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Do the Deficits Matter?

Authors: Arthur Laffer, and Kenneth S. Rogoff, Professor of Economics and Thomas D. Cabot Professor of Public Policy, Harvard University
April 19, 2005
Council on Foreign Relations

Speaker: Arthur Laffer, founder and chairman, Laffer Associates

Speaker: Kenneth S. Rogoff, professor of economics, Harvard University

Presider: Gerard Baker, U.S. editor, the Times of London

Council on Foreign Relations
New York, N.Y.
April 19, 2005


GERARD BAKER: I'm Gerard Baker; I'm with the Times of London. I always slightly resent having to say the Times "of London" after the name, but I understand in this city there is another newspaper that goes by a similar name. And it's a very auspicious day, obviously. We have a new Pope [Benedict XVI] and we have a fascinating discussion to come here on an economic issue of importance to us all, which is the deficits. And we're going to discuss whether or not these deficits, the fiscal and current-account deficits, matter, and we have two eminent economists here to discuss it.

Let me just quickly run through some housekeeping before we get into the— into the event itself. If you could please take a moment to turn off your cell phones, BlackBerries, PDAs, whatever else that may go beep during the course of the next hour, that would be appreciated. And also just to remind you that this session is on the record. So for some of my fellow journalists here, we're in luck this evening.

We have, as I said, two eminent economists— two leaders in their field. Let me introduce them before going into some questions for them, and then after a while opening it up to the audience. Immediately to my left, all of you know, I'm sure, Arthur Laffer, founder and chairman of Laffer Associates, but much more famous, I think it's fair to say, for his role in the revolution of economic policy thinking, particularly in the 1970s and 1980s. He has been called the father of supply-side economics, which is quite a burden to bear some would say, I think, Professor Laffer. But the— he's also achieved that greatest status of— that all economists crave, which is not a Nobel prize, but having something— a curve named after him. [Laughter] Like the great British economist, A. W. Phillips, and [Alfred] Marshall and [inaudible] and various others, Arthur Laffer has the Laffer curve named after him, which of course plots tax rates against overall government revenue, and it was an extremely important and influential theory that was, it's fair to say, I think, moved, considerably moved governments throughout the 1970s and certainly the 1980s, and we're very privileged to have him here.

To his left is Kenneth Rogoff, who again many of you will know; professor of economics at Harvard, and also for two years, 2001 to 2003, the chief economist of the International Monetary Fund in Washington, where he played a significant role in helping the global economy stabilize through that very turbulent period of the post-9/11 period and the first two years of the Bush administration. Professor Rogoff doesn't have a curve, as far as I'm aware, named after him, but he is an international grandmaster of chess, so he probably has a gambit or a defense or an opening named after him, which I'm afraid I'm not aware of. But he, too, of course, is an extremely eminent and influential economist and we're grateful— very grateful and privileged that he's here.

Let me start off, if I may, by just with— the title of this conversation is, "Do the Deficits Matter?" And it's striking that we have the definite article "the" deficits, which I think helps us to understand we are talking about two sets of economic issues here— economic and financial issues. We are talking about both the U.S. fiscal deficit, the government deficit, and the current-account deficit which is, you know, more or less— a proxy which is more or less a trade deficit. We know that in the 1980s— the late 1980s, these twin deficits, as they were called then— caused no end of worry and trouble for the— for international financial markets and for economists around the world, and they are back now, the twin deficits, back as we have them now, and again people are worrying about them with all kinds of alarms being sounded about what the resolution of these deficits might mean, how we get through this period of large deficits, what it may mean for the global economy.

So if I could just start by asking Professor Rogoff, can— could you— I know you believe, and I think we're going to have a pretty divergent discussion here because we have two very different sets of views on this, but could you tell us, first of all explain to us— if you would just explain the background of these two deficits, what they are, what they mean, and then explain to us briefly if you would why both the, why the current-account deficit and the fiscal deficit, why they matter, why they need to be addressed, what the problems are, and what the implications for the world economy might be if they're not addressed in the way that you had proposed?

KENNETH ROGOFF: Thank you, Gerry. Let me just use half a minute of my two minutes to thank fellow Council members for being here. It's an honor to speak to you. It's an honor to speak with Dr. Laffer, whose curve makes it into every undergraduate and graduate course I've taught and makes economics more interesting and entertaining. And I hope that will be [laughter]--be true today as well.

You know, I want to start by saying I'm much more concerned about our borrowing from abroad than our domestic borrowing. The current account, basically our trade balance— how much more we've been importing than we export— has reached an astounding level. We're running at a rate of over $700 billion a year at the moment, 6 percent of our income. By another metric, if you added up all the countries that are running surpluses in the world— China, Japan, Germany, whatever— the United States is taking up 70 [percent] to 80 percent of those net savings. Now, a lot has been written about this, and I actually think it may have reached the point where you need poets to address it, rather than two economists, to think of something different to say.

But let me say that I think that the main issue really is that this probably isn't sustainable and that the current account is the Achilles' heel of U.S. budget-deficit policy and our low rate of savings. I would be worried about the other deficit. I would be worried about budget deficits. I believe for many reasons, because of old-age patterns, because of future medical expenses, but also because of the tax cuts we've had in recent years, we are going to see much, much higher tax rates 15 to 20 years from now, and the Laffer curve is going to boomerang with a vengeance with the same effect that makes output grow when tax rates are low. It's going to make output low and lead to all sorts of intergenerational problems at some period in a decade or two, and quite possibly we'll solve that by inflating some of it away, which we've done frequently in the past, but I don't think we'll get there.

I think that well before then we're going to have a problem with our foreign borrowing, which isn't just our government, our government is a big part of it, the past few years it's been almost all of it, but it's also that our private borrowing is very low— astoundingly low. At some point a shock, for example a housing crisis, just might stop going up at 10 [percent] to 15 percent a year in the United States; they'll stabilize and savings will rise or perhaps banks— central banks in Asia who have been buying up a lot of our debt are going to suddenly decide that they don't want so much of it, and we're going to have to make an adjustment. It's going to be a difficult adjustment. It certainly is going to lead to a slowdown in the global economy. It even more certainly is going to lead to a big further drop in the dollar another 20 [percent], 25 percent, maybe more against the Asian currencies, a little less against currencies like the euro and the Canadian dollar, the British pound. We're going to see those adjustments.

Now, we have a very flexible economy, and [Federal Reserve Board] Chairman Alan Greenspan likes to point that out, and maybe it won't be so bad. It happened in the 1980s and, with the little casualty of Japan, the rest of the world seemed to survive it fairly well. But I see a world much more parallel to the 1970s today than to the 1980s. For one thing, we're coming off a wicked political business cycle over the last two years with tax cuts and low interest rates and promises of future entitlement payments all engineered to pump up the economy and help the incumbents get re-elected, both Democrats and Republicans, and that eventually is going to unwind. Maybe we're already seeing some of it today. We see rising energy prices which we saw in the ‘70s, we see open-ended security prices, open-ended security costs, and we see a weak dollar, so I don't necessarily see us landing as softly as we did in the ‘80s. I won't say that a hard landing— a catastrophe— is a certainty by any means, but I think it's a risk, and in light of this risk, some policy response is required now to deal with it.

BAKER: Arthur Laffer, can I say, the U.S. is running a current account. It's borrowing a sum from overseas equivalent to 6 percent of its national income, and still rising. As Kenneth said, there are all kinds of potential shocks that could— that could create real problems in the economy. At the same time, the rest of the global economy is weak; there is potentially a housing bubble. Some people say, there is, you know, some doubts about whether or not inflation is on the rise again. You think, however, this— none of this is— we shouldn't be worrying about this. The sky isn't falling. This is not something— in fact, in some ways, it's actually a sign of the United States economy's great [inaudible].

ARTHUR LAFFER: You guys are scaring me. No, I don't think the sky is falling; far from it. In fact— can I first just give you a greeting from my home state of California, or we now have renamed it California. My governor wants to say thank you to all of you here, but the— that's fine. But no, I think you're describing the problem incorrectly. I don't want to look at the current-account deficit because that sort of gives you the notion that it's the trade accounts that are generating the problem, and it leads to the [Council Chairman] Pete Peterson, [Berkshire Hathaway Chairman] Warren Buffet notion that we are living beyond our means, that we've taken this credit card and going out and squandering and all of that.

The truth of the matter is it's not a current-account deficit we're seeing. It's a capital-account surplus. If you go back to the mid and early 1990s, the U.S. was the only game in town. We had [President Bill] Clinton, who had done the, what, the welfare reform; he reappointed Greenspan twice, he cut government spending as a share of GDP [gross domestic product] dramatically, he brought us into surpluses, he put on the biggest capital-gains tax cut in our nation's history— I mean, just a spectacular period of very high returns. [President] Bush, when he came in, did those tax cuts you mentioned, which increased the after-tax rate of return on U.S.-located assets dramatically. At the same time, we had in France a man named [inaudible] and then we had [former French Prime Minister] Lionel Jospin, who were to the left— inventing a 35-hour work week is the mildest of their proposals. And then we had [former European Central Bank (ECB) President] Wim Duisenberg, who didn't know how to run anything, let alone a central bank, the ECB. You then had, of course, in Germany you had [Chancellor] Gerhard Schroeder along with [former Minister of Finance] Oskar LaFontaine, who did everything they could to [inaudible] tax increase in Germany. It was a tragedy in the making. And then you had— in Japan you had [former Prime Minister Keizo] Obuchi being replaced by [Yoshiro] Mori, which was again just a tragedy— the market falling. After-tax rates of return in the U.S. were high. They were low in the rest of the world, and everyone tried to invest in the U.S.

Now, the question is, how do foreigners generate the dollar cash flow to buy U.S.-located assets? There are only two ways they can do this. They've got to sell more goods to us and buy less goods from us. What I'm trying to say here, very simply, is the U.S. trade deficit is one in the same as the U.S. capital surplus. And the capital surplus— we are the great attractor of capital in the world, my view of the world— and as a result of incompetent policies abroad and the spectacular policies here, we had such a high rate of return that everyone tried to invest in the U.S. We had the largest capital surplus as a share of GDP in our nation's history, and this goes back to [economist] Oliver Williamson, all the data way back to the beginning of time, I mean it's amazing, back to 1640. I mean, I would have put Ken's point, as we were— and we were absorbing 70 [percent] to 80 percent of world savings and resources in the U.S. through our investment. I mean, they were trying to all come in here.

And far from being a problem, the demand for dollars and the demand for U.S.-located assets pushed the dollar up strongly until probably March of— March or April of 2002, and at that time, changes occurred abroad. You found France changing. I mean [French politician] Jean-Marie Le Pen single-handedly destroyed French socialism, got rid of Lionel Jospin; he did. [President Jacques] Chirac now has gotten rid of the 35-hour work week, as you probably all know. In fact, I'm on the board of a French company called [inaudible], which is— used to be Vivendi, and I'm on the only American on that board. And Chirac was proposing— if you can imagine it— getting rid of two French holidays to underpin the French economy. And my comment to my fellow board members is, if Chirac actually were successful and eliminated two French holidays, that would double the French work year. [Laughter] Just joking.

The Germans are now for sure going to have major tax cuts. We have replaced Wim Duisenberg with Jean Claude Trichet. Christian Noyez has now taken over the head of the central bank in France; just great supply-siders. In fact, if you read Jean Claude Trichet's piece last June of how France and Europe all need the supply-side tax cuts, the growth policies, which they don't have. Four new members of the European Community now are low-rate, flat-tax countries. Junichiro Koizumi has now replaced Mori in Japan [as prime minister]. You all know what's happened in our— a huge change here.

And what's happening very simply is the rest of the world is now getting higher rates of return and you're getting a natural shift in the excess demand function for capital, and investors worldwide are shifting those. And as you would expect, when there's a shift in an excess demand function, the first response is in price, and sooner or later you're going to get quantity responses. The dollar is about as low in terms of trade terms as it's ever been. We hit that same low about ‘93 [inaudible] in there. We hit that same low about 1978. We've had a huge drop in the terms of trade from— what was it? If I use euros, 83 cents to the euro in March of ‘82, something like that, to now, what is it, $1.30, in that range there, Gerry, you know? And that's a huge change. And my guess is you're going to get all the substitution effects taking place in demand and supply. It's a natural market force.

And my only fear is not that markets aren't going to have dislocations. It's that my government is going to make a huge mistake and try to do something when there's not a problem. And markets are really far better correcting themselves than they are trying to be prodded by the secretary of the Treasury breaking the link with the [inaudible] or something like that. And it is a natural market reaction to changes in underlying conditions; markups are responding exactly as they should respond, and we are seeing that process working. My guess is the dollar is far from going to fall— not going to much fall much further if at all, and I'd be willing to bet you anything at the end of the year we're going to have a stronger dollar, not one weaker.

BAKER: But sometimes markets respond in ways that are not entirely benign. I mean, sometimes you get—

LAFFER: Of course they do.

BAKER: --a sharp market break as you did in— you know, you can get it in equity markets, you can get it in— there are markets operated, you know, supposedly very well in the late 1990s and tremendously overbid the price of equities, and the U.S. economy continues to labor under the costs of that. Surely, what we have is an economy which is essentially, you know, running this deficit of 6 percent a year.

Art, can I be clear what you're saying? Are you saying that this 6 percent a year deficit can just go on forever? I mean, is it— can the U.S. continue to assume— continue to accumulate these liabilities in this way?

LAFFER: As prescient as I may be, I can't see forever. But what I can see is that from about 1640 till about 1870, that's a couple of years, we ran trade deficits that whole 230-year period, approximately. We built our country through foreign capital. I mean, that's what we did. What we have right now are natural market responses occurring to relative rates of return. And if European and Asian and the rest of the world returns go up, that number will come down through very normal market forces. That's why you've gotten a weakening of the dollar. It's exactly what should happen. When those substitution effects take place, I would expect— and Ken, I don't know [if] your model is doing this— but I would expect the next six months, 12 months, 18 months, you'll see a very sharp reduction in the capital surplus of the U.S., or what you people like to call the trade deficit. But it's a very natural thing. Where would you invest? I mean, would you invest in France now with a 2 percent wealth tax? Is that where you really think is cool? Or do you wan to go into Germany? Or how about [laughter]--how about into Russia? That's one neat place. Or how about— you can go into Argentina and get 30 cents on the dollar. I mean, where, Ken? Here.

ROGOFF: Well, I enjoy Euro-bashing as next, as much as the next person, although I'll point out that markets abroad gave much higher rates of return last year than the United States. And indeed, we— many people talk about what's going on here, this huge capital inflow, which is a flip side of the trade deficit. The United States is just a great country. Everyone wants to invest here. Really productive. That's what's going on. You've got to be kidding. Look at the numbers. The foreigners are not holding equity. They're not holding direct foreign investment. Only 38 percent— less than 40 percent of their holdings is in those things. Much more is in bonds. A lot of it are governments holding bonds. They've earned astoundingly low rates of return. In fact, we benefited a lot from that. Our debt today is higher than it was even when we were a growing country, but it would be a lot higher had they actually earned better rates of returns.

And I think the story that the money is going in because we've got these supply-side tax cuts, great investments— there isn't more investment going on here. The money is not being invested. The money is being spent. Saving is low, government saving is also low, private saving is low. Yes, there's a lot of residential housing construction going on and a price frenzy in residential housing. I mean, the fact that we can tell a story about why the United States might borrow from the rest of the world for a while, even though the natural course of things with demographics with wealth would be for money to go the other way, we can tell a story. But we're way out of line here with 6 percent. And yeah, we'll have prices adjust, but I don't think the adjustment is going to be so smooth. Maybe in the United States, but the rest of the world is not that flexible. Europe is not; Japan is not. As former Treasury Secretary John Connally told his counterparts: it's our dollar; your problem.

BAKER: Can we just ask you—

LAFFER: I want to come back to you on that.

BAKER: But can you just take us through, then, what you think is the scenario if something isn't done to address this U.S. current-account deficit? Take us through what is, if you like, the nightmare scenario. What is the worst that can happen to the U.S. over the next few years?

ROGOFF: Well, I mean the nightmare scenario is simply— it probably comes from financial markets rather than coming from the goods markets. I mean, I think—

BAKER: Which means what? [Inaudible]

ROGOFF: Yeah. People— Asian central banks are holding over $2 trillion in dollars. They've basically been funding the whole U.S. borrowing the last few years. And they hold it in dollars. Well, yeah, [the] euro is, you know, not so good and the pound is not so good, and the Canadian dollar is not good, but you know what, they're all, you know, gone up a lot against the dollar the last couple years. There's a good chance they'll go up more. And even if you don't believe that, what about if you just want to diversify? What if you just don't want all your money in dollars? There's certainly a risk that there'll be a reaction in financial markets, a spike in U.S. interest rates. Even if it— even a soft landing is going to involve a global slowdown, mainly because most of the world is not flexible. The U.S. is the place that will probably suffer least on the direct effect, but certainly there could be a boomerang in our exports. Although mind you, right now we export a dollar in debt for every dollar of everything else we export.

BAKER: Just— I want to come back to— explain what the U.S. should do either at the policy level, or what the world should do at the policy level, and then I want to come back to Arthur and he'll explain why that will actually make things worse.

ROGOFF: OK. I mean [laughter]--OK. I mean there are certainly policy levers we have, which I think would make a lot of sense to use, and for starters, the most important is the federal government should raise taxes. It should not be shifting all taxes to the future— these huge future taxes that we face. A bit of the burden should be shifted to the present. We don't have a recession now. There's no reason to be running a large deficit. There's no reason to be running a deficit. The government is aiming to halve the deficit five and six years out in the future. This is an absurdity. We should be going to a balanced budget.

Asia needs to go to more flexible exchange rates to allow prices to adjust— to allow the price mechanism. They can't do it overnight. China is very underdeveloped, financially. The have to do it slowly, but this just has to happen. And Europe, of course the best thing would be if they decided to be a little more flexible in their economies. That's the most important thing. And I completely agree with Dr. Laffer on that. Barring that miracle happening quickly, I mean, I think in a crisis, the ECB probably would need to cut its interest rates to try to prevent the euro from going up too much.

BAKER: Arthur, I take it this is not the moment you're going to renege on your lifelong commitment to opposing tax increases.

LAFFER: You got— yeah. Let me, if I do— Ken, if I can— I mean, Chinese say they don't earn very high returns on the assets the foreigners have here, especially Asians. They hold basically cash, very low interest-bearing [inaudible], but that doesn't mean they don't get very high returns. They get huge returns. China does not hold liquid U.S. securities as a favor to us. That's not why they do it. What China has done is, it's outsourced its monetary policy to Alan Greenspan, much the way Argentina did in 1990s— early 1990s, when they did the currency board. They held 105 [percent], 110 [percent], 15 percent reserves.

China has had a dollarization of China for a long time. It's been part of their two-pronged policy: No. 1, cutting tax rates, which they've done dramatically since 1980 to the present. And the other is imposing sound monetary policy. I mean, it's supply-side Reaganomics all the way. If you'll remember, in the 1980, 1998 Asian contagion, the one country that didn't depreciate its currency was China, because they virtually had 100 percent backing by U.S. dollars. They hold over 600 billion U.S. dollars, basically because they want to have over 100 percent reserve to guarantee that there's no run.

My big fear, Ken, is that [Treasury Secretary] John Snow is going to be successful and that this administration is going to be successful and get the Asian currencies to break the link with the dollar, violate all of the [economist Robert] Mondell hypotheses here, and by doing that— if China breaks the link from the dollar, my fear is that if the yuan can go up, believe me it can go down. Today the peso in Argentina is 30 cents on the dollar because they broke the currency board. Now, when you talk about taxes, I don't know. It's just too much for me. I'm going to— we're plenty taxed [inaudible]--I would love to see us increase tax revenues. Enough said? [Laughter]

I will go to the next line after that: deficits. Now come on, everybody. All of you know the story on deficits. Borrowing by itself is neither good nor bad. It's what you do with the proceeds. If you can borrow all you want at 2 percent and lend all you want at 20 percent risk-free, how much should you borrow? Infinite amounts. Reverse those numbers. You can borrow all you want at 20 percent and lend all you want at 2 percent. How much should you borrow? Zero. Borrowing is neither good nor bad: it's a tool. And it depends upon the spread.

When this president came into office, through no one's fault— and I'm not blaming— he had a huge asset-value collapse in this country. Shortly after being in office, he had September 11th. We had a collapse in revenues in the United States of dramatic proportions, and we were faced with terrorist problems. What was he to do, raise taxes on the last three people working? No, I don't think so. What he chose to do, because of the flexibility that Bill Clinton had provided him— Bill Clinton by cutting spending and by running surpluses had given Bush enormous fiscal flexibility. He did what I think was correct, is he borrowed at this circumstance so that we could stimulate asset values and also stimulate growth in the economy, and at the same time, do the war on terrorism, which is what he did. I think that was the correct thing to do at that time. Do I think Clinton was completely correct in his day to reduce the deficit and to increase revenues? Not— I think Clinton did a beautiful job as president of the United States. In fact, shocking though you may not believe it, but I voted for Clinton twice. I think Reagan, when he was there, had a perfect time to run deficits. You know, there's a time when you run deficits, a time when you don't.

If we ran this $430 billion deficit for the next 10 years, and if nominal growth were 5 percent a year for the next 10 years each year, so we had $4.35 trillion net debt over the next decade and we had 5 percent growth per year, the national debt as a share of GDP would be substantially less than it was in 1993, and I don't remember that being the beginning of the worst era. If you're going to get revenues up in this country, it's far better to get them up with growth and with appreciation in asset values, which is the big killer in revenues. It's not a spending problem or a tax rate problem. We have [an] asset-value problem.

BAKER: I mean Ken, isn't it true that this sort of fear of foreigners striking and, you know, refusing to invest in U.S. assets without much higher rates of return, isn't it slightly overdone? I mean, isn't it very much in the Chinese interest, very much in the Japanese interest, to continue to invest in the U.S. economy, to have a strong, growing U.S. economy so they can send their exports to this market? I mean, why are they— why would they suddenly, you know, decide they didn't want U.S. assets anymore?

ROGOFF: Let me first say I debate many left-wingers who like to hold China out as the country that goes against the evil Washington consensus and grows, and now I hear that it's following Reaganomics, so it's— success has many fathers, I guess. [Laughter]

I think, first of all, this Chinese policy is good for the Chinese government. It is not necessarily the case that it's good for China in the long run. Fixed exchange rates, which Dr. Laffer seems to think is a good idea, I think have been a lightning rod for catastrophe. In most of the financial crises— if Argentina had never— had gotten off its currency board a lot sooner, it would have been a lot better off. China's big problem is precisely that: if it sticks to its fixed exchange rate, some day instead of fighting appreciation it's going to be fighting depreciation and it might not wake up because the leaders want to stay in power and things keep going because of that. So just because the Chinese leadership is choosing to invest its money this way to maintain this rocky social stability does not mean that it's the best policy for China.

BAKER: And just before we turn it to the audience, can I ask you, I mean, didn't, in the end, the tax cuts of the early 1980s have to be reversed? Reagan raised tax cuts in his second term, first President Bush raised— so Reagan raised taxes in his second term, [the] first President Bush raised taxes. President Clinton, who you admired and voted for twice, apparently we learned tonight, raised taxes in his first term. And in the end, didn't the U.S. have to get its fiscal house in order by raising taxes?

LAFFER: No. No, let me [laughter]--Reagan left office with [inaudible]. I'm talking about tax rates, now. [Reagan] left office with a 28 percent marginal tax rate on capital gains, on earned— on income earned from assets, on personal income. I mean, this is pretty massive, beautiful tax-rate reduction. We broadened the tax base and lowered the rates. Bush senior was a disaster. I mean, I can only tell you that I did not vote for him the second time, believe me.

BAKER: Did you support the Clinton deficit-reduction plan in—

LAFFER: Not in ‘93, no, in fact. But then— from then on, I supported Alan Greenspan being reappointed twice. I supported the monetary policy that was done. I supported welfare reform. I supported the cut in government spending as a share of GDP. I supported the largest capital-gains cut in our nation's history. What other ones would you like me to say I supported? I thought Clinton was a great president. I thought he was a disgusting human, but he would have—

BAKER: Let's leave that for another—

LAFFER: But he would have been a disgusting human had he not been president, but he wouldn't have been a good president if he had not been.

BAKER: Can I [laughter]--

LAFFER: So I voted for the president, not for the person.

BAKER: So you don't deny that he raised taxes and the—

LAFFER: No.

BAKER: [Inaudible] the second [inaudible].

LAFFER: In ‘93, he raised marginal tax rates and personal income, and he did that, and he lost the House, he lost the Senate, and he almost lost if he'd have been running for election. And he then hired [adviser] Dick Morris, got rid of [former Labor Secretary] Robert Reich, and then became more Reagan than Reagan throughout the next six years of his term. He was exquisite on economic policies.

BAKER: Thank you for that. Let's turn it open now to the [laughter]--the audience, if we may. Could I just ask you, as we go to all these questions, just to remind you [to] please wait for the microphone to come to you after you've signaled you want to speak, and speak directly into it. When the microphone reaches you, stand, state your name and affiliation, and obviously please keep your questions as concise as possible. So who would like to go first? Yes, sir, in the middle over there.

QUESTIONER: My name is Steve Hellman. I have a quick question for Dr. Laffer. We've heard your colleague's policy prescriptions. What would be your policy prescriptions today, if any?

LAFFER: I would personally pass the elimination of the inheritance tax right now and make permanent the tax cuts that were done. I would like to see lifetime savings accounts done. I'd love to see the Social Security privatization accounts. I think a flat tax would be great. I think all of those would be the right things to do. And just, basically, keep steady as you go with monetary policy. I think we've licked inflation. I think we're having a major adjustment in the world community, but my best guess is that benign neglect in this case is by far the best policy, and let markets adjust through natural market forces of prices followed by quantities. And you're going to see the trade deficit— or in my way, capital surplus— decline dramatically in the next six, 12, 18 months. My view.

BAKER: Yes, sir? There please.

QUESTIONER: Roman Martinez. I'm a private investor. For Mr. Rogoff, I'm always puzzled about the— and amused about the concerns of the current-account deficit. After all, we have tried to build free trade. We talk about a globalized world. So what is so surprising about current-account deficit? Somebody has to have them. And in a world where we're the economic locomotive now, it depends on our buying from other countries and it behooves them to finance those purchases. So I don't see the crisis. I can only see a crisis if we have an inflation problem in which the— the currency is not sound. But other than that, worrying about the current-account deficits is almost— why don't we worry about the current-account deficit between California and New York, or Mississippi and New Jersey?

ROGOFF: Well, first of all, and let's remind ourselves the U.S. is basically soaking up everybody's current-account surpluses at 70 [percent] to 80 percent. It's a highly extraordinary situation. Maybe it's something sustainable. When Britain was the empire in the 19th century, it ran 8 [percent] and 9 percent surpluses, fueling investment in the rest of the world. I think it's true that we have free trade, but that doesn't mean we have responsible savings policies. It doesn't mean that it's responsible for us to cut our taxes and run deficits so that, in the future, we will have to sharply raise taxes, because I think the empirical evidence on the Laffer curve, I'm sorry, is that overwhelmingly, the tax cuts will have to be reversed, and all projections going forward are that.

And also, going back to the question of the deficit, we're not just looking at the federal deficit, that's not the whole issue. There's— we have demographic problems. We have retirements coming up with the baby boom. We have huge increases in medical expenditures. We can't be running deficits in our main current expenditures when we have these other problems going on. So it's a savings problem. And it is a problem when there's this imbalance, because you can see very sharp asset changes, which— asset-price changes, especially the exchange rate, potentially interest rates, which can be very dislocating, that it makes sense not to have a topsy-turvy tax policy, where you're cutting it one day and sharply raising it later, and have something more stable.

QUESTIONER: Can I have a follow-up? [Inaudible] about that as well, because the definition of savings, it's somewhat inadequate, isn't it?

ROGOFF: Yes.

QUESTIONER: When you have a situation that certain expenditures are— for example, capital-gains taxes are considered an expenditure but capital gains are not— that, to me, doesn't seem to make sense when you're talking about savings.

ROGOFF: I mean, there's no question that a big piece of what's going on is we've had a $9 trillion increase the past couple years in housing prices, and people are spending it. But is that sustainable? Is that something that's a risk? Is that something that's due to very soft interest-rate policy during the past couple years? Yes.

BAKER: Ken, do you want to say—

LAFFER: Yeah, just one quick one. I agree with you on the definition of savings. I mean, Japan has had one of the highest savings rates in the world and their wealth has declined over the last 15 years, 16 years dramatically. The U.S. has had one of the lowest savings rates in the world and our wealth has increased. It is the wrong measure. It's using a Keynesian measure of savings, which is very useful for certain purposes, but it is not useful for measuring the increase in wealth. The U.S. has had a huge increase in wealth, which to me, is savings. Japan has had a huge decline in wealth, to which to me means dis-savings. That's not the way the demand side looks at it. And I totally agree with your point on savings. It's the wrong measure.

BAKER: Just let me say, in principle I'm against follow-ups, and in practice, I'm not going to allow any more. So [laughter] sir, there in the second row, please. You.

QUESTIONER: Thank you. Sir, I was at a meeting where [Princeton] Professor Allen Blinder spoke. He, of course, has been vice chairman of the Fed [Federal Reserve Board]. And a question to him was exactly the discussion here on dollar. His fear is that the dollar— not his fear— but his view is that the dollar may be facing a [inaudible] period of decline; the mid ‘80s, or early- to mid-80s, not the late ‘70s, which is what you referred to. Could you, perhaps— both of you, perhaps discuss the pros and— the argument for one case versus the other, the Plaza model of decline of the dollar [based on the 1985 Plaza Accord] versus the ‘70s to early ‘80s? Thank you.

LAFFER: Well, I mean you're referring to two different things. The Plaza Accord is how the governments reacted where the U.S. raised taxes and Europe and Asia took other measures to try to achieve a softer landing in what was then a similar unsustainable situation in a more benign global environment, with oil prices; we didn't have Vietnam, and it was reasonably successful.

The point is that we have similar macro vulnerabilities at the moment, but we face open-ended security costs, we have rising energy prices. That's the sense in which it's like the ‘70s. I'm leery about saying I'm in favor of the Plaza Accord, although I could write one down that would be a good idea. I don't think it's a good idea to engineer exchange rates. I think that's a terrible mistake. But I do think we should make global exchange rates of the major regions more flexible.

BAKER: Do you want to—

LAFFER: No, that's fine. That's fine.

BAKER: OK. Yes, sir?

QUESTIONER: I have two questions for—

BAKER: Sorry, could you stand up and identify yourself, please?

QUESTIONER: Morris Mark, Mark Asset Management Corp. Two questions for [laughter]--I'm not used to doing this.

LAFFER: A free advertisement.

QUESTIONER: Two questions for the panelists. The first one deals with the issue of China and fixed-rate currency policy. Is that an inadequate description of the issue? Isn't the issue really whether the currency is convertible? This country had a fixed-rate currency for, I guess, 35 years under [the 1944] Bretton Woods [Agreement], but it was totally convertible. You knew what the rules were. And as long as we chose to maintain it, the world was quite happy with that, because people could get as many dollars as they want. And the British, I think, had it for hundreds of years— fixed rate for the pound, fully convertible. So isn't the issue, really not, "Is China fixing the currency?" but rather, if they made it convertible at a fixed rate and they could hold it, God bless them? That's the first question. [Laughter] The—

BAKER: Can we just leave it that? Yeah.

QUESTIONER: OK.

BAKER: Yeah.

QUESTIONER: Oh, please. Oh, sorry. Thank you.

BAKER: I'm sorry, I just want to allow everybody to get— there's going to be a lot of questions here, and it's unfair if people ask two.

LAFFER: I agree with you, Morris, on this, and what China is doing is evolutionarily right towards that. What I think they want to do is have a convertible yuan. Slowly but surely, they're going in [that] direction. And to do that, they have to have huge amounts of dollar reserves. If you want to think of it in just technical terms, just think of us as outsourcing Alan Greenspan to China, and that is exactly what we're doing. That is exactly what they're paying for. They are buying our monetary policy and they are trying to make it convertible so that they can have a stable currency inside China going forward, and continue to evolutionarily go to complete convertibility, I think.

ROGOFF: I mean, I just don't see that they need to do that in this day and age. Because of the process of globalization, more flexible prices, productivity growth, everybody has got low inflation. The Congo, whose prices have gone up nine quadrillion times since 1970— I won't even explain what that is— they have inflation under 10 percent. Brazil has inflation under 10 percent. They've gone up almost as much as the Congo. We have the idea of having independent central banks, having more transparent central-banking policy. You don't need to outsource monetary policy. It's a complete anachronism in this—

LAFFER: But we have less central banking.

ROGOFF: --in this day and age.

LAFFER: In Europe, I mean we have now one central bank instead of 20. It's a— well, but you know, we—

BAKER: Not quite. Bank of England is still around. [Laughter]

ROGOFF: I would hardly call the euro project a resounding success.

BAKER: Yeah.

LAFFER: No, I would though.

BAKER: Nor would an Englishman. [Laughter] Yes, sir?

QUESTIONER: Dr. Laffer, Jorge Mariscal from the [inaudible] Group. Just following the implications of the way you see the world, so there is going to be an adjustment, because the relative rate of return in the U.S. has gone down and it's getting better elsewhere. Now, that's OK from a market theoretical perspective, but it does mean that U.S. consumers have to end up consuming less. And it does mean also that, for that adjustment to take place, there has to be some flexibility on the other side on exchange rates, for example, because if not, the adjustment is going to be more on quantities. So is— do you foresee, if you're right, that this trend is going to continue relative returns changing and shifting away? Do you see the risk of recession and a significant squeeze on the part of the U.S. consumer coming?

LAFFER: No, I really don't see that. I mean, you can have [a] nice slowdown, but I don't see a real recession. I mean, I think the dollar— what happens in the short run is, when you shift an in-excess demand function with inelastic demand and supply in the short run, you get vary large movements in price, and then as substitution effects take place, you then get quantity adjustments taking place, and I think we're right in the middle of that process. The dollar has fallen down to about its lowest level it's been. It was about the same level in ‘93, about the same level in ‘78. It's within that band, and it's— you know, it's right where it should be, given that we're going to have major shifts in asset flows.

And, you know, I just don't see that precipitating the end of the world. I mean, you know, we had a strong dollar during the beginning of [the] Reagan era. Then we had from, what was it, ‘85 until ‘92 or ‘3 we had a weak dollar, and then we have a strong dollar from then until 2002. We've not— all of these just are relative rates of return. I do not believe, however, as you've said, that it's because the U.S. returns are falling. That I don't think is true. I think really what's happened, is the rest of the world is coming into the supply-side revolution and you're seeing major improvements in their after-tax returns. Our corporate income tax rate, max-tax, federal, is about the highest in the world. That wasn't true 20 years ago. I mean, the world is catching up.

BAKER: Ken, do you want—

ROGOFF: Well, I mean, you're telling a story where the rest of the world is growing faster and being more productive, but that's not really explaining why the money is getting sucked into the United States. And, I mean, I admit this unprecedented situation where we have— taking up 70 [percent] to 80 percent of the world savings; never seen anything like it. We haven't even seen small countries go on for very long the way the United States has for the last 10 years, much less large countries. Maybe it'll be fine. Maybe we live in pox Americana— Pax American; excuse me. Freudian slip.

BAKER: To be fair [laughter]--to be fair, the difference is they didn't have the dollar. I mean those countries, you know, I mean the [inaudible]--

ROGOFF: Well, Australia, Canada.

BAKER: [Inaudible]--something called the dollar, but [inaudible]--

ROGOFF: No, no. No, no. No. [Laughter] No. Absolutely. But I mean, there's a question of whether, you know, you can speculate that we're in this new age and that the world, you know, isn't going to change. My read of the history of crises is they take a long time to boil. And you— the big ones you can see coming for a long time and there are various vested interests that don't want them to change, that want to [inaudible] as you go.

I have to pick on one thing, I'm sorry. [Inaudible] I would like to have low taxes if it were viable. The inheritance tax, I have to say, is one which I find utterly bizarre. The Laffer curve has very good points, but it distorts behavior. I mean, I'm not going to die quick— decide to die quicker because there's no inheritance tax. I mean, the— it's, you know, the quintessential tax, which you— is one of the less distorting taxes and one of the last ones we should want to get rid of.

BAKER: Yes?

LAFFER: Let me just say this, if I can, about that, to quote a fellow Californian. [Laughter]. [In the] first place, the amount of revenue collected from the inheritance is very low. The high tax rates that you see there are not operational. All the really rich people can buy enough congressman and senators to get this stuff, and they don't pay the taxes. The ones you get are John— John [F.] Kennedy [Jr.] and his wife going over in the plane and having an accident, they hadn't done estate planning. It really is just the counterpart to what you're saying here.

But now, let me just say it in these terms in economics. I mean, if you earn your income and you pay your taxes fair and square, you can take that money, you can go to Vegas, you can carouse, you can gamble, you can drink, and you can smoke, and as far as my federal government is concerned, God bless you, have a ball. But if you take that same money, you rats, and give it to your kids, they'd tax you up to 55 percent on the margin. That makes no sense whatsoever. As much as your kids out there may be lovely, I'm not working for your kids. I'm working for my kids. And that's my incentive for working. And the Laffer curve works more in the inheritance tax than probably any other.

Now, there is one point I'm going to give you, Ken. I am very much opposed— and I want you all to know this publicly, I am very much opposed to elimination of the phase-out of the inheritance tax. I do not want the elimination to be accelerated to the present. I want it to be phased out over a number of years. My kids have never treated me nicer. [Laughter]

BAKER: Yes, sir, over there.

QUESTIONER: Andrew Gundlach, Artemis Partners. My question for Professor Rogoff is, why should we save more? All the data shows that all the deterioration in personal savings is from the 10 percent richest people in America. We can't possibly think that they don't know what they're doing with their money. And so— and then on the other private side, on the corporations, corporations' balance sheets have never looked better. As a matter of fact, I look at Coca-Cola, that pays $2 billion in cash taxes, and wonder why they can't put more debt on that balance sheet to not pay taxes. They don't have any debt. My question for— question for Professor Laffer is, if you outsource— or if you view it as a capital-account surplus—

LAFFER: They don't make it the same— I mean—

QUESTIONER: It's similar. But if you make it a capital-account surplus, then that rate of growth of that surplus is going to be determined by domestic— or sorry— international policies with respect to their country's growth, and therefore, in a way, our asset values are going to be dependent on the domestic decisions made in China and other places, and I'm not sure that's such a great—

LAFFER: But they are right now. I mean, look at Smoot-Hawley tariffs if you want to see what happens to asset values when you want to fool around with foreigners. I mean, free trade is really important to asset values here. And by the way, you know, China— I've got to tell you, China is not our problem. China is our solution. You know, if you saw high— if you saw a store that sold you high-quality products at low cost, is your first thought, how can I boycott that store? Give me a break, John Snow. These guys are crazy. China is our best friend. They make our prices low. They give us all these wonderful high-quality products at very low cost. Thank God for Wal-Mart.

BAKER: Ken, the question was about savings and the—

ROGOFF: Well, I like shopping at Wal-Mart, too, so— but I mean, all the studies show, in fact, that the big driver of the low savings rates in recent years has been housing-price rises. In fact, you know, just statistically, the variable that's most correlated with our foreign borrowing is the rising— rising mortgages, which are coming much more broadly from the economy because, of course, we have 80 percent home ownership.

BAKER: Quickly, quickly, if you—

LAFFER: But you have assets rise. If you sit there and you get a windfall, if your portfolio doubles in value, are you going to save an increasing amount of your paycheck? Absolutely not. You're going to [inaudible] your friends a beer. And what happens is, when you have a huge increase in asset values, whether it be housing or stock market or any of these, your Keynesian savings rates go way down, because you increase your consumption even though your wealth— especially because your wealth is increasing. It's not contradictory that housing prices and stock prices cause lower savings rates. That's what they're supposed to do.

ROGOFF: Oh, absolutely. The question is, is it stable, or is this something that we can expect to be sustainable? What goes up can come down.

BAKER: Next question, please. At the back there, please. Yeah, you, sir. Yep, exactly. Name and affiliation, please.

QUESTIONER: Rick deNey with [inaudible] and Company. Dr. Rogoff, you seem to have a certain skepticism of the Laffer curve. Why do you believe that revenues increased rather dramatically after the Reagan tax-rate reductions?

ROGOFF: Well, the economy went into recession when [former Federal Reserve Board Chairman Paul] Volcker, who by the way, [President Jimmy] Carter appointed— when Volcker took office, we had a huge recession as we wrung inflation out of the economy, and coming back there was a big rebound after that, so— and of course oil prices declined sharply during that era. There were a lot of things— a lot of things going on.

BAKER: Yes, sir, there.

QUESTIONER: Thank you. Leo Goldstein from CitiGroup. Dr. Laffer, you're saying that in the next 12 to 18 months, eventually the current account is going to adjust because amazing things are going on in Europe and in Japan. But when you actually look at Europe, the last month [of] data is just showing that they're doing worse and worse, and Japan is even worse than Europe. So why— I mean, what's going to happen in 12 to 18 months that is really going to resolve this issue when the trend actually has deteriorated in the last four, six weeks in these two areas? Thank you.

LAFFER: Yeah. Well, you've asked a lot there. But Europe is proposing and starting to do tax cuts. There's a problem that Ken and I would disagree again on the ‘81, ‘82 period. My view is that we passed the tax bill in ‘81, and of course, the tax cuts didn't take place until January 1st, '83, because we phased them in. If you know they're going to cut tax rates next year, what do you do this year? You defer all the income you can. And that is exactly what happened in ‘81, ‘82. It was a disaster. It was a mistake. We should have done the tax cuts immediately. We didn't. I don't think it was Volcker that caused that. I'm a big fan of Volcker's. I think Europe is having the same type of problems. The numbers you're seeing are a reflection of the good that's happening in Europe, not the good that has happened in Europe. In anticipation of tax cuts, you will get a slowdown like you're seeing now. But I think that's all going to go to pass, and you're going to see a very major improvement.

BAKER: Yeah, next question. Yes, sir, here.

QUESTIONER: John Hartzell, KWR International. Question for Dr. Laffer, and Professor Rogoff should feel free to comment on it. What's your view on the use of targeted tax cuts for incentive purposes like IRAs [individual retirement accounts], like the write-off of housing, as— and if [the U.S.] went to a flat tax, would you maintain those things or would they not be necessary? How do you see that?

LAFFER: Let me just tell you the proposal I did in 1992 was Jerry Brown's flat tax, if any of you remember. It was a truly flat tax; 13 percent both on personal unadjusted gross income and on business net sales, or value-added with no deductions, no exemptions, no exclusions, started off on dollar one to the end. That's the proposal I would like to see. In the absence of something that's truly a flat tax, where all revenues are driven to this, frankly, you've got to play the game the way you can. But I would much rather see us not do targeted tax cuts. I'd much rather see a low flat-rate tax starting at the first dollar to the Nth dollar done. That's my view on it.

BAKER: Ken, do you—

ROGOFF: Completely agree with Dr. Laffer.

BAKER: That's unique, I think. [Laughter]

LAFFER: We have lots of areas of agreement.

BAKER: Yes, sir, here, please, in the—

QUESTIONER: Thad Gray, Capital Management. The sequel to that question is, how would you feel about a consumption-based tax system? In other words, completely ditch the income tax, replace it with a value-added type consumption tax— what's your view on the policy implications of that? For both of you.

BAKER: Yeah. Actually Ken, why don't you go first.

LAFFER: Ken, why don't you go first. Yeah.

ROGOFF: Yeah. I mean, like most economists, I favor that. You can have, by the way, a progressive consumption tax if you want it, also, but— so as not to have a tax on savings. But I think there's universal feeling that that would be better and that we should move towards that. But, especially, we need a simpler tax system, that there's huge deadweight caused from the complexity and distortion from our tax system.

LAFFER: The difference between a national sales tax and an income tax, if you will, there's a correspondence here— a theorem here as between direct and indirect, just for you Brits who want [inaudible] difference there. But there is exact correspondence. In theory, they're both equally as valid. The question is, which one is easier to implement? Which one is simpler, fairer, and really is more efficient [in] collection? And that really is up in the air. They're both great types of taxes, as long as you replace the current codes for them, not add them on.

BAKER: All right. Five more minutes. Can we get off this area of consensus here, which is most unusual? Any more questions? Yes— oh, actually, sorry— this lady there. Sorry.

LAFFER: Poor Morris.

BAKER: You almost got away with it there.

QUESTIONER: One of the concerns that [Federal Reserve Board Governor] Ben Bernanke raised about the current-account deficit or capital-account surplus, however you like to look at it, is that a lot of the funds are flowing from emerging markets to the U.S. What are the longer-term implications in your mind of that kind of imbalance?

ROGOFF: Well, I mean, it's not a bad thing that they're rebuilding their balance sheets, but it's very temporary. Maybe more than a third, 40 percent of our current-account surplus is founded by various emerging markets. That's not going to last. That's going to change. It's one of the reasons that our current-account deficit is going to close up, and it's one of the reasons that there are going to be some big adjustments in what we can consume.

LAFFER: You know, the problem is with the developing countries' policies, which is tragic. I mean, people don't want to put their money in a country where they can't get it out. People don't want to invest in losers. And you know, unfortunately, these emerging countries have to make their economic policies work. That's why I'm so much in favor of China pegging their yuan to the dollar, so they don't have a 1998 Asian currency contagion. They were the only ones that didn't depreciate during that period. You know, it's just amazing how they went through that. That's what other developing countries need. I agree with floating rates between the euro, the yen, and the dollar, but you can't have a floating rate in Zambia.

ROGOFF: The other countries had pegs in Asia. They had a crisis. They just had much more strong capital controls that protected them.

LAFFER: They just held also bigger reserves, too, and they didn't want to do it.

BAKER: Any more questions? Let me just quickly then, if I may, ask one. Social Security reform: what— if— I mean, I'll say that we don't know quite what is going to happen here, but if there is a need— well, Arthur, you don't accept that there is a need for the U.S. to do anything about its deficits, but what is going to be the impact of a short— of some kind of, you know, introduction of private accounts, the immediate 10-, 15-year effect on the fiscal position? What would be the— if that happens in line with the president's proposal, which today seems unlikely, but some things still may happen along those lines, what is going to be the impact on U.S. borrowing and on these questions that we've talked about with regard to the finance-ability of the U.S. deficit?

LAFFER: Let me, if I can— the U.S. president's proposal on Social Security and the savings, it's the biggest gap that we missed in the supply-side revolution. Today, if you're an average worker and you go through all the average workers, and you make just enough money to pay one additional dollar in payroll tax, employer and employee, what can you expect as a discounted present value of all future benefits from Social Security for that additional dollar in tax? And the answer comes in pretty close to zero. The Social Security tax on the margin is almost a direct wedge between wages paid and wages received. If you die at 64, your family doesn't get the benefits. You're out. You know, what you should do is make it your account, except for the welfare, which I do agree with the welfare and redistribution, but except for welfare, it should be a one-for-one elimination of that wedge between wages paid and wages received, and that is exactly what the president has proposed. No other president has ever proposed anything like this. This is the most revolutionary proposal I've seen, and unfortunately, they're not defending it the way I'd like to see them defend it, Jerry, but it's one-third of that wedge eliminated here.

Next we do Medicare and Medicaid. We internalize all of these private accounts and then have an honest-to-God good welfare system for people who aren't taken care of. But if it's a privatized savings account, it should be your money in your account that you have control of for the rest of your life.

BAKER: Won't it raise— I mean, isn't that a good measure to raise private savings, the sort of thing you think needs to be done in the medium term?

ROGOFF: Well, I think that's pretty [inaudible]; I think Social Security is simply not in crisis. It's not the big problem. The big problem is Medicare and Medicaid. The big problem— as my Harvard colleagues, like David Cutler, project— [is] that, over the next 40 years, expenditures on healthcare is going to go up to something like 30 percent of GDP. And what do we do about it? Is it something we give to everyone as an entitlement, which would be much more Marxist than our economy today? We need to confront that problem, and we're not confronting it. We're going in the opposite direction. That's by far the big question in the whole deficits debate; everything is how we're going to deal with that problem. We're not confronting it.

LAFFER: See, I think we are with privatized savings. I mean, I think we're starting the process that way. We have an unfunded liability, which is a serious problem, too. But this is a different problem of associating effort and reward in privatized savings, my view.

BAKER: That's all we have time for. Thank you very much indeed. Can I just ask you all to join me in thanking our speakers for a really good discussion? [Applause]

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