate, as it was permitted to trade below the 5.25 percent 
target set on August 7. That approach continued until the Federal 
Reserve reduced the target to 4.75 percent on September 18. On August 
17, the Federal Reserve also reduced the discount rate from 6.25 
percent to 5.75 percent, and it extended the length of loans to 30 days 
and allowed borrowers to renew them.\15\ On October 31, the Federal 
Reserve again cut the target federal funds rate by another 25 basis 
points, to 4.5 percent (see Figure 11).
    The trouble in the U.S. subprime mortgage market also directly 
affected banks in other countries that had invested heavily in U.S. 
securities backed by subprime mortgages or were relying on short-term 
interbank financing (which became disrupted by the troubles in the 
mortgage markets) for longer-term loans. The European Central Bank 
(ECB), the Bank of Japan, the Bank of Canada, and the Bank of England 
all have injected substantial amounts of liquidity into their 
countries' financial markets to contain the credit crisis. For example, 
on August 9, the ECB provided an unprecedented amount equivalent to 
$129 billion, which the Bank of Japan followed the next day with $9 
billion. On September 6, the ECB injected $59 billion into temporary 
reserves. Even the Bank of England, which was reluctant to intervene 
earlier, announced on September 19 that it would inject $20 billion 
into money markets, in a bid to bring down short-term interest rates, 
which had risen after the Northern Rock bank experienced difficulties 
in refinancing. So far, those foreign central banks have not yet cut 
their interest rates, but they have held off planned increases.
    The resurgence of market jitters in November has prompted the 
central banks to take or announce new steps intended to calm the 
markets. For example, that month, the Bank of Canada provided to money 
markets funds totaling more than $3 billion to bring the overnight rate 
down to its target (4.5 percent). On November 26, the Federal Reserve 
announced that it would extend the length of loans to bond dealers to 
ease funding pressure on banks through the end of the year. On November 
29, the Bank of England announced that it would inject about $20 
billion to alleviate concerns about overly tight credit conditions. 
Earlier this month, the ECB also announced that it would inject $85 
billion in three-month loans on November 23, to be followed by another 
$85 billion on December 12.
                              oil markets
    Developments in oil markets could also affect the macroeconomic 
outlook, although their impact to date has been modest. In 2007, the 
price of crude oil increased by over 60 percent, reaching almost $100 a 
barrel in recent weeks, an inflation-adjusted level not seen since the 
1980s (see Figure 12). Supply and demand fundamentals account for much 
of the recent increase in crude oil prices, but geopolitical tensions 
and related increases in speculative and precautionary demand for oil 
have also exerted upward pressure on prices. The increase in crude oil 
prices has pushed higher the prices of petroleum products such as 
gasoline and heating oil.
    The Energy Information Administration (EIA) of the Department of 
Energy projects that world consumption of crude oil will have increased 
in 2007 by about 1.1 million barrels per day, to 85.8 million barrels 
per day.\16\ China, India, and nations in the Middle East together 
account for over 75 percent of the projected increase. Although the 
United States accounts for about 25 percent of global oil consumption, 
it accounts for much less of the recent increase: Only about 10 percent 
of the increase in 2007 is attributable to the United States.
    That increase in global demand comes against the backdrop of slow 
growth in world oil production. According to EIA's forecasts, total 
production will be about 200,000 barrels per day higher in 2007 than in 
2006. Total production by nations outside of the Organization of 
Petroleum Exporting Countries (OPEC) will increase, but that increase 
will have been almost completely offset by the organization's cuts in 
production in November 2006 and February 2007.\17\ Crude oil prices 
have declined in recent days to below $90 a barrel, on the basis of 
expectations of a near-term increase in OPEC's production, though the 
organization has yet to confirm such an increase. With such limited 
growth of supply, the increase in crude oil consumption is being drawn 
from privately held inventories. While tight markets result in elevated 
prices, lower inventories reduce the buffer against uncertainties about 
the supply and increase the potential for price volatility.
    Over the longer term, there is some concern that future supply may 
not be able to keep pace with increased demand and that prices could 
rise further. World consumption is expected to continue to grow, 
reflecting large growth in demand in China, India, the Middle East, and 
elsewhere. The International Energy Agency forecasts growth of world 
petroleum consumption of about 2 percent per annum in the years 
ahead.\18\ However, the supply may become increasingly limited as crude 
oil from existing reserves becomes harder and more expensive to access. 
In some areas, for example, the North Sea, Mexico, and Venezuela, 
production has been unresponsive to rising prices. But analysts differ 
on whether the market as a whole is constrained by a limited accessible 
supply or whether specific factors, such as political unrest in Nigeria 
or slow development of new central Asian oil fields, account for 
relatively flat production despite rising prices. Regardless of the 
underlying cause of a sluggish supply response, prices will increase if 
future increases in demand are not matched by a growing supply.
    Some analysts argue that the rise in the price of oil also reflects 
increases in speculative and precautionary demand for oil. For example, 
Middle East tensions could disrupt the supply and drive prices higher, 
and some of that risk is currently reflected in the market price. 
Similarly, some investors may conclude that holding crude oil is a 
better investment than other assets.
    Looking to the future, both EIA's price forecasts and futures 
prices available at the New York Mercantile Exchange (NYMEX) suggest 
that crude oil prices will decline from current levels next year, 
though prices are still projected to remain high relative to historical 
experience. In its most recent forecast, EIA estimates that the prices 
for West Texas Intermediate crude oil will be about 11 percent lower at 
the end of 2008 than at the beginning of that year.\19\ That projection 
is somewhat greater than current NYMEX futures prices; the current 
price for December 2008 is about $85 per barrel, or about 4 percent 
below the January 2008 prices.\20\
                                gasoline
    The price of gasoline has broadly reflected the rise in crude 
prices since the beginning of the year. As of late November 2007, the 
weekly average retail price for all grades of gasoline in the United 
States was about $3.15, or about 32 percent higher than it was at the 
beginning of January. (See Figure 13). However, short-term movements in 
gasoline prices did not necessarily reflect movements in crude oil 
prices throughout the year. As is typical, average gasoline prices 
peaked during the late spring in anticipation of increased summer 
driving. By late August, average prices for retail gasoline in the 
United States declined by nearly 15 percent from the spring peak even 
as crude oil prices had risen by about 10 percent.\21\ Since August, 
both crude oil prices and average retail prices for gasoline have 
increased.
                      heating oil and natural gas
    According to current data from EIA, average real prices for heating 
oil are about $3.30 a gallon, about 38 percent higher than they were a 
year earlier.\22\ In contrast, winter 2006-2007 heating oil prices were 
approximately unchanged from those of the previous winter. By EIA's 
projections, heating oil prices will decline in 2008 by about 8 
percent, approximately the same amount that the agency predicts for 
crude oil prices. However, the severity of the winter will be a key 
determinant of whether heating oil prices continue to increase over the 
next several months.
    Natural gas prices have fluctuated throughout the past year and 
currently stand at about $8 per million British thermal units, a level 
approximately consistent with prices a year earlier. EIA estimates that 
natural gas prices will grow by about 3 percent in 2008,\23\ while 
NYMEX futures indicate greater growth of about 11 percent.\24\
                         macroeconomic effects
    The historically high crude oil and related energy prices have had 
a limited impact on the U.S. economy to date. At the consumer level, 
individuals tend to be inflexible in their use of gasoline, at least in 
the short term. Estimates of the short-run elasticity of demand for 
gasoline suggest that a 10 percent increase in the price of gasoline 
will cause the consumption of gasoline to decline by 0.5 percent or 
less. According to CBO's research, higher gasoline prices have induced 
only a small change in driving patterns. Individuals are buying 
somewhat more fuel-efficient vehicles than in the past, and the share 
of sport utility vehicles has declined as the share of passenger cars 
has increased. But even if high prices persist, the full effect of that 
higher efficiency on gasoline demand will not be completely realized 
for many years because fully replacing the automobile fleet takes about 
15 years.
    The relatively modest effects on the economy from higher oil and 
related prices may seem puzzling to those who remember the substantial 
impact from the oil price shocks of the 1970s. At that time, however, 
monetary policymakers had been unable to control inflation in the years 
before energy prices rose, and many other aspects of the structure of 
the U.S. economy made it less able to respond to energy price shocks 
than it is today.\25\
                   the current account and the dollar
    The current-account balance has stabilized in recent years and real 
net exports have increased sharply since early last year, providing an 
important offset to the weakness of housing spending. But after 
increasing for many years, the nation's current-account deficit has 
become unsustainably large. Between 2000 and 2005, it grew from about 
$400 billion to about $800 billion. Since then, it has remained roughly 
constant, even though the cost of oil imports has risen sharply. 
Indeed, with oil excluded, the deficit has begun to decrease since 
2005. The stabilization of the current account reflects a slight 
increase in the real growth of exports and a sharper decrease in the 
real growth of imports. Thus far, the adjustment in the current account 
has occurred in an orderly way without major disruptions of exchange 
markets.
    Both strong growth abroad and depreciation of the dollar have 
played roles in stabilizing the current account. The economic growth of 
major U.S. trading partners has been stronger than expected so far this 
year, mainly because of the strength of emerging economies. The 
problems in the U.S. subprime mortgage market, though they have caused 
a credit squeeze in advanced economies, appear to have channeled 
capital to some emerging economies, especially those of Brazil and 
India, supporting their domestic growth and imports and adding to the 
growth of their asset prices and exchange rates. Economic growth in 
other countries, however, appears to have slowed since the summer, as 
industrial economies grapple with the problems in financial markets, 
the sharp rise in oil prices, and the appreciation of their currencies 
against the dollar.
    The dollar, which has been on a downtrend since early 2002, has 
dropped by more than 5 percent against the currencies of the country's 
major trading partners since midsummer. The recent more rapid decline 
probably largely reflects the consequences of the financial strains in 
the United States, through the following channels:
     The Federal Reserve cut interest rates more aggressively 
than most other central banks have, lowering the rate of return on U.S. 
short-term securities;
     Investors remained concerned about the dollar's status as 
the main reserve currency for central banks, and some countries are 
rebalancing their official portfolios and reducing the share of dollar 
assets; and
     Fear of a U.S. recession and uncertainty about the true 
scale of U.S. corporations' exposure to the fallout from the financial 
turmoil may also have reduced foreign demand for U.S. stocks and bonds.
    Eventually, such a large movement of exchange rates would be 
expected to have some impact on consumer prices, but little impact has 
been seen yet. Several studies have observed that the ``pass-through'' 
from exchange rates to U.S. prices has recently been smaller than it 
used to be, perhaps because foreign exporters have so far been able to 
absorb a large part of the dollar's depreciation without changing U.S. 
prices much.\26\ However, there is a limit to how much compression of 
profits those exporters can absorb, and eventually more of the decline 
in exchange rates is likely to be passed through to prices. That 
limit--whose position is unknown--is likely to be reached more quickly 
when exchange rates depreciate more rapidly.
                  consumption and consumer confidence
    Because consumption accounts for such a large share of overall 
economic activity, the economic outlook will be substantially affected 
by what happens to consumer spending. The turmoil in credit markets 
could affect consumption because consumer and mortgage loans may be 
more difficult to obtain, because the decline in house prices reduces 
consumer wealth, and because consumer confidence about future economic 
activity may be diminished. Moreover, continued weakness in stock 
markets also would work to reduce consumption spending somewhat.
    So far, there is little direct evidence of any significant slowing 
in consumption. Through the third quarter of this year, real personal 
consumption expenditures had not moved to a significantly lower trend 
growth path (see Figure 14). The first look at overall consumer 
spending in October, which came out last Friday, indicates weaker 
growth, but some of that weakness may reflect unseasonably warm 
temperatures that reduced heating needs and purchases of seasonal 
clothing and shoes. Despite the problem of delinquencies of subprime 
mortgage loans, delinquency rates on consumer loans at commercial banks 
have moved up only slightly in the past year and are not signaling 
major problems.
    The apparent resilience of consumption is somewhat less reassuring 
in light of some other factors. First, consumers' energy bills have 
risen significantly this year, by roughly $80 billion (at an annual 
rate) in the first half of the year, which may force consumers to cut 
back on other spending. Although energy costs fell by about $18 billion 
between June and September--just as the financial turmoil emerged--oil 
and gasoline prices have risen again since September. Second, the 
effect of weaker house prices and the lower stock market may not have 
yet filtered through to consumer spending. As house prices continue to 
decline, they may affect consumer spending because houses are the main 
source of collateral for loans (mortgages and home equity lines) to 
consumers. But such effects are likely to take some time to occur. 
Third, the Federal Reserve reports that commercial banks have tightened 
their lending standards and terms on consumer loans other than credit 
cards and on residential mortgage loans, including prime mortgages.
    Moreover, consumers' attitudes have deteriorated this year and 
suggest that a broader slowing of economic activity from its pace 
during the middle of this year may be in the offing. The consumer 
sentiment index, created by the University of Michigan, fell to 76.1 in 
November, its lowest level since the aftermath of the 2005 hurricanes 
(see Figure 15). Higher energy prices and continued weakness in the 
housing market continue to depress consumers' assessments of current 
conditions. The Conference Board's index of consumer confidence also 
has fallen sharply since the summer. Both of those entities' indexes of 
consumers' expectations also have fallen this year and are at levels 
that, if maintained, appear to be consistent with weak growth in 
consumer spending.
        the possibility of a recession and effects on the budget
    Recessions are notoriously hard to forecast, so it is not 
surprising that very few forecasters have a recession in their base 
forecast for the near future, though most have revised down their 
forecasts of growth since last summer (see Table 1). From the point of 
view of the budget, however, the effects of being in a mild recession 
may not differ very much from those of being in a period of slow 
growth.

         TABLE 1.--COMPARISON OF FORECASTS OF REAL GDP FOR 2008
          [Percentage change, fourth quarter to fourth quarter]
------------------------------------------------------------------------
                                         Current         As of Mid-2007
------------------------------------------------------------------------
Administration....................               2.7                3.1
Blue Chip.........................               2.4                2.9
Federal Reserve...................        1.8 to 2.5        2.5 to 2.75
Global Insight....................               1.9                2.9
Macroeconomic Advisers............               2.8                2.9
NABE..............................               2.6                3.1
------------------------------------------------------------------------
Sources: Council of Economic Advisers, Department of the Treasury, and
  Office of Management and Budget, ``Administration Economic Forecast''
  (joint press release, November 29, 2007, and June 6, 2007); Aspen
  Publishers, Inc., Blue Chip Economic Indicators (November 10, 2007,
  and July 10, 2007); Federal Reserve Board of Governors, Minutes of the
  Federal Open Market Committee (October 30-31, 2007), and Monetary
  Policy Report to the Congress (July 18, 2007); Global Insight, Inc.,
  U.S. Economic Outlook (November 2007 and July 2007); Macroeconomic
  Advisers, LLC, Economic Outlook (November 21, 2007, and July 10,
  2007); National Association for Business Economics (NABE), NABE
  Outlook (November 2007 and May 2007).Notes: GDP = gross domestic product.The Blue Chip consensus is the average of about 50 forecasts by private-
  sector economists. The forecast from the Federal Reserve is termed the
  central tendency, which reflects the most common views of the Federal
  Open Market Committee. The NABE Outlook is a survey of about 50
  professional forecasters.

    Forecasters currently face considerable uncertainty about what has 
already happened--not an unusual occurrence.\27\ In the third quarter 
of 2007, the most recent for which data are available, real growth of 
GDP was reported to have been 4.9 percent at an annual rate. However, a 
measure of total income in the economy--which apart from measurement 
errors should be the same as GDP--suggests much slower growth of 
slightly below 2 percent.
    In evaluating the possibility of a recession, forecasters must 
balance the negative aspects of the economy described above--the 
collapse of housing, the risk of contagion, and the likely weakness of 
consumption--against the better news from the rest of the economy. 
Among that better news is the improvement of the current-account 
balance and inflation that is still contained despite the increases in 
oil prices and the weakness of the dollar. Such news gives the Federal 
Reserve room to adjust interest rates.
    One way of thinking about the probability of a recession is to look 
at indicators that in the past have been correlated with recessions. 
The best single such indicator is an inverted yield curve--which occurs 
when a short-term interest rate (such as the rate for one-year Treasury 
bills) is above a long-term interest rate (such as the rate on 10-year 
notes). Such an inversion has preceded every recession in the past 50 
years and has given only one false signal (see Figure 16). The yield 
curve was inverted for much of last year and the first five months of 
this year It is not inverted now, but such an inversion has frequently 
ended before a recession starts.
    Another approach is to see what people are willing to put money on. 
Trading on the Intrade Web site, which allows investors to trade a 
derivative based on a recession in 2008, in September put the 
probability of a recession close to 60 percent. Since then, the 
probability dropped to 30 percent and is now a little below 50 percent, 
according to that market. That indicator is a very thinly traded 
contract, though, and therefore may not accurately reflect the broader 
views of investors.
    A third approach is to survey forecasters. The November Blue Chip 
survey asked participants about the probability of recession in 2008. 
While the consensus of the 10 most pessimistic forecasters thought that 
the probability was over 43 percent, the consensus of all responders 
put that probability at about 1 in 3 (up from 1 in 4 in August). No 
forecaster in the survey thought that a recession was the most likely 
outcome. Forecasters do agree, however, that the next year will see GDP 
growing considerably below its potential trend, and the next survey 
will probably reveal forecasts of lower projected growth.
    In January, CBO will release its comprehensive analysis of the 
current economic situation and the implications for the federal budget. 
Pending that full analysis, a look back at what past recessions have 
meant for the budget provides a rough guide to what might happen in the 
event of a recession in the coming year. Since 1968, recessions have 
worsened the annual budget balance--by CBO's rough estimate, by between 
about 1 percent and 3 percent of GDP from just before the cyclical peak 
to the second fiscal year following. In the current economy, a 
recession similar to those experienced over the past four decades might 
therefore increase the deficit by between $140 billion and $420 billion 
(see Table 2).

           TABLE 2.--BUDGET EFFECTS OF THE PAST SIX RECESSIONS
                 [Percentage of gross domestic product]
------------------------------------------------------------------------
                                                  Change in
  Period Before (Peak to Trough)   -------------------------------------
                                      Actual Deficit    Adjusted Deficit
------------------------------------------------------------------------
1969 to 1971......................              -2.5               -2.5
1973 to 1975......................              -2.3               -2.0
1979 to 1981......................              -1.0               -0.8
1981 to 1983......................              -3.5               -2.0
1990 to 1992......................              -0.8               -1.5
2000 to 2002......................              -4.0               -2.9
Average...........................              -2.3               -2.0
------------------------------------------------------------------------
Source: Congressional Budget Office.Notes: In this table, the period before the peak is the fiscal year
  preceding the onset of a recession, and the trough is either the
  fiscal year containing the last quarter in which the economy was in
  recession or the fiscal year following that last quarter.

    The deterioration in the budget deficit during periods of economic 
weakness provides a form of automatic stimulus to the economy. As the 
economy slows, the decline in income, payrolls, profits, and production 
causes tax receipts to fall relative to spending--and causes outlays, 
for unemployment compensation and food stamps, for instance, to rise. 
The combination temporarily boosts demand for goods and services, 
thereby helping to offset some of the macroeconomic weakness.\28\
    Fiscal policy interventions that go beyond those automatic 
stabilizers in attempting to boost the economy during periods of 
economic weakness have had a mixed track record. Although there have 
been examples of effective discretionary fiscal stimulus, in several 
other cases, attempts to stimulate demand through changes in fiscal 
policies have proved to be poorly timed or relatively ineffective. Part 
of the reason has to do with the time lag typically involved in 
enacting such legislative changes. Another involves the specific 
stimulus policies enacted in the past, as different types of changes in 
spending and tax policies can have substantially different effects on 
short-term macroeconomic demand.\29\ Policymakers considering whether 
to adopt measures beyond the budget's existing automatic stabilizers 
would need to carefully weigh not only the macroeconomic environment 
but also the lessons from past attempts at such economic stimulus.
    The adjusted deficit is calculated by removing from the actual 
deficit (1) all discretionary spending; (2) the effects of legislation 
on taxes and mandatory spending; and (3) all interest payments. In 
addition, the adjusted deficit has the impact of inflation attributable 
to progressivity (bracket creep) removed from individual income tax 
receipts (except for the last two recessions, because personal income 
tax brackets have been indexed for inflation since 1985). Finally, it 
includes the effect that the increase in the deficit has on debt 
service.
                                endnotes
    1. The federal funds rate is the rate at which banks make overnight 
loans to one another.
    2. Securitization is a process whereby mortgages are pooled and 
then their cash flows sold as securities (tranches) with different risk 
characteristics. Some of the risk tranches are designed to be 
relatively safe, and others can be quite risky; investors can choose 
according to their preferences and objectives.
    3. Certain ARMs may have been among the more difficult mortgages 
for first-time borrowers to understand. Many of those mortgages made in 
recent years included teaser rates, which may have confused some 
borrowers about the eventual size of their mortgage payments when their 
mortgage rates were reset. Most of those mortgages also included 
prepayment penalties.
    4. Statement of Ben S. Bernanke, The Economic Outlook, before the 
Joint Economic Committee (November 8, 2007).
    5. See Christopher L. Cagan, Mortgage Payment Reset: The Issue and 
the Impact (Santa Ana, Calif.: First American CoreLogic, March 19, 
2007).
    6. Defaults on mortgages might even have helped to support consumer 
spending at first. Such defaults mean a loss for investors (who tend to 
be relatively wealthy and may not have needed to adjust their 
consumption) but can be a gain for the people who default because they 
no longer need to make unaffordable mortgage payments and may be able 
to spend the money on other things.
    7. See Jonathan McCarthy and Richard W. Peach, ``Are Home Prices 
the Next 'Bubble'?'' Federal Reserve Bank of New York Economic Policy 
Review, vol. 10, no. 3 (December 2004), pp. 1-17.
    8. The S&P/Case-Shiller 10-City Composite Home Price Index tracks 
changes in the value of residential real estate in 10 metropolitan 
regions. Futures based on that index trade on the Chicago Mercantile 
Exchange.
    9. See Congressional Budget Office, Housing Wealth and Consumer 
Spending (January 2007).
    10. The Federal Reserve conducted similar experiments using its 
model and found smaller effects. See Frederic S. Mishkin, Housing and 
the Monetary Transmission Mechanism, Finance and Economics Discussion 
Series No. 2007-40 (Washington, D.C.: Federal Reserve Board, August 
2007). Both CBO's and the Federal Reserve's analyses assume that the 
Federal Reserve adjusts its target for the federal funds rate to offset 
some of the negative effects of the decline in house prices. In the 
Federal Reserve's simulation, the federal funds interest rate is more 
than 1\1/2\ percentage points lower by the end of the third year; in 
CBO's simulation, the rate is between one-half of a percentage point 
and 2 percentage points lower at the beginning of the third year.
    11. Asset-backed commercial paper is collateralized by receivables 
including MBSs, credit card loans, and student loans.
    12. Some of the financial contracts underlying that paper contain 
clauses that delay price discovery if the market for an underlying 
asset is too illiquid. Designed to prevent a ``fire sale'' of an 
individual asset, in the aggregate such mechanisms have partially 
contributed to the slow emergence of the losses sustained as a result 
of the turmoil in the subprime mortgage market. Generally, if an asset 
becomes subject to some triggering event, an agent solicits bids for 
the asset to discover the asset's current value. If the agent receives 
too few bids, the agent solicits bids at a later date. Although the 
subsequent valuation dates and the requisite number of bids are 
privately negotiated, such mechanisms may delay price discovery by 30 
days or more. That delay effect is compounded if the new-found values 
then cause triggering events for another set of contracts.
    13. Citigroup has been identified as having the largest exposure to 
losses arising from SIVs. In its third-quarter financial filings, 
Citigroup's total risk-based capital was 10.6 percent of assets, barely 
above the 10 percent level needed to be considered well capitalized 
under current law.
    14. Alt-A mortgages are higher rated than subprime mortgages but 
lower rated than prime mortgages.
    15. The discount rate is the rate at which banks can borrow from 
the Federal Reserve.
    16. Energy Information Administration, Short-Term Energy Outlook 
(November 2007), available at www.eia.doe.gov/emeu/steo/pub/
contents.html.
    17. OPEC nations are Algeria, Angola, Indonesia, Iran, Iraq, 
Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, 
and Venezuela.
    18. International Energy Agency, Medium-Term Oil Market Report 
(July 2006), p. 6, available at http://omrpublic.iea.org/currentissues/
MED--OMR06.pdf.
    19. Energy Information Agency, Short-Term Energy Outlook (November 
2007).
    20. New York Mercantile Exchange, Light Sweet Crude Oil, accessed 
December 3, 2007, available at www.nymex.com/lsco--fut--csf.aspx.
    21. Energy Information Agency, Weekly Heating Oil and Propane 
Prices, accessed December 3, 2007, available at http://
tonto.eia.doe.gov/dnav/pet/pet--pri--wfr--a--EPD2F--prs--cpgal--w.htm.
    22. Ibid.
    23. Energy Information Administration, Short-Term Energy Outlook 
(November 2007).
    24. New York Mercantile Exchange, Natural Gas, accessed December 3, 
2007, available at www.nymex.com/ng--fut--csf.aspx.
    25. See Congressional Budget Office, The Economic Effects of Recent 
Increases in Energy Prices (July 2006).
    26. See Mario Marazzi and others, Exchange Rate Pass-Through to 
U.S. Import Prices: Some New Evidence, International Finance Discussion 
Paper No. 833 (Washington, D.C.: Federal Reserve Board of Governors, 
April 2005), available at www.federalreserve.gov/pubs/ifdp/2005/833/
ifdp833.pdf. See also Mario Marazzi and Nathan Sheets, ``Declining 
Exchange Rate Pass-Through to U.S. Import Prices: The Potential Role of 
Global Factors,'' Journal of International Money and Finance, vol. 26, 
no. 6 (October 2007), pp. 924-947.
    27. See Dennis J. Fixler and Jeremy J. Nalewaik, News, Noise, and 
Estimates of the ``True'' Unobserved State of the Economy, Finance and 
Economics Discussion Series No. 2007-34 (Washington, D.C.: Federal 
Reserve Board of Governors, September 18, 2007).
    28. Economists have long noted that the tax system serves as an 
automatic stabilizer that offsets at least part of demand shocks to the 
economy. A decline in aggregate before-tax income of one dollar 
generates a decline in aggregate after-tax income of less than one 
dollar. As a result, the tax system helps to stabilize demand for goods 
and services, which in turn helps to reduce fluctuations in the overall 
economy. See Alan J. Auerbach and Daniel Feenberg, ``The Significance 
of Federal Taxes as Automatic Stabilizers,'' Journal of Economic 
Perspectives, vol. 14, no. 3 (Summer 2000), pp. 37-56; and Thomas J. 
Kniesner and James P. Ziliak, ``Tax Reform and Automatic 
Stabilization,'' American Economic Review, vol. 92, no. 3 (June 2002), 
pp. 590-612.
    29. See Congressional Budget Office, Economic Stimulus: Evaluating 
Proposed Changes in Tax Policy (January 2002).
             addendum.--cbo charts presented in the hearing

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]


    Chairman Spratt. Thank you, Dr. Orszag.
    And now Dr. Feldstein.

                 STATEMENT OF MARTIN FELDSTEIN

    Mr. Feldstein. Thank you very much, Mr. Chairman.
    I am very pleased to appear before this committee at this 
important time.
    Although I think we need to remember that the U.S. economy 
has great long-term strength, I am also worried about the near-
term outlook. In my testimony today and in an op-ed piece in 
today's Wall Street Journal, I suggest what the Congress can do 
to reduce the risk of a serious recession. I think the U.S. 
economy is now getting substantially weaker. There is likely to 
be virtually no increase in real GDP in the current fourth 
quarter. Virtually every economic indicator, including credit 
conditions, housing markets and consumer sentiment, has 
deteriorated significantly during the past month.
    I believe that the probability of a recession in 2008 has 
now reached 50 percent. If it occurs, it could be deeper and 
longer than the recessions of the recent past. As Peter Orszag 
has just noted, most analysts are forecasting that by the time 
we get to the middle of 2008, the U.S. economy will not be in 
recession but will be growing at a slow pace. And yet those 
same economists, when surveyed, say that they believe that the 
probability of a recession is, at least the last time I saw 
such a survey, somewhere in the 30 to 40 percent range. I find 
it hard to square these two sets of comments by professional 
forecasters; on the one hand, pretty high probability that we 
will have negative GDP growth and, at the same time, a belief 
that in some sense the most likely, or the average--they never 
make it clear what they mean by their forecast--growth will be 
around 2 percent.
    I think the probability of recession that is embodied in 
the views of these economists needs to be given more weight. I 
think the Federal Reserve should, and I believe it will, reduce 
the Fed funds rate next week at its meeting. And I think it 
should then continue cutting the Federal funds rate toward 3 
percent in 2008 unless there is a clear sign of an economic 
improvement. Today's 4.5 percent Federal funds rate is 
essentially neutral. It is not low enough to stimulate growth. 
And that is why it needs to be reduced and, if the economy 
weakens, needs to be reduced substantially. But I think because 
of the current credit market conditions that Peter Orszag has 
summarized, there is a risk that interest rate cuts will not be 
as effective in stimulating the economy as they were in the 
past. Nevertheless, rate cuts can still help by lowering the 
monthly payments on adjustable rate mortgages and thus freeing 
up spendable cash for households that have adjustable rate 
mortgages--that is about a third of all mortgages--by 
decreasing the cost of borrowed funds to households and 
businesses, and by making the dollar more competitive. So the 
Federal Reserve really does need to keep reducing interest 
rates.
    But let me turn now to the role that I think the Congress 
should play to reduce the risk of recession or to reduce its 
seriousness if a recession occurs. I believe that the lower 
interest rates should be supplemented by enacting a tax cut, 
enacting it now, but triggering it in 2008 if the economy 
deteriorates substantially. There are many possible forms of a 
tax cut stimulus. It could be a flat rebate per taxpayer, or it 
could be a percentage reduction in each taxpayer's liability. 
In some sense, that matters less than just the magnitude of the 
increased spending that can be generated in that way, household 
spending that can be generated in that way. And there are also 
a variety of possible triggering events.
    My judgment now is that the most suitable of these would be 
a 3-month decline in payroll employment. If the payroll 
employment number falls for 3 months, the tax cut would 
automatically occur. So this fiscal stimulus would be, in 
effect, like an automatic stabilizer. In order to be effective, 
the PAYGO rule would have to be set aside for this specific tax 
cut. It makes no sense to have a PAYGO rule that blocks short-
term fiscal stimulus, even though a PAYGO rule can be a useful 
thing for longer-term fiscal discipline.
    Enacting such a conditional stimulus would have two 
desirable effects. First, it would immediately boost confidence 
of households and businesses since they would know that a 
significant slowdown would be met immediately by a substantial 
fiscal stimulus. And second, if there is a decline of 
employment, and therefore of output and incomes, a fiscal 
stimulus would begin without the usual delays of the 
legislative process. In effect, as I said a moment ago, such a 
preenacted conditional fiscal stimulus would act as an 
automatic stabilizer in much the same way that the pay out of 
unemployment benefits does now. So a key advantage of a 
preenacted conditional tax cut is that it would eliminate the 
legislative lag that has made economists critical, correctly 
critical, of countercyclical fiscal policy in the past. It 
would also mean that the countercyclical fiscal action would 
respond to actual economic weakness rather than to potentially 
unreliable economic forecasts.
    Let me conclude with two further brief points. First, the 
case that I have just made for using fiscal as well as monetary 
policy when the economy weakens shouldn't be limited to just 
the current situation. I think we have learned something about 
the use of very low and sustained interest rates. Excessive 
asset price increases caused by past monetary expansions, 
especially the rise in real estate prices, provide a further 
reason to use fiscal as well as monetary policy. In other 
words, a fiscal stimulus can provide a more balanced expansion, 
not just pumping up house prices and construction. And my 
second and final point is a comment about the dollar. The 
falling dollar, that is a more competitive dollar, is a 
necessary part of reducing the massive U.S. trade deficit. I 
think we can look ahead and expect to see the dollar continuing 
to fall for quite a while in the future. Moreover, it is going 
to be an important source of demand and of growth in 2008 and 
2009.
    As Peter Orszag has already commented, the fall in the 
dollar that has occurred over the last 2 years has already 
shown itself to be an important source of economic demand. So a 
more competitive dollar should not be seen as a problem for the 
United States. Thank you, Mr. Chairman.
    [The prepared statement of Martin Feldstein follows:]

    Prepared Statement of Martin Feldstein, Professor of Economics,
                           Harvard University

    (1). The U. S. economy is now very weak and could get substantially 
weaker.
    There is likely to be virtually no increase in real GDP in the 
current quarter. Virtually every economic indicator--including credit 
conditions, housing, and consumer sentiment--has deteriorated 
significantly during the past month.
    I believe that the probability of a recession in 2008 has now 
reached 50 percent. If it occurs, it could be deeper and longer than 
the recessions of the recent past.
    (2) The Federal Reserve should reduce the fed funds rate at its 
December meeting and should continue cutting that rate toward three 
percent in 2008 unless there is a clear sign of an economic 
improvement.
    The current 4.5 percent federal funds rate is essentially neutral--
not low enough to stimulate growth.
    Because of current credit market conditions, there is a risk that 
interest rate cuts will not be as effective in stimulating the economy 
as they were in the past.
    But rate cuts can still help--lowering monthly payments on 
adjustable rate mortgages, decreasing the cost of borrowed funds, and 
making the dollar more competitive.
    (3) The lower interest rate should be supplemented by enacting a 
tax cut now that is triggered to take effect if the economy 
deteriorates substantially in 2008.
    There are many possible forms of stimulus, including a flat rebate 
per taxpayer or a percentage reduction in each taxpayer's liability.
    There are also a variety of possible triggering events. The most 
suitable of these would be a three month cumulative decline in payroll 
employment. The fiscal stimulus would automatically end when employment 
began to rise or when it reached its pre-downturn level.
    (4) Enacting such a conditional stimulus would have two desirable 
effects.
    First, it would immediately boost the confidence of households and 
businesses since they would know that a significant slowdown would be 
met immediately by a substantial fiscal stimulus.
    Second, if there is a decline of employment (and therefore of 
output and incomes), a fiscal stimulus would begin without the usual 
delays of the legislative process. In effect, such a pre-enacted 
conditional fiscal stimulus would be an automatic stabilizer in the 
same way that the payout of unemployment benefits is now.
    (5) The advantage of the pre-enacted conditional tax cut is that it 
would eliminate the legislative lag that has made economists critical 
of countercyclical fiscal policy.
    It would also make the countercyclical fiscal action respond to 
actual economic weakness rather than potentially unreliable economic 
forecasts.
    (6) The case for using fiscal as well as monetary policy when the 
economy weakens is not limited to the current situation.
    The excessive asset price increases caused by some past monetary 
expansions--especially the induced rise in the prices of real estate--
provide a further reason to use fiscal as well as monetary policy.
    (7) The falling dollar is not only a necessary part of reducing the 
massive U.S. trade deficit but will be a source of demand and growth in 
2008 and 2009.
    A more competitive dollar should not be seen as a problem for the 
United States.

    Chairman Spratt. Thank you very much, Dr. Feldstein.
    And now Dr. Bergsten.

                 STATEMENT OF C. FRED BERGSTEN

    Mr. Bergsten. Thank you very much, Mr. Chairman.
    It is a great pleasure to appear again before the 
committee. And as you have suggested, what I will do is add a 
couple of important global dimensions to this discussion of the 
U.S. outlook and what policy steps might be taken to improve 
the outlook. I want to give you a piece of good news and a 
piece of bad news just to verify my standing as a well-trained 
and good economist. The good news, and it is very good news, is 
that the world economy continues to expand robustly and 
provides an important buffer against significant reductions in 
U.S. growth. Global expansion this year in 2007 is running at 
about 5 percent for the fourth consecutive year. And despite 
all the risks and uncertainties, and even if we in the U.S. 
slow sharply, world growth is likely to approximate at least 4 
percent next year for the sixth consecutive year. This is in 
fact the most robust growth performance in the world economy in 
the entire post-World War II period; little bit beyond the 
previous record, which was in the late '60s and early '70s. So 
it is critical to keep in mind that our U.S. slowdown is 
occurring in the context of a world economy that continues to 
boom or very close to it.
    In essence, I am suggesting that the global economy has now 
in essence decoupled from the United States to a substantial 
extent. There has always been a kind of mantra that says, if 
the U.S. catches cold, the rest of the world will get 
pneumonia. Well, it is no longer true, as indicated by the 
continued buoyancy of the world economy even when we began to 
slow in 2006 and the early part of this year. In fact, I am 
going to suggest we may now be witnessing reverse coupling, 
where the U.S. is going to be held up, to some important 
extent, by the world instead of the world being dragged down by 
the United States.
    Now, a major reason for this critical structural change in 
the economic environment is the dramatic rise in the global 
economic role of emerging market nations, notably China and 
India, but lots of others. When you calculate exchange rates in 
the right way for this purpose, the emerging markets now 
account for fully half the world economy. And they are growing 
at rates of 6, 7, 8 percent, depending on which of the last 
several years you want to look at. So even if the U.S. and 
other industrial countries, Europe and Japan, drop to 2 percent 
or even less, that continued rapid growth in the rest of the 
world, which will slow a little but has enormous domestic 
momentum, will keep the world economy quite strong and help 
pull us up.
    Now, as Dr. Orszag, Dr. Feldstein have both already 
indicated, that robust global growth boosts the U.S. economy 
directly--and Mr. Chairman, you noted it in the numbers for the 
third quarter--by expanding demand for our exports. Exports in 
real terms, that means volume terms, have been growing at more 
than 8 percent for the last 4 years and at annual rates of 10 
to 20 percent over the last year, more than five times the pace 
of import increases. That is why our trade deficit in real 
terms has fallen substantially and added more than 1.25 
percentage points to overall economic growth during three of 
the last four quarters.
    What is really important to keep in mind, however, is the 
swing. Over the 10 years from the mid '90s until 2 years ago, 
the increase in our trade deficit was subtracting between half 
a percentage point and a full percentage point from U.S. growth 
every year. Now the reduction in the deficit is adding a like 
number, between half and a full percentage point a year, maybe 
more, to our growth rate. So we have gone from minus one to 
plus one, more or less. This is a swing of 2 percentage points 
per year in the U.S. growth picture emanating from our 
international position based on strong world growth and the 
more competitive dollar. Note that that swing of 2 percentage 
points in a positive direction offsets the downturn in the 
housing market. Now there are all sorts of statistical 
comparisons one can make in components of GDP, but if you want 
to think of it in those terms, you can think of the world boom 
and our improved competitive position as compensating for the 
turndown in the economy generated by the housing slump. And 
that is no mean element to keep in mind as you look at that 
picture.
    Now, as Peter and Marty have both indicated, the export 
boom is also being fueled by the sharp rise in our 
competitiveness stemming from a fall in the exchange rate of 
the dollar. The dollar has declined by a trade-weighted average 
of 20 to 25 percent over the last 5 years in quite a gradual 
and orderly way and with the usual lags, that is, in textbook 
fashion. And despite the nay sayers who said it wouldn't work 
in terms of improving the trade performance, the real trade 
deficit peaked 3 years ago. It has been coming down since.
    What we are experiencing, Mr. Chairman, and it is important 
for everybody to keep that in mind, is a reversal of the U.S. 
growth composition of the prior 10 years. From the mid '90s to 
about 2 years ago, we were experiencing very rapid growth in 
domestic demand, consumption, investment, including housing 
investment, which exceeded our ability to meet our own 
resources and to pay for it with domestic savings. So we ran a 
huge trade deficit and borrowed massive amounts from the world. 
Now that process, as I testified to this committee many times 
would inevitably have to happen, has gone in reverse. Domestic 
demand will now be growing more slowly than domestic potential, 
but we will get an output boost from the improvement in our 
trade position so that output growth will not suffer nearly as 
much as it would in the absence of that swing. This is a change 
in the composition of U.S. growth, which is likely to stay in 
place for a number of years. As I say, the external side will 
provide help. The bottom line from this point is that the 
strength of the world economy will cushion the intensity of the 
coming downturn here at home. A world recession is 
inconceivable given the sharp momentum of the past 5 years and 
the robust outlook in most of the emerging markets. And trade 
improvement is in fact the strongest likely counterweight to 
the slowdown in domestic economic demand that is looming over 
this coming period. That is the good news.
    The bad news, but it is only a risk, is that the continuing 
decline of the dollar, which as Marty indicated and I fully 
agree is a necessary and desirable part of this adjustment, 
however, like other things it could become too much of a good 
thing. It could accelerate into a free fall, which would add 
very significant complications to our prospects and to our 
proper policy responses. I won't take the time to outline--I do 
in my statement--why the dollar is likely to keep falling. Some 
of it is short term. Some of it is structural, having to do 
with the advent of the euro, which for the first time in a 
century provides a competitor to the dollar. For a century the 
dollar was the world's dominant currency for a simple reason: 
There was no competition. There was no other currency based on 
an economy anywhere near the size of the United States, based 
on financial markets anywhere near the size or resilience of 
those in the United States. Now there is. There is another game 
in town. There is a place where you can alternatively invest 
your money. There is a global structural portfolio 
diversification going on from dollars into euro as the euro 
moves up and inevitably alongside the U.S. as a key global 
currency. And that adds to the short-term interest rate 
differentials, current account imbalances in pushing the dollar 
exchange rate down. So far it has been gradual and orderly.
    The risk is that, with the Fed lowering interest rates 
more, with the downturn in U.S. growth, with the continued 
large trade deficit and this structural advent of the euro, the 
dollar could fall out of bed and create a free fall and a hard 
landing, which would be extremely adverse for our efforts to 
come out of the problem. Markets frequently overreact. And a 
sharp fall of the dollar could trigger sharp and sudden 
increases in U.S. inflation and interest rates, particularly if 
energy prices were going up further at the same time and the 
two would interact.
    In short, and we heard reference to that before from Mr. 
Ryan from a different standpoint, that combination would to 
some extent replicate what we experienced actually in the 
1970s, push the economy in the direction of stagflation and 
make it much more difficult to come out. At a minimum, such a 
scenario would limit the ability of the Fed to reduce interest 
rates to counter the slowdown. I agree with Dr. Feldstein, the 
Fed should reduce rates, 3 percent would be a good target, but 
it will be extremely difficult for them to do so if the dollar 
was to fall sharply, push up inflation pressure and interest 
rate pressures. Indeed, at some point, the Fed might even feel 
it had to raise interest rates to resist that scenario. And 
that then would foul things up. To me, that is the greatest 
risk to the modest slowdown prospect that I agree with the 
majority of economists is the most likely course, but a risk to 
be kept in mind.
    I would note that that scenario would add to the case for 
Dr. Feldstein's proposal for a conditional temporary tax cut. 
Because if there is increased inflation pressure that limits 
the flexibility of the Federal Reserve to reduce interest rates 
to respond through monetary policy, it adds to the case for 
doing so through fiscal policy. But the basic point, and it is 
not to say I told you so, but the basic point is the U.S. might 
have to pay dearly now in the teeth of a financial crisis and 
possible recession in an election year for living so far beyond 
its means for so long and thus becoming dependent for large in-
flows of capital from the rest of the world to finance our 
internal economy. There are steps the U.S. can take to minimize 
those risks, the most important for this committee and the 
Congress as a whole being to assure continued reductions in the 
structural budget deficit, with the goal of restoring the 
modest surpluses of the early part of this decade whenever 
economic growth gets back to trend levels.
    I would note that the pending AMT fix actually already goes 
in the opposite direction by reducing the revenue base on a 
lasting basis. I think that is a good change to make, but it 
has to be noted it moves against strengthening the budget 
position over time.
    So, in sum, I would actually modify Dr. Feldstein's 
proposal and make it symmetrical in light of the long-term 
fiscal problem. If he wants to return to fine-tuning fiscal 
policy, with which I have no quarrel in this case, and wants to 
put in place a temporary conditional tax cut if the economy 
weakens, I would say, fine, balance it with a predetermined 
conditional temporary tax increase when the economy returns to 
strong growth. And we need to strengthen the fiscal base by 
bringing the budget position into the kind of long-term, modest 
surplus that we need to make up for low private saving, avoid 
getting again into the thrall of foreign debt and running the 
risks that we face in coming out of this very difficult 
situation today. Thank you very much.
    [The prepared statement of C. Fred Bergsten follows:]

 Prepared Statement of C. Fred Bergsten, Director, Peterson Institute 
                      for International Economics

    The US economy faces significant risks over the coming period. 
Developments in the financial and housing markets raise the specter of 
a sharp turndown or even a recession. High energy prices and the 
falling dollar, in the context of nearly full employment, trigger 
concerns about inflation as well. The current course for US policy, 
including fiscal policy per the mandate of this Committee, is thus much 
more complicated than usual.
    My focus today will be on several aspects of the world economy, and 
the international economic position of the United States, that have an 
important bearing on these considerations. There is both good news and 
bad news on that front.
                         global economic growth
    The good news is that the world economy continues to expand 
robustly and thus provides an important buffer against significant 
cutbacks in US growth. Global expansion is running at about 5 per cent 
for the fourth consecutive year in 2007. Despite all the risks and 
uncertainties, and even if the US slows sharply, world growth is likely 
to approximate at least 4 per cent in 2008 for the sixth consecutive 
year.
    The global economy has now in essence decoupled from the United 
States. As late as the 1990s, it could be argued that the world 
depended on the United States--that ``the world caught pneumonia when 
the United States caught a cold.'' That is no longer true, however, as 
revealed by continued buoyant global expansion in 2006 despite the 
beginning of the US slowdown. In fact, my colleague Michael Mussa has 
correctly suggested that we are now witnessing ``reverse coupling'' in 
which the United States has become heavily dependant on developments in 
the rest of the world.
    A major reason for this phenomenon is the dramatic increase in the 
global economic role of emerging market nations, especially China and 
India but many others as well. With exchange rates calculated at 
purchasing power parity, which is appropriate for these purposes, the 
emerging markets now account for fully one half of the world economy. 
They are expanding at 6-7 per cent annually and will thus sustain 
worldwide activity at a brisk pace even if the United States and the 
other industrial countries fall to 2 per cent or less.
    This robust global growth boosts the US economy directly by 
expanding demand for our exports. Exports in real (volume) terms have 
in fact been growing at more than 8 per cent for the past four years 
and at annual rates of 10-20 per cent for the past year, more than five 
times the pace of import increases. Hence our trade deficit, in real 
terms, has fallen substantially and added more than \11/4\ percentage 
points to overall economic growth during three of the last four 
quarters. (In value terms, the external deficit has fallen by less 
because of the sharp rise in oil prices and in some other import prices 
due to the decline in the dollar.)
    This compares with the subtraction of 0.5 per cent annually from US 
growth over the past decade due to the steady climb in the trade 
imbalance. This swing, of 1-2 percentage points annually, is a major 
positive component of the US growth picture that is likely to prevail 
for some time.
    The US export boom is also being fueled by the sharp rise in US 
competitiveness stemming from the fall in the exchange rate of the 
dollar. The dollar has now declined by a trade-weighted average of 20-
25 per cent since its peak in early 2002, correcting an important part 
(thought not yet all) of the overvaluation generated by its rise of 
about 40 per cent from 1995 until that time. Currency changes translate 
into recorded trade flows with a lag of two to three years and, in 
textbook fashion, the real trade deficit peaked in 2004 and has been 
coming down since.
    I have testified to this Committee many times over the years that 
the large US external imbalances of recent years, and the overvalued 
dollar that helped produce them, were unsustainable and would have to 
come down. They would do so through a combination of a lower exchange 
rate and a slowdown in the growth of domestic demand (e.g., consumption 
and housing investment) coupled with improvement in our trade position. 
That is precisely the change in the composition of US growth that we 
are now experiencing and can expect to continue for at least a couple 
of years.
    The good news from all this for the short run is that the strength 
of the world economy is likely to cushion the intensity of the coming 
downturn here at home. A world recession is inconceivable given the 
sharp momentum of the past five years and the robust outlook in most of 
the emerging markets. A US recession is not impossible but would 
probably be quite shallow, as in 2001, rather than sharp and steep as 
in the more typical past US experience. Trade improvement is in fact 
the strongest likely counterweight to the slowdown in domestic economic 
activity that is looming over the coming quarters.
                           the external risks
    The bad news, however, is that the continuing decline of the dollar 
could accelerate and add significant complications to our economic 
prospects and proper policy responses to them. There are at least four 
reasons to expect the dollar to keep falling, perhaps by another 10-20 
per cent on a trade-weighted average, even without taking account of 
any broad collapse of market confidence in the US economy due to the 
subprime crisis and related developments:
     the current account deficit, though reduced, is still 
unsustainably high at more than 5 per cent of GDP;
     the US growth slowdown, relative to the rest of the world, 
reduces the appeal of investment in the United States;
     the associated reductions in short-term US interest rates 
also reduces the incentives for capital to move into dollar assets; and
     the creation and maturation of the euro provides, for the 
first time in almost a century, a real competitor to the dollar that is 
already triggering a structural portfolio adjustment into the world's 
second key currency.
    A further decline of the dollar, if gradual and orderly as has been 
the case since 2002, is a desirable and indeed necessary component of 
completing the adjustment of the unsustainable US and international 
imbalances. However, markets frequently overreact and a free fall of 
the dollar could trigger sharp and sudden increases in US inflation and 
thus interest rates (especially if energy prices were to rise further 
at the same time). This would push the economy in the direction of the 
stagflation of the 1970s (albeit presumably with less intensity on 
either the ``stag'' or ``flation'' sides of the equation that occurred 
at that time).
    Such a scenario could, at a minimum, limit the ability of the 
Federal Reserve to reduce interest rates to counter the economic 
slowdown (and provide additional liquidity to the financial markets). 
It might even force the Fed to raise rates to halt the currency 
depreciation. I believe this is in fact the greatest risk to the 
``modest slowdown'' prospect posited above as the most likely course 
for the US economy over the next year or so.
    Hence the United States might have to pay dearly now, in the teeth 
of a financial crisis and possible recession (in an election year), for 
living so far beyond its means for so long and thus becoming dependent 
on large continuing inflows of capital from the rest of the world. 
There are of course steps that the United States can take to minimize 
these risks. For this Committee and the Congress as a whole, the most 
important is by assuring continued reductions in the structural budget 
deficit with the goal of restoring the modest surpluses of 1998-2001 
when economic growth returns to trend levels of 2\1/2\-3 per cent. This 
is the only way to assure that the United States will continue to 
benefit from global economic developments as it seeks to cope with the 
domestic difficulties that loom so importantly now and will inevitably 
arise from time to time in the future as well.

    Chairman Spratt. Thank you very much. And Dr. Feldstein, we 
just started a bidding process here. Can you buy the other half 
of the solution?
    Mr. Feldstein. I think it is a lot harder to buy. I think 
the idea that we are having a surge of economic activity and 
therefore want to raise taxes temporarily would be a dangerous 
thing. That really would be a kind of fine-tuning. After a 
recession, economies generally bounce back at a pretty fast 
clip. And it would be a mistake I think to try to offset that 
bounce back. So what I proposed is that the temporary fiscal 
stimulus be turned off once we get back to the predownturn 
level of employment, but not that we try to stop the strong 
recovery that usually comes after a recession.
    Chairman Spratt. Well, we have a problem around here that 
some say, when you don't renew an expiring tax cut, that is 
tantamount to increasing taxes. So we would be subject to the 
same charge that by not providing for the continuation of 
whatever tax relief we----
    Mr. Feldstein. But I think this should really be seen as a 
countercyclical tax change. It is not part of a broad 
structural incentive program for the long term.
    Chairman Spratt. Let me pursue that with you. If a problem, 
at least at its core, is structurally the fallout in the 
residential credit markets, if it started there and its 
ramifications run from there, if the problem is structural, 
shouldn't the solution be structural, targeted to the very 
problem itself, since we can identify the problem, as opposed 
to having a countercyclical response that is scattered over a 
whole----
    Mr. Feldstein. Well, I don't the think we can go back and 
undo all the mistakes that were made that created the subprime 
losses or that caused the financial institutions to take on 
their books assets whose values they can't now calculate and 
therefore are afraid to transact in. So I think that what we 
can do, what the Congress can do, what the Fed can do is to 
avoid the adverse consequences for the economy as a whole. And 
that is why the Fed lowers interest rates, and that is why I 
think a fiscal stimulus coming from the Congress would be a 
good thing.
    Chairman Spratt. Secretary Paulson is proposing now an 
industry-wide agreement to freeze rates at the introductory 
level for those who are at least not already in default at that 
level. And what he is trying to do is a heck of a balancing 
act, because he does not propose to spend any money to bail out 
the borrowers or to bail out the lenders, just get them to 
agree to somehow absorb the impact of freezing things in place. 
If that doesn't work, wouldn't it be wise, if we are going to 
have some stimulus to get the economy going at a faster pace 
that addresses that problem by maybe using some money to get--
to spare us from a raft of foreclosures?
    Mr. Feldstein. It is really very hard to undo the mortgage 
problems because these mortgages are no longer held by the 
originators. So a mortgage starts with a mortgage company, but 
that mortgage then gets sliced up in various ways, put into 
collateralized debt obligations, held around the world. As 
Peter Orszag's chart showed, you talk about the triple B 
tranche of those, that is not a bunch of mortgages; that is 
conditional claims on mortgages. So it is very hard to see how 
you compensate people for this idea of stopping the contractual 
changes in interest rates. It is hard to see through what that 
does to the individual pieces of that. Legally, no doubt, it 
would be possible to order that to happen. But I think it would 
have very bad long-run effects on the willingness of investors 
around the world to buy assets created in the United States if 
the Treasury could come along and say, no, we are going to stop 
the interest rate payments on those loans, or we are going to 
roll them back, or we are going to not let them go up. If I 
were an investor in a pool of mortgages, I would like to 
believe that whatever the contract said was going to be 
fulfilled.
    Chairman Spratt. But if that is the risk that there will be 
an adverse reaction to the effect of we asking them to forego 
contracted interest rate increases, shouldn't we be addressing 
that particular problem with a structural solution to that 
particular problem as opposed to a possible countercyclical 
solution, particularly since that might be the precipitant that 
says to the international market, hey, what if the United 
States does this with other dollar denominated assets at some 
other point in the economy?
    Mr. Feldstein. I don't see how you do it. That is to say, I 
don't think that the proposal that started with the FDIC and 
that the Treasury seems to be supporting this roll back or 
freeze as a viable option because of its adverse effects on 
long-term acceptability of U.S. borrowing. I don't mean 
government borrowing; I mean private borrowing. So I don't see 
how one--you could provide relief to the individuals who would 
otherwise have their mortgages foreclosed. Congress could spend 
money doing that. But people are pretty clever, and they would 
quickly find ways to stop paying their mortgage payments in 
order to line up and get a check from the U.S. Government. So I 
think the incentive effects of that are all wrong.
    Chairman Spratt. Dr. Orszag, do you have a response to 
this? Particularly in light of the fact that we would have to 
lower some of the budget disciplines that we have put in place 
that have worked pretty well for us, like PAYGO, in order to 
allow this trigger to be a net impact on the economy? Does that 
give you a problem, or do you have other problems with his 
proposed solution? We have got a $13 trillion economy. How 
large does the stimulus have to be to get the economy chugging 
back at a more normal rate of growth?
    Mr. Orszag. Let me answer the question in the following 
way. I already mentioned that the budget does have a set of 
automatic stabilizers. And those automatic stabilizers mean 
that when the economy weakens by a dollar, roughly 33 cents of 
additional deficit results from that. So there is some sort of 
offsetting impact that is already automatically baked in. The 
history of moving beyond that is, as I mentioned, mixed in 
large part because of timing lags and then also the specific 
interventions that were adopted.
    Professor Feldstein's proposal would address the timing lag 
issue but at the cost of having a specific trigger. And that 
then makes the proposal very sensitive to the details of that 
specific trigger. And in addition, it is worth noting, given 
the specific trigger that he chose, employment is not a leading 
indicator of a recession; it is at best a contemporaneous or 
maybe even a lagging indicator. So if you think of--if you are 
expecting that the fire truck will already be on the scene when 
the fire starts, that is not going to be the case. Maybe, at 
best, it will be sort of on its way as opposed to arriving 
after the rebuilding has already started, which has 
unfortunately been the case in some past episodes.
    So it is important to sort of calibrate expectations, and 
then, obviously, also the form of the intervention also 
matters. All of that having been said, I want to return to one 
of the questions that you posed in your opening remarks. During 
a period of economic weakness, there is attention between what 
is good in the short run and what is good in the long run. In a 
period of economic weakness, the key thing that is constraining 
economic activity is the demand for goods and services that 
firms could produce with existing capacity. And in order to 
boost that demand, you need additional spending power, 
basically, and tax cuts, or increased spending help to provide 
that. Over the long term, however, the key constraint on 
economic activity is that underlying capacity of firms to 
produce goods and services. And there you need higher national 
saving in order to be increasing the capacity at a higher rate. 
So during periods of economic weakness, what is good in the 
short run is exactly the opposite of what is good in the long 
run. And that creates a very difficult policy--set of policy 
trade-offs for all of you.
    Chairman Spratt. Dr. Bergsten, one last question. Do you 
think that policy like this would have an impact on the dollar 
and particularly on whether or not there might be a run on the 
dollar?
    Mr. Bergsten. I think it is hard to tell, Mr. Chairman. 
There would be crosscutting currents. On the one hand, when the 
U.S. has had sizable fiscal stimuli in the past, I am thinking 
back, particularly to the Reagan tax cuts in the 1980s and with 
some lag the Bush tax cuts more recently, the flip side was 
higher, and considerably higher, interest rates, which drew in 
a lot of foreign capital and actually strengthened the dollar. 
Now, that was a short run phenomenon. And as Dr. Orszag just 
said, it undermined our long-term position. But in the short 
term, it actually shored up the dollar.
    On the other hand, if at the current time we were both 
cutting interest rates, as the Fed obviously would like to do, 
and now came along with fiscal stimulus at the same time, I 
think there would be a risk of triggering international 
concerns and domestic concerns that inflation would again rear 
its ugly head. And that would be the kiss of death for the 
dollar. Keep in mind in all this discussion going forward about 
the weakening of the economy, correct as it is, remember that 
in his backward look at the start, Dr. Orszag pointed out, we 
are an economy that is still very close to full employment. 
There is not a lot of slack in the economy. So whatever 
stimulus one puts in, you better be correct that there is going 
to be an autonomous easing of demand pressures from autonomous 
sources or else you are going to pump up the economy much too 
sharply. And that could be, as I say, the kiss of death 
internationally. That could trigger a free fall in the dollar.
    Chairman Spratt. Thank you. Mr. Ryan.
    Mr. Ryan. Thank you, Chairman.
    There are just three areas I want to get into, the fiscal 
policy prescriptions you gentlemen have made, the subprime and 
then some monetary questions. I will try to do this quickly. 
Both Dr. Bergsten and Dr. Feldstein are suggesting a 
precondition, some kind of precondition tax cut to send signals 
to the market, it seems, that help is on its way and that we 
are going to prevent this sluggish downturn or a recession. I 
would suggest that we have something right in front of us, 
which is an enormous tax increase scheduled to occur in law 
already. And add insult to that, from an economic perspective, 
we have a proposal by the chairman of our Ways and Means 
Committee to replace the AMT with an even higher tax rate on 
small businesses, which is where, you know, 75 percent of our 
jobs come from, which would raise the top rate on small 
businesses to 44.2 percent. So not only do we have tax 
uncertainty on the horizon, cap gains goes up, dividends goes 
up, marginal rates go up across the board, child tax credit, 
marriage penalty all coming in in 2011, providing this 
uncertainty, hampering this investment, we have a new proposal 
that says, let us go even farther than that with even higher 
tax rates on sub S corporations, small businesses and the like.
    So let me start with you, Dr. Feldstein. Wouldn't it be a 
good fiscal policy to, even before we get to talking about a 
tax cut, prevent the largest tax increase in history from 
occurring in the first place and giving investors and the 
markets and families certainty that their tax burden is not 
going to dramatically escalate?
    Mr. Feldstein. I would like to think that that will happen. 
I think that those----
    Mr. Ryan. This could happen, and then what would be the 
result?
    Mr. Feldstein. The result of those sharp increases in 
taxes, as they begin to be more concrete in the minds of 
individuals and businesses would be adverse both in the short-
term sense that Peter Orszag spoke of--that is, it would cause 
them to cut back on expansion plans for their businesses, 
investment decisions, hiring decisions because they would see 
themselves facing much higher tax rates. The individuals would 
see that their net incomes going forward would fall and so they 
would cut back on spending plans. So all of that would be a 
serious damper on the economy. I think it has not yet gotten 
salient enough in the thinking of the--those taxpayers for it 
to have had that effect. But as we get closer to that date, I 
think that would have a very serious effect.
    Mr. Ryan. Do you think it is becoming salient in the 
capital markets?
    Mr. Feldstein. I don't really know. I mean, it--the 
reduction in capital gains tax rates, I think--and the 
reduction in the tax on dividends I think both helped the 
capital markets, both lowered the cost of equity capital. I 
don't see that reversing at this stage. I think if they knew 
for sure that we were going to go back to the kinds of tax 
rates we had on capital gains and on dividends, that would be a 
serious blow to equity markets. I don't think that has happened 
yet. I think that the decline in the equity market that we have 
seen makes it very hard to know how to unravel any of these 
things. I think the decline we have seen in the equity market 
has been more a reaction to--short-term economic conditions 
than to the overhang of this potential very large tax increase 
on equity income.
    Mr. Ryan. Peter, I don't know if you want to get into that 
or not. I understand if you don't feel comfortable answering 
that. Let me ask you a more CBO side to that question. If we 
are heading into the sluggish growth and the lowering of GDP 
does expose our deficit, increases our deficit, would it not be 
a good idea to add $23 billion in higher discretionary spending 
this year, which when you put it into the baseline translates 
into $204 billion over the next 5 years? Would it not be a 
prudent fiscal path seeing sluggish growth at best coming which 
will increase the deficit not to build more spending into the 
baseline which will actually increase the deficit? That is 
really the one thing we know we can control. We can't control 
GDP, but we can control discretionary spending on a year-by-
year basis. So If our goal is to lower or keep low the deficit, 
wouldn't it be wise not to add $23 billion on top of the 954 
that we are doing right now which translates into $204 billion 
in spending over the 5 years?
    Mr. Orszag. I think the real question is what the goal is. 
If the goal is to offset short-term economic weakness as 
Professor Feldstein and others have noted, that could be 
accomplished both through tax relief and through additional 
spending. Additional spending does boost demand for goods and 
services.
    Mr. Ryan. Do you believe spending increases are just as 
effective an economic tool to boost growth as tax cuts are?
    Mr. Orszag. I think we need to separate the short term and 
the long term. Again, coming back to the period of economic 
weakness in the short term, certain types of spending that 
especially involve transfer payments--so, for example, food 
stamps are an example, do boost demand for goods and services 
pretty quickly and pretty effectively in the short run. There 
is a different question about the long run. And there as CBO 
has said in the past, higher levels of government spending, 
especially if they are not financed--in other words, if they 
are deficit financed do constrain economic activity. We are in 
one of these periods where the short run and the long run can 
be a lot different in terms of sort of what works.
    Mr. Ryan. Dr. Bergsten, if you don't care to comment, I 
understand. Let me ask you about the subprime.
    Peter, you brought a number of charts and Marty--I am 
sorry--Dr. Feldstein, we know each other, so I get too casual 
sometimes. Your op-ed in the Washington Journal today, you 
talked about the various ideas that are out there. Isn't it 
true that the worst vintage of loans have yet to come? Isn't it 
true that the worst vintage are kind of coming into the cycle 
in 2008? So we are going to see the worst paper coming through 
the system; the ARMs are snapping more in 2008 than they did in 
2007. So there is going to be tremendous pressure put upon 
Congress to do something about it. But as we look at doing 
that, you say don't raise the Fannie-Freddie limit, you say 
don't freeze--take the FDIC suggestion and lock in mortgage 
rates. We know your position. And if you care to comment more, 
I would appreciate it.
    But I want to ask Dr. Bergsten and Dr. Orszag, Peter, if 
you could just take your CBO hat off and put on your economic 
hat, doesn't the phrase moral hazard scream out with these kind 
of proposals? Aren't we inviting future disaster in our bond 
markets, in our mortgage markets, in the confidence of our 
paper? And shouldn't investors who took risks bear the down 
side of those risks? And if we do try to incorporate some kind 
of a federally financed taxpayer-paid-for bailout package, 
aren't we inevitably going to end up bailing out people who 
don't deserve it, who made bad decisions and use the taxpayer 
dollars from people who made good decisions to do that? And 
isn't this one of those cases where you--it is a clear short-
run trade-off for long-term losses?
    Mr. Orszag. Maybe I could talk about, just for a second, 
about the broad outlines of the Treasury proposal, which does 
not involve Federal money.
    Mr. Ryan. I realize that.
    Mr. Orszag. And it is important to realize that all the 
details of that proposal have not yet been specified. But in 
addition to the risks that Professor Feldstein has already 
identified in terms of whether going down that path will impede 
the reestablishment of normal credit conditions in particular, 
there is also a question about the details of how homeowners 
are--the borrowers, the mortgage borrowers, will be sorted into 
different categories, and those can be quite complicated. On 
the other hand, it is--I had to do that. On the other hand, it 
is the case that individual level negotiations between 
borrowers and other entities can be administratively 
complicated, and having some sort of structural system can help 
from an administrative perspective. Another thing is that some 
investors belief there is a collective action problem; that is, 
that it is difficult for them to renegotiate the terms of these 
mortgages on a sufficient scale to address a broadbased problem 
and that they would all be better off if the problem were 
addressed on a broad scale.
    Mr. Ryan. Let me ask it more clearly. Facilitating 
communications between the market is a fine thing, and I don't 
think there is a moral hazard involved in getting people at a 
table to talk to one another. But raising Fannie and Freddie 
loan limit and freezing rates, is that not a problem?
    Mr. Orszag. There is a moral hazard problem when you step 
in and renegotiate contracts that have already been adopted, 
and that hazard or that risk has to be weighed against the 
potential benefits.
    Mr. Ryan. If you were advising us to raise the Freddie and 
Fannie loan limit, what would you say, whether to do it or not?
    Mr. Orszag. I am not allowed to make policy 
recommendations.
    Mr. Ryan. I tried.
    Dr. Bergsten, if you have any interest in answering.
    Mr. Bergsten. I think raising the loan limits on Fannie and 
Freddie would be okay. I wouldn't put that in the moral hazard 
category.
    I do think the freezing of loan rates is a big problem. I 
happen to think the subprime lending market was a good 
innovation. I would like to see it continue in the future. It 
gets housing to a lot of people who otherwise wouldn't have 
gotten it.
    Mr. Ryan. So better underlining guidelines.
    Mr. Bergsten. Well, it obviously overshot. It went too far. 
It needs to be better regulated. But I want to see that market 
continue. I'm afraid that if you now ask lenders or more 
extremely force the lenders to freeze those rates, they won't 
make those loans again in the future, and it does raise the 
broader problem that the chairman raised of whether or not the 
same reaction might be sought from lenders in other categories, 
and that would have very broad implications for our financial 
markets.
    Mr. Ryan. Yes, Dr. Feldstein.
    Mr. Feldstein. As you said, as this thing gets worse, there 
will be pressure to, quote, do something. There was a recent 
study that the new President of the Federal Reserve bank of 
Boston spoke about. I haven't read the study. I just received 
it. But I think if it is worth careful examination because what 
he claims is that a very large fraction, about half of the 
people with subprime loans, are in a position to shift away 
from subprime loans back into loans with lower rates. So there 
may be a lot of self-help that is possible out there, and it 
may be that there is a role to guide people in that as opposed 
to forcing the lenders to undo their contractual rights.
    Mr. Ryan. One last--both you and Dr. Bergsten suggested 
moving the Fed funds rate to 3 would be a good idea. That means 
we would have to see anywhere from three to six more rate cuts 
from the Fed given the way they typically do rate cuts in 25 
and 50 basis point cuts. Dr. Feldstein, if I recall, you were 
the chairman of the CEA in the Reagan administration when we 
were fighting back inflation. Don't you think we are in this 
position where the trade-off of sluggish growth in the short 
run versus inflation in the long run, which would be very 
difficult to deal with, is at that tipping point where we are 
going to get to that point where inflation is the bigger cost, 
the bigger problem, versus this possible sluggish growth we are 
going to have? Don't you think we are getting close to that? If 
we do six cuts, you don't think----
    Mr. Feldstein. What I said about the 3 percent was I think 
they should be moving in that direction unless the economy 
improves. So I am not saying that they should put themselves on 
automatic pilot to go down to 3 percent. But if the economy is 
continuing to weaken over the next 12 months, I think that is a 
reasonable thing to do.
    And, of course, the inflation situation now is dramatically 
different from what it was when President Reagan came to 
office. At that time, we were looking at double digit 
inflation. People had no confidence in the Fed. They had no 
confidence in the government with respect to inflation. There 
was a fear that inflation would spiral out of control as it was 
in Latin America and even in some of our European allies.
    Now there is a very different attitude and of course much, 
much lower actual inflation rates. So I think that the 
seriousness of the risk of the damage associated with a 
recession is greater than the risk associated with increasing 
inflation. But having said that, I think one of the advantages 
of using a fiscal policy is you don't bump up the money supply. 
You don't build in that longer-term inflation price level risk.
    Mr. Bergsten. Just two comments on that. I am somewhat 
surprised that we are all assuming without yet any hard 
evidence of a really sharp turn down in the economy and maybe 
even a recession. We are coming off very strong growth. The 
economy is still very close to full employment. Yes, there are 
all these worrisome signs that we talked about, but we haven't 
yet seen the turn down. We have been surprised on the upside 
for several years. I pointed to the strength of the world 
economy as helping to hold us up. So I would be a little less 
certain that there is going to be this huge falling off a cliff 
that we have to offset on a contingency basis.
    On the other side, I agree with Marty's analysis of the 
differences of today from the early 1980s in terms of 
inflation. But there are the two big risks that I mentioned. We 
are one or two untoward supply side events away from an oil 
price at $120 or $150. We could easily see the dollar falling 
very sharply with a rapid pass through to inflationary price 
increases in this country. Those were the factors, in fact, 
which created the stagflation of the 1970s. That was the story, 
an interaction between subsequent sharp rises in world oil 
prices and periodic declines of the dollar. There were three or 
four episodes of each. They reenforced each other. I could 
trace that analytically if you want. But the worst thing would 
be to subject ourselves to that cycle for the reason you 
indicated. So I would put a little less certitude on the sharp 
fall off the cliff of the real economy; a little more weight as 
you were doing, Mr. Ryan, on the risks to the inflation side as 
I came to my policy judgment in trading off short run, long 
run.
    Mr. Feldstein. The advantage of a conditional tax cut, 
enacting it but triggered only if the economy does turn down is 
that you don't have to make the judgment today about whether 
the economy is, as Fred said, going to fall off a cliff. You 
can wait and see where we are when the economy moves into 2008. 
But having said that, we don't want to be fooled by the fact 
that we had 5 percent growth in the third quarter. The fourth 
quarter is likely to come out at essentially zero, and that 
will feel to a lot of people like falling off a cliff.
    Mr. Bergsten. If I could put a quick question to my friend 
and fellow panelist here, Marty. In your conditional criterion 
for implementing the tax cut, you have no inflation variable. 
So your method, if endorsed by the Congress as you propose it, 
would go into effect even if inflation was shooting up. Surely 
that is not what you intended.
    Mr. Feldstein. I think the chance of inflation shooting up 
at a time when the economy is slipping into recession is very 
low.
    Mr. Orszag. Very quickly. I just want to again put a caveat 
that a trigger might look very attractive, but the details of 
the trigger matter a lot, and the specific proposal that Mr. 
Feldstein has put forward involving 3 months of consecutive 
declines in employment can send false signals. For example, in 
2003, there was a 7-month decline in employment during a period 
in which the economy was not technically in recession. So one 
needs to trade-off the fact that it is not exactly always 
geared to one's definition of what a recession is. The counter 
argument to that might be, well, if employment is falling that 
much even if we are not in recession, you might be concerned 
anyway.
    Chairman Spratt. Mr. Edwards.
    Mr. Edwards. Thank you, Mr. Chairman. I think there is a 
clear difference of opinion between Democrats and Republicans 
today. Democrats believe tax cuts should be paid for. My 
Republican colleagues in general seem to think they should not 
be. My concern about my Republican colleagues' approach in some 
cases is that it is a feel-good philosophy. In good times, they 
support tax cuts because it is your money; you deserve it back. 
So we get rid of the surpluses that are supposed to be a 
cushioning of the fall when we have recessions.
    Then when we get on the verge of recessions, they say, 
well, we have got to cut taxes to help us get out of the 
recession. The problem with that fuzzy math is it is not fuzzy. 
It is very clear what the result has been, and that is the 
creation of the largest national debt and deficits in our 
history.
    Dr. Orszag, I just want to get on the record some answers 
to questions without getting you in the middle of a 
philosophical debate. And there is an honest difference, and I 
respect that, between Republicans and Democrats. I just want to 
get some facts on the table in light of the discussion we have 
had here. Did the United States Federal government hit a $9 
trillion national debt in the last 2 or 3 weeks for the first 
time in our Nation's history?
    Mr. Orszag. If you measure by gross Federal debt.
    Mr. Edwards. So the answer is, yes, if you count the gross 
debt. What is the interest to taxpayers on that each year?
    Mr. Orszag. On the publicly held debt, net interest is 
somewhere in the range of $250 billion a year.
    Mr. Edwards. So the interest on the debt is one of the 
largest spending programs in the Federal Government; is that 
correct?
    Mr. Orszag. It is a significant component of the Federal 
budget.
    Mr. Edwards. How much has the gross debt gone up, Dr. 
Orszag, since President Bush was sworn into office in 2001?
    Mr. Orszag. In general, I prefer using the publicly held 
debt number. So I don't have the gross Federal debt numbers in 
my head.
    Mr. Edwards. The publicly held debt number then.
    Mr. Orszag. It has gone up by several--I will have to get 
you the exact number. I don't have it----
    Mr. Edwards. Over $2 trillion?
    Mr. Orszag. We will get it for you in a second.
    Mr. Edwards. Okay. Probably in the $2 trillion range or 
more. In your opinion, without getting in a long discussion, 
because I would like to go on to another question or two, did 
the tax cuts of 2001 and 2003, because they were not paid for 
by corresponding spending cuts, contribute to the unprecedented 
increase in national debt in recent years?
    Mr. Orszag. The tax cuts have been deficit financed, and 
they have expanded the fiscal deficit, yes.
    Mr. Edwards. Next question. Without lengthy elaboration, 
could you just list for me quickly and in maybe 30, 45 seconds, 
the potential negative consequences, long-term negative 
consequences of tax cuts paid for by borrowing?
    Mr. Orszag. Yes. And for deficit financed tax cuts over the 
long-term, there is a trade-off. You can have benefits from 
lower marginal tax rates which can spur economic activity. On 
the other hand, to the extent they are deficit financed, they 
increase the budget deficit and reduce national saving, and 
that imposes harm on the long-term economy. Most studies 
suggest that those two factors roughly offset each other and 
you wind up with very little and perhaps even a small negative 
long-term impact.
    Mr. Edwards. Okay. I think your previous report at CBO has 
indicated that. Finally, with a little less than the 2 minutes 
I have left, I would like to get to the Consumer Price Index. I 
keep hearing that the CPI is 2 percent, 3 percent. I think 
Social Security seniors are going to get a 2 percent--little 
over 2 percent increase based on inflation. But yet when I am 
back home, anecdotally, and I talk to average working families, 
their health insurance rates have risen dramatically higher 
than the CPI; their food costs in the last year have gone up 
significantly. Gasoline prices are now on average over $3 a 
gallon for the average family out there. And I think you said 
crude oil has gone up by 60 percent this year. When I talk to 
families about the cost of educating their children in college, 
those have gone up dramatically. Utility bills are up. Now many 
people are facing huge increases in variable mortgage costs 
because they didn't have locked-in mortgage rates, and now 
those who lost their homes moving into apartments are seeing 
significant increases in apartment rates. In your opinion, Dr. 
Orszag, does the CPI reflect the real expenditures of an 
average, typical working family in America?
    Mr. Orszag. CBO actually put out an issue brief on 
precisely that topic, whether perceptions of inflation matched 
the mechanics of the Consumer Price Index. I guess I would say 
the Consumer Price Index is designed with a particular 
objective in mind. It has some imperfections that economists 
have long noted. And I just would be happy to provide that 
issue brief to you which explores these issues in more detail.
    Mr. Edwards. I would welcome that. Thank you very much.
    Thank you, Mr. Chairman.
    Chairman Spratt. I beg your pardon, Mr. Lungren, I had 
already indicated you were up anyway.
    Mr. Lungren. I have great respect for my chairman. I wait 
until you give me the word, sir.
    Dr. Feldstein, I recall being here in Congress when you 
came here with President Reagan. And I recall the economic 
circumstances we faced at that time. I am not a Pollyanna, but 
one of the things that bothers me a bit is when we seem to have 
a lack of confidence in the underlying economic strength of our 
society. If I am not mistaken, during those first 2 years I was 
here in Congress prior to when Ronald Reagan comes, we had this 
perfect storm of inflation rate that was double digit, 
exceedingly double digit. We had unemployment rates that were 
close to that it seems to me, if I am not mistaken. I mean, 
they were very high compared to what we have seen over the last 
6 to 8 years. Interest rates were exceedingly high. As I 
recall, at one point in time, they hit 22 percent if I am not 
mistaken. That to me, if we saw that today, would be such a 
perfect storm that people would be talking about the underlying 
weaknesses of the American economy. We haven't seen anything 
like that in the last 20-plus years, 25-plus years.
    And while I don't want to be a Pollyanna about it, I 
wonder, number one, whether you could tell us what the 
significant differences are in the structural strength of the 
U.S. economy now versus then; secondly, why you think there 
might be this fear or uncertainty about the underlying strength 
of the economy. Is that real? Is that imagined? And I say that 
knowing your opening statement with respect to your concern 
about the possibility of a recession coming upon us.
    Mr. Feldstein. Well, I began, not in my written statement 
but in what I actually said, by emphasizing the fact that the 
U.S. economy has great long-term strength, and I can continue 
to believe that that is the dominant condition. When I talk to 
my friends from Europe, I marvel and they marvel as how much 
stronger our fundamentals are, how much better our labor 
markets, our capital markets, our education system operate than 
in other industrial countries. And that has given us the 
stronger productivity growth over the last decade.
    I think the changes in the tax rules that were put in place 
back in the 1980s represent a major reason why incentives are 
stronger and economic performance is better in this country. It 
is easy to forget that when Mr. Reagan came to Washington, the 
top tax rate was 70 percent on investment income; on capital 
gains, could easily reach over 40 percent; on dividends, it was 
70 percent. Nobody would think about going back to those bad 
old days at the present time.
    Mr. Lungren. I hope not.
    Mr. Feldstein. I hope not, too. So those changes in 
personal tax rates and in the structure of taxes between taxes 
on savings versus taxes on other forms of income have made a 
big difference I think in terms of the underlying strength and 
the productivity growth of the U.S. economy.
    But people are worried now because the economy is 
softening, and they are seeing increases in prices. And they 
are seeing, whether it is immigration or it is off-shoring, 
there are all kinds of things that make people nervous. But I 
think that is sort of a continuing state that the public is in, 
that they are nervous that things are going to get worse for 
them and get worse for their children, and yet we see that 
decade after decade things do get better.
    Mr. Lungren. Very quickly. To me, the remarkable difference 
between then and now is our accepted unemployment rate versus 
then. Can you give us any indication as to what structurally 
has changed such that----
    Mr. Feldstein. The amazing thing is, in this country, our 
unemployment rate is around 5 percent, and it was 5 percent 
when I first started studying these numbers back in the 1960s. 
And to me, the amazing thing is that our friends in Europe then 
were a source of envy for us. We would look at Germany, and we 
would say, they have 2\1/2\ percent unemployment, and we have 
5. Now they have 10. So the big change in unemployment has 
happened there as their economies have failed to adjust and 
failed to get their incentives right. And we have had cyclical 
ups and downs when they had that very, very high double-digit 
inflation. The economy was forced to go through the ringer in 
order to bring inflation down, but now that we have inflation 
down, we hope to avoid the kind of counter inflationary spikes 
that Paul Volcker was forced to visit on the economy back in 
those days.
    Chairman Spratt. Mr. Cooper of Tennessee.
    Mr. Feldstein. Could I just maybe add one sentence to the 
last question? Because you raised the distinction between what 
is really happening in the economy and people's anxieties about 
it. And I share virtually everything Dr. Feldstein said about 
the strength of the economy as measured by macro economic 
indicators, but I think most of the anxiety comes from the way 
that the pie has been distributed. And the anxieties that the 
growth, the low unemployment, the low inflation rates have not 
been widely shared in terms of real incomes, and therefore the 
macro payoffs that we expected to happen have not passed 
through to the populous as widely as should have been the case.
    Chairman Spratt. Thank you, Dr. Bergsten.
    Mr. Cooper.
    Mr. Cooper. Thank you, Mr. Chairman.
    And I thank the distinguished panel. I worry that we are 
being presumptuous even talking about efforts to fine tune the 
economy in the short term when we have done such a terrible job 
of getting the long-term picture right. I am particularly 
worried that Dr. Feldstein's proposal to have a conditional 
temporary tax cut could be as dangerous for this Congress as 
offering an alcoholic another drink. We always err on the side 
of stimulus, and we seldom are on the side of fiscal 
discipline. Regarding the subprime market, these instruments 
have become so complex that they are almost impossible to 
unwind. You know, years ago, we had this doctrine of too big to 
fail for some banks. Now some of these instruments are so 
complex that you have to have almost a macro solution to an 
individual mortgage origination problem.
    The testimony of Dr. Orszag, I think, was particularly 
interesting, and this may be down in the weeds too much, but 
you mentioned just offhandedly that banks have the option of 
putting a structured investment vehicle on balance sheet or off 
balance sheet. And apparently it can go back and forth at will. 
Could you elaborate on that?
    Mr. Orszag. Sure. Most structured investment vehicles are 
not on the balance sheets of banks. Some are. The motivation I 
should say for keeping them off balance sheet is that they can 
generate income for the bank without adding to the bank's 
required capital, which is part of our banking regulatory 
system. Structured investment vehicles fund themselves largely 
through short-term commercial paper and then invest in longer-
term assets like commercial-backed--I am sorry--mortgage-backed 
securities. And the difficulty is that, as the short-term 
financing market has dried up, they have a refunding problem 
that in addition the value of their assets has been impaired. 
That is causing severe pressure on these structured investment 
vehicles. And many banks, whether out of a requirement or out 
of concern about the reputation, are either providing 
additional liquidity to the structured investment vehicles or, 
as I mentioned, one European bank actually taking the step of 
moving it back onto the balance sheet.
    Mr. Cooper. So this creates a situation in which it is 
optional for the bank whether to have these SIVs on or off 
balance sheet?
    Mr. Orszag. There is some choice involved, yes.
    Mr. Cooper. And their decision is based on the advantage of 
the individual bank. So you get a remarkably different 
financial picture judging on the bank's preference.
    Mr. Orszag. I think one of the concerns that is going on in 
financial markets is a lack of transparency about exactly where 
all the problems are arising. And part of that has to do with 
off balance sheet entities like structured investment vehicles.
    Mr. Cooper. Time is short. If I could switch now to Dr. 
Bergsten. I thought an important but little noted part of his 
testimony was the strength of the rest of the world. And in 
this day and age in which protectionism is very much en vogue 
and, according to the front page of the Wall Street Journal, 
even two-thirds of the Republicans now think of themselves as 
protectionists, your comment basically pointing out that it is 
the strength of world trade that is essentially offering us 
recession protection today here in the United States. Because 
as you pointed out in your testimony, we used to think, when we 
got a cold, they got pneumonia. Now the coupling may have been 
reserved, and we may depend on world trade to keep our economy 
strong. And that is a fundamental insight I think that perhaps 
has escaped most of Congress.
    Mr. Bergsten. I hope you and others will inject it further 
into congressional debate. We have also done studies that show 
that the U.S. economy today is $1 trillion per year richer as a 
result of our trade globalization of the last 50 years. That is 
10 percent of the whole economy; it is $10,000 per household. 
It has been a big winner. Now, on top of that, comes this 
improvement in the trade balance which, yes, could keep us from 
at least the worst of the turn down that is being feared.
    Mr. Cooper. I have seen your study on the $1 trillion 
benefit from world trade to the U.S. Economy. But that study 
admits that there is a $50 billion annual dislocation. But our 
remedial programs of trade adjustment assistance and things 
like that only ameliorate $2 billion of the $50 billion. So 
there is a clear lack of remedy there for that painful 
dislocation cost. But I see my time has expired.
    Mr. Bergsten. You get an A-plus for your studious attention 
to our work.
    Chairman Spratt. We have a vote on the floor with about 12 
minutes and 29 seconds. What I propose to do is, I am willing 
to miss this vote for anybody who wants to ask questions, but 
we have three 5-minute votes thereafter. So we will go through 
this complete vote. Anybody who wants to ask questions, and if 
you are just about on deck and ready to come up, fine. We will 
stay here, and then we'll vote three votes, three 5-minute 
votes, and get back as quickly as possible. We appreciate our 
witnesses' indulgence.
    Mr. Hensarling.
    Mr. Hensarling. Thank you, Mr. Chairman.
    I am not sure what survey the gentleman from Tennessee was 
alluding to where two-thirds of the GOP considers themselves 
anti-trade. If it is two-thirds of the GOP, it must be about 95 
percent of the Democrats. And I certainly lament any falling 
off of support for international trade.
    The question I would first pose is to you, Dr. Feldstein. 
You mentioned earlier that you feel the pressure will mount for 
some type of subprime response by Congress. You are probably 
aware that the House has already passed subprime legislation. I 
am not sure how closely you observe that legislation. I think 
my own observation, if you looked at it closely, the 
legislation de facto outlawed certain mortgage products by 
creating certain so-called safe harbor provisions. But if you 
look even closer, the safe harbor provisions are not 
particularly safe. There are all types of liability exposure 
issues, including assignee liability in the secondary market, 
causing many of us to conclude that, unfortunately, at a time 
when more liquidity is needed in the secondary mortgage market, 
that this legislation would actually dry up due to the 
questionable increased liability exposure saying that as people 
try to refinance their adjustable rate mortgages, that there 
will be fewer products available for them to do that. So my 
fear is that we have taken a bad situation and perhaps made it 
worse. My question to you is, have you looked at the House 
passed legislation, and if so, have you made any conclusions of 
what impact it might have on the subprime challenge?
    Mr. Feldstein. I am afraid I have not.
    Mr. Hensarling. Okay. That will be a quick and honest 
answer. You spoke about--the term moral hazard came up earlier. 
And we know there have been proposals floated by various 
Members that would somehow modify these particular terms. Could 
you in some greater detail tell us that if Congress would 
unilaterally step in to either freeze rates or modify rates, 
modify terms, what will that do to the secondary mortgage 
market? What will it do to liquidity? What impact will it have 
on our economy?
    Dr. Feldstein.
    Mr. Feldstein. The moral hazard problem is that it will 
encourage people to take just the kind of risks that have 
gotten us into this trouble; that they will go for mortgages 
with high loan-to-value ratios, mortgages with low teaser rates 
that will go up later in the future because they will expect 
that if there is a problem, the government will come along and 
bail them out by the kind of legislation that is being 
proposed. But I think that is the real danger in this. And to 
the extent that there are more bad loans being created, there 
will be greater nervousness in the secondary markets about 
taking on those loans. So I think it would exacerbate the 
problems that we have seen and cause a continuation of the 
incentives rather than rolling back those incentives.
    Mr. Hensarling. Another proposal that is on the table, as 
you are aware, is increasing the loan limits of Fannie and 
Freddie which are essentially, as you well know, a government 
sanctioned duopoly in the secondary mortgage market. If most of 
the challenge is in the subprime market, which tends to be at 
the lower end of the mortgage market, why not lower Fannie and 
Freddie loan limits as opposed to increase them so that they 
can take their taxpayer subsidies and focus it where the 
challenge resides?
    Mr. Feldstein. Well, I certainly think raising it from the 
current limit to a million dollars doesn't make sense in terms 
of the problems that we face. The average home being sold is 
around 200 and something thousand dollars, $250,000. So why we 
would want to use taxpayer funds to guarantee, to subsidize the 
million dollar mortgages just doesn't make sense to me as 
public policy.
    Mr. Hensarling. Dr. Bergsten, in the 18 seconds I have 
left, I think you advocated for increasing Fannie and Freddie 
loan limits. Why not move in the opposite direction.
    Mr. Bergsten. What I meant was raising the total ceiling on 
their portfolio, not the per-loan limits.
    Mr. Hensarling. Sorry. My misunderstanding. And I yield 
back.
    Chairman Spratt. Thank you, Mr. Hensarling.
    Ms. Schwartz.
    Ms. Schwartz. Thank you, Mr. Chairman.
    Well, thank you. It was an interesting discussion, and I 
appreciate your comments. But I wanted to follow up on some of 
the other questions that have been raised and sort of maybe 
take it a little bit further. About the long-term issues we are 
facing, it seems if we do just focus on the short term, we are 
really missing making sure that we grow this economy and that 
Americans are better off in the long term. And if we keep just 
looking short term, we are not really going to be helping to 
deal with what are really very significant problems for us both 
in the Federal Government and for the economy. And it seems 
that you can almost phrase the questions--the issue in the same 
way for the Federal Government as you do for American families, 
which is that we don't have enough money to meet our expenses. 
We are borrowing money at pretty extraordinary rates, and we 
don't even have the money to borrow from Americans. We are 
borrowing from foreign governments. And the Americans are doing 
the same thing. They are borrowing on credit card. We are 
encouraging them to spend money they don't have, so actually 
behaving similarly. So we need to both rein in what the Federal 
Government is doing both in terms of spending but also in terms 
of being able to commit to paying for what we spend, which of 
course as Democrats we are trying to do, the whole pay-for, 
PAYGO is a major issue for us. But for Americans as well, the 
President keeps encouraging them to spend, that that is going 
to get us out of any potential recession we are facing. When in 
fact we know seriously that many Americans are in serious 
credit card debt. Many have borrowed against their homes. Now 
that is at risk as well. So I would ask you to speak to not 
just the fiscal stimulus, but really what is a long-term 
economic stimulus and how we can encourage more economic 
growth, which I would interpret as not just more money in the 
system but more jobs and better paying jobs, because that is 
obviously an issue as well. If we have more jobs that are low 
paying, that doesn't exactly help our families to be able to do 
what we are asking them to do. So I just wanted you to comment 
if you would--this is what we are facing tomorrow as a matter 
of fact.
    We have put forward a serious and fundamentally different 
policy on energy, which seems to me to answer some of these 
questions. We are saying, we want to stimulate job growth in 
energy. We want new jobs and alternative renewable fuels. We 
want to use innovation. We want to be able to see the job 
growth in both small and large businesses, and we want to 
reduce the cost of energy for Americans and be more self-
reliant so we don't have to borrow so much or rely on foreign 
governments. That, seems to me, is a perfect place to go, and 
we ought to be doing that in other areas as well. So could you 
speak to how important it is for us to look long term and, 
again, not just from a fiscal stimulus but really an economic 
stimulus package, which we are trying to do through energy 
tomorrow? We may well see that vetoed by the President. Where 
does that put us as a country if we aren't in fact making those 
long-term growth decisions right now? I think we have just 
about 2 minutes for each of you----
    Mr. Orszag. I can take a quick crack at that. In fact, I 
will be back here next week, I gather, to talk about the long-
term budget outlook. The Nation faces many important long-term 
challenges that are not just fiscal but include fiscal 
challenges, and I would include the long-term fiscal problems 
in that. Climate change is another one. With regard to some of 
the comments about national saving, basically, not just the 
Federal Government but private also. Over the long term, it is 
not in the Nation's best interest to be saving only 1 or 2 
percent of our national income, which is what we have been 
doing. And there are many steps that can be taken in addition 
to improving the Federal budget's saving basically to boost 
private saving. And I would highlight one in particular. 
Research has shown that making saving easier so that it is more 
automatic is a very effective tool to boosting saving. You 
already took steps to boost automatic saving in 401(k) plans. 
There are opportunities for the other half of the workforce 
which are not offered a 401(k) at work to boost their automatic 
savings opportunities also. And I understand that on a 
bipartisan basis, there is legislation that has already been 
crafted to create something called an automatic IRA which would 
do that kind of thing. So there are opportunities to boost 
national saving over the long term even beyond getting the 
Federal Government's own books in order.
    Ms. Schwartz. Thank you. I appreciate that. I will say, 
though, it is very hard on American families. I am very 
committed to saving. I think what we do with the 401(k)s is 
really important, and we should do more. We do know, for 
American families whose wages have not gone up as fast as 
inflation, who are seeing increasing expenses for healthcare 
and energy and mortgage and everything else, that it is really 
hard to then say, by the way, you have to save. I do think we 
ought to say that, but I think it is the reality for very many 
Americans who are making more money than they ever imagined; it 
is still hard for them to do that.
    Mr. Bergsten. I would just add one sentence. The time is 
up. I heartily endorse every objective you cited. I would 
simply suggest that when you look at proposals for policy 
changes, you test them against one critical criteria, will they 
increase U.S. productivity growth? The underlying answer to 
your question is to maximize U.S. productivity growth. The 
reason the U.S. economy has done well from the mid 1990s until 
the last couple of years is because productivity growth, 
depending on how you measure it, doubled or tripled from what 
it had been in the 1970s, the 1980s, the early 1990s. That 
provided a quantum jump in professional growth in the U.S. 
which we realized over this last decade period. So whether it 
is a tax issue or spending issue, an energy policy issue, you 
always want to test it against whether it will increase 
productivity growth because that is the only ultimate way that 
you get real incomes and wages up.
    Chairman Spratt. Mr. Campbell of California. Let me say 
that, after you have your questions, we will recess to go vote. 
I may disappear before you finish your question, but you have 
the floor for the full 5 minutes.
    Mr. Campbell. Thank you, Mr. Chairman.
    I will make these quick so that we don't--we all have to 
get to votes.
    For Dr. Feldstein and Dr. Bergsten, talking about the 
potential temporary stimulating tax cut next year, how do you 
do that? And then, under current law, as has been discussed in 
2010 and 2011, all the tax reductions of 2003 and 2001 expire. 
If you did a temporary stimulative tax cut and it was followed 
by an elimination of that temporary tax cut and then followed a 
year or something later by all of these things--all of these 
tax increases, wouldn't that be a whipsaw on the economy which 
would cause a lot of distortions in investment decisions and so 
forth because of a significant difference in as short of a 3-
year period in tax rates?
    Mr. Feldstein. I see this temporary tax stimulus not as 
something that drives incentives; it is basically a transfer of 
cash that people will spend. It will be--if it comes to pass, 
if we actually have the downturn, it will be turned off long 
before we get to 2011. Just the enactment of it will help 
reduce the risk of recession because it will give people more 
confidence that there is that fiscal back stop should the 
economy soften. So I think it is quite separate from these 
other long-term incentive effects of pushing tax rates up and 
particularly pushing tax rates up on investment income, both 
capital gains and dividend income.
    Mr. Campbell. Do you agree with that.
    Mr. Bergsten. I agree with that. This is Marty's proposal. 
I mainly suggested making it symmetrical. I also must admit 
that I make an implicit assumption that you are going to work 
out that problem of the termination of the current tax cuts. 
And so my baseline is probably a little different than you were 
suggesting.
    Mr. Campbell. Another question, would elimination of the 
AMT, just elimination of the AMT tax without any replacing, 
supplanting tax, is that a good idea for the wealth--for the 
transfer back economic stimulus, or is it geographically and 
income distributionally not ideal.
    Mr. Feldstein. It seems to me, before you get there, it is 
a tremendous fiscal problem if you simply repeal the AMT and 
you don't put anything in its place. You are looking at a very 
large increase in the fiscal deficit. That is one of the things 
that would both worsen our trade situation with the rest of the 
world and also the size of the ongoing national debt.
    Mr. Campbell. Any tax reduction will do that without--I 
mean, I am just saying, taking your suggestion of a stimulating 
tax reduction.
    Mr. Feldstein. Well, you could say if the--I don't think 
you want to solve the AMT problem by linking it to what happens 
to unemployment in--it is a kind of cyclicly adjusted patch. 
Using it as a way--is that what you are proposing?
    Mr. Campbell. I was just throwing it out there and saying--
--
    Mr. Feldstein. I haven't thought about doing that before. 
It seems to me turning it off for a year and then turning it 
back on again just adds to the complexity of the AMT.
    Mr. Campbell. Fair enough.
    Mr. Orszag. I would just add, if you were for a similar 
sized--and again, I don't--I am not--I want to emphasize again, 
it is not clear that fiscal stimulus is or should be warranted. 
But if it were that for the same size tax relief, say $50 
billion, AMT versus an alternative, the AMT's relief unpaid for 
would likely be somewhat less effective at boosting demand in 
part because of the distributional effect that you noted. It 
would largely go to sort of upper-middle-class or lower upper-
income taxpayers. And the evidence does suggest that if you 
want to get the biggest bang for your buck from tax relief in a 
period of economic weakness, tilting towards moderate-income 
households would be a benefit.
    Mr. Campbell. Last question for you, Dr. Orszag. What was 
CBO's forecast for economic growth during the time that we were 
projecting out what future deficits would be? And if economic 
growth dropped for each--is there any kind of calculus that if 
economic growth is 1 percent down and if we have declining 
interest rates, then our interest on that national debt will be 
offsetting some of the other factors of that. But is there any 
kind of rough economic calculus for if GNP growth drops a 
percent, then the deficit increases by $100 billion or 
whatever.
    Mr. Orszag. Yes. We will have updated rules of thumb in our 
January outlook. And I will be delighted to talk to about them 
when we come out with that.
    Chairman Spratt. The committee stands in recess subject to 
the call of the chair. With the indulgence of our witnesses, we 
will be back in about 15 minutes. We have got three 5-minute 
votes. Make yourself at home. And I will be back as quick as 
possible.
    [Recess.]
    Mr. Cooper [presiding]. The hearing will return to order. 
And our first questioner will be Mr. Doggett from Texas.
    Mr. Doggett. Thank you very much. And thanks for all the 
testimony you have all been presenting. I certainly agree with 
our ranking member, Mr. Ryan, that the goal here is not to 
pursue policies that would sink the economy. But I think he has 
framed the question in a somewhat backward way. We have pursued 
policies for at least the last 7 years of cutting regulations, 
cutting taxes, cutting at the expense of significant increases 
in debt, combined more recently with a foreign policy that has 
contributed to international instability and the soaring price 
of oil. And the real question we have now is whether these 
policies that we followed for 7-plus years are sinking the 
economy or merely contributing to sluggish growth. And the 
Republican--our Republican colleagues, like this 
administration, pursue every economic condition, as Mr. Edwards 
noted, with an economic medicine chest that only has one brand 
of medicine, and that is tax cut elixir with a stack of IOUs, 
because really their approach to a credit crunch is to ask for 
more credit for more tax cuts.
    Let me begin with a question to you, Dr. Bergsten. Do you 
believe that, given our current economic situation, we should 
have another unpaid tax cut with or without a trigger?
    Mr. Bergsten. Well, I am a big supporter of moving to a 
budget surplus, as I said in my remarks. That is the structural 
budget deficit which I look at as the main indicator, so I am 
willing to see fluctuations around that depending on the state 
of the cycle. So I don't rule out a short-term tax cut aimed at 
a cyclical downturn in the economy of the type Dr. Feldstein 
was trying to advocate. But as I said in my own remarks, I 
would be very nervous about any kind of further additions to 
the budget and therefore the external deficits. I think any 
kind of tax cut of the type he proposed ought to be symmetrical 
and you ought to have a conditional tax increase on the other 
side that would take advantage of a strengthening position of 
the cycle in order to strengthen the underlying position and 
avoid a net weakening and addition to the debt at the time.
    Mr. Doggett. Do you recommend a tax cut at this time?
    Mr. Bergsten. No, not at this time. If you were going to do 
it, you should only do it with a trigger because it should be 
conditional and----
    Mr. Doggett. But you don't recommend doing it either way.
    Mr. Bergsten. No, I would not recommend doing it either 
way.
    Mr. Doggett. Dr. Orszag, recognizing your position is a 
little different on policy matters, let me ask the question 
this way. Do the economic conditions that have been relied on 
in the past to justify a stimulus package exist today?
    Mr. Orszag. Not currently. And most of the discussion we 
have had about it today is about the risk of about whether it 
will in the future and, in particular, next year.
    Mr. Doggett. You mentioned that the history of 
congressional action with stimulus is not altogether a happy 
picture, that the stimulus is often late and often misdirected.
    Mr. Orszag. That is correct.
    Mr. Doggett. You have written, prior to coming to your 
current position, I believe when you were at Brookings, that 
there were times that certain kinds of fiscal stimulus is 
preferable to a tax cut.
    Mr. Orszag. Sure. I mean, as I mentioned earlier and as CBO 
also has said before, if you were to do fiscal stimulus, it 
does not need to be done on the tax side. It can be very 
effectively done also through particular kinds of transfer 
payments. For example, research has shown that the unemployment 
insurance system, for example, is among the most effective 
dollar-for-dollar automatic stabilizers that we have in terms 
of counterbalancing periods of economic weakness.
    Mr. Doggett. As far as continued commitment to our PAYGO 
rule, which you have advocated and I certainly have supported, 
is it possible to have short-term stimulus that is paid for in 
the out years still comply with the PAYGO rule but have a 
stimulative effect over the short term?
    Mr. Orszag. Absolutely it is.
    Mr. Doggett. If it becomes necessary to have a stimulus 
package because of the policies of the past that haven't worked 
as well as the boundless economic growth we were promised from 
one tax cut for the rich after another and we do need some 
short-term stimulus, it doesn't mean we have to abandon the 
PAYGO approach?
    Mr. Orszag. No, in fact, as you noted, you can have some 
deficits in the first couple of years that are offset by 
additional fiscal discipline thereafter.
    Mr. Doggett. Thank you very much.
    Dr. Feldstein if time----
    Mr. Feldstein. When I made my comment about waiving PAYGO, 
and I thought about it in concurrent terms, but I would 
subscribe to the idea that--and that would also deal with what 
Fred Bergsten said--as the economy recovers, you want to have 
more revenue being collected. So I don't see this as a net 
permanent tax cut but rather something counter cyclical. And 
let me point out that, as the Chairman said in his opening 
remarks, in a Financial Times article the other day, Larry 
Summers, Democrat, Secretary of the Treasury in the Clinton 
administration, also argued for a fiscal stimulus next year of 
the economy. So it is not just----
    Mr. Doggett. I heard his comments last night as well. And 
just to clarify on that point, because I think it is 
significant. You can tell from the drift of my comments, I 
don't share enthusiasm for your proposal, but you are saying 
that if we do a short-term stimulus using the tax approach that 
you have recommended, that it is not essential that we abandon 
PAYGO. We could have it paid for in the out years and be true 
to our concern for a pay-as-you-go approach and still 
stimulate?
    Mr. Feldstein. Yes, that is correct.
    Mr. Doggett. Thank you so much.
    Mr. Feldstein. And it could be done on the spending side 
through transfer payments. But the danger to tying it to 
something like unemployment insurance is that it may increase 
the length of time that individuals with a tendency to become 
unemployed because of the incentive effects that go with it. So 
that would have to be traded off. On the other hand, that is a 
population where they are more likely to spend the money dollar 
for dollar than just giving it across the board to all 
taxpayers.
    Mr. Doggett. Dr. Orszag.
    Mr. Orszag. If I could add one comment. Obviously, as 
policymakers, you are going to have a difficult set of 
decisions to make if the economy does weaken. And I want to 
underscore two features just for emphasis about the proposals 
that are being discussed. The first is that they are 
conditional, and the second is that, as Professor Feldstein 
just said, they are offset. So in discussions about potential 
stimulus, those important features--and I am not saying that 
even with them it is desirable to do. But without them I think 
there would be much less support among many economists for that 
kind of step.
    Mr. Doggett. Thank you very much. Thank all three of you.
    Mr. Cooper [presiding]. The gentleman's time has expired. 
The gentleman from North Carolina is recognized.
    Mr. Etheridge. Thank you, Mr. Chairman.
    Dr. Bergsten, let me ask you a question because I think, 
given your looking at the world view, there was a time if you 
go back, you know, 12, 15, even 20 years ago now, if you looked 
at the world economy versus ours and you looked at the world 
stock markets versus the U.S., there is a lot of stuff moving 
to different markets around the world.
    I would be interested in your comments, as you shared 
earlier, about how we can look to the world economies, 
depending upon how they are doing versus ours, but also at 
those markets. Even though they may move from market to market, 
we are far more integrated today than we have ever been in the 
history of this world, probably, in terms of the markets.
    I would be interested in your comments as relates to those 
markets and their movement, because I think they tend to be 
more barometers than anything else--or thermometers, more than 
a barometer, up and down--but how that interplays with the 
economies as they move around the world and how much stronger 
some of those tend to be in terms of trading volume versus what 
they were 10 or 15 years ago, how that impacts the economy of 
the world and the United States.
    Mr. Bergsten. You can observe the same trend in financial 
markets that I mentioned in terms of economic output and GDP. 
The U.S. share, while still by far the biggest of any single 
country, has declined relatively to that of other parts of the 
world. I mentioned briefly that the euro has now become a 
second global currency, moving up alongside the dollar. It is 
interesting, some indicators of financial markets, the euro 
actually already exceeds the dollar. There are more flotations 
of private bond issues, for example, now in euros than in 
dollars. There is more euro currency held around the world than 
dollar currency. So those are indicators of that set of 
financial markets.
    The dramatic expansion in recent years, again as with the 
GDP growth, has been in emerging markets, where their financial 
markets also have developed rapidly. They are still much 
smaller than ours or the European or even the Japanese, but 
they have been growing very rapidly. They have been attracting 
very large amounts of capital relative to what they had in the 
past, relative to the global supply.
    So the diversification of the world economy is happening 
very much on the financial side, as well as the output side. 
That is, on balance, good news because it provides these 
buffers and offsets and greater options for achieving world 
growth that I mentioned at the outset. But it is also a risk 
because it means that people have lots of places to go other 
than the dollar or the U.S. markets if they don't like our 
performance.
    Mr. Etheridge. Let me ask each of you, because I want you 
to just comment quickly--because I only have a little time 
left--certainly as we are looking in hindsight at the 
tremendous debt that has now been created, it is going to have 
a significant impact on our ability to invest in the long run 
in core infrastructure needs in this country long beyond water, 
sewer, schools, education. You know, if we are looking down the 
road, that is what got us here and that is what will get us 
down the road in our ability to invest in the future of our 
young people.
    My question is as you look at the outyears, we have been 
talking about the drag with all the other stuff, no one has 
touched on this issue of investment in education and the other 
pieces. I would be interested in comments from each of you very 
briefly how you see that switch coming that could greatly 
impede our ability to be a major competitor in the world 
economy 20, 25 years from now if we don't start investing more 
today in tomorrow's workforce.
    Mr. Feldstein. Let me distinguish between investment in the 
traditional sense, as you say, everything from infrastructure 
to business plant and equipment----
    Mr. Etheridge. Well, let me tell you what I am talking 
about in investment. I believe education is an investment.
    Mr. Feldstein. Okay.
    Mr. Etheridge. Some people call it an expenditure. You 
expend today, you invest in the future.
    Mr. Feldstein. No question about that. I accept that. I was 
just going to say that that expenditure is mostly publicly 
financed, both local and State, and national. And so that has a 
different--that requires a commitment on the part of 
governments at these levels to spend money on education and to 
change the nature of the education so we get more for the 
dollars that we spend. No quarrel about that.
    On the other kinds of investment, the traditional bricks 
and mortar and infrastructure, that requires an increase in our 
saving rate. If we continue to have a low saving rate, then we 
become dependent on the rest of the world to finance that kind 
of investment. There is a limited ability to do that. As our 
trade deficit shrinks, the inflow of funds from the rest of the 
world will shrink. And therefore our ability to invest will 
shrink. So if we want to invest, we have to save more.
    Mr. Orszag. I guess what I would say, just briefly, is just 
as different forms of taxation have different effects on 
economic growth over the long term, different forms of 
government expenditures also do. The evidence, for example, on 
high quality pre-K education suggests potential for significant 
returns there. And that is different than other kinds of 
spending. So the same kind of more nuanced approach that is 
required with regard to forms of taxation is also required in 
terms of evaluating different kinds of Federal spending and 
other government spending, I should say.
    Mr. Bergsten. I had mentioned earlier the emphasis on 
productivity growth, which gets to your question. And a 
critical element of that is investment, ``capital deepening'' 
as we call it. So yes, that is absolutely essential. And I 
think, again, you ought to test all of your policy proposals 
against the criteria of whether they will enhance productive 
investment.
    Mr. Etheridge. Thank you. Thank you, Mr. Chairman. I yield 
back.
    Mr. Cooper. The gentleman's time has expired. The gentleman 
from California is recognized.
    Mr. Becerra. Thank you, Mr. Chairman. And thank you to the 
panelists for their testimony today and all their responses.
    I would like to, if I may, begin with Mr. Bergsten and find 
out from you, if you could elaborate a little bit more on a 
comment you made earlier in response to some questions that we 
have been living so far beyond our means that what we are 
seeing now is a reaction to the consequences of that. And we 
now are going to hear any number of proposals that will come 
our way to try to get us back into a prosperous economy.
    And I am wondering if you could tell me, as we move 
forward. Is it more important in your mind, given that we are 
not yet certain if we are going to go into a recession, to talk 
about the short-term fix or deal with the long-term instability 
that we have in our fiscal house?
    Mr. Bergsten. What I meant by living beyond our means was 
the fact that the country as a whole has been for 15 years 
spending more than we produce at home. That difference was met 
through net imports of product from the rest of the world. And 
then we had to borrow from the rest of the world to finance 
that imbalance and built up sizable foreign debt. The number 
that is often cited is that our net foreign debt is now 
something like $3 trillion. But in a way, the relevant number 
is $20 trillion. That is the amount of dollar holdings by 
foreigners all around the world, and in different forms, which 
provides the base from which sell-offs could occur if there was 
a sharp decline in confidence in the U.S. and in the dollar. 
And that is why this risk of a shortfall in the dollar or a 
hard landing is not fanciful.
    The way we got to that position, spending more than we 
produced at home, was just as the terms imply. The domestic 
demand growth in our economy, private consumption, private 
investment, government spending, all that added up to more than 
we were able to produce at home. So domestic demand growth 
exceeded our output growth, and the difference was the trade 
deficit, the buildup of foreign debt.
    Mr. Becerra. Let me stop you there and ask a question. So, 
as we continue to see our spending exceed our production, and 
we saw the size of the budget deficits for the Federal 
Government explode, would you say that that had a consequence? 
Do deficits matter, I guess, is the question.
    Mr. Bergsten. Sure. The budget deficit and the increases in 
the budget deficit clearly were a component of that excess of 
domestic demand over domestic output. That was clear in the 
eighties. It was not so clear in the late nineties, when 
actually the budget was headed toward surplus and the external 
deficit went up. So there were other factors in there. It is 
not twin deficits in any kind of Siamese sense.
    Mr. Becerra. Well, and in 2000 we were told we were heading 
towards massive surpluses, but that quickly reversed itself. By 
the middle of this decade we saw that we were not going to have 
surpluses, yet we continued to run some fairly substantial 
deficits. And today now we see the consequences of not having 
the freedom to try to act more agilely in responding to the 
debt crisis and so forth.
    So as we look forward to how we make sure that we move the 
economy in a good direction and make sure people have stable 
jobs and the rest, I guess the question will confront us: Do we 
deal with this through a short-term fix or do we try to do 
something more to stabilize us down the road? While as most 
people say 5 percent unemployment ain't that bad, I am one of 
those who always says it is 5 percent more than I would like to 
see. But it is certainly lower than you see in other places 
around the world. And we still haven't seen the type of real 
dislocation that you have seen in other recessions.
    So while things aren't that bad, isn't it time for us to 
try to make sure that we put our fiscal house in order so that 
we can deal with any of these hiccups again, so they don't 
become more than a hiccup, rather than try to figure out some 
quick fix, which may actually, as I think some of you have 
said, may actually go in the wrong direction if we do it the 
wrong way?
    Mr. Bergsten. Well, I would certainly put my emphasis on 
that, as I did in the last paragraph of my statement; that the 
best thing we can do to avoid risks of a dollar collapse or 
some other calamities would be credible, steady movement toward 
modest budget surpluses over the long run to boost our national 
saving rate, as Dr. Orszag said.
    What I wanted to add was that as this buildup of our 
foreign debt now inevitably--and I underline inevitably--
reverses, it means that the growth in our domestic spending has 
to be a bit less than the growth of our economic output, so 
that the difference is freed up to improve our trade balance, 
which is happening now. So we always kind of knew there would 
be that period of adjustment.
    Mr. Becerra. I like to pull this out. This is actually a 
government credit card. This is what we have been using to do 
any number of things, whether it is pay for the war in Iraq, 
pay for the Bush tax cuts, pay for any number of things. And we 
still, after using this, are finding that we don't have enough 
money at the end of the year to cover the costs.
    Most Americans, if they were to spend the way we have spent 
on Iraq, tax cuts or the rest, would find themselves quickly in 
bankruptcy. We, fortunately, can print up money, I guess, to 
cover some of that, some of the debts we have to our creditors.
    My final question, because my time has expired, is to say 
this. If we do what you just finished saying, which is don't 
spend quite as much as we produce, we won't have to worry about 
using this. But until that time that we are spending less than 
we are producing, what we are really doing is just using the 
people's credit card and putting the debt on our children's 
backs, because we are not paying it today.
    As Dr. Orszag mentioned, we have got about a quarter of a 
trillion dollars in interest payments on that debt. And so as 
long as we don't get ahold of ourselves and be fiscally 
responsible and continue to just use the credit card, we are 
actually telling our kids you will pay later.
    Mr. Bergsten. And compounding that, a lot of that debt is 
owed to citizens, countries outside our own boundaries, where 
we have less control and there is less offsetting within our 
own national economy.
    Mr. Becerra. Which, in a world where the U.S. is no longer 
the only king, means that we are not the only ones in control 
of our destiny.
    Mr. Bergsten. And that is what I think we are beginning to 
see and could see with a vengeance. That is the risk I foresaw.
    Mr. Becerra. I thank you very much, all of you, for your 
testimony. Mr. Chairman, I thank you very much.
    Mr. Cooper. The gentleman's time has expired. The gentleman 
from Virginia is recognized.
    Mr. Scott. Thank you, Mr. Chairman. I had another committee 
meeting I had to go to. I am sorry I am running a little late.
    I would like to ask Dr. Feldstein, the Ranking Member 
mentioned how well the stock market was going. If the stock 
market had gone up in the last 7 years like it had gone up 
during the Clinton administration, what would the Dow be at, 
approximately, right now?
    Mr. Feldstein. I just don't know.
    Mr. Scott. It almost quadrupled under the Clinton 
administration. It would be around 30- to 40,000.
    He mentioned the unemployment rate, which suggested that we 
are doing well in jobs. Could you give us an idea of how this 
administration compares to other administrations in creation of 
jobs?
    Mr. Feldstein. We have effectively full employment now. So 
any change, any differences over time, would have to be in the 
growth of the labor force.
    Mr. Scott. Is it worst creation in jobs or tied for worst 
since Herbert Hoover----
    Mr. Feldstein. Let us say if we could double the number of 
jobs that were created over the last 8 years, we would have 
negative unemployment now. Is that the goal we should be aiming 
for?
    Mr. Scott. Well, you have a lot of people that are 
discouraged and stopped looking.
    Mr. Feldstein. I think even if you counted ``discouraged,'' 
if you added them in we would have negative unemployment.
    Mr. Scott. So the average of 200-some thousand a month 
under Clinton was not sustainable?
    Mr. Feldstein. Well, if you tell me--I don't have the 
numbers in front of me. So what I am saying is we now have 
effectively full employment. And if you had much more job 
creation, I am not sure who would take those jobs. But you 
would be driving the unemployment rate down to numbers which 
historically have created big increases in inflation. That was 
one of the problems that we ran into toward the end of the 
Clinton administration. The Fed was keeping monetary conditions 
too easy, and so in the end Mr. Greenspan pushed up interest 
rates and pushed us into a recession in the beginning of this 
decade.
    Mr. Scott. In terms of improving the economy, everybody 
talks about tax cuts like they are all equal in their stimulus 
effect. Isn't it true that some tax cuts are more stimulative 
to the economy than others?
    Mr. Feldstein. Absolutely.
    Mr. Scott. And which of those tend to have more of a 
stimulus effect?
    Mr. Feldstein. Well, tax cuts that are focused on business 
investment of the sort that Congress passed in--whenever, 2003.
    Mr. Scott. The accelerated depreciation?
    Mr. Feldstein. Accelerated depreciation can have a very----
    Mr. Scott. Which is an interesting one because long term if 
you ignore the present cost of money doesn't really cost 
anything.
    Mr. Feldstein. Well, that is right. There is the minor 
factor of ignoring cost of money. But, yes.
    Mr. Scott. So that is a very--it stimulates the economy and 
doesn't cost much. That is very cost-effective.
    Mr. Feldstein. Yeah.
    Mr. Scott. Earned income tax credit?
    Mr. Feldstein. I wouldn't have said that that was--I would 
say that there are a lot of negative things associated with the 
phase-out range for the earned income tax credit, so it has 
quite negative impacts.
    Mr. Scott. The $300-a-person cash rebate?
    Mr. Feldstein. You know, I am close to saying something 
like that is what I think ought to be in the conditional tax 
cut that I am talking about. It is easy to implement. It 
doesn't have incentive effects of a long-term sort. It neither 
encourages more work effort nor more saving. But it stimulates 
some spending at a time when you need it. And that is why 
Congress passed it then, and that is why I think it ought to be 
put up where it would be easy to do and fast to do if the 
economy warrants it in 2008.
    Mr. Scott. Did you want to make a comment, Dr. Orszag?
    Mr. Orszag. I guess I would just say I think some humility 
is needed in terms of our ability to pick out the best possible 
tools for this purpose. For example, I agree with Professor 
Feldstein that economic theory and sort of the conventional 
wisdom in economics suggests that accelerated depreciation 
provisions are a relatively cost-effective tool for stimulating 
the economy. In fact, CBO has said that. But the evidence from 
our experiment with that provision was not overwhelmingly 
supportive of that conclusion.
    Mr. Scott. Well, reducing the rate for dividends and 
capital gains, is that stimulative? Of the numbers I have seen, 
that is about the worst thing or least effective in terms of 
stimulating the economy.
    Mr. Feldstein. You don't do it for short-run stimulation 
purposes. You do it for long-term incentives in terms of how we 
invest, whether we have excessive debt versus equity and so on.
    Mr. Scott. I had one other question I would like to get in 
real quickly, if I could. And that is that I thought I heard 
from the panel the idea that a collapse in the value of the 
dollar is a necessary element of digging ourselves out of the 
debt we have gotten ourselves into in the last 7 years. Is that 
right?
    Mr. Bergsten. No. What I said----
    Mr. Scott. How else are we going to pay our way out of it?
    Mr. Bergsten. I think we all agree that the decline in the 
dollar is an essential part of this adjustment process. The 
dollar rose by 40 percent in value from 1995 to 2002. It 
overpriced us in world markets. That was a big factor in going 
to the large trade deficit. Now you have to work that back 
down. People differ in amounts. I think it has come down 20 to 
25 percent. Probably got another 10 percent or so to go.
    The issue is whether that happens in a continued gradual, 
orderly way that does not disrupt markets and the economy--
which it has so far--or whether it accelerates and maybe 
overshoots and then causes a rapid run-up in inflation and 
interest rates. And I was worried about the latter. I have 
always felt that we needed a big decline in the dollar--and 
that is in the process of happening--but needed to do 
everything we could to avoid a collapse of the dollar in terms 
of the pace at which that decline occurs.
    Mr. Scott. And what does the deficit have to do with that?
    Mr. Bergsten. The budget deficit?
    Mr. Scott. Right.
    Mr. Bergsten. Budget deficit, as we said a minute ago, is a 
contributor to the trade and current account deficits, which in 
turn are a reason why the dollar exchange rate has to come down 
to improve our competitive position.
    Mr. Scott. Thank you, Mr. Chairman.
    Mr. Cooper. The time of the gentleman from Virginia has 
expired. Let me ask unanimous consent that members who did not 
have the opportunity to ask questions of the witnesses be given 
7 days to submit questions for the record.
    Without objection, so ordered.
    I would like to thank our unusually distinguished panel for 
their patience and their expertise. Without objection, the 
committee meeting is adjourned.
    [Whereupon, at 12:54 p.m., the committee was adjourned.]

                                  
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