[Senate Hearing 107-]
[From the U.S. Government Publishing Office]
S. Hrg. 107- 835
FEDERAL RESERVE'S SECOND MONETARY POLICY REPORT FOR 2002
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED SEVENTH CONGRESS
SECOND SESSION
ON
OVERSIGHT ON THE MONETARY POLICY REPORT TO CONGRESS PURSU-
ANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF 1978
__________
JULY 16, 2002
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
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WASHINGTON : 2003
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
PAUL S. SARBANES, Maryland, Chairman
CHRISTOPHER J. DODD, Connecticut PHIL GRAMM, Texas
TIM JOHNSON, South Dakota RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York WAYNE ALLARD, Colorado
EVAN BAYH, Indiana MICHAEL B. ENZI, Wyoming
ZELL MILLER, Georgia CHUCK HAGEL, Nebraska
THOMAS R. CARPER, Delaware RICK SANTORUM, Pennsylvania
DEBBIE STABENOW, Michigan JIM BUNNING, Kentucky
JON S. CORZINE, New Jersey MIKE CRAPO, Idaho
DANIEL K. AKAKA, Hawaii JOHN ENSIGN, Nevada
Steven B. Harris, Staff Director and Chief Counsel
Wayne A. Abernathy, Republican Staff Director
Martin J. Gruenberg, Senior Counsel
Thomas Leo, Republican Senior Economist
Joseph R. Kolinski, Chief Clerk and Computer Systems Adminstrator
George E. Whittle, Editor
(ii)
?
C O N T E N T S
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TUESDAY, JULY 16, 2002
Page
Opening comments of Chairman Sarbanes............................ 1
Opening statements, comments, or prepared statements of:
Senator Gramm................................................ 1
Senator Dodd................................................. 2
Senator Shelby............................................... 3
Senator Akaka................................................ 4
Senator Allard............................................... 5
Senator Corzine.............................................. 5
Prepared statement....................................... 40
Senator Enzi................................................. 5
Senator Bayh................................................. 6
Senator Bunning.............................................. 6
Prepared statement....................................... 40
Senator Miller............................................... 7
Senator Hagel................................................ 7
Senator Ensign............................................... 7
Senator Bennett.............................................. 30
Senator Carper............................................... 32
Senator Schumer.............................................. 34
WITNESS
Alan Greenspan, Chairman, Board of Governors of the Federal
Reserve System, Washington, DC................................. 7
Prepared statement........................................... 41
Response to written questions of:
Senator Sarbanes......................................... 47
Senator Miller........................................... 49
Additional Material Supplied for the Record
Monetary Policy Report to the Congress, July 16, 2002............ 51
(iii)
FEDERAL RESERVE'S SECOND MONETARY
POLICY REPORT FOR 2002
----------
TUESDAY, JULY 16, 2002
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10:05 a.m., in room SH-216 of the Hart
Senate Office Building, Senator Paul S. Sarbanes (Chairman of
the Committee) presiding.
OPENING COMMENTS OF CHAIRMAN PAUL S. SARBANES
Chairman Sarbanes. The hearing will come to order.
We are very pleased this morning to welcome back before the
Committee Chairman Alan Greenspan to testify on the Federal
Reserve's Semi-Annual Monetary Policy Report to the Congress.
This is a time of significant uncertainty for the U.S.
economy and a time of considerable stress. Just a few months
ago, it appeared that the economy might emerge strongly from
last year's recession. Economic growth in the first quarter
this year was 6.1 percent and there were some Fed watchers who
were even predicting that the Fed would have to raise rates by
the middle of this year.
That outlook has clearly changed. The economic growth in
the first quarter was largely influenced by a one-time swing in
inventories as the FMOC noted in the statement it released
after its most recent meeting on June 26. And the blue chip
consensus now calls for second-quarter growth of about 2\1/2\
percent.
We have seen a significant decline in jobs in the private
sector, more than in the previous recession, and we have a
worrisome job situation, resembling in some respects the
jobless recovery period after the last recession in 1990 and
1991.
I was going to go through the various indicatorsm, but
rather than using the Committee and the Chairman's time in
order to do that, I will forgo that exercise and I may come
back and address it to the Chairman when we get to the question
and answer period.
Actually, I am anxious to get to the Chairman and have an
opportunity to hear from him this morning. And with that, I
will yield to my colleagues.
Senator Gramm.
COMMENTS OF SENATOR PHIL GRAMM
Senator Gramm. Mr. Chairman, thank you very much.
I just want to make a personal comment. This will be the
last of these hearings that I will have with Chairman
Greenspan. I have had the privilege over an extended period of
time as a Member, as Chairman, as Ranking Member, to work with
Alan
Greenspan in his capacity as Chairman of the Board of
Governors, and it is something that I will always be proud of.
I will always be proud to be able to say that I worked with the
greatest central banker of the era.
I want to thank you, Mr. Chairman, for your great work in
this period during which I have had an opportunity to serve in
the Senate. We have seen many issues come and go, but we have
had a stable monetary policy.
When I was a boy in graduate school, we had a lot of focus
on what the money supply was. One was a monetarist or a
Keynesian. Now, we can hardly define the money supply. And yet,
under your leadership, we have had a monetary policy which has
been the envy of the world. It has been the foundation of our
economic stability, and I want to thank you for your
leadership.
I also want to thank you for one additional thing. It is so
easy to duck tough issues. It is so easy when you have massive
swings in public opinion, to simply not be available for
comment or to not have an opinion on a subject.
I think one of the great services you provided to this
country has been the wisdom of your views and the credibility
that they contain when you have been willing to speak out on
issues like energy derivatives, a complicated subject that very
few people know anything about, but a critically important
subject. And your willingness, when asked, to state your
opinion on an issue like that, in an era such as the one we
currently are operating in, has been critically important and
has had a profound effect on the policy of the Government and
the country.
And so, I just want to take this opportunity to thank you
for the great job you have done.
Chairman Greenspan. Thank you, Senator.
Chairman Sarbanes. I just want to observe that Senator
Gramm is being very restrained in his praise this morning, Mr.
Chairman. He said you were the greatest central banker of the
era. I remember one hearing when he said you were the greatest
central banker in the history of the world. I think that is the
way it was put.
Senator Gramm. Well, it is true.
[Laughter.]
I would say, Mr. Chairman, the problem is, when I say it,
people do not know that one of my areas of specialization in
economics was monetary theory and history. In reviewing the
great bankers in world history, I think Alan Greenspan
qualifies as the greatest central banker in the history of the
world.
People not knowing my background think that that is some
blowhard making an overstatement. So, I simply stated it in a
form where no living person that has any knowledge would
disagree.
[Laughter.]
Chairman Sarbanes. Senator Dodd.
COMMENTS OF SENATOR CHRISTOPHER J. DODD
Senator Dodd. How do you follow that?
[Laughter.]
Welcome, Mr. Chairman. It is always a pleasure to have you
before the Committee.
Chairman Greenspan. Thank you, Senator.
Senator Dodd. I am sure you are going to get to this, but
there are some very conflicting indicators out there, at least
it seems to me conflicting.
Consumer confidence is down, yet consumer spending is up,
and we see problems obviously related to the events of the last
number of months in terms of people's trust and confidence in
the markets.
Integrity has always been, I think, one of the marketing
points of our Nation. The world has come here for many reasons,
not the least of which has been the integrity of our markets
and that there is a tremendous sense of fairness and
transparency about them.
I am concerned about the capital flight. We have seen
foreign capital not coming here, going elsewhere, specifically,
the Pacific Rim, and what observations you may have about that.
I know it has been said, and repeated here this morning,
the Senate did itself proud by supporting the bill dealing with
the accounting reforms, 97 to 0.
While it may not be perfect, and while we may find in time
there are some additional changes that may be necessary, I
think it was the right step for the Senate to take.
I would be interested in any observations you may have
generally about these steps, or additional steps that you think
we could take in the remaining weeks of this Congress that
would be our form of participation in restoration of investor
confidence.
Thank you, Mr. Chairman.
Chairman Sarbanes. Thank you.
Senator Shelby.
STATEMENT OF SENATOR RICHARD C. SHELBY
Senator Shelby. Thank you, Mr. Chairman.
Chairman Greenspan, I want to thank you for coming here
today. Senator Gramm has already talked for us all this morning
in praise, and praise that I think is deserved. But it is very
important, Chairman Greenspan, important to the Committee and
for the country, to be hearing from you today at this
particular time.
Obviously, Mr. Chairman, there are some very strong, very
real concerns about the conditions in our markets today.
Perhaps the phrase, irrational exuberance, that you accurately
commented on a few years ago led to irrational expectations.
For whatever reason, numerous publicly traded corporations
began misstating their financial condition. The professionals'
charge was sifting through that information and I believe they
failed to properly perform their role as gatekeepers.
Ultimately, bad information, information that obscured economic
reality, was admitted into the marketplace. American investors
then relied upon it when making billions of dollars of
investment decisions.
As you well know, Mr. Chairman, Congress and the Bush
Administration are now addressing the systemic weaknesses that
allowed this to occur. There are, however, other areas, I
believe outside the direct influence of Congress that require
reform. Principally, the accounting rules need to be changed, I
believe, so that stock options are treated as an expense on the
balance sheets. You have spoken to this before, Mr. Chairman.
Stock options provide material value to recipients, dilute
shareholder ownership, and can be deducted, as we all know, by
the granting company on their tax returns. Keeping their costs
off the books does not provide a firm with tangible value. It
only contributes, I believe, to an illusion of profitability.
Allowing a firm to take tax deductions without expensing
defines the expression--having one's cake and eating it, too.
For the sake of investors, it is my hope that the Financial
Accounting Standards Board, provided greater independence under
the bill that Senator Sarbanes has sponsored and we passed last
night, I hope will revisit this rule and develop a new standard
that requires companies, Mr. Chairman, to provide information
that affords investors the most reliable picture of economic
reality. In other words, the truth.
Chairman Greenspan, while an element of uncertainty remains
in investors' minds because of their lack of confidence in
financial information, I believe we would be wrong if we failed
to point out that there are significant positive factors in
place in our economy right now. Strong fundamentals provide the
underpinnings of strong economic growth. Inflation, under your
stewardship, Mr. Chairman, I might add, has been kept in check,
and productivity has advanced to never-beforeseen levels. We
have a great economy, but we have some problems, and I hope you
will speak to that and continue to do that.
Thank you.
Chairman Sarbanes. Thank you, Senator Shelby.
Senator Akaka.
COMMENTS OF SENATOR DANIEL K. AKAKA
Senator Akaka. Thank you very much, Mr. Chairman.
I join you and the Committee in welcoming Chairman
Greenspan. I look forward to his presentation of the Federal
Reserve's Semi-Annual Monetary Policy Report.
It appears that the economic recovery is continuing. This
growth can be partially attributed to substantial inventory
adjustment, large increases in work productivity and housing
construction, which is approaching record levels, even in
Hawaii.
However, despite the continuing economic recovery, the
stock markets have lost significant amounts of their value. And
if I had a question to ask you now, I would certainly ask about
what your impression was of the vote yesterday on the
accounting bill when the vote came out 97 to 0. It was quite
outstanding. I think that
reflects what has happened recently. Accounting fears,
corporate misdeeds, and concerns about earnings have all
contributed to the current equity price levels.
Chairman Greenspan, I look forward to hearing your thoughts
on the economy and monetary policy.
Thank you.
Chairman Sarbanes. Thank you, Senator Akaka.
Senator Allard.
COMMENTS OF SENATOR WAYNE ALLARD
Senator Allard. Mr. Chairman, thank you.
Chairman Greenspan, I always look forward to your comments
and views on the economy and I am under the impression that the
country is in pretty good shape right now. I am here today to
listen to what you are going to say on the economic and
monetary policy issues.
I do not know what we can do as a Congress to help this
recovery. My thought is that we need to deal with the problems
in Medicare and Social Security, but more importantly, as that
applies to making sure that we do not allow our public debt to
get out of hand and to get deficit spending under control. And
if you have an opportunity to comment on that, I would be
anxious to hear what your have to say.
Thank you, and I look forward to hearing your testimony.
Chairman Sarbanes. Senator Corzine.
COMMENTS OF SENATOR JON S. CORZINE
Senator Corzine. Thank you. Mr. Chairman, I would just echo
what I presume most of my colleagues have said. Congratulations
on your extraordinary leadership in passing the Accounting
Investor Protection Act yesterday. I very much am anxious to
hear Chairman Greenspan's remarks with regard to that as well.
As always, I welcome him and thank him for the service he gives
our Nation.
I think that we have all had concern about the dissonance
of what we see in markets, not only equity markets, but the
dollar as well, with regard to this expansion that seems to be
in place and taking hold, at least by macroeconomic statistics.
I think we have an unprecedented situation here, certainly in
post-World War II, where you are well into an expansion and we
get reinforcement of that by data, and seeing the decline in
markets. Is that simply a reflection of the corporate
malfeasance or earnings restatements that maybe are not
reflective of malfeasance, but aggressive accounting? Or is
there something else here?
I note that the Board asked for a staff study of some of
the issues that surrounded the decline of the Japanese economy
in the late 1980's and early 1990's, and whether there is
anything to be learned from that, are there any parallels?
Certainly, I would like to hear your views on that.
And more broadly, our erosion of debt or our fiscal
stability is certainly something that is of concern to me. So,
I am anxious to hear your remarks on a number of these issues
and I appreciate you joining us.
Again, I thank you for your service.
Chairman Sarbanes. Thank you very much, Senator Corzine.
Senator Enzi.
COMMENT OF SENATOR MICHAEL B. ENZI
Senator Enzi. Thank you, Mr. Chairman.
As with everyone else on the panel, I am anxious to hear
and anxious about the comments that Chairman Greenspan will
make.
Chairman Sarbanes. Senator Bayh.
COMMENT OF SENATOR EVAN BAYH
Senator Bayh. Thank you, Mr. Chairman.
I believe we are here to listen to Chairman Greenspan, not
to me. So, I will defer to him.
Chairman Sarbanes. Senator Bunning.
STATEMENT OF SENATOR JIM BUNNING
Senator Bunning. Thank you, Mr. Chairman, for holding this
hearing and I would like to thank Chairman Greenspan for coming
before this Committee today.
We have a crisis in our economy, a crisis of confidence. We
have all seen it. The majority of Americans have felt it.
Whether they own stock, have a 401(k) plan, or any other type
of pension plan, millions have been personally hit very hard by
the recent market dips.
Since you visited us 2 years ago, over $10 trillion has
been taken out of the markets--$10 trillion. It may at this
point only be paper losses, but we all know how to add and
subtract, and the sheer drop of the Dow, Nasdaq, and the S&P in
the last few weeks obviously has people on edge.
To make things worse, the markets are dropping at a time
when most of us think that the overall economic news is pretty
good. The economy grew at a little better than 6 percent in the
first quarter. Retail sales were up in June, and inflation is
almost nonexistent. But the last I heard, over one thousand
companies--over one thousand companies--have restated their
earnings.
The stock markets are in the tank. Investors keep waiting
for the other shoe to drop--again. They are waiting to see if
there will be another Enron or Global Crossing or Worldcom.
To be fair, the retail investor seems to be more willing to
ride out the market and sit on their hands. It would be nice if
the institutional investors would do the same. But the bottom
line is that investors large and small are going to do what is
right for them. No one can blame them.
We must restore confidence in our markets. And I am very
glad that yesterday, we passed, I hope, a first step, 97 to 0,
to help to restore some of that confidence. But it is going to
take more than enacting a bill to restore the confidence. The
President has taken some good steps, too, and I think his ideas
will help greatly.
I think it would be nice if some of the political opponents
would stop taking potshots at the President for things that
started long before he came into office. Some of the rhetoric
that has been flying around the past few days has been
dangerous and irresponsible. Clearly, it has been more about
political agendas than the overall economic mood of the
country. But those who try to use recent problems for political
gain, whether they be Republican or Democrat, are playing with
fire. Markets can go up just as fast as they go down.
I think that one way we could restore some confidence in
the market would be for the public to see some of the
executives who have committed fraud to walk around in handcuffs
and orange jumpsuits. When the American people see that the
system works and those who have committed crimes pay the piper,
they will feel a lot more sincere about their investments and
security.
I would like to figure out a legal constitutional way to
expedite the prosecution of those who have committed crimes and
get them in jail right away. I know that is a little far afield
from this hearing, but I really believe that it is one of the
real, tangible things that could be done that would send out
the right signal to investors, markets, and businesses.
I look forward to hearing from Chairman Greenspan about our
economy. I would hope to hear any suggestions on what else he
thinks can be done to restore confidence in our markets. And I
look forward to talking with you during the question and answer
period.
Thank you very much, Mr. Chairman.
Chairman Sarbanes. Thank you, Senator Bunning.
Senator Miller.
COMMENTS OF SENATOR ZELL MILLER
Senator Miller. Mr. Chairman, I do not have any opening
remarks, except to thank you again for all that you did to make
sure that we got that needed bill through the Senate, and I am
looking forward to hearing Chairman Greenspan's remarks
especially on the current market situation.
Chairman Sarbanes. Thank you.
Senator Hagel.
COMMENT OF SENATOR CHUCK HAGEL
Senator Hagel. I have no statement. Thank you.
Chairman Sarbanes. Senator Ensign.
COMMENT OF SENATOR JOHN ENSIGN
Senator Ensign. Pass.
Chairman Sarbanes. Chairman Greenspan, we would be very
happy to hear from you.
Chairman Greenspan. Thank you very much.
Chairman Sarbanes. Let me just note that we have received
from the President two nominees to the Federal Reserve Board:
Donald Kohn and Ben Bernanke. Their nominations have been
received. Their papers are not yet fully in order. So, we are
waiting for all of the papers, and once that is in place, we
intend to move promptly to hold their hearings and to consider
the nominees, so that we can have a fully nominated and
confirmed board at the Federal Reserve.
Chairman Greenspan. We would appreciate that, Mr. Chairman.
Mr. Chairman, I will excerpt from fairly extended written
remarks and request that the full text be included for the
record.
Chairman Sarbanes. The full text will be included in the
record, without objection.
STATEMENT OF ALAN GREENSPAN,
CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
Chairman Greenspan. Over the four and one-half months since
I last testified before this Committee on monetary policy, the
economy has continued to expand largely along the broad
contours we had anticipated at that time. Although the
uncertainties of earlier this year are as yet not fully
resolved, the U.S. economy appears to have withstood a set of
blows--major declines in equity markets, a sharp retrenchment
in investing spending, and the tragic terrorist attacks of last
September--that in previous business cycles almost surely would
have induced a severe contraction. The mildness and brevity of
the downturn, as I indicated earlier this year, are a testament
to the notable improvement in the resilience and flexibility of
the U.S. economy.
But while the economy has held up remarkably well, not
surprisingly, the depressing effects of recent events linger.
Spending will continue to adjust for some time to the declines
that have occurred in equity prices. In recent weeks, those
prices have fallen further on net, in part under the influence
of growing concerns about corporate governance and business
transparency problems that evidently accumulated during the
earlier run-up in these markets. Considerable uncertainties--
about the progress of the adjustment of capital spending and
the rebound in profitability, about the potential for
additional revelations of corporate malfeasance, and about
possible risks from global political events and terrorism--
still confront us.
Nevertheless, the fundamentals are in place for a return to
sustained healthy growth: Imbalances in inventories and capital
goods appear largely to have been worked off; inflation is
quite low and is expected to remain so; and productivity growth
has been remarkably strong, implying considerable underlying
support to household and business spending as well as potential
relief from cost and price pressures. In considering policy
actions this year, the Federal Open Market Committee has
recognized that the accommodative stance of policy adopted last
year in response to the substantial forces restraining the
economy likely will not prove compatible over time with maximum
sustainable growth and price stability. But, with inflation
currently contained and with few signs that upward pressures
are likely to develop any time soon, we have chosen to maintain
that stance pending evidence that the forces inhibiting
economic growth are dissipating enough to allow the strong
fundamentals to show through more fully.
As has often been the case in the past, the behavior of
inventories provided substantial impetus for the initial
strengthening of the economy. However, as inventories start to
grow more in line with sales in coming quarters, the
contribution of inventory investment to real GDP growth should
lessen. As a result, the strength of final demand will play its
usual central role in determining the vigor of the expansion.
While final demand has been increasing, the pace of forward
momentum remains uncertain.
Household spending held up quite well during the downturn
and through recent months, and thus served as an important
stabilizing force for the overall economy. Spending was boosted
by ongoing increases in incomes, which were spurred by strong
advances in productivity as well as by legislated tax
reductions and, in recent months, by extended unemployment
insurance benefits.
Monetary policy also played a role in cutting short-term
interest rates, which helped lower household borrowing costs.
Particularly important in buoying spending were the very low
levels of mortgage interest rates, which encouraged households
to purchase homes, refinance debt and lower debt service
burdens, and extract equity from homes to finance expenditures.
Fixed mortgage rates remain at historically low levels and thus
should continue to fuel reasonably strong housing demand and,
through equity extraction, to support consumer spending as
well.
But those sources of strength probably will be tempered by
other influences. As we noted in February, because consumer and
residential expenditures did not decline during the overall
downturn, there is little pent-up demand to be satisfied.
Consequently, a surge in household spending early in this
recovery is unlikely. Moreover, the declines in household
wealth that have occurred over the past couple of years should
continue to restrain spending in the period ahead. Still,
despite concerns about economic prospects, equity valuations,
terrorism, and geopolitical conflicts, consumers do not appear
to have retrenched in retail markets. Indeed, consumers
responded strongly to the new interest rate incentives of motor
vehicle manufacturers this month. Early reports indicate a
significant improvement in sales over June.
By contrast, business spending has been depressed. The
recent downturn was driven, in large measure, by the sharp
falloff in the demand for capital goods that occurred when
firms suddenly realized that stocks of such goods were
excessive. Overall, the level of real business fixed investment
plunged about 11 percent between its quarterly peak in the
final months of 2000 and the first quarter of this year.
With the adjustment of the capital stock to desired levels
now evidently well advanced, business fixed investment may be
set to improve. A recovery in this category of spending is
likely to be gradual by historical standards and uneven across
sectors. Still, firms should respond increasingly to the
expected improvement in the outlook for sales and profits, low
debt financing costs, the heightened incentives resulting from
the partial expensing tax provisions legislated earlier this
year, and especially the productivity enhancements offered by
continuing advances in technology.
Indeed, despite the recent depressed level of investment
expenditures, the productivity of the U.S. economy has
continued to rise at a remarkably strong pace. The magnitude of
the recent gains would not have been possible without ongoing
benefits from the rapid pace of technological advance and from
the heavy investment over the latter half of the 1990's in
capital equipment incorporating such advances.
Despite these encouraging developments regarding longer-
term prospects for the economy, financial markets have been
notably skittish of late, and business managers remain
decidedly cautious. In part, these attitudes reflect the
lingering effects of the shocks that our economy endured in
2000 and 2001.
Also contributing to the dispirited attitudes among many
corporate executives is the intensely competitive business
environment facing their firms. Increased competition, while
producing manifold benefits for consumers and for the economy
as a whole, clearly makes individual firms' operations more
difficult.
Those businesses where heightened competition has
engendered a loss of pricing power have sought ways to raise
profit margins by employing technology to lower costs and
improve efficiency. In the United States, as a consequence of
the interaction of monetary policy, globalization, and cost-
reducing productivity advances, price inflation has fallen in
recent years to its lowest level in four decades, as has the
recent growth rate of nominal GDP and consolidated corporate
revenues.
In part because nominal corporate revenues, although no
longer declining, are growing only tepidly, managers seem to
remain skeptical of the evidence of an emerging upturn. Profit
margins do appear to be coming off their lows registered late
last year, but, unsurprisingly, the recovery in economic
activity from a shallow decline appears less vigorous than in
the past. The lowest sustained rates of inflation in 40 years
imply that nominal growth in sales and profits looks
particularly anemic. Reflecting concerns about the strength of
the recovery, managers continue to limit capital spending to
only the most pressing needs.
Given the key role of perceptions of subdued profitability
in the current period, it is ironic that the practice of not
expensing stock option grants, which contributed to the surge
in earnings reported to shareholders from 1997 to 2000, has
imparted a deceptive weakness to the growth of earnings
reported to shareholders in recent quarters. According to
estimates by Federal Reserve staff, the value of stock option
grants for S&P 500 corporations fell about 15 percent from 2000
to 2001, and grant values have likely declined still further
this year. Moreover, options grants are presumably being
replaced over time by cash or other forms of compensation,
which are expensed, contributing further to less robust growth
in earnings reported to shareholders from its trough last year.
In contrast, the measure of profits calculated by the
Department of Commerce for the National Income and Products
Accounts is designed to gauge the economic profitability of
current operations. It excludes a number of one-time charges
that appear in shareholder reports, and, importantly, records
options as an expense, albeit at the time of exercise. Although
this treatment of the cost of options is not ideal, it is
arguably superior to their treatment in shareholder reports,
where options are generally not expensed at all. NIPA profits
closely approximate those obtained from reports submitted for
tax purposes, and, for obvious reasons, corporations tend not
to inflate taxable earnings. Consequently, NIPA profits have
been far less subject to the spin evident in reports to
shareholders in recent years. NIPA profits have increased
sharply since the third quarter of last year, partly reflecting
the dramatic jump in productivity and decline in unit labor
costs.
The difficulties of judging earnings trends have been
intensified by revelations of misleading accounting practices
at some prominent businesses. The resulting investor skepticism
about earnings reports has not only depressed the valuation of
equity shares, but it also has been reportedly a factor in the
rising risk spreads on corporate debt issued by the lower rung
of investment-grade and below-investment grade firms, further
elevating the cost of capital for these borrowers.
The recent impressive advances in productivity suggest that
to date any impairment of efficiency of U.S. corporations
overall has been small. Nonetheless, the danger that breakdowns
in governance could at some point significantly erode business
efficiency
remains worrisome. Well-functioning markets require accurate
information to allocate capital and other resources, and market
participants must have confidence that our predominantly
voluntary system of exchange is transparent and fair. Although
business transactions are governed by laws and contracts, if
even a modest fraction of those transactions had to be
adjudicated, our courts would be swamped into immobility. Thus,
our market system depends critically on trust--trust in the
word of our colleagues and trust in the word of those with whom
we do business.
In recent years, shareholders and potential investors would
have been protected from widespread misinformation if any one
of the many bulwarks safeguarding appropriate corporate
evaluation had held. In too many instances, none did.
Why did corporate governance checks and balances that
served us reasonably well in the past break down? At root was
the rapid enlargement of stock market capitalizations in the
latter part of the 1990's that arguably engendered an outsized
increase in opportunities for avarice. An infectious greed
seemed to grip much of our business community. Our historical
guardians of financial information were overwhelmed. Too many
corporate executives sought ways to harvest some of those stock
market gains. As a result, the highly desirable spread of
shareholding and options among business managers perversely
created incentives to artificially inflate reported earnings in
order to keep stock prices high and rising. This outcome
suggests that the options were poorly structured, and,
consequently, they failed to properly align the long-term
interests of shareholders and managers, the paradigm so
essential for effective corporate governance. The incentives
they created overcame the good judgment of too many corporate
managers. It is not that humans have become any more greedy
than in generations past. It is the avenues to express greed
had grown so enormously.
Perhaps the recent breakdown of protective barriers
resulted from a once-in-a-generation frenzy of speculation that
is now over. With profitable opportunities for malfeasance
markedly diminished, far fewer questionable practices are
likely to be initiated in the immediate future. To be sure,
previously undiscovered misdeeds will no doubt continue to
surface in the weeks ahead as chastened CEO's restate earnings.
But even if the worst is over, history cautions us that
memories fade. Thus, it is encumbent upon us to apply the
lessons of this recent period to inhibit any recurrence in the
future.
A major focus of reform of corporate governance, of course,
should be an improved functioning of our economy. A related,
but separate, issue is that shareholders must perceive that
corporate governance is properly structured so that financial
gains are fairly negotiated between existing shareholders and
corporate officeholders. Shareholding is now predominantly for
investment, not corporate control. This has placed de facto
control in the hands of the chief executive officer. Generally,
problems need to become quite large before CEO's are dislodged
by dissenting shareholders or hostile takeovers.
Manifestations of lax corporate governance, in my judgment,
are largely a symptom of a failed CEO. Having independent
directors, whose votes are not controlled by the CEO, is
essential, of course, for any effective board of directors.
However, we need to be careful that in the process, we do not
create a competing set of directors and conflicting sources of
power that are likely to impair a corporation's effectiveness.
The functioning of any business requires a central point of
authority.
In the end, a CEO must be afforded full authority to
implement corporate strategies, but also must bear the
responsibility to accurately report the resulting condition of
the corporation to shareholders and potential investors. Unless
such responsibilities are
enforced with very stiff penalties for noncompliance, as many
now recommend, our accounting systems and other elements of
corporate governance will function in a less than optimum
manner.
Already existing statutes, of course, prohibit corporate
fraud and misrepresentation. But even a small increase in the
likelihood of large, possibly criminal penalties for egregious
behavior of CEO's can have profoundly important effects on all
aspects of corporate governance because the fulcrum of
governance is the chief executive officer. If a CEO
countenances managing reported earnings, that attitude will
drive the entire accounting regime of the firm. If he or she
instead insists on an objective representation of a company's
business dealings, that standard will govern recordkeeping and
due diligence. It has been my experience on numerous corporate
boards that CEO's who insist that their auditors render
objective accounts get them. And CEO's who discourage corner-
cutting by subordinates are rarely exposed to it.
I recognize that I am saying that the state of corporate
governance to a very large extent reflects the character of the
CEO, and that this is a very difficult issue to address.
Although we may not be able to change the character of
corporate officers, we can change behavior through incentives
and penalties. That, in my judgment, could dramatically improve
the state of corporate governance.
Our most recent experiences clearly indicate, however, that
adjustments to the existing structure of regulation of
corporate governance and accounting beyond addressing the role
of the CEO are needed. In designing changes to our regulatory
framework, we should keep in mind that regulation and
supervision of our financial markets need to be flexible enough
to adapt to an ever-changing and evolving financial structure.
Regulation cannot be static or it will soon distort the
efficient flow of capital from savers to those who invest in
plant and equipment. There will be certain areas where Congress
will choose to provide a specific statutory direction that will
be as applicable 30 years from now as today. In other cases,
agency rulemaking flexibility under new or existing statutes is
more appropriate. Finally, there are some areas where private
supervision would be most effective, such as that of the New
York Stock Exchange, which requires certain standards of
governance for listing.
Above all, we must bear in mind that the critical issue
should be how to strengthen the legal base of free market
capitalism: the property rights of shareholders and other
owners of capital. Fraud and deception are thefts of property.
In my judgment, more generally, unless the laws governing how
markets and corporations function are perceived as fair, our
economic system cannot achieve its full potential.
To sum up, the U.S. economy has confronted very significant
challenges over the past year or so. Those problems, however,
led to only a relatively brief and mild downturn in economic
activity, reflecting the underlying strength and increased
resiliency that the economy has achieved in recent years. The
effects of the recent difficulties will linger for a bit
longer, but, as they wear off, and absent significant further
adverse shocks, the U.S. economy is poised to resume a pattern
of sustainable growth. Our prospects for
extending this performance over time can be enhanced through
the implementation of sound monetary, financial, fiscal, and
trade policies.
Thank you, Mr. Chairman. I look forward to your questions.
Chairman Sarbanes. Thank you, Chairman Greenspan.
It is my intention to do 6 minute rounds, given the number
of Members who are here. That will probably take us about an
hour and a half. And then if the Chairman's time permits, we
will do a second round if some Members have other questions
they want to ask. But I think we have to hold down the amount
of time in order to move though and give everyone a fair chance
here.
Mr. Chairman, I want to address first your comments in your
statement, traditionally, consumer spending on housing and
autos and other consumer goods has led both the downturn and
the upturns in the business cycle, while business investment
has lagged. Traditionally, the swings in housing and autos have
been wider than for business investment. But that has not
happened this time. Housing and autos and other durables
remained relatively stable in 2001. In fact, spending on
housing and durables has been at cyclical highs relative to
GDP. Meanwhile, business investment began a sharp decline early
and has not turned around.
Ordinarily, we come out of these because housing and autos
and other durables give us a good boost coming out of the
recession. This time, they did not go down the way they have in
previous economic downturns. And so, we do not expect we are
going to get the same boost coming out, and we have not thus
far. What are the implications for that for hopes for an
economic recovery as we look ahead?
Chairman Greenspan. Mr. Chairman, the only difference that
one would perceive between past business cycle recoveries where
the economy had gone down appreciably and then rebounded, is
that the phase of sharp decline and sharp recovery is
essentially truncated, but the expansionary elements that are
building in the economy today will create, as best we can
judge, a level of economic growth which was typically what we
would perceive after the very sharp upswings that occurred in
past economic contractions and
expansions.
So the best way I think to view the current situation is to
essentially take past business cycles and excerpt out that
sharp decline and rise, and I think we will find that the
pattern of expansion is pretty much similar to ones we have
seen in the past.
And indeed, the financial markets--I should say the money
markets, the structure of credits and a number of other
measures of that type--all are consonant with that type of
outlook.
Chairman Sarbanes. I might note for the record, since the
media makes a lot of this nowadays, that at the beginning of
the Chairman's statement, the Dow was down 200 points. And at
the end of his testimony, it was down 132 points. So, in other
words, it rose 70 points over the course of his testimony. The
Nasdaq, which was down 8.65 at the beginning of his statement,
was up 5.56 at the end of his testimony.
Senator Shelby. Mr. Chairman, can you let him continue his
statement.
[Laughter.]
Chairman Sarbanes. I invite Members to yield back their
time and we will give it to Chairman Greenspan to continue.
[Laughter.]
Senator Dodd. Filibuster.
[Laughter.]
Chairman Greenspan. I thought you were going to dismiss me
for the rest of the day, Mr. Chairman.
[Laughter.]
Senator Gramm. It started down when you started talking.
[Laughter.]
Senator Shelby. Yield to the Chairman.
[Laughter.]
Chairman Sarbanes. Let me ask you. When we get the rates
down as low as you have them, how much stimulative benefit do
we derive from a further lowering of the rates? I think the
Japanese actually got their rates down so far that they really
could not exercise that monetary policy any further. Is that
correct?
Chairman Greenspan. That is correct. They have run into
very significant problems with endeavoring to enhance liquidity
and have it spill over into economic activity. For a number of
structural reasons, they have had difficulty in doing that.
Mr. Chairman, our general view of monetary policy is to
evaluate what the interaction between our policies and the
economy are, and endeavor to adjust accordingly.
Chairman Sarbanes. As you get down at these lower levels
where you do not have too much room to go before you are at
zero, are you inhibited in reducing rates in order to stimulate
the economy because you think to yourself, well, the economy
may get worse. We may need a clearer signal that we need to
provide some stimulus, and therefore, we should hold off at the
moment.
Chairman Greenspan. Well, Mr. Chairman, all the evidence
that we have been able to accumulate in recent weeks suggests
that the economy is improving. It is pretty much in line with
our expectations. And since our monetary policy posture was
based on those projections, it is fairly evident that things at
this particular stage are not behaving in a manner which
creates a significant amount of uncertainty on our part as to
what is happening.
Chairman Sarbanes. Okay. Let me get one final question in
before my time expires. The Euro edged past the dollar for the
first time in more than 2 years. What are we to make of that,
and what are its implications for the state of our own economy?
Chairman Greenspan. First of all, as I stipulated in my
prepared remarks, all issues with respect to the exchange rate
are left----
Chairman Sarbanes. You skipped over that and I wanted to
draw you out a little bit on it.
Chairman Greenspan. Yes. The particular issue of what the
actual exchange rate number is is wholly arbitrary, so that the
fact that it is above or less than 1.0 has no economic
significance whatsoever. Beyond that, Mr. Chairman, that is as
much as I am going to say on the exchange rate, and I suggest
that you address further questions to the Secretary of the
Treasury.
Chairman Sarbanes. Senator Gramm.
Senator Gramm. Well, Mr. Chairman, let me thank you for an
outstanding statement. I want to ask you three questions that
have to do with corporate governance and accounting.
We have passed a bill in the Senate--it is obvious by the
vote that Senators believe that the bill addresses the right
issues. Obviously, as we try to put together a compromise with
the House bill, the question becomes how do we address these
issues. And I want to ask you about your views in terms of
basic principles of what works and does not work in three
related areas.
First of all, the question of whether or not we should give
the board the power to set standards. For example, there are
many strong feelings that Members have and the public has about
what auditors should do in providing other services. Obviously,
everything we do in this bill that we have adopted applies to
16,254 different publicly-traded companies, some of them big,
some of them not too big. As a matter of principle, would you
rather have standards set by the board or set in law?
Chairman Greenspan. Senator, it depends on whether the
types of issues we are concerned about are immutable. In other
words, for example, certain issues with respect to rights and
penalties are not going to change from one year or maybe one
generation to the next, and it is far better that they be hard-
wired into a statute.
If you conclude that the particular elements within a
regulatory structure are likely to be changing or need to be
changed through time, then I think the appropriate procedure is
to empower, say, the Securities and Exchange Commission to do
certain things under a statute specifically delineated by the
Congress.
Then, finally, there are areas where it is far better that
the Government were not involved at all. And as I indicated in
my prepared remarks, the issue of the, I think, very helpful
activities of the New York Stock Exchange in this regard is an
example.
I myself do not know enough about a number of the areas of
the accounting profession as such. I know a lot about
accounting, but not about the business of accounting. So, in
general, I find that the elements within the bill that you just
passed strike me as really to the point about what has to be
addressed. But I have no real judgment because I do not have
competence in the area of knowing which of the various
elements, which of the various different areas would be most
effectively addressed by either hard-wiring or by empowering
the SEC.
Senator Gramm. Let me ask you a second question. You are
familiar with the securities litigation reform that we did. We
had all these strike lawsuits. We had one law firm that did 80
percent of the work. Senator Dodd was a leader in that effort.
Do you see any evidence that we should be backtracking from
that reform?
Chairman Greenspan. I do not, Senator.
Senator Gramm. So, you would think that, for example,
changing the statute of limitations set in that reform would
not be something based on what you have seen that would be
desirable?
Chairman Greenspan. Well, let me put it this way. I have
seen nothing in the structure of corporate governance as it has
evolved in the last year or two, or last several years, which
suggests that significant changes in that area are needed. But,
again, let me emphasize, these are areas in which I do not
perceive to have significant competence and I do not wish to
suggest that I do. I am just merely giving you my impression
that as I evaluate the relationship between corporate
governance and the economy, this is not an issue that has
surfaced which suggests to me a problem.
Senator Gramm. Let me on a third question raise the issue
of stock options. I want to conclude by asking you to explain
your view on stock options so that everybody knows exactly what
it is. But no matter what the view is, do you believe that
Congress should vote on the issue of setting an accounting
standards with regard to how stock options are treated? In
other words, should Congress be making accounting rules by law?
For example, a proposal that clearly at some point will be
voted on is should stock options be expensed? One can have a
view for or against. The question I am posing, and then I am
going to conclude by asking your view on the issue, should
Congress be voting on that or should that be set by FASB or
some similar system?
Chairman Greenspan. I frankly do not think that one needs
to do anything, as best I can judge, with what is happening. My
own impression is that FASB will rule in a manner which I
think, from listening to what the various discussions are,
would appropriately expense stock options, which is a very
important issue.
If you take a look at what is happening, for example, two
companies yesterday are moving to stock option expensing, and I
suspect we are going to see many more. I think we are going to
find that the advantages of not expensing stock options which
were so evident in the earnings reports to shareholders from
1997 to 2000, are now reversing and working adversely. So those
corporations which switch to expensing are probably going to
find that an underlying trend of earnings growth is going to be
more apparent as they switch. So my own judgment is that
nothing needs to be done at all. I think it is going to happen,
and I think quite correctly so.
Senator Gramm. Thank you, Mr. Chairman.
Chairman Sarbanes. Senator Dodd.
Senator Dodd. Thank you very much, Mr. Chairman.
Mr. Chairman, let me commend you for your statement. It is
an excellent statement.
Just as a personal note here, I wish that these remarks had
been given a week ago by someone else when it comes to the
issue of corporate governance. And some of the suggestions that
you have made here have been very strong and very worthwhile,
and I appreciate them immensely.
You mentioned specifically in your testimony, and I
indicated in the question in my brief opening comments about
other areas in which you think Congress might act. I have
listened to you very clearly and I understand what you are
saying, that in many areas, we ought to be careful about
statutory changes because they are so hard to change.
There is a rule for the private sector and self-regulatory
organizations that can be very helpful. And then, of course,
there is a regulatory framework as well which allows far
greater flexibility as circumstances change.
But you made some pretty strong statements in here about
corporate governance and the issue of directorships and the
like questions. I wonder if you might make some suggestions to
us here about whether or not these are areas in which you think
Congress should act statutorily. Some of us are reluctant to
get into the corporate governance issues, but it may be at a
moment when we probably should. I am curious whether you think
such a moment has arrived.
Chairman Greenspan. Senator, it is crucially important to
diagnose what the nature of the problem is. If there are
differing views as to what is causing the problem that clearly
created what is a massive degree of accounting imagination, if
I may choose a new word, unless you get it right, the
initiatives that you are going to employ to fix it will not
work. And what I am concerned about is, having served on 15 or
20 boards, from the first board I was on, where shares were
publicly held, in 1962, I have seen the evolution of corporate
governance over a long period of time. And one thing I have
become acutely aware of is how crucial the issue of what the
chief executive officer believes and does is to governance.
If you have a situation in which the chief executive
officer basically takes his external auditor aside and says,
look, you are not doing me any favors by managing my earnings
or making me look better. The purpose of accounting from my
point of view is to find out whether the corporate strategy I
have initiated is working or not. And if it is not working, I
want to change it.
My impression or my experience over the years is that CEO's
that have done that have gotten very effective auditing. They
have gotten very effective governance because they have
basically changed the view from trying to make the company look
better whether it was or it was not, to really finding out
whether the strategy of producing goods and services, enhancing
the wealth of the company, was actually working.
I do not wish to make a generalized statement, but I
suspect that if the CEO issue were fully and completely
resolved, which it never will be because we are dealing with
human beings, I think all of the rest of the problems will just
disappear. Now that is not going to happen and therefore, it is
appropriate to do what I think the Senate did yesterday and
pass a whole series of changes in corporate governance which,
in my judgment, are moving in the right direction and will be
helpful.
But I will say this, that if you do not get the CEO
changing in the way that particular position functions, a
goodly part of the work of the Senate is not going to be very
effective. There are just too many people out there who, for
example, will get a legal opinion from a general counsel and
then say, I do not like that. Get me a different opinion. If
you are going to have that going on, you are dealing with human
nature and I do not see how one can effectively legislate
morality or character. But what you can do is to try to create
an environment and a legal structure which very significantly
penalizes malfeasance.
Senator Dodd. The yellow light is on, but--I think we are
doing that. Part of the bill yesterday incorporated some
stiffer penalties, criminal penalties.
Chairman Greenspan. I think that was the most important
part of the bill, frankly.
Senator Dodd. Senator Leahy will be happy to hear that.
But you mentioned one thing here, just quickly. You say
shareholding is now predominantly for investment, not corporate
control. If that is in fact the case, then the character of the
CEO becomes a diminished factor, it seems to me almost. If that
is what we are doing here, then control and discipline within
the corporation by shareholders and people who serve them on
boards seems to be diminishing, and will continue to do so.
Therefore, it seems to speak more loudly to the need for some
legislative action in the area of audit committees,
institutional investors having seats on boards. Again,
legislating in this area is dangerous, but----
Chairman Greenspan. It is dangerous. And I would suggest
that you be careful about how you move in this direction
because, remember, the system is frayed, but it is not broken.
If we, indeed, had a very extraordinarily weak corporate
governance or the system broke down, we would not be
experiencing the productivity growth that we are basically
seeing.
Remember, our economy is remarkably efficient. It has
developed a resiliency and a flexibility in recent years which
makes it very difficult to understand how this is going on in
the context of what clearly is many breaches of what
appropriate corporate governance is. What it basically is
saying is, beneath all of the problems that we have is still a
very sound structure. And if we endeavor to try to change the
system in a fundamental way, we may end up doing more damage
than help.
I am merely saying to go slow in this area, but there is
not a need at this point to rush because I will tell you,
corporate governance will be just fine for the next 2 years
because everyone has been chastened. The opportunities and,
indeed, the incentives to do the types of things that people
did, are no longer there. They do not have these huge stock
market capitalizations from which to draw off large earnings
for themselves. It is not there.
We do not need to worry about the short term. We do,
however, have to be concerned about the next episode. And
unless and until structure is put in place so that if 5, 7, 10
years from now a similar situation arises, we will be much
better able to handle it. So, I would say that speed and
expeditiousness are not important here. Doing it right is very
important.
Senator Dodd. Thank you, Mr. Chairman.
Chairman Sarbanes. In the extended hearings which the
Committee held on the corporate governance and accounting
issue, we received very strong testimony from those who had
chaired previous commissions that examined the situation, the
O'Malley Commission, and a number of others. The constant
refrain that we heard from them was that they had made very
important recommendations, that they had not been adopted
because in the short run, there was this kind of reaction and
pick-up.
The consequence, though, was that then there was a lapse
back in terms of behavior subsequently, and the structural
changes had not been accomplished to help forestall that. And
of course, that is one of the things that the legislation we
passed yesterday is designed to accomplish.
So at the moment, everyone is very uptight and measuring up
to--presumably, high standards. But the danger that they will
simply slip back, as has happened on past occurrences, and that
is one of the reasons that we want to put the legislation in
place, in order to help ensure that that does not happen.
Chairman Greenspan. Well, I agree with that, Mr. Chairman.
While there is very little chance, in my judgment, for really
significant new initiatives towards manipulation of markets or
anything else like that, it is the case that, as I said in my
prepared remarks, memories do fade. Optimizing that trade-off
is a very tricky issue.
Chairman Sarbanes. Yes.
Senator Shelby.
Senator Shelby. Thank you. Mr. Chairman, I only have 6
minutes. I am going to cede most of it to you with quick
questions because maybe the market will respond positively if
you keep doing it like it is.
Mr. Chairman, how long do you think it will take roughly
for all these restatements to come through? I know the
environment is there today of fear, of concern. And the sooner
they clean up, the better off we are going to be. But I figure
there are going to be continuous restatements.
Chairman Greenspan. I think that is correct, Senator.
Remember that there is a deadline of August 14, which the SEC
has promulgated for these statements to come in place, and I
think we are going to see a lot of restatements in the process.
Senator Shelby. So it is going to be about 4 weeks of hard
work.
Chairman Greenspan. I would think so. Remember that it is
most unlikely we have seen all of the undiscovered events. But
as I said in my prepared remarks, this is old stuff. It is
history. We will learn something from it.
Senator Shelby. It is history, in a sense. You are right.
But it is not history to a lot of the investors until it comes
out and they see what the real truth on the restatements are.
Isn't that correct?
Chairman Greenspan. I agree with that. And indeed, I think
that until it becomes fairly clear that the degree of spin in
earnings estimates is gone, it is going to be very difficult.
Remember, it is not as though everybody should be shocked
by this. We had these pro forma statements for months and
quarters back when the market was roaring away and it was the
most imaginative accounting I have ever seen.
In other words, the pro forma earnings were your revenues,
however you wished to present them, less some of the expenses,
and you determined which of them they were. Everybody knew that
was going on. So it was not as though people were creating
forms of accounting which people who were watching the numbers
were not aware of.
Senator Shelby. Sir, you are not saying that all the
investors in America knew it was going on.
Chairman Greenspan. No, they certainly did not. We are
talking about security analysts.
Senator Shelby. Absolutely. The security analysts and the
accountants and a lot of the CEO's and chief financial officers
knew a lot of this accounting stuff was going on. But a lot of
the investors in America obviously did not know it was going
on.
Chairman Greenspan. They did not. That is certainly true.
Senator Shelby. Because they would have gone into bonds
fast, I believe.
Chairman Greenspan. Well, let me just take a step back.
Senator Shelby. Sure.
Chairman Greenspan. We do have a set of profits data which,
for all practical purposes, are free of spin. That is the
numbers I was mentioning, the National Income and Product
Accounts numbers, which essentially take corporate reports and
make the types of adjustments that one is required to see what
is going on. Those numbers are improving fairly dramatically,
as indeed they must, because the necessary implications of a
productivity growth at 7 percent annual rate in the average of
the fourth and first quarters are very difficult to engender
without a very major increase in operating earnings. And
indeed, that is exactly what is happening.
Senator Shelby. Mr. Chairman, you used the word spin just a
few minutes ago, and it is a term that we see used here a lot.
But what we are looking for in the capital markets is accuracy,
which is basically truth, isn't it?
Chairman Greenspan. Yes.
Senator Shelby. What is the true situation, not what is the
spin or something, maybe even fraud, that comes from that.
Chairman Greenspan. Yes. I was encouraged, incidentally,
yesterday by the fact that when Coca-Cola announced it was
going to expense, its stock price went up, not down.
Senator Shelby. Along those lines, could you see in the
future the emergence of a credibility premium--you just alluded
to it--in the markets? In other words, will honesty, Mr.
Chairman, lead to higher share prices and to a lower cost of
capital? I am talking about real stocks.
Chairman Greenspan. I think it is already happening. I
think that there is a definite tiering that is going on.
Senator Shelby. People believe that people are honest and
this is true, they are going to invest, aren't they?
Chairman Greenspan. The risk premiums of investing go down
because, first of all, it is tough enough to make a judgment of
what the real earning capacity of a corporation is. It is not
simple. To have on top of that a question as to whether the
data are accurate creates an additional risk premium.
Senator Shelby. That is essentially the whole problem,
isn't it?
Chairman Greenspan. Yes. In other words, earnings estimates
are very complex. The best of the earnings analysts spend a
good deal of time on 10-K reports to try to unearth what the
underlying profitability is. If on top of that there are
serious questions of whether or not the numbers they are
working with are correct, then you are imposing an additional
risk premium on the earnings estimates, which, of necessity,
lowers the potential market value of the firm. And there is
definite tiering, as we say in the marketplace, that
differentiates these various different types of views. And I
hope, as indeed I expect, this will become a far more prevalent
experience.
Senator Shelby. Mr. Chairman, when do we reach the point
where productivity gains are maximized and firms have to then
turn to new hiring to make additional gains?
Chairman Greenspan. That is a very good question. We are
finding that productivity is still moving at a really quite
remarkable pace. And indeed, as I am sure you may know, the
Federal Reserve released this morning a fairly significant
increase in industrial production. We also know that this is
occurring without a major
increase in employment in manufacturing. That is true for the
economy as a whole.
It is not possible for productivity to advance at the pace
that it did in the 6 months ending March 31, and indeed, the
second quarter, as best we can judge, shows some positive,
continued positive productivity gains, but nowhere near what
they were previously.
At some point, these very dramatic gains are going to slow
down to a more sustainable, long-term pace, at which point
there will be a fairly marked pick-up in employment.
Senator Shelby. Thank you, Mr. Chairman.
Chairman Sarbanes. Thank you, Senator Shelby.
Senator Akaka.
Senator Akaka. Thank you very much, Mr. Chairman.
Chairman Greenspan, I was very interested in your remarks
about the need for trust in our system. It made me recall
discussions I had with Mr. Hiyami. This is a few years back,
when Japan was early into their financial problems, and how
even at that time, the word trust was not really a part of
their system. I was indicating that this is where they need to
go. I was very interested, therefore, in your comment about
trust.
Also lately, as far as last Tuesday, the Chief Cabinet
Secretary of Japan made comments about whether they should be
discussing whether the yen is moving too fast.
The Associated Press has reported that Japan has intervened
in the currency markets to weaken the yen against the dollar
seven times since last May. AP also reported that the U.S.
Federal Reserve and the European Central Bank have sold yen and
bought dollars on the Bank of Japan's behalf. So my question to
you, Mr. Chairman, is this intervention occurring and is the
Federal Reserve providing assistance to the Bank of Japan? If
so, what is your evaluation of the intervention? And what will
be the immediate and long-term effects of these actions?
Chairman Greenspan. Well, Senator, I cannot confirm any
individual degree of intervention on the Bank of Japan. But
what does happen is that we and the European Central Bank will,
at the request of the Bank of Japan, engage in exchange rate
activity in terms of yen against our individual currencies
outside the trading hours of Tokyo. So that what has happened
on occasion over the years is that when the Bank of Japan has
decided that it wanted a 24-hour degree of intervention, it
requested the other central banks to act on their behalf, and
we do it as their agent.
Senator Akaka. Secretary of the Treasury Paul O'Neill has
been quoted as saying that the current account deficit is a
meaningless concept. Please share your thoughts on the
significance of the current account deficit and potential
problems that it could cause.
Chairman Greenspan. I know that comment is attributed to
the Secretary and I am not sure it is in the full context.
Chairman Sarbanes. If the comment was properly in context,
I take it you would disagree with it.
Chairman Greenspan. Yes, indeed I do. The current account
deficit is a meaningful statistic. It does not, however,
necessarily mean that it is bad because one of the things that
obviously must be the case is that the current account deficit
must be exactly matched by a capital account surplus of the
same order of magnitude because balance sheets must balance.
What, therefore, is the problem in evaluation is that
unless you see what is happening to the exchange rate, you
cannot make a judgment as to whether the demand for dollars,
for example, is much larger than the financing requirements of
those, for example, who import goods and services. In that case
the dollar exchange rate would rise.
If, on the other hand, U.S. importers had a far more
significant demand to borrow foreign currency to finance their
imports than foreigners' demand for dollars to invest in the
United States, the exchange rate would go down.
All we can observe is the end result. It is a very complex
issue, and indeed, I addressed that in part in my prepared
remarks, Senator, as to how difficult it is to forecast
exchange rates.
Senator Akaka. Chairman Greenspan, last week, Ernst & Young
issued a report which indicated that nonperforming loans in
Asia have risen 33 percent to $2 trillion over the past 2
years. What factors have led to the increase in nonperforming
loans in Asia? And what impact could these nonperforming loans
have on the global economic recovery?
Chairman Greenspan. Well, Senator, I did not see the
particular report, but it is certainly the case that, for
example, nonperforming loans in the Japanese banking system
have gone up measurably and it is one of the major difficulties
confronting the Japanese government who are looking to reform
the underlying structure of the banking industry.
And in part, one of the big problems that they have in the
restructuring is how to resolve the issue of these
nonperforming loans. Nonperforming loans are not good.
Obviously, it merely indicates that a considerable amount of
capital was moved out into the private sector and essentially
used in an inefficient manner and it did not create wealth to
pay off the loans.
Clearly, it is not a good issue. Having nonperforming loans
is not good. But let me hasten to add that to have zero
nonperforming loans is not good, either. That basically tells
you that your banking systems are not doing what you would like
them to do. There is a trade-off here, and I think what
concerns the Japanese authorities is that, however one wants to
look at this, the nonperforming loan issue is too high in
Japan.
Senator Akaka. Thank you very much for your responses,
Chairman Greenspan.
Thank you, Mr. Chairman.
Chairman Sarbanes. Thank you, Senator Akaka.
Senator Allard.
Senator Allard. Thank you, Mr. Chairman.
Chairman Greenspan, the housing sector has been I think
relatively strong since our downturn started early in year
2000. Would you elaborate a little bit about why you think that
is happening? The interest rates I know are very low right now,
around 5 percent, 6 percent. Do you think that this is a major
factor or not? I would like to hear some of your discussion.
Chairman Greenspan. Well, I think that there are three
issues which are driving the housing market, new home
construction to begin with. First, is mortgage interest rates,
which are at really quite low levels, lower than they have been
in a really long time. Second is the issue, as I point out in
my prepared remarks, of the increasing shortage of buildable
land. And third, a very important issue which is not discussed
often, is immigration. The increase in household formation in
the United States is essentially about one-third immigration,
and that is enough to put a demand on the system and on the
capacity to produce homes in this country which has been fairly
pressing.
And so, what we have seen is very good housing markets.
Prices are going up. Home equities are going up. In a sense, we
have an expanding population to a large extent being driven by
immigration. The net effect of that has been a very buoyant
element within the housing market. It would not have been if
interest rates were not lower. So it is a combination of those
three factors.
Senator Allard. Do you think that the investors are perhaps
looking at housing as perhaps a stable area where they could
put their money where they could count on at least some
increase in equity and perhaps some inflation to protect their
value?
Chairman Greenspan. I think the answer to that is clearly
yes. We also have to remember, Senator, that if you
disaggregate the issue of equity ownership and homeownership by
income groups--it is pretty evident that the lower four-fifths
of households arrayed by income have a far greater proportion
of their wealth in housing than they do in the stock market,
and for the upper fifth, it is the other way around.
As a consequence of the fact that there is such a
predominance of homeownership in the upper middle-income
groups, which, while they hold stock, do not hold as much as
they do in home equity, the impact on the economy, the
stabilizing effect from housing, both from construction and the
extraction of equity which is assisted very significantly in
supporting consumer expenditures, has been critical.
Senator Allard. I would like to get back to this issue of
corporate governance again. I have always been under the
impression that the transparency of our financial sheets and
what not with businesses was much greater than other countries
throughout the world, and that was one of the strengths of our
system here, which actually encouraged investors from other
countries to invest in our stocks here in this country. What is
your view on our transparency as it compares to the rest of the
world?
Chairman Greenspan. I still think that, as best I can
judge, we are far more transparent than most. Even with the
problems that have surfaced in the last 6 to 9 months, our
system is still quite superior, in my judgment, to competing
systems around the world.
And, indeed, if we can resolve the corporate governance
issue, the underlying improvements in the American economy,
this really quite notable improvement in resilience and
flexibility in our economy, bodes exceptionally well for the
future.
So, we will get past this corporate governance issue. It is
most unfortunate and I think very regrettable, and it has had
negative effects, unquestionably. But beneath it all is still a
very soundly functioning system, as best I can see it.
Senator Allard. I noticed in your comments that you did not
say anything about our unemployment figures. I wondered if you
might comment on those. The unemployment figures have gone up
here. Is this something that could have been predicted or not?
Chairman Greenspan. Indeed, I think it was predicted. If
you have a slowdown in economic growth in the context of very
strong growth in productivity, the algebra is almost inevitable
that the unemployment rate will rise. As I pointed out in my
prepared remarks, the projection of the Federal Open Market
Committee at its last meeting was that the unemployment rate
will peak and come down from where it is.
Senator Allard. What has to happen to expedite our
unemployment to make those figures go down?
Chairman Greenspan. I think that the lingering impact of
the negative events of the last 2 years, which are still
pressuring our economy but are dissipating, have to finally
work their way through. That will take some time.
It is going through, as far as I can judge, pretty much on
schedule in the sense that, as I indicated in my earlier
remarks, the economy over the last 6 months has pretty much
followed the pattern that we had expected it would earlier in
the year. What that suggests is that it is going to take a
while, but that things are gradually improving as the negatives
continually become less.
Senator Allard. Finally, what can the Congress do in order
to help assure that we have economic growth in the short term?
Chairman Greenspan. There are two areas in which I think
action could be quite helpful. First is to restore the various
elements of fiscal discipline which really worked so well in
the early 1990's through the point where we ran into a surplus.
To get effective discretionary caps and PAYGO rules back in
place would be a very important issue to create a fiscal
environment which would be helpful to maintain low long-term
interest rates, which have been critical to the housing area.
Second is in the area of trade. I do not think we fully
appreciate how important the gradual breaking down of trade
barriers during the post-World War II period has been on
economic growth globally and especially in the United States.
And it is most important that we continue to move forward in
that area because the ever increasing division of labor that is
implicit in globalization has been a very major factor which
has enabled our high-tech industries in general, but our
economy overall, to function as well as it has.
Senator Allard. Mr. Chairman, I see my time has expired.
Thank you.
Chairman Sarbanes. Thank you.
Senator Corzine.
Senator Corzine. Thank you, Mr. Chairman. I appreciate the
remarks of Chairman Greenspan, thoughtful as always.
Let me say ask a question in specifics. Do you believe that
it would be appropriate for FASB to put back on its calendar of
consideration stock options, sooner rather than later?
Chairman Greenspan. Yes, Senator.
Senator Corzine. Second, do you feel that in the context of
the developments that have occurred, certainly been revealed in
the last several months, that the SEC's funding is appropriate,
that pay parity issues are appropriate consideration for the
Congress, and that the additional resources to match up with
the $10 trillion economy are reasonable requests that we should
pursue?
Chairman Greenspan. Senator, I have testified over the last
2 or 3 years, when the occasion arose, that the SEC is
underfunded.
Senator Corzine. I presume that underfunding means under-
resourced.
Chairman Greenspan. Yes.
Senator Corzine. With regard to people to review
statements.
Chairman Greenspan. Yes. But most specifically, their
salary level for lawyers, for example, is much lower than it
would be at the Federal Reserve. One of the reasons that has
occurred is that we had the same problems that they did many
years ago, and with the assistance of the Congress, we were
able to pay premiums to get the types of people we need to
supervise and regulate the banking system.
In my judgment, if we are going to implement the type of
legislation which you have just passed, we are going to need a
fairly expanded capability which at this particular stage does
not exist. If you are going to pass laws and not enforce them,
you are doing an injustice to a democratic system.
Senator Corzine. I could not agree more. And that is one of
the reasons, and I do not expect you to comment on it, a $100
million increase in the SEC's budget, I think was
disappointingly recom-
mended, when in fact, we need serious funding resources, and
pay parity for the individuals who----
Chairman Greenspan. Pay parity is very important.
Senator Corzine. I was interested in your comments to
Senator Allard with regard to the fiscal environment. You
talked about PAYGO and the spending issues. But conditions do
change through time and policies need to change, spending
policies, potentially. Do you still believe we can afford the
tax cuts that are expected to roll through the economy in the
context of the fiscal deterioration that we have seen,
certainly with the issue of irreducible minimum debt not being
quite the problem that it was a year ago at this time, or 18
months?
Chairman Greenspan. Senator, I have always believed that
one of the things that we do poorly at this stage is project
and simulate various different outlooks into the future for our
Federal budget.
Thirty years ago, there was nothing in the budget that
really had a major impact in years forward. We now no longer
have a 1, 2, or even a 3 year budget. We have commitments, both
contingent and otherwise, which go many years into the future.
I think we need far more in the way of analysis and
projections and trade-offs with our whole budget, both receipts
and outlays. That is specifically the case, as I have testified
before,
because we are running into an unquestioned significant shift
in demographics toward the end of this decade, which is going
to mean that the number of retirees which are going to put
pressure on resources in this economy is going to be very
significant.
Now my view has always been that I think that we can
curtail spending far more than we do. And my own personal view
is that the best way in which the economy can function is to
hold spending down and get as low a tax base as you can to
enable the economy to expand as rapidly as you can. But, having
said that, whatever it is that is done should at least be
projected in a manner which is consonant with credible long-
term outlooks.
I am not going to address the specific question that you
asked because that question can then lead to five or six other
questions of what do I think about one specific program,
another program.
Senator Corzine. That would be fun.
[Laughter.]
Chairman Sarbanes. What a path to go down.
[Laughter.]
Senator Corzine. Right.
Chairman Greenspan. I have tried----
Senator Corzine. I guess the central point of what I was
trying to make, though, is that there are two tracks. And I
will interpret your statement that one needs to look at
receipts and outlays, and one needs to prioritize those in the
context of the importance that we have. One of those that is,
and I think I just heard you say that making sure that we had
the proper resources at the SEC is going to mean that we have
to increase spending, at least in one area. Now, we have a huge
budget and we have lots of choices. But those choices need to
be made and they need to be made inside the context of receipts
and outlays, depending on what the needs of the Nation and
projections are.
Chairman Greenspan. Yes, that is precisely why I am
somewhat distressed by what has been a breaking down of fiscal
responsibility in the process of engendering budgets.
Senator Corzine. Thank you.
Chairman Sarbanes. Senator Bunning.
Senator Bunning. Thank you, Mr. Chairman.
I ask this question always to you and you spoke about it
earlier. You see no evidence of inflation in our economy
presently?
Chairman Greenspan. None that is evident to any of the
analysts in our organization.
Senator Bunning. Thank you. I want to make sure that is the
case.
You spoke to stock options and you spoke to Coca-Cola. I
received a fax--not a fax, but an e-mail from Bank One today
announcing, effective with today's earnings announcement, it is
reporting stock options granted to executives and other
employees as expenses. So here is another one joining the team
voluntarily. I think that when we see the effect of what
voluntary compliance does in reporting stock options as
expenses, we may not need to react with some type of
legislation.
Last Friday, after the markets closed, both Fannie Mae and
Freddie Mac agreed to voluntarily register their securities
with the SEC. The TVA or the Tennessee Valley Authority has
about $20 billion in public-traded securities, but they are
exempt from SEC's jurisdiction. Do you think TVA should also be
under SEC's jurisdiction with that amount of debt out?
Chairman Greenspan. Senator, I am not familiar with the
TVA's issue. But I do know that Under Secretary Peter Fisher of
the Treasury Department is testifying today on the GSE's issues
of registration and the like.
There are several questions here which are emerging. One is
not only on their securities, but also on mortgage-backed
securities, which is a much more controversial issue. I think
that this issue requires further examination, as indeed it is
getting. I do not know what the consequence of the testimony is
this morning. But I do think that issues such as you raise
should be examined to determine what the appropriate role of
GSE's and related organizations are with respect to the
questions of disclosure.
Senator Bunning. Let me talk to you about something that
has been in the news as of yesterday, about wash sales, that
Enron and others have been accused of. In other words, buying
and selling on the same day in the electric and gas markets. Do
you have an opinion on those?
Chairman Greenspan. People do that all the time. I do not
think that is the issue. It is how they record it on their
books which I think is what the real question is. And there
have been allegations, which I frankly do not know whether they
are accurate or not, that part of this problem we are having
with dubious accounting procedures is they bloat revenues by
essentially double-counting activities. For example, if you and
I were, say, two corporations, I could sell you something and
you could sell me back the same thing, and both of us would
increase our revenues, where really, as a practical matter,
nothing important happened. There has been a good deal of that
going on. I am a little puzzled in certain respects as to why
some people do that because, while it is the case that revenues
do rise, margins, by definition, go down.
There are, unfortunately, certain types of incentives which
are tied to revenues within a corporation and not profits, and
so that there is an incentive to play those types of games. I
am not sure that it makes any sense whatever. But clearly, it
does not do credit to those who are trying to keep credible
books.
Senator Bunning. Okay. Last question, and it has to do with
the electricity market, since we have had some major problems
in certain areas of the country. Do you believe more regulation
is needed in our electricity markets to stabilize the supply
and demand that occurs in certain areas of the country?
Chairman Greenspan. Well, Senator, we are undergoing a
major change in the technology of electric power. Remember, one
of the crucial characteristics of electric power is we cannot
store it, which means that there is no buffer involved between
supply and demand. For generations, we therefore constructed a
public utility
operation in which individual utilities would function under a
regulatory scheme in which they would be guaranteed rates of
return, and in the process, function in an adequate manner.
What became apparent, however, was that capital was being
grossly misused in the sense that because you were able to get
a guaranteed rate of return on stand-by capacity, there was a
tendency to create more of it than we really needed. And with
the increased ability to wheel power from one area to the other
and get improved technologies, we have perceived a major
capability of reducing the amount of capital we need to produce
the amount of energy that we have. The trouble is that in this
transition, we are getting all sorts of very technically
difficult problems arising.
I do not think that we should go back to the regulatory
structure we had in the past. I think what we have to do is
address the issues as best we can, but not to stop the
continuous deregulation of electric power, which in the long
run will be very helpful to this economy.
Senator Bunning. The only question is, which everybody
asks, should the Feds do it or should it be done State by
State? Obviously, the Federal Government has not chosen to do
it and it is being done by all the 50 States.
Chairman Greenspan. Well, one of the problems basically is
that when you start to wheel power across grids, it is an
interstate action. So it is difficult to avoid the fact that
there is a Federal role in this regard.
Senator Bunning. Thank you very much, Mr. Chairman.
Chairman Sarbanes. Thank you, Senator Bunning.
Senator Bayh.
Senator Bayh. Chairman Greenspan, thank you for being with
us. Your testimony, as always, is substantively insightful and
rhetorically Delphic, which is appropriate since, as our
Chairman pointed out, your words, can literally move markets.
[Laughter.]
So it is good to have you with us today.
I would like to begin with a couple of questions about
productivity growth, which is so important at both the macro
and the microlevel, and specifically how it relates to your
anticipated acceleration of capital expenditures and
investments.
You mentioned four factors that may contribute to improved
capital expenditures. One of them was profitability of the
firms, improved clarity. But there things seem to be a little
murky. You mentioned that revenues are growing only tepidly.
Profit margins are less vigorous than in the past. Growth in
sales and profits are particularly weak.
Mr. Chairman, it seems to me, reading between the lines of
your testimony, that you expect capital investment to
accelerate largely because of a productivity imperative
before clarity and profitability improves. Is that an accurate
interpretation?
Chairman Greenspan. Senator, when you are confronted with a
situation in which pricing power is nonexistent, and you are
endeavoring to improve your profitability, there is only one
way to do it, and that is improve your profit margins. And the
only way to do that is to increase productivity of your firm.
That is the process that is going on. And it has been very
successful, and indeed, surprisingly so because I cannot
imagine anybody who projected the extraordinary acceleration in
output per hour that has occurred in the last 9 months as
recently, let us say, as a year ago. It has been a very
interesting indication of how much progress we have made in the
underlying capabilities and efficiency of our system.
Senator Bayh. Which leads me to my second productivity-
related question. You have spoken to us in the past about
cycles of innovation and productivity acceleration, which then
at some future point level off to a mean average. What would we
look at to try and anticipate approaching a saturation point of
information technology of other new information, suggesting
that this wonderful acceleration in productivity growth that we
have experienced may at some point--how can we anticipate at
what point it might subside?
Chairman Greenspan. That is of course the crucial issue in
forecasting, Senator. What we try to do is to glean from
various surveys what the extent of the application of existing
technology has been put in place in firms. What has been a
remarkably consistent survey, when purchasing managers, for
example, who have these various different capabilities of
reporting what companies are doing, are asked, ``What
proportion of the existing technology currently available to
you today is already in place?'' The usual number is 50
percent, which essentially says that the part that is as yet
unexploited is still very significant. But because the 50
percent does not change, it is essentially saying that it is
expanding at the other end.
Senator Bayh. Innovation and application seem to be
proceeding apace.
Chairman Greenspan. Yes. So, obviously, at some point, they
are going to find that there is an element of saturation and we
have exploited the potentials as much as we can.
Senator Bayh. But we are nowhere near at this point.
Chairman Greenspan. But we have not seen any evidence of
that yet.
Senator Bayh. I am going to try to fit two additional
questions in before my time expires, Mr. Chairman. The first
deals with housing. I was interested in your remarks about the
role of immigration, scarcity of land, and low mortgage rates,
seem to have offset for the time being the fact that housing
prices--I believe that housing price escalation has exceeded
personal income growth for some time. Is it your view that this
can go on indefinitely?
Chairman Greenspan. Well, it is an interesting question as
to whether prices of homes, by the nature of the industry, will
tend to rise relative to the underlying level of prices
generally in an economy.
I am sure there are a lot of people who would argue with me
on this question. But my impression is that because so much of
our home construction is individual and customized, that the
level of productivity advance that you can get in the economy
as a whole is not feasible in the housing construction area.
Indeed, people do not want it. You want to have something which
is unique. And if it is unique, you cannot create significant
productivity.
Now, I am not saying that productivity in housing is not
going anywhere. It is going at a quite remarkable pace, but
less than the economy as a whole, which means, over the long
run, the prices of homes will rise relative to the average.
Senator Bayh. I am on the yellow light, Mr. Chairman. I
will just slip in a very short question here. And I do not
intend to ask you about the value of the dollar. I understand
why that would be a perilous territory to tread upon. But are
there factors that you would look at that would allow you to
judge whether the revaluation of the dollar is proceeding in an
orderly manner, or at some point would be more precipitous and
thereby would verge upon the disorderly or run the risk of
destabilizing or creating inflationary pressures? Or is it not
possible to address that without implicitly getting into the
value of the dollar?
Chairman Greenspan. Correct.
Senator Bayh. Okay. I understand. I was interested, not in
what the valuation point might be, but instead, the rate of
revaluation and the risk of instability and the economy
resulting from that. But it is a conversation for another time.
Thank you, Mr. Chairman.
Chairman Sarbanes. Thank you very much, Senator Bayh.
Senator Bennett.
COMMENTS OF SENATOR ROBERT F. BENNETT
Senator Bennett. Thank you very much, Mr. Chairman.
Chairman Greenspan, when you come in a little bit late,
that means you are in a circumstance where virtually everything
has already been explored. I am going to take you in a
direction that probably has nothing to do with your testimony
today, but takes advantage of your presence and might have some
implications for the situation in which we find ourselves. I
want to talk to you about tax treatment of dividends.
It is very easy to--not very easy, but it is possible as we
have seen to deal with the books in such a way as to manipulate
earnings, or at least manage earnings. That is a concept I
never learned at the beginning of my business career and it
started coming up at the end. Well, we are going to manage the
earnings. I always thought that earnings were a factor of how
well you manage the business and came or did not come,
depending on----
Chairman Greenspan. Doesn't that sound like an old-
fashioned concept, Senator?
Senator Bennett. Yes.
[Laughter.]
Chairman Greenspan. I wish we could restore it.
[Laughter.]
Senator Bennett. Now, dividends cannot be managed nearly as
easily as earnings. But when the question was raised in the
company where I was involved as to whether or not we should
start to pay some dividends because we had some fairly
significant cash, the response we got from the people who were
Wall Street savvy--we started out as a private company,
obviously, so we did not have any of those folks around. But as
we became a public company, then we had to have people with
that expertise.
They said, no, no, you do a disservice to the shareholders
if you pay dividends because, if you pay dividends, what you
are saying to them is that you do not expect the company to
grow as rapidly as other companies into which they could put
after-tax dollars. And since you expect that you can manage
their money better than they can manage their money, and you
are dealing with pre-tax dollars, you do the shareholders the
best service by hanging onto the money and investing it in your
own company.
It raises the issue, then, of tax treatment of dividends
because if the investor had the opportunity to take his or her
money out in the form of a dividend and not pay the tax on it,
he or she might say, I can do a better job than the managers of
this company.
Now, you and I have questioned each other in what has been
kind of a Kabuki ritual over the years when I have asked you
what the capital gains tax should be, and you looked thoughtful
and then tell me you think the optimum capital gains tax should
be zero, and then we both say, yes, that is the thing we want.
Then I do it again at the next hearing.
Let us talk about taxes on dividends because dividends,
like capital gains, represent a return on capital. And since
every other issue has been discussed and we have a little bit
of time, let us get philosophical about this issue, and
particularly against the backdrop of dividends as a measure of
corporate performance, as opposed to managed earnings as a
measure of corporate performance.
Chairman Greenspan. Senator, I think there are two
interesting aspects to this question. I remember, and I am sure
you do, when yields on stocks were 5 and 6 percent.
Senator Bennett. Yes.
Chairman Greenspan. This goes back 50 years but people
bought stocks for dividends. They did not buy them for
earnings. And one of the problems that we did not have back
then is earnings manipulations were not very important because
nobody cared.
Earnings are very difficult to estimate. In fact, there is
no such thing as an objective earning level of incorporation
until a corporation is fully liquidated. So earnings are always
provisional.
Cash dividends are not. As I indicate in my prepared
remarks, there is a question here as to the value of cash
dividends inducing corporations to start to build up cash, and
in that process probably think in terms of increasing cash
dividends.
Now that changed very dramatically. And indeed, there is
another element here: remember, one of the reasons why
dividends as a means of pay-out have gone down somewhat is that
there has been an awful lot of stock buy-back which effectively
does not
address the question of taxation. At root, this question, or
the fundamental aspect of this question, really gets down to
the double taxation of dividends and the issue of the
integration of the corporate tax with the individual tax. And I
think a lot of economists will tell you that that is an
extraordinarily useful and efficient way, if you can do it, to
put all of the tax burden on shareholders and not have double
taxation of dividends through taxing the corporation and then
taxing the dividends again.
My own impression is that we should have a very large
expansion of Subchapter S corporations which effectively would
enable dividends to be paid out and effectively taxed only
once. I do not expect that to happen at this particular stage
and there are very good reasons why problems of revenue loss
are creating a concern. There are issues of equity.
But if you are asking as an economist and looking strictly
at the question of the optimum allocation of capital in the
system, eliminating double taxation of dividends is a very
valuable thing to do. And indeed, as you may be aware, the
Secretary of the Treasury has very strongly been proposing
that.
Senator Bennett. Just quickly, with the time gone, the
company that I managed that was most successful was in fact an
S corporation. And as shareholders in that S corporation, we
could make the decision as to whether or not we were going to
leave the money in the company to make it grow or take it out.
Since there were no shares to sell in the public arena, the
whole question of stock options did not come up. So, we watched
very carefully the amount of cash accumulating in the company
and the amount that we could take out in the form of dividends.
And as you say, it was not double-taxed.
Thank you very much.
Chairman Sarbanes. Senator Carper.
COMMENTS OF SENATOR THOMAS R. CARPER
Senator Carper. Thanks, Mr. Chairman.
Chairman Greenspan, welcome. It is good to see you and we
thank you for meeting with us today. I have been in and out. We
have had a couple other hearings going on and I am in and out
of another one dealing with clean air. So, I apologize for not
being here to hear all of the questions. I heard most of your
statement.
I want to revisit an issue that revolves around the
legislation that the Senate passed yesterday, which the House
passed their own version of it a month or so ago. We will now
create a conference committee, as you know, and we will hammer
out our differences. Somewhere along the line we are going to
be asking you publicly or privately for your own counsel as to
which provisions are most important that we retain from the
Senate bill or maybe in which instances you think the House
language is preferable. Do you have today any particular
thoughts that you might share with us as to what provisions of
the Senate bill that you feel are most worth preserving as we
go forward?
Chairman Greenspan. Senator, I thought that the initiative
that the Senate produced was very important and very effective.
As I said to the Chairman before the hearing, my original
view was that taking accounting standards and moving them out
of the private sector was really unnecessary because my view
was always that accountants basically knew or had to know that
the market value of their companies rested on the integrity of
their operations and that, indeed, that signature that they put
on an order form is where the net worth of the company comes
from.
And that, therefore, their self-interest is so strongly
directed at making certain that their reputation was
unimpeachable, that regulation by Government was utterly
unnecessary and, indeed, most inappropriate. I was wrong.
I was really deeply distressed to find that actions were
being taken which very clearly indicated a lack of awareness of
where the market value of accounting is. Consequently, what
essentially your bill, the Chairman's bill, and that of the
House is endeavoring to do, is to substitute for something
which should not have been necessary in the first place. I have
no views as to what pieces of what bills to take. I frankly
have not read the bills in detail. Is it 112 pages or
something?
Senator Carper. It is a quick read.
[Laughter.]
Chairman Greenspan. I am not competent to answer a number
of these questions. I think I am in the area of accounting
where I have some very considerable history. But in the
business of accounting, I do not, and I am not really
knowledgeable enough to be able to make judgments.
Senator Carper. All right. Thank you.
I have heard you testify a number of times and I thought
today your testimony was uncommonly clear and precise. Some
have suggested that it is not always that way, and I always
thought it was just me.
Senator Bennett. If I may, Senator, you are just getting
better at decoding it.
[Laughter.]
Senator Carper. Well, I hope so. I thought your testimony
was just very clear and very compelling.
Chairman Sarbanes. It is better than Volcker. You had to
decode the smoke rings that he was blowing from his cigar.
[Laughter.]
Senator Carper. I thought one of the things you said that
really struck home with me was, and I will paraphrase, you said
that the state of corporate governance within a corporation
reflects the character of the CEO. I thought that was a very
telling statement.
Let me just change gears a little bit, if I could, and ask
us to focus on our trade deficit, which is large and seems to
be growing, and to relate to that. Maybe you could just take a
moment and give us a little primer on the financing of the
trade deficit. Last year I think it exceeded $300 billion. The
role that foreign investment plays in enabling us to finance
that trade deficit, and why restoring investor confidence in
our markets is important as we deal with financing the trade
deficit.
Chairman Greenspan. Well, Senator, as I indicated
previously, thinking in terms of the broader issue, the current
account deficit is distinct from the trade deficit, you have to
determine how it is being financed. And by construction, the
current account deficit, as I indicated earlier, has to be
exactly the same amount with the sign changed as the capital
accounts surplus because it is double-entry bookkeeping. One
must balance the other.
And obviously, when the demand to invest in the United
States is increasing or is very large, it may very well create
a demand for dollars to invest in the United States much larger
than the demand for foreign currency by our importers who need
to finance goods from abroad. That is in fact the best simple
explanation of why the dollar goes up or down. When the demand
for investment is greater than the demand for foreign
currencies to import, the dollar will be up, and vice-versa.
The notion, however, that you have to be careful about is
that we are talking about the rate of increase in investment.
In other words, you can have a significant decline in the rate
of inflow of capital investment in the United States, but it is
still positive and so the aggregate amount of investment is
growing. It is the rate of change which determines whether in
fact the pressures are for or against the dollar--whether the
price of the currency is going up or going down. And I think,
as I indicated in my prepared remarks, it is such a complex
type of structure--that is, the markets are so efficient and so
complex in exchange rate markets, that it is very difficult to
forecast them much in advance.
We at the Federal Reserve have spent an inordinate amount
of time trying to find models which would successfully project
exchange rates, not only ours but everybody else's. It is not
the most profitable investment we have made in research time.
Indeed, it is really remarkable how difficult it is to
forecast, which is another way of saying how successful the
markets have become in absorbing the knowledge that everyone
has about supply and demand for currency, supply and demand for
goods and services, imports and exports. So, our inability to
forecast is a testament to how good the markets have basically
become.
Senator Carper. Thank you, Chairman Greenspan.
Thank you, Mr. Chairman.
Chairman Sarbanes. Thank you, Senator Carper.
Senator Schumer.
COMMENTS OF SENATOR CHARLES E. SCHUMER
Senator Schumer. Thank you, Mr. Chairman. And thank you,
Chairman Greenspan, for your dedication to our country and its
economy.
I have one general question and two specifics. My general
relates to this. Many of us are scratching our heads here
wondering why are the markets to skittish, so far up, so far
down. And I guess you hear a whole melange of reasons--
corporate governance, obviously, September 11 and the residue
from September 11, people's fear about the future and unwilling
to say, well, we will have a great future.
But then maybe there is the other answer, which is that
stock price ratios are still very high. Maybe they were just so
high that the exact details of what brings them back to
traditional levels is less important than they come back to
traditional levels and are not going to pop back up again. So,
I guess my questions are; could you comment on that generally?
How much is this specifically driven by the situations of the
times, the Enron's and the Worldcom's, as well as the September
11's? How much is just possibly a return to more normal ratios
of stock price ratios? And related to that, just a specific--
how great is the confidence of the markets in Washington's
ability to get on top of all of this?
Chairman Greenspan. I am glad you are asking such easy
questions this morning. If we were dealing with, as you put it,
normal stock price valuation processes, then we could just very
readily look at a chart and say, price/earnings ratios are
higher or lower, equity premiums are higher or lower, and make
judgments accordingly. There is a tricky problem here, and the
problem basically is the productivity problem. The change in
structural productivity, the order of magnitude of which is not
all that easy to judge, clearly must have an effect on the
long-term equilibrium price/earnings ratio. Obviously, with
productivity growth rising, the equilibrium P/E ratio is
higher. What we do not know is where it is. And so, it makes it
very difficult to answer that question.
Senator Schumer. So the traditional valuations do not work.
We do not know where they end up, but they do not work. Or as
well.
Chairman Greenspan. They do not work as well. No, I am not
saying that we throw them out. I am just basically saying----
Senator Schumer. Let me ask then the second part of that.
How great do you think is the confidence in the markets of
Washington's ability to get on top of this crisis of confidence
that we have?
Chairman Greenspan. I do not know the answer to that.
Senator Schumer. When the President gives a speech, then
the markets go down, things like that.
Chairman Greenspan. Well, I do not know.
Senator Schumer. You know, I am not saying cause and
effect.
Chairman Greenspan. Well, confidence is a difficult thing
to put your finger on. You do not reverse investor, consumer,
or other confidence----
Senator Schumer. By a speech.
Chairman Greenspan. ----overnight, or by any particular
action by anybody. And the reason is that we have an
extraordinarily complex economy which is fairly stable, in the
sense that it used to be that we had many regional economies in
the United States. I remember the time when mortgage interest
rates were 50 basis points higher in California than in New
York. We now have a single financial market--indeed, I would
argue, international financial market--which does not move with
minor changes.
Senator Schumer. So, again, maybe what you are saying here,
and I do not want to put words in your mouth, is that it has
become--even creating that kind of confidence in a complicated
economy has become complicated. So the jury is out as to
whether we can do it.
Chairman Greenspan. Yes. At root, confidence occurs when
you have a stable economic environment from which to function.
We know, for example, that inflation is very antithetical to
investor confidence, and we see it in the marketplace.
Stability and predictability are crucial elements to
confidence. And those are not easy issues to really produce.
Senator Schumer. You had mentioned that you supported the
Leahy part of the bill, the increase in the penalties to the 10
years.
Chairman Greenspan. I supported all of the elements in
which the issue of taking fraud as an action of theft and
treated accordingly is appropriate.
Senator Schumer. Right. There was some talk yesterday or
this morning of backing off some of those tougher provisions as
we get to the conference. I take it you would regard that as a
bad idea.
Chairman Greenspan. Well, now you are getting into areas of
jurisprudence and criminal law in which my expertise is zero or
less. I do not know how one should basically interpret it. All
I can tell you, from an economist's point of view, that the
issue of fraud and misrepresentation are extraordinarily
deleterious to the functioning of a voluntary free market
capitalist system, and that if you want the benefits from the
type of system that we have, you cannot have issues of fraud,
which are the equivalent of violence to the markets themselves.
Senator Schumer. I would read into that that we ought to
stick with the tougher penalties.
Chairman Greenspan. I have really said what I believe as an
economist. How that is interpreted into the criminal law is
something which I do not have a clue about.
Senator Schumer. Okay. One final question. A proposal has
been put together. I could not offer it in this bill because it
was not germane. But being aware, and this again relates to
transparency and knowledge, which I think are really the main
functions of how we ought to regulate the markets, rather than
with a heavier hand. But you have large numbers of companies,
when they file their earnings under the Securities Act and
others, so differ with the filings of their taxable income on
their IRS statements.
For instance, Worldcom supposedly reported $16 billion of
earnings to its shareholders between 1996 and 2001, and yet,
reported only a billion dollars of taxable earnings, to the
IRS. Now, admittedly, the accounting standard and the tax
standard are different. They do not seem to be so different.
Chairman Greenspan. Partly. Partly illusion, Senator.
Senator Schumer. Yes. But the proposal being that with ways
to protect proprietary information of the companies, in other
words, not filing the whole tax return, but some kind of
summary, what would be your initial thinking on a proposal that
said that companies had to file those tax returns with the SEC
and they would be made public to the investing public, again,
with the caveat of leaving out specific proprietary
information. Not to say they would be the same, but maybe they
would have some salutary, prophylactic effect of having fewer
disparities.
Chairman Greenspan. Well, my initial reaction is that
unless you can see some real advantages in doing it, which I
cannot, I would not be in favor of that. And I think that the
issue really gets to the question of appropriate governance.
For example, there is no question that the accounting
treatment for tax purposes is not the same thing as the
accounting treatment for other corporation puposes. Indeed,
there used to be jokes that everyone had two or three sets of
books, as though that was something bad. The truth of the
matter is you might want two or three separate sets of books.
You may want, for example, and the most important one from
the point of view of the chief executive officer is to have a
set of accounts which says, as I indicated earlier today,
whether in fact a particular corporate strategy is successful.
That is a very specific request and you would keep your
accounts in a certain manner.
There is another set of accounts which you may want to keep
to determine, what is the probability that you will default?
And that is a different set. You value assets differently.
For example, in one case, you try to get an exact measure
of the value of assets. In a default issue, you want to get a
very conservative estimate, to lean over backwards. Then you
have tax accounting, which is different again.
And all I would suggest is that, as I indicated in my
prepared remarks, in the National Income and Product Accounts,
which, as I indicated, profits are rising quite significantly,
are essentially derived from the IRS data system, and in that
regard offer the macrodata more accurately.
Senator Schumer. No one is disputing there should be
different types of books and accounts. What is wrong with
having the public see them? What is wrong with more knowledge
rather than less?
Chairman Greenspan. Well, largely because I do not think
you can effectively maintain the confidentiality that is
required for proprietary purposes, no matter how hard you try.
Senator Schumer. Thanks, Mr. Chairman.
Chairman Sarbanes. As we draw the hearing to a close, first
of all, Senator Schumer, you talked about restoring confidence
and so forth. I do not think you were here at the outset. When
Chairman Greenspan began his testimony, the Dow was down 200
points and the Nasdaq was down 8.65. When he concluded his
testimony, the Dow was down 132 and the Nasdaq was up 5.56. And
we checked, just a moment ago, now that we are about to
complete the questioning. The Dow is now down 20, and it was
down 200 when he began. So through his testimony, and then the
question and answer session, we have gone from minus 200 to
minus 20. And the Nasdaq has gone from minus 8.65 to plus 21.
Senator Schumer. We should keep talking, Mr. Chairman.
[Laughter.]
Chairman Sarbanes. I was going to say, regrettably, we are
not going to be able to extend this hearing indefinitely. And
so, we take no responsibility for what happens the balance of
the day.
[Laughter.]
Mr. Chairman, I want to put just a couple of questions to
you before we draw to a close. First of all, I want to
underscore how much I agree with you when you made the point
that fraud undercuts the very fundamentals of the workings of
our economic system. That is why we have penalties, severe
penalties, in the bill for corporate executive officers who
engage in fraud or misleading information. Second, the ability
of investors to rely on information in order to make judgments
as to where they invest their money is why we have developed
this strengthening of the system in terms of oversight of the
accounting industry and the effort to eliminate the conflicts
of interest that affect auditors making a tough call as they
audit the books, or stock analysts in terms of their buy or
sell recommendations. So that is certainly something that the
legislation is addressed to accomplish.
I just want to ask two questions as we close. You referred
to the Federal Reserve's release this morning on industrial
production, that it was up, I think, eight-tenths of a point.
I note in the material that the production of business
equipment, however, fell in June, that it fell at a 6.6 percent
rate in the second quarter, and that capacity utilization,
while up a bit, remains at the lowest levels in almost 20
years. What will it take to get our capital goods sector back
to reasonable growth?
Chairman Greenspan. I think that underlying profitability
is by far the most important way of doing that. It is fairly
evident that the cutting edge of technologies continue to be
important in this economy. And that should in itself be the
major force which will induce recovery.
Remember that one of the problems we ran into subsequent to
the early months of the year 2000 was that we found that even
though demand for high tech was rising at a fairly significant
pace, the supply was rising at twice the pace, and that
inevitably created a glut which had to be worked off. And as
best we can judge, as I indicated in my prepared remarks, that
is largely complete.
Chairman Sarbanes. I want to invite you to think with me
for a moment about an issue that I think is out there in the
future, but I want to try to anticipate it. It has been raised
in my mind by the question I put to you earlier about the Euro
now being worth more than the dollar, but it really addressed
the European Union and what that possibly represents as a
challenge.
I am prompted to this by a story in The Wall Street Journal
a few weeks ago. The headline was: U.S. Loses Sparkle as Icon
of Market Place. Wave of Corporate Scandals Could Tilt World
Business Away From American Model. There are comments from the
Europeans. One of their leading industrialists in Germany says,
``I warn people not to simply take over rules from the United
States without first reflecting on them critically.'' And then
they go on to say, ``European leaders are also pushing for
greater acceptance of their auditing rules, known as the
International Accounting Standards, as an alternative to
American rules. The great virtue of the International
Accounting Standards, which all European Union companies will
have to adopt by 2005, is that it is a simple and fairly
compact list of basic principles.''
The chief executive of KPMG in India said that there had
been a painful loss of face for consultants and accountants
representing American companies. The scandal has been
unhelpful, especially since we as a profession operate on a
reputation and the implicit trust that follows.
The point I want to make is, that the American accounting
industry needs, in effect, to cleanse itself and shape up and
have a proper system in which it functions, or it is going to
end up finding itself severely challenged internationally.
Traditionally, the United States has this reputation for
the most transparent markets, the ones with the most integrity.
It has been our standard so to speak--that is the prevailing
standard. That is in part, I think, because we have been
overwhelmingly the largest economy, although the EU now is fast
approaching equivalency with the United States in terms of the
size of the economy.
Also, as this notes, all the countries are going to adopt
the same international accounting standards in the EU by 2005.
And I think this is going to be, looking down the road, a very
serious challenge to the preeminence of the American accounting
profession which it has had up to this point.
Which it seems to me is just another very strong argument
why we need to put these changes into place to get it back up
to a standard that commands universal respect, because it is
very clear now that the Europeans looking at it no longer
concede that we have this established lead, that our system is
necessarily better than theirs. They are now large enough
economically, in a sense, to challenge it. And so I see a
competition developing down the road which, it seems to me, we
need to pay attention to.
I think the integrity of the American capital markets has
been a great economic asset for the United States, and that
anything that jeopardizes that carries with it the erosion of
our economic strength and our international economic position.
Do you have a view on this issue?
Chairman Greenspan. I agree with the general comments you
are making, Mr. Chairman. We thought at one point that the
detailed GAAP rules actually produced clarity. What we
regrettably found in too many cases is that the various sets of
GAAP rules were used as a hurdle for legal cover of various
different types of actions. And the reason I think that, as in
your bill and other requirements, that a CEO or CFO certifies
the overall accounts, what is in effect occurring is not merely
a stipulation that we passed say 104 of GAAP requirements and
we met them all and therefore, we have disclosed what needs to
be disclosed. What we have learned, regrettably, is that in
order to get a really important understanding of what the
underlying profitability and the nature of a corporation is,
you need far more than merely a listing of whether or not you
met a certain set of GAAP requirements.
Now what that says is that you are requiring over and above
having met individual GAAP requirements that the CFO and CEO
are certifying, that irrespective of that, the system has
basically--the set of accounts that are being offered does
indeed correctly portray, as best one can, what the nature of
the company is. A combination of GAAP and oversight by the CEO,
certification by the CEO, may be an important way of looking at
accounting.
Now, I am not denying that having principles rather than
specifics has certain advantages, and I think that the
competition that we now see between the two different systems
is very healthy. What will ultimately emerge out of it, in my
judgment, is probably an international system which will
combine the best of both systems and be applicable on a
worldwide basis.
Chairman Sarbanes. Mr. Chairman, we thank you very much. It
has been a very interesting and informative hearing.
The hearing stands adjourned.
[Whereupon, at 12:35 p.m., the hearing was adjourned.]
[Prepared statements, response to written questions, and
additional material supplied for the record follow:]
PREPARED STATEMENT OF SENATOR JON S. CORZINE
Mr. Chairman, I want to again congratulate you on the overwhelming
passage of the accounting and investor protection reform legislation
yesterday, your leadership in that effort was nothing short of stellar.
I also want to thank you for holding this hearing this morning, and of
course want to welcome Chairman Greenspan before the Committee and
thank him for joining us today.
Chairman Greenspan, I look forward to your testimony on the issue
of the state of our Nation's economy. In a speech in Alabama yesterday,
President Bush outlined that with low interest rates, relatively low
inflation, and increasing productivity that ``our economy is
fundamentally strong.'' That may well be true, but we have this
unprecedented decline of equity markets and at the beginning of an
economic recovery. My question is ``why?''
Are we facing the risk of slipping into a deflationary spiral that
parallels what we witnessed during the Japanese crisis of the 1990's?
Or is this all attributable to the fact that corporate scandals, like
we have witnessed at Enron and Worldcom, have led to a crisis of
confidence in corporate management and corporate financial statements
that have called many to question not only the integrity of our
equities markets, but also the fundamental underpinnings of our
economic well-being.
Hopefully, last night's reform package passed here in the Senate
will be embraced not only in conference by the House membership, but
also by President Bush, who to date has been reluctant to state his
support for this bill over the far weaker legislation passed by the
House.
Like the rest of my colleagues, I look forward to your perspectives
about what, if any, impact you believe the legislative proposal passed
by the Senate yesterday will have toward helping to soothe the fragile
psyche of investors.
Finally, Chairman Greenspan, I look forward to a discussion about
some of the elements the legislation did not deal with, in particular,
the issue of expensing stock options. And whether you believe more
companies will follow suit in light of Coca-Cola's announcement
yesterday that they would begin expensing employee stock
options.
As always, Chairman Greenspan, it is a pleasure to have you serve
in front of this Committee, I look forward to your testimony and to
perspectives on America's future economic prospects.
Thank you, Mr. Chairman.
----------
PREPARED STATEMENT OF SENATOR JIM BUNNING
Mr. Chairman, I would like to thank you for holding this hearing,
and I would like to thank Chairman Greenspan for coming before the
Committee today.
We have a crisis in our economy today--a crisis of confidence. We
have all seen it, and the majority of Americans have felt it. Whether
they own stock, have a 401(k) or another type of pension plan, millions
have been personally hit by the recent market dips. At this point, the
losses might be only on paper. But we all know how to add and subtract.
And the sheer drop of the Dow, Nasdaq, and S&P 500 in the last few
weeks has folks on edge.
To make things worse, the markets are dropping in a time when,
overall, most of the economic news is pretty good. The economy grew at
6 percent in the first quarter. Retail sales were up in June. And
inflation is almost nonexistent. But the last I heard, over one
thousand companies have restated earnings.
The stock markets are in the tank. Investors keep waiting for the
other shoe to drop--again. They are waiting to see if there will be
another Enron, or Global Crossing, or Worldcom. To be fair, the retail
investor seems to be more willing to ride out the market and sit on
their hands. It would be nice if institutional investors would do the
same. But the bottom line is that investors large and small are going
to do what is right for them. No one can blame them.
We must restore confidence in our markets. I am glad that Congress
is well on its way to passing legislation to help. But it is going to
take more than enacting a bill to restore that confidence. The
President has taken some good steps too. I think his ideas will help
greatly.
It would be nice if some of his political opponents would stop
taking potshots at the President for things that started long before he
came into office. Some of the rhetoric that has been flying around the
past few days has been dangerous and irresponsible. Clearly it has been
more about political agendas than the overall economic mood of the
country. But those who try to use recent problems for political gain--
whether they be Republican or Democrat--are playing with fire. Markets
can go back up just as fast as they go down.
Personally, I think that one way we could restore some confidence
in the market would be for the public to see some of these executives
who have committed fraud to walk around in handcuffs and orange
jumpsuits. When the American people see that the system does work and
those who have committed crimes pay the piper, they will feel a lot
more secure about their investments and security. I would like to
figure out a legal, constitutional way to expedite the prosecution of
those who have committed crimes and get them in jail right away. I know
that is a little far afield for this hearing. But I really believe that
it is one of the real, tangible things that could be done that would
send out the right signal to investors, markets, and business.
I look forward to hearing from Chairman Greenspan about our
economy. I would hope to hear any suggestions on what else he thinks
can be done to restore confidence in our markets. And I look forward to
talking with you further during the question and answer period.
Thank you, Mr. Chairman.
----------
PREPARED STATEMENT OF ALAN GREENSPAN
Chairman, Board of Governors of the Federal Reserve System
July 16, 2002
I appreciate this opportunity to present the Federal Reserve's
Monetary Policy Report to the Congress. Over the four and one-half
months since I last testified before this Committee on monetary policy,
the economy has continued to expand, largely along the broad contours
we had anticipated at that time. Although the uncertainties of earlier
this year are as yet not fully resolved, the U.S. economy appears to
have withstood a set of blows--major declines in equity markets, a
sharp retrenchment in investment spending, and the tragic terrorist
attacks of last September--that in previous business cycles almost
surely would have induced a severe contraction. The mildness and
brevity of the downturn, as I indicated earlier this year, are a
testament to the notable improvement in the resilience and flexibility
of the U.S. economy.
But while the economy has held up remarkably well, not surprisingly
the depressing effects of recent events linger. Spending will continue
to adjust for some time to the declines that have occurred in equity
prices. In recent weeks, those prices have fallen further on net, in
part under the influence of growing concerns about corporate governance
and business transparency problems that evidently accumulated during
the earlier rapid runup in these markets. Considerable uncertainties--
about the progress of the adjustment of capital spending and the
rebound in profitability, about the potential for additional
revelations of corporate malfeasance, and about possible risks from
global political events and terrorism--still confront us.
Nevertheless, the fundamentals are in place for a return to
sustained healthy growth: Imbalances in inventories and capital goods
appear largely to have been worked off; inflation is quite low and is
expected to remain so; and productivity growth has been remarkably
strong, implying considerable underlying support to household and
business spending as well as potential relief from cost and price
pressures. In considering policy actions this year, the Federal Open
Market Committee has recognized that the accommodative stance of policy
adopted last year in response to the substantial forces restraining the
economy likely will not prove compatible over time with maximum
sustainable growth and price stability. But, with inflation currently
contained and with few signs that upward pressures are likely to
develop any time soon, we have chosen to maintain that stance pending
evidence that the forces inhibiting economic growth are dissipating
enough to allow the strong fundamentals to show through more fully.
As has often been the case in the past, the behavior of inventories
provided substantial impetus for the initial strengthening of the
economy. Manufacturers, wholesalers, and retailers took vigorous steps
throughout 2001 to eliminate an unwanted buildup of stocks that emerged
when final demand slowed late in 2000. By early this year, with
inventory levels having apparently come into better alignment with
expected sales, the pace of inventory reduction began to ebb, and
efforts to limit further drawdowns provided a considerable boost to
production. The available evidence suggests that, in some sectors,
liquidation may be giving way to a rebuilding of
inventories. However, as inventories start to grow more in line with
sales in com-
ing quarters, the contribution of inventory investment to real GDP
growth should lessen. As a result, the strength of final demand will
play its usual central role in determining the vigor of the expansion.
While final demand has been increasing, the pace of forward momentum
remains uncertain.
Household spending held up quite well during the downturn and
through recent months, and thus served as an important stabilizing
force for the overall economy. Real consumer outlays and spending on
residential construction each rose about 3 percent over the course of
2001, even as the growth of real GDP fell off to only \1/2\ percent.
Household spending was boosted by ongoing increases in incomes, which
in turn were spurred by strong advances in productivity as well as by
legislated tax reductions and, in recent months, by extended
unemployment insurance benefits.
Monetary policy also played a role by cutting short-term interest
rates, which helped lower household borrowing costs. Particularly
important in buoying spending were the very low levels of mortgage
interest rates, which encouraged households to purchase homes,
refinance debt and lower debt service burdens, and extract
equity from homes to finance expenditures. Fixed mortgage rates remain
at historically low levels and thus should continue to fuel reasonably
strong housing demand and, through equity extraction, to support
consumer spending as well. Indeed, recent sizable increases in home
prices, which reflect the effects on demand of low mortgage rates,
immigration, and shortages of buildable land in some areas, have
significantly increased the equity in houses that homeowners can
readily tap through home equity loans and mortgage refinancing.
But those sources of strength probably will be tempered by other
influences. As we noted in February, because consumer and residential
expenditures did not decline during the overall downturn, there is
little pent-up demand to be satisfied. Consequently, a surge in
household spending early in this recovery is unlikely. Moreover, the
declines in household wealth that have occurred over the past couple of
years should continue to restrain spending in the period ahead. Still,
despite the concerns about economic prospects, equity valuations,
terrorism, and geopolitical conflicts, consumers do not appear to have
retrenched in retail markets. Indeed, consumers responded strongly to
the new interest rate incentives of motor vehicle manufacturers this
month. Early reports indicate a significant improvement in sales over
June.
By contrast, business spending has been depressed. The recent
economic downturn was driven, in large measure, by the sharp falloff in
the demand for capital goods that occurred when firms suddenly realized
that stocks of such goods--both those already in place as well as those
in inventory--were excessive. The resulting declines in the production
of capital goods were particularly sizable in the high-tech sector.
Monthly shipments of computers and peripherals, for example, fell by
about 40 percent from their peak in 1999 through their trough in 2001.
Sales by communications equipment producers slumped just as sharply.
Outside the high-tech sector, production also declined. Assemblies of
commercial aircraft slowed abruptly. In addition, the construction of
office and industrial buildings fell off noticeably. The collapse of
many Internet firms and the difficulties of the high-tech sector more
generally led to a significant drop in the demand for office space that
was exacerbated as the economic slowdown widened beyond the tech
sector. Overall, the level of real business fixed investment plunged
about 11 percent between its quarterly peak in the final months of 2000
and the first quarter of this year.
With the adjustment of the capital stock to desired levels now
evidently well advanced, business fixed investment may be set to
improve. A recovery in this category of spending is likely to be
gradual by historical standards and uneven across sectors. For example,
an upturn in production of semiconductors and computers has been under
way now for nearly a year, but with significant overcapacity still
prevailing in some segments of the telecom industry, investment in
communications equipment is likely to remain subdued for some time to
come. Overall capital
expenditures should strengthen with time. In particular, firms should
respond increasingly to the expected improvement in the outlook for
sales and profits, low debt financing costs, the heightened incentives
resulting from the partial expensing tax provisions legislated earlier
this year, and especially the productivity enhancements offered by
continuing advances in technology.
Indeed, despite the recent depressed level of investment
expenditures, the productivity of the U.S. economy has continued to
rise at a remarkably strong pace. In the nonfarm business sector,
output per hour is currently estimated to have soared at an average
annual rate of about 7 percent over the fourth quarter of 2001 and
first quarter of 2002, and the available evidence points to continued
gains last quarter--though not at the frenetic pace of the preceding
half year. In part, these increases in productivity reflect the very
cautious attitudes of managers toward hiring. But the magnitude of the
recent gains would not have been possible without ongoing benefits from
the rapid pace of technological advance and from the heavy investment
over the latter half of the 1990's in capital equipment incorporating
such advances.
Despite these encouraging developments regarding the longer-term
prospects for the economy, financial markets have been notably skittish
of late, and business managers remain decidedly cautious. In part,
these attitudes reflect the lingering effects of the shocks that our
economy endured in 2000 and 2001. Particularly given the dimensions of
those shocks, some persistent uncertainty and concern are not
surprising.
Also contributing to the dispirited attitudes among many corporate
executives is the intensely competitive business environment facing
their firms. Increased competition, while producing manifold benefits
for consumers and for the economy as a whole, clearly makes individual
firms' operations more difficult. Past deregulation and, more recently,
the enhanced speed and efficiency of information flows resulting from
technological advances are strengthening competition domestically. In
addition, globalization is intensifying competition in a broad range of
markets and damping pricing power across developed and developing
nations alike.
Those businesses where heightened competition has engendered a loss
of pricing power have sought ways to raise profit margins by employing
technology to lower costs and improve efficiency. In the United States,
as a consequence of the interaction of monetary policy, globalization,
and cost-reducing productivity advances, price inflation has fallen in
recent years to its lowest level in four decades, as has the recent
growth rate of nominal GDP and consolidated corporate revenues.
In part because nominal corporate revenues, although no longer
declining, are growing only tepidly, managers seem to remain skeptical
of the evidence of an emerging upturn. Profit margins do appear to be
coming off their lows registered late last year, but, unsurprisingly,
the recovery in economic activity from a shallow decline appears less
vigorous than in the past. The lowest sustained rates of inflation in
40 years imply that nominal growth in sales and profits looks
particularly anemic. In contrast, in the 1950's and early 1960's, the
last period of stable prices, populations and employment were growing
considerably faster than the recent pace so that growth in nominal GDP,
consolidated corporate sales, and profits was seen as still quite
respectable. Reflecting concerns about the strength of the recovery,
managers continue to limit capital spending to only the most pressing
needs.
Given the key role of perceptions of subdued profitability in the
current period, it is ironic that the practice of not expensing stock
option grants, which contributed to the surge in earnings reported to
shareholders from 1997 to 2000, has imparted a deceptive weakness to
the growth of earnings reported to shareholders in recent quarters. As
stock market gains turned to losses a couple of years ago, the
willingness of employees to accept stock options in lieu of cash or
other forms of compensation apparently diminished. According to
estimates by Federal Reserve staff, the value of stock option grants
for the S&P 500 corporations fell about 15 percent from 2000 to 2001,
and grant values have likely declined still further this year.
Moreover, options grants are presumably being replaced over time by
cash or other forms of compensation, which are expensed, contributing
further to less robust growth in earnings reported to shareholders from
its trough last year.
In contrast, the measure of profits calculated by the Department of
Commerce for the National Income and Product Accounts is designed to
gauge the economic profitability of current operations. It excludes a
number of one-time charges that appear in shareholder reports, and,
importantly, records options as an expense, albeit at the time of
exercise. Although this treatment of the cost of options is not ideal,
it is
arguably superior to their treatment in shareholder reports, where
options are generally not expensed at all. NIPA profits closely
approximate those obtained from reports submitted for tax purposes,
and, for obvious reasons, corporations tend not to inflate taxable
earnings. Consequently, NIPA profits have been far less subject to the
spin evident in reports to shareholders in recent years. NIPA profits
have increased sharply since the third quarter of last year, partly
reflecting the dramatic jump in productivity and decline in unit labor
costs.
The difficulties of judging earnings trends have been intensified
by revelations of misleading accounting practices at some prominent
businesses. The resulting investor skepticism about earnings reports
has not only depressed the valuation of equity shares, but it also has
been reportedly a factor in the rising risk spreads on corporate debt
issued by the lower rung of investment-grade and below-investment grade
firms, further elevating the cost of capital for these borrowers.
Businesses concerned about the impact of possible adverse publicity
regarding their accounting practices on their access to finance could
revert to a much heavier emphasis on cash generation and accumulation.
Such an emphasis could slow new capital investment initiatives.
The recent impressive advances in productivity suggest that to date
any impairment of efficiency of U.S. corporations overall has been
small. Efficiency is of course a key measure of corporate governance.
Nonetheless, the danger that breakdowns in governance could at some
point significantly erode business efficiency remains worrisome. Well-
functioning markets require accurate information to allocate capital
and other resources, and market participants must have confidence that
our predominately voluntary system of exchange is transparent and fair.
Although business transactions are governed by laws and contracts, if
even a modest fraction of those transactions had to be adjudicated, our
courts would be swamped into immobility. Thus, our market system
depends critically on trust--trust in the word of our colleagues and
trust in the word of those with whom we do business. Falsification and
fraud are highly destructive to free-market capitalism and, more
broadly, to the underpinnings of our society.
In recent years, shareholders and potential investors would have
been protected from widespread misinformation if any one of the many
bulwarks safeguarding appropriate corporate evaluation had held. In too
many cases, none did. Lawyers, internal and external auditors,
corporate boards, Wall Street security analysts, rating agencies, and
large institutional holders of stock all failed for one reason or
another to detect and blow the whistle on those who breached the level
of trust essential to well-functioning markets.
Why did corporate governance checks and balances that served us
reasonably well in the past break down? At root was the rapid
enlargement of stock market capitalizations in the latter part of the
1990's that arguably engendered an outsized increase in opportunities
for avarice. An infectious greed seemed to grip much of our business
community. Our historical guardians of financial information were
overwhelmed. Too many corporate executives sought ways to ``harvest''
some of those stock market gains. As a result, the highly desirable
spread of shareholding and options among business managers perversely
created incentives to artificially inflate reported earnings in order
to keep stock prices high and rising. This outcome suggests that the
options were poorly structured, and, consequently, they failed to
properly align the long-term interests of shareholders and managers,
the paradigm so
essential for effective corporate governance. The incentives they
created overcame the good judgment of too many corporate managers. It
is not that humans have become any more greedy than in generations
past. It is that the avenues to express greed had grown so enormously.
Perhaps the recent breakdown of protective barriers resulted from a
once-in-a-generation frenzy of speculation that is now over. With
profitable opportunities for malfeasance markedly diminished, far fewer
questionable practices are likely to be initiated in the immediate
future. To be sure, previously undiscovered misdeeds will no doubt
continue to surface in the weeks ahead as chastened CEO's restate
earnings. But even if the worst is over, history cautions us that
memories fade. Thus, it is incumbent upon us to apply the lessons of
this recent period to inhibit any recurrence in the future.
A major focus of reform of corporate governance, of course, should
be an improved functioning of our economy. A related, but separate,
issue is that shareholders must perceive that corporate governance is
properly structured so that financial gains are fairly negotiated
between existing shareholders and corporate officeholders. Share-
holding is now predominately for investment, not corporate control. Our
vast and highly liquid financial markets enable large institutional
shareholders to sell their shares when they perceive inadequacies of
corporate governance, rather than fix them. This has placed de facto
control in the hands of the chief executive officer. Shareholders
routinely authorize slates of directors recommended by the CEO.
Generally, problems need to become quite large before CEO's are
dislodged by dissenting shareholders or hostile takeovers.
Manifestations of lax corporate governance, in my judgment, are
largely a symptom of a failed CEO. Having independent directors, whose
votes are not controlled by the CEO, is essential, of course, for any
effective board of directors. However, we need to be careful that in
the process, we do not create a competing set of directors and
conflicting sources of power that are likely to impair a corporation's
effectiveness. The functioning of any business requires a central point
of authority.
In the end, a CEO must be afforded the full authority to implement
corporate strategies, but also must bear the responsibility to
accurately report the resulting condition of the corporation to
shareholders and potential investors. Unless such responsibilities are
enforced with very stiff penalties for noncompliance, as many now
recommend, our accounting systems and other elements of corporate
governance will function in a less than optimum manner.
Already existing statutes, of course, prohibit corporate fraud and
misrepresentation. But even a small increase in the likelihood of
large, possibly criminal penalties for egregious behavior of CEO's can
have profoundly important effects on all aspects of corporate
governance because the fulcrum of governance is the chief executive
officer. If a CEO countenances managing reported earnings, that
attitude will drive the entire accounting regime of the firm. If he or
she instead insists on an objective representation of a company's
business dealings, that standard will govern recordkeeping and due
diligence. It has been my experience on numerous corporate boards that
CEO's who insist that their auditors render objective accounts get
them. And CEO's who discourage corner-cutting by subordinates are
rarely exposed to it.
I recognize that I am saying that the state of corporate governance
to a very large extent reflects the character of the CEO, and that this
is a very difficult issue to address. Although we may not be able to
change the character of corporate officers, we can change behavior
through incentives and penalties. That, in my judgment, could
dramatically improve the state of corporate governance.
Our most recent experiences clearly indicate, however, that
adjustments to the
existing structure of regulation of corporate governance and accounting
beyond addressing the role of the CEO are needed. In designing changes
to our regulatory framework, we should keep in mind that regulation and
supervision of our financial markets need to be flexible enough to
adapt to an ever-changing and evolving financial structure. Regulation
cannot be static or it will soon distort the efficient flow of capital
from savers to those who invest in plant and equipment. There will be
certain areas where Congress will choose to provide a specific
statutory direction that will be as applicable 30 years from now as
today. In other cases, agency rulemaking flexibility under new or
existing statutes is more appropriate. Finally, there are some areas
where private supervision would be most effective, such as that of the
New York Stock Exchange, which requires certain standards of governance
for listing.
Above all, we must bear in mind the critical issue should be how to
strengthen the legal base of free market capitalism: The property
rights of shareholders and other owners of capital. Fraud and deception
are thefts of property. In my judgment, more generally, unless the laws
governing how markets and corporations function are perceived as fair,
our economic system cannot achieve its full potential.
A considerable volume of market commentary in recent weeks has
suggested that concerns about earnings prospects and the proliferating
revelations of serious governance and accounting issues have
contributed not only to lower equity prices but also to a decline in
the foreign exchange value of the dollar. And some of that commentary
has extrapolated the trend of dollar weakness. As you know, the
Secretary of the Treasury speaks for our Government on exchange rate
policy. But, given the recent intense interest in the future course of
the dollar, I would like to raise a technical issue and a flag of
caution regarding those forecasts--or, for that matter, any forecast of
exchange rates. There may be more forecasting of exchange rates, with
less success, than almost any other economic variable.
The reason that it is so difficult is that an exchange rate is a
very complex price that balances, on the one hand, the demand for, for
example, dollars stemming from the demand for dollar investments and
for U.S. exports against, on the other hand, the demand for foreign
currencies by U.S. investors desiring to acquire foreign
assets and by U.S. importers of foreign goods and services. Hence,
exchange-rate movements depend on shifting perceptions of the relative
returns from investing in different countries and on the myriad
influences on relative tendencies to import and export. The net effect
of these factors over any future time period is extraordinarily
difficult to assess in advance. Although measures such as real interest
rate differentials, differential rates of productivity gains, and
chronic external deficits are often employed to explain exchange rate
behavior, none has been found to be consistently useful in forecasting
exchange rates even over substantial periods of 1 or 2 years.
Our ability to attract foreign capital in coming years will help
facilitate the
increases in investment that will promote continued gains in
productivity and standards of living. But policymakers should also
recognize the important role that prudent fiscal policy can play in
promoting national saving and maintaining conditions conducive to
investment and continued strong growth of productivity. Beginning in
the late 1980's, impressive progress was made in reining in Federal
expenditures and restoring a better balance between spending and
revenues. The lower Federal deficits and, for a time, the realization
of surpluses contributed significantly to improved national saving and
thereby put downward pressure on real interest rates. This, in turn,
enhanced the incentives of businesses to invest in productive plant and
equipment.
Recently, however, some of those gains have been given up. To a
degree, the return to budget deficits has been a result of temporary
factors, especially the falloff in revenues and the increase in outlays
associated with the economic downturn. Those influences should tend to
reverse over the next year or two, other things equal, although the
decline in revenues reflecting the drop in capital gains realizations,
including those on options is unlikely to be fully reversed. And the
necessary rise in expenditures related to the war on terrorism and
enhanced homeland security has also played a role, as have the tax
reductions legislated last year. Unfortunately, there are also signs
that the underlying disciplinary mechanisms that formed the framework
for Federal budget decisions over most of the past 15 years have
eroded. The Administration and the Congress can make a valuable
contribution to the prospects for the growth of the economy by taking
measures to restore this discipline and return the Federal budget over
time to a posture that is supportive of long-term economic growth.
To sum up, the U.S. economy has confronted very significant
challenges over the past year or so. Those problems, however, led to
only a relatively brief and mild downturn in economic activity,
reflecting the underlying strength and increased resiliency that the
economy has achieved in recent years. The effects of the recent
difficulties will linger for a bit longer but, as they wear off, and
absent significant further adverse shocks, the U.S. economy is poised
to resume a pattern of sustainable growth. Indeed, the central tendency
of Federal Reserve policymakers' forecasts is for expansion of real GDP
over the four quarters of 2002 of 3\1/2\ to 3\3/4\ percent, somewhat
above the rates anticipated in our February report. Economic growth is
projected to be solid again next year, with real output rising 3\1/2\
to 4 percent. Monetary policymakers anticipate that these gains should
be sufficient to bring the unemployment rate down to 5\1/4\ to 5\1/2\
percent by the end of next year. Inflation is expected to be subdued
throughout, with prices for personal consumption expenditures
increasing at only a 1\1/2\ to 1\3/4\ percent rate. Our prospects for
extending this performance over time can be enhanced through
implementation of sound monetary, financial, fiscal, and trade
policies.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES FROM ALAN
GREENSPAN
Budget for Economic Statistics
The Senate Appropriations Committee has recently voted out
the Fiscal 2003 spending levels for the Bureau of Economic
Analysis and the Bureau of the Census. The bill covers only pay
raises for personnel and nothing more for economic statistics.
According to the Bureau of the Census, the Senate bill does not
provide the funds necessary to carry out the once every 5 years
2002 Economic Census that forms the foundation for many monthly
and economic statistics over the next 5 years. It also provides
no funding for the quarterly survey of service industries, the
earlier release of trade statistics, or the modernization of
the GDP that were included in the President's budget.
Q.1. What is your view about providing the funds necessary to
carry out the 2002 Economic Census?
A.1. As you know, I am reluctant to support increased spending.
In the case of certain economic statistics, however, the
benefits are so large relative to cost that there should be
little question as to its desirability.
Because the Economic Census, which is taken every 5 years
by the Census Bureau, covers all businesses and not just a
sample of businesses, the data collected in this effort are
among the most fundamental building blocks of the Nation's
economic statistics. The information gathered by the Economic
Census is critical to maintaining the quality of our national
income accounts and a host of other economic statistics,
including the Federal Reserve's industrial production and
capacity programs. I support full funding, at the level
requested by the President, for the Economic Census.
The President's budget also requests funding for other
important statistical initiatives at both the Census Bureau and
the Bureau of Economic Analysis. These include several
initiatives important to the Federal Reserve, such as
establishing a new quarterly indicator of service sector
activity, collecting more information on business purchases of
services and materials, and the earlier release of trade
statistics. I also support funding of such initiatives at the
levels requested by the President.
Dynamic Scoring
On January 10, 1995, you testified on the issue of budget
estimating before a joint hearing of the House and Senate
Budget Committees. You stated at that time that:
. . . full dynamic estimates of individual budget
initiatives should be our goal. Unfortunately, the
analytical tools required to achieve it are deficient.
In fact, the goal may ultimately be unreachable. The
estimation of full dynamic effects requires a model
that captures micro and macroeconomic processes and
produces reliable long-term forecasts of economic
outcomes. Unfortunately, no such model exists. Indeed,
no model currently in use can predict macroeconomic
effects without substantial ad hoc adjustments that
effectively override the internal structure of the
model. We should not assume that models can capture the
long run dynamic effects of specific tax and outlay
changes any better than they can forecast the economy.
(1) Have economists improved their analytical tools over
the last 7\1/2\ years enough so that we can reach the goal of
full dynamic estimates of individual budget initiatives now or
in the near future?
At a Senate Banking Committee hearing March 7, 2002,
Senator Bennett asked your views on a series of columns by
Robert Bartley that had raised the issue of the relationship
between taxes, surpluses, and economic growth. A transcript of
your response includes the following:
I also come out pretty much where he does on most of
those issues, but in certain places I do not. And I
think on the issue of surpluses in the most recent
period, I think that created some value, especially in
reducing long-term real interest rates, and I think
that has been an effective factor in the last several
years.
But there is no question that it is important that,
in approaching those different forms of economic policy
in Government, that we have answers to those questions.
As you know, Senator, most economists will agree that
in evaluating the effects of various different fiscal
policies, it would be far better to use what we call
dynamic scoring--that is, the ability to get the
interaction of the effect as well as the initial
impact.
The only problem is, is that the interaction is a
function of the particular model you are using, and no
one can quite agree on what the appropriate model is.
So that we have fallen back to a static analysis which
we all can somehow agree on as the first stage of the
effect. . . .
In certain instances, we are making very specific
adjustments in our budgetary analysis. We are seeing
that the secondary impacts of tax and spending programs
are zero. Now, we know that to be false. But we are
making those judgments because we have no alternative.
(2) Is one of the reasons that ``we have no alternative''
to assuming ``that the secondary impacts of tax and spending
programs are zero'' because the macroeconomic feedback effects
can plausibly be modeled to be either positive or negative,
depending on whether the ``ad hoc adjustments'' are more or
less favorable? What are other reasons that ``we have no
alternative?''
(3) Would you recommend that the Congressional Budget
Office or the Joint Committee on Taxation devote the resources
necessary to make alternative dynamic scoring estimates that
were both positive and negative?
(4) Do you believe that the budget packages of 1990 or 1993
that reduced future budget deficits by raising taxes and
putting limits on spending probably had the effects of (a)
raising national savings? (b) lowering longer-term interest
rates? (c) raising the level of investment by businesses and
households? (d) raising the growth rate of the economy?
Q.2. Do you support increased funding for the statistical
initiatives in the President's budget, particularly the
quarterly survey of service industries, the earlier release of
trade statistics, and the BEA's plans to modernize its GDP
measures?
A.2. With regard to dynamic scoring, my assessment has not
changed. Full dynamic estimates of the budget and economic
effects of fiscal policy decisions should be our goal, but,
unfortunately, the econometric tools that we have available to
evaluate the effects of fiscal policy on the economy are still
inadequate for the task.
Essentially, the profession has yet to reach a consensus on the
magnitudes of a variety of key behavioral responses, such as
the response of labor supply to changes in the after-tax real
wage, as well as the expectations formation process that are
necessary to
reliably evaluate the effects of fiscal policy on the economy.
The short-run impact of either a tax cut or an outlay increase
under almost all dynamic scoring models tends to exhibit a
lower increase in the budget deficit than does static analysis.
Longer term, the results will depend on the specific nature of
the policy initiative.
In such an environment, the current framework of evaluating
the fiscal effects of a policy is a standard approach. The
Congressional Budget Office and Joint Committee on Taxation
allow for behavioral adjustments at the micro level, while
leaving the macroeconomic projection unchanged. The second
step, evaluating the macroeconomic effects, is typically
conducted by numerous public and private sector analysts which
allows decisionmakers to incorporate judgements about these
effects.
An example of the difficulties of reaching a consensus on
the macroeconomic effects of fiscal policy changes is the range
of views regarding the macroeconomic impact of the budget
reduction packages passed in the early 1990's. It is my
judgement that the move to budget surpluses contributed to the
rise in national saving and the reduction in long-term interest
rates. The increase in net investment, and higher productive
capacity of the economy largely reflected increased long-run
expected profit growth, though lower long-term interest rates
doubtless helped.
RESPONSE TO WRITTEN QUESTION OF SENATOR MILLER FROM ALAN
GREENSPAN
Q.1. Are you aware of any factors or information that would
have caused the California energy crisis? Have you seen
anything further to suggest that energy derivatives trading
contributed either to the California energy crisis or to
Enron's bankruptcy?
A.1. I am aware of no solid evidence that energy derivatives
trading contributed to the California energy crisis. The
primary cause of the crisis clearly was a deeply flawed
approach to the deregulation of electricity prices in
California. As I understand it, the CFTC and the FERC are
investigating whether energy derivatives trading may have
exacerbated the imbalances created by the flawed deregulation,
but those investigations have not been completed. Nor have I
seen evidence that energy derivatives trading contributed to
Enron's bankruptcy. To the contrary, Enron's energy derivatives
trading business seems to have been profitable--in fact, its
EnronOnline energy trading business was purchased by another
firm. Available evidence suggests Enron's implosion resulted
from a loss of market confidence following revelations that it
been hiding large losses on merchant investments in a variety
of other businesses.
I continue to oppose legislation providing for additional
regulation of energy derivatives because the public policy case
for such legislation has not been made and because such
legislation has the potential to impair the important risk
transfer functions that such instruments perform.