Speaker: Alan Greenspan, chairman, Federal Reserve Board
Moderator: Peter G. Peterson, senior chairman, The Blackstone Group, and chairman of the board of directors, Council on Foreign Relations
Council on Foreign Relations
New York, N.Y.
March 10, 2005
PETER PETERSON: Good evening, all. Welcome to the Councils Corporate Conference. I want to thank BNP Paribas, Citigroup, Credit Suisse, Group Satander, Guardsmark, Lehman Brothers, and McKinsey for helping us with this dinner.
First of all, I would like to present Alan Greenspans transcendent achievement. The great woman the chairman persuaded to marry him, Andrea Mitchell, you are his transcendent achievement. Please stand so we can welcome you. [Applause]
Shes just written a book, or writing a book where her advance is orders of magnitude larger than mine, so that delivers a message, Andrea, and I understand it.
Second, its such a cliché at these events, and a travesty really, to say the person needs no introduction, and then you proceed to recite a long list of widely known biographics. I was thinking about James Shannon, the Nobel Prize Winner, who once said that real information is surprise. What Im about to tell you about the chairman may be in the nature of trivial pursuit, but some of it may well surprise you a bit. Let me start with golf. If you think his congressional testimony is impenetrable, try getting an answer to the simple question on the first tee. Alan, what precisely is your golf handicap? Also, the chairman has never heard of the concept of a gimme putt. He thinks its an oxymoron. Thus, if you think he is an effective practitioner of tight money at the Fed, you aint seen nothing until youve seen him deny even the elementary golf courtesies.
Now, what about tennis? You recall President Truman once said that he was desperately looking for a one-handed economist. He hated economists who said, on the one hand this, and on the other hand that. Well, if Harry Truman had watched Alan Greenspan on the tennis court, he could never have been chairman of the Fed in a Truman administration. Alan Greenspan is the ultimate two-handed economist on the tennis court. At the decisive moment when I assume that the ball is out of his reach, he suddenly switched hands, doubles his wing span, and wins the point. We can only hope that the constant switching from left to right and right to left is not a metaphor for his economic views.
Now, I did some research that really reports some truly surprising items that I would like to tell you about. I looked at something called Andy Borowitz Report. And this item was utterly stunning to me, and I think it will surprise you. The headline is, Greenspan to head up U2, becomes the lead singer as Bono leaves for World Bank. Now, the long-time Federal Reserve Chairman, and I quote from this report, Im not making this up, Alan Greenspan stunned the worlds of finance and pop music today by announcing that he would leave his post effective immediately to become head of the rock band U2. In filling the key position with the platinum-selling musical act, Greenspan is replacing U2 singer Bono, who is reported to be heading for the top job at the World Bank. Mr. Greenspan struck many observers as an unlikely choice to assume such an important role in one of the worlds most important rock bands, since his convoluted and often cryptic use of the English language seems incompatible with the more straightforward demands of rock music. Now, reportedly, the former Fed Chairman has already written the lyrics of one of U2s most famous songs, With or Without You. He changed it as follows: Going forward, the cost of my living, with or without you, may exceed my capacity to fulfill any reasonable expectations of success in either or both of these endeavors. Now, Im sure you would agree with me, those are some memorable lyrics. Some of you may think this is a low note, others a high note, but I think all of you would agree, its a surprising note to read an item like that.
Finally, a word about the poor soul who succeeds Alan Greenspan at the Fed. Ive often said, nothing is more important in life than being able to pick your predecessor. Let me put this to you simply, how would you like to have Alan Greenspan as your predecessor. I now present the chairman of the Federal Reserve Bank, Alan Greenspan. [Applause]
ALAN GREENSPAN: Pete, I suspect that you think that I accepted the invitation to come speak before this esteemed audience because of the nature and quality of that audience, but thats only partially true. My ultimate motive was to once again expose myself to an introduction by Peter G. Peterson, the nature of which is always the ultimate in surprise. And I must tell you, you have succeeded once again. I feel like Linus. That was supposed to be funny, but never mind. [Laughter]
With respect to the rumors about U2, as you are well aware, we at the Fed neither affirm nor deny any particular rumors irrespective of how melodious. And in case you really want to know, my handicap is my backswing.
Now, I may perceive that weve now gone well into this session with no frivolous remarks being uttered yet, so if I may get to a more serious issue that provided your chairman and others will facilitate that. If that is okay with you, sir, I should like to. Anyway, its certainly a pleasure, in all seriousness, being back here. I spent enumerable evenings at sessions such as this. I was hopefully one of the members of the board which helped bring this organization forward in spite of Pete, and I hoped it would stay together when you all went back to different occupations, and Im pleased to see that it still is an impressive and important institution in this country, as its been since the early days of David Rockefeller, and a number of his predecessors, which really, in many respects, formulated the foreign policy of this country.
The U.S. economy appears to have been pressing a number of historic limits in recent years without experiencing the types of financial disruption that almost surely would have arisen in decades past. This observation raises some key questions about the longer-term stability of the U.S. and global economies that bear significantly on future economic developments.
Among the limits that we have been pressing against are those in our external and budget balances. In the United States, we have been incurring ever-larger trade deficits with the broader current account measure moving into the neighborhood of 6 percent of our gross domestic product [GDP]. Yet the dollars real exchange value, despite its recent decline, remains above its 1995 low.
Meanwhile, we have moved from a budget surplus in 2000 to a deficit that is projected by the Congressional Budget Office to be around 3-1/4 percent of GDP this year. In addition, we have enacted commitments to our senior citizens that, given the impending retirement of our large baby-boom generation, will create significant fiscal challenges in the years ahead. Yet the yields on Treasury notes maturing a decade from now remain at low levels. Nor are households experiencing inordinate financial pressures as a consequence of record-high levels of household debt relative to income.
Has something fundamental happened to the U.S. economy that enables us to disregard all the time-tested criteria for assessing when economic imbalances become worrisome? Regrettably, the answer is no; the free lunch has still to be invented. We do, however, seem to be undergoing what is likely, in the end, to be a one-time shift in the degree of globalization and innovation that has temporarily altered the specific calibrations of those criteria.
Globalization has altered the economic frameworks of both advanced and developing nations in ways that are difficult to fully comprehend. Nonetheless, the largely unregulated global markets, with some notable exceptions, appear to move smoothly from one state of equilibrium to another. Adam Smiths invisible hand remains at work on a global scale.
Because of deregulation, increased innovation, and lower barriers to trade and investment, cross-border trade in recent decades has been expanding at a far faster pace than GDP. As a result, many economies are increasingly exposed to the rigors of international competition and comparative advantage. In the process, lower prices for some goods and services produced by our trading partners have competitively suppressed domestic price pressures.
Production of traded goods and services has expanded rapidly in economies with large, low-wage labor forces. Most prominent are China and India, which over the past decade have partly opened up to market forces, and the economies of Central and Eastern Europe, which were freed from central planning by the fall of the Soviet empire. The consequent significant additions to world production and trade have clearly put downward pressure on prices in the United States and in the economies of our trading partners.
Over the past two decades, inflation has fallen notably, virtually worldwide, as has economic volatility. Although a complete understanding of the reasons remains elusive, globalization and innovation would appear to be essential elements of any paradigm capable of explaining the events of the past ten years. If indeed this is the case, because the extent of globalization and the speed of innovation are limited, the current apparent rapid pace of structural shift cannot continue indefinitely. While the outlook for the next year or so seems reasonably bright, the outlook for the latter part of this decade remains opaque because it is uncertain whether this transitional paradigm, if that is what it is, is already far advanced and about to slow, or whether it remains in an early, still-vibrant stage of evolution.
Globalization, the extension of the division of labor and specialization beyond national borders, is patently a key to understanding much of our recent economic history. With a deepening of specialization and a growing capacity to conduct transactions and take risks throughout the world, production has become increasingly international.
The pronounced structural shift over the past decade to a far more vigorous and competitive world economy than that which existed in earlier post-World War II decades apparently has been adding significant stimulus to world economic activity. This stimulus, like that which resulted from similar structural changes in the past, is likely a function of the rate of increase of globalization and not its level. If so, such impetus would tend to peter out as we approach the practical limits of globalization.
Full globalization, in which production, trade, and finance are driven solely by risk-adjusted rates of return and in which risk is indifferent to distance and national borders, will likely never be achieved. The inherent risk aversion of people, and the home bias that is one manifestation of that aversion, will limit how far globalization can proceed. But because so much of our recent experience has little precedent, as I noted earlier, we cannot fully determine how long the current globalization dynamic will take to play out. And even then we have to be careful not to fall into the trap of equating the achievement of full globalization with the exhaustion of opportunities for new investment. The closing of our frontier at the end of the nineteenth century, for example, did not signal the onset of a new era of economic stagnation.
The increasing globalization of the post-World War II era was fostered at its beginnings by the judgment that burgeoning prewar protectionism was among the primary causes of the depth of the Great Depression of the 1930s. As a consequence, trade barriers began to fall after the war. Globalization was enhanced further when the inflation-ridden 1970s provoked a rethinking of the philosophy of economic policy, the roots of which were still planted in the Depression era. In the United States, that rethinking led to a wave of bipartisan deregulation of transportation, energy, and finance. With respect to macro policies, there was a growing recognition that inflation impaired economic performance. Moreover, a tightening of monetary policy, and not increased regulation, came to be seen by the end of that decade as the only viable solution to taming inflation. Of course, the startling recovery of war-ravaged West Germany following Ludwig Erhards postwar reforms, and Japans embrace of global trade, were early examples of the policy reevaluation process.
It has taken several decades of experience with markets and competition to achieve an unwinding of regulatory rigidities. Today, privatization and deregulation have become almost synonymous with reform.
By any number of measures, globalization has expanded markedly in recent decades. Not only has the ratio of international trade in goods and services to world GDP risen steadily over the past half century, but a related measure, the extent to which savers reach beyond their national borders to invest in foreign assets, has also risen.
Through much of the post-World War II years, domestic saving for each country was invested predominantly in its domestic capital assets, even when there existed the potential for superior risk-adjusted returns from abroad. Because a countrys domestic saving less its domestic investment is essentially equal to its current account balance, such balances, positive or negative, were therefore generally modest, with the exception of the mid-1980s. But in the early 1990s, home bias began to diminish appreciably, and, hence, the dispersion of current account balances among countries has increased markedly. The widening current account deficit in the United States has come to dominate the tail of the distribution of external balances across countries. Nonetheless, the worldwide dispersion of current account balances has risen since the early 1990s, even excluding the United States.
Thus, the decline in home bias, or its equivalent, expanding globalization, has apparently enabled the United States to finance and, hence, incur so large a current account deficit. As a result of these capital inflows, the ratio of foreign net claims against U.S. residents to our annual GDP has risen to approximately one-fourth. While some other countries are far more in debt to foreigners, at least relative to their GDPs, they do not face the scale of international financing that we require.
A U.S. current account deficit of 6 percent of GDP would probably not have been readily fundable a half-century ago or perhaps even a couple of decades ago. The ability to move that much of world saving to the United States in response to relative rates of return almost surely would have been hindered by the far-lesser degree of both globalization and international financial flexibility that existed at the time. Such large transfers would presumably have induced changes in the prices of assets that would have proved inhibiting.
Nonetheless, we have little evidence that the economic forces that are fostering international specialization, and hence cross-border trade and increasing dispersion of current account balances, are as yet diminishing. To be sure, as I pointed out earlier this year, we may be approaching a point, if we are not already there, at which exporters to the United States, should the dollar decline further, would no longer choose to absorb a further reduction in profit margins. An acceleration of U.S. import prices, of course, would impede imports and give traction to the process of adjustment in our trade balance.
Moreover, individual investors, private and official, faced with an increasing concentration of dollar assets in their portfolios, will at some point choose greater balance in their asset accumulation. That shift, over time, would likely induce contractions in both the U.S. current account deficit and the corresponding current account surpluses of other nations. To date the proportional shift out of dollars from the total of official and private sector foreign currency accounts has been modest, when adjusted for exchange rate changes. Of course, the shift has been larger on an unadjusted dollar equivalent basis. However, the market has absorbed this change in an orderly manner.
The more-rapid aging of European and Japanese populations relative to the aging of the U.S. population should slow the flow of foreign savings available to the United States. Although those population dynamics are already in train, little evidence as yet of slowed savings transfers has surfaced.
Can market forces incrementally defuse a buildup in a nations current account deficit and net external debt before a crisis more abruptly does so? The answer seems to lie with the degree of market flexibility. In a world economy that is sufficiently flexible, as debt projections rise, product and equity prices, interest rates, and exchange rates presumably would change to reestablish global balance. We may not be able to usefully determine at what point foreign accumulation of net claims on the United States will slow or even reverse, but it is evident that the greater the degree of international flexibility, the less the risk of a crisis.
Should globalization continue unfettered and thereby create an ever-more flexible international financial system, history suggests that current account imbalances will be defused with modest risk of disruption. Two Federal Reserve studies of large current account adjustments in developed countries, the results of which are presumably applicable to the United States, suggest that market forces are likely to restore a more long-term sustainable current account balance here without substantial disruption. Indeed, this was the case in the second half of the 1980s.
I say this with one major caveat. Protectionism, some signs of which have emerged in recent years, could significantly erode global flexibility and, hence, undermine the global adjustment process. We are already experiencing pressure to slow down the expansion of trade. The current Doha Round of trade negotiations has faced difficulties largely because the low-hanging fruit available through negotiation has already been picked in the trade liberalizations that have occurred since the Kennedy Round. On a more encouraging note, some recent indications of progress may be pointing to a heightened probability of completion of the Doha Round.
The remarkable technological advances of recent decades have doubtless augmented and fostered the dramatic effect of increased globalization on economic growth. In particular, information and communication technologies have propelled the processing and transmission of data and ideas to a level far beyond our capabilities a decade or two ago.
The advent of real-time information systems has enabled managers to organize a workforce without the redundancy required in earlier decades to ensure against the type of human error that technology has now made far less prevalent. Real-time information, by eliminating much human intervention, has markedly reduced scrappage rates on production lines, lead times on purchases, and errors in many forms of recordkeeping. Much data transfer is now electronic and far more accurate than possible in earlier times.
The long-term path of technology and growth is difficult to discern. Indeed, innovation, by definition, is not forecastable. In the United States, we have always employed technologies at, or close to, the cutting edge, and we have created many innovative technologies ourselves. The opportunities of many developing economies to borrow innovation is not readily available to us. Thus, even though the longer-term prospects for innovation and respectable U.S. productivity growth are encouraging, our productivity growth has rarely exceeded an average rate of 3 percent annually for any protracted period.
We have, I believe, a reasonably good understanding of why Americans have been able to reach farther into global markets, incur significant increases in debt, and yet not suffer the disruptions so often observed as a consequence. However, a widely held alternative view of the past decade cannot readily be dismissed. That view holds that the postwar paradigm is still largely in place, and key financial ratios, rather than suggesting an evolving economic structure, reflect extreme values that have materialized within an unchanged structure and must eventually adjust, perhaps abruptly.
To be sure, even with the increased flexibility implied in a paradigm of expanding globalization and innovation, the combination of exceptionally low saving rates and historically high ratios of household debt to income can be a concern if incomes unexpectedly fall. Indeed, virtually any debt burden doubtless will become oppressive if incomes fall significantly.
But, rising debt-to-income ratios can be somewhat misleading as an indicator of stress. Indeed the ratio of household debt to income has been rising sporadically for more than a half-century, a trend that partly reflects the increased capacity of ever-wealthier households to service debt. Moreover, a significant part of the recent rise in the debt-to-income ratio reflects the remarkable gain in homeownership.
Over the past decade, for example, the share of households that own homes has risen from 64 percent to 69 percent. During the decade, a significant number of renters bought homes, thus increasing the asset side of their balance sheets as well as increasing their debt. It can scarcely be argued that the substitutions of debt service for rent materially impaired the financial state of the new homeowner. Yet the process over the past decade added more than 10 percent to outstanding mortgage debt and accounted for more than one-seventh of the increase in total household debt over that period.
Thus, short of a period of appreciable overall economic weakness, households, with the exception of some highly leveraged sub-prime borrowers, do not appear to be faced with significant financial strain. With interest rates low, debt service costs for households have been essentially stable for the past few years. Accounting for other fixed charges such as rent, utilities, and auto-leasing costs does not materially alter this assessment of stability.
Even should interest rates rise materially further, the effect on household expenses will be stretched out because four-fifths of debt is at fixed rates and varying maturities, and it will take time for debt to mature and reflect the higher rates. Despite the almost 2 percentage point rise in mortgage rates on new originations from mid-1999 to mid-2000, the average interest rate on outstanding mortgage debt rose only slightly, as did debt service.
In a related concern, a number of analysts have conjectured that the extended period of low interest rates is spawning a bubble in housing prices in the United States that will, at some point, implode. Their concern is that, if this were to occur, highly leveraged homeowners would be forced to sharply curtail their spending. To be sure, indexes of house prices based on repeat sales of existing homes have significantly outstripped increases in rents, suggesting at least the possibility of price misalignment in some housing markets.
But a destabilizing contraction in nationwide house prices does not seem the most probable outcome. To be sure, the recent marked increase in the investor share of home purchases suggests rising speculation in homes. Remember, owner occupants are rarely home speculators because to sell, they must move. However, nominal house prices in the aggregate have rarely fallen and certainly not by very much. And even should more-than-average price weakness occur, the increase in home equity as a consequence of the recent sharp rise in prices should buffer the vast majority of homeowners. House prices, however, like those of many other assets, are difficult to predict, and movements in those prices can be of macroeconomic significance.
There appears, at the moment, to be little concern about corporate financial imbalances. Debt-to-equity ratios are well within historical ranges, and the recent prolonged period of low long-term interest rates has enabled corporations to refinance liabilities and stretch out bond maturities.
The resolution of our current account deficit and household debt burdens does not strike me as overly worrisome, but that is certainly not the case for our fiscal deficit, which, according to the Congressional Budget Office, will rise significantly as the baby boomers start to retire in 2008. Our fiscal prospects are, in my judgment, a significant obstacle to long-term stability because the budget deficit is not readily subject to correction by market forces that stabilize other imbalances.
One issue that concerns most analysts, especially in the context of a widening structural federal deficit, is inadequate national saving. Fortunately, our meager domestic savings, and those attracted from abroad, are being very effectively invested in domestic capital assets. The efficiency of our capital stock thus has been an important offset to what, by any standard, has been an exceptionally low domestic saving rate in the United States.
Although saving is a necessary condition for financing the capital investment required to engender productivity, it is not a sufficient condition. The very high saving rates of the Soviet Union, or China and India in earlier decades, often did not foster significant productivity growth in those countries. Saving squandered in financing inefficient technologies does not advance living standards. In light of the uncertain link between saving and productivity growth, it is difficult to measure the exact extent to which our relatively low gross national saving rate will limit the future growth of an efficient capital stock. What we know for sure, however, is that the 30 million baby boomers who will reach 65 years of age over the next quarter century are going to place enormous pressures on the ability of our economy to supply the real benefits promised to retirees under current law, and our success in attracting savings from abroad may be masking the full effect on investment of deficient domestic saving.
Our day-by-day experiences with the effectiveness of flexible markets as they adjust to, and correct, imbalances can readily lead us to the mistaken conclusion that once markets are purged of rigidities, macroeconomic disturbances will become a historical relic. However, the penchant of humans for quirky, often irrational behavior gets in the way of this conclusion. A discontinuity in valuation judgments, often the cause or consequence of the building and bursting of a bubble, can occasionally destabilize even the most liquid and flexible of markets. I do not have much to add on this issue except to reiterate our need to better understand it.
The last three decades have witnessed a significant coalescing of economic policy philosophies. Central planning has been judged as ineffective and is now generally avoided. Market flexibility has become the focus, albeit often hesitant focus, of reform in most countries. All policymakers are struggling to understand global and technological changes that appear to have profoundly altered world economic developments. For most economic participants, these changes appear to have had positive effects on their economic well-being. But a significant minority, trapped on the adverse side of the markets process of creative destruction, are suffering. This is an issue that needs to be more fully addressed if globalization is to sustain the public support it requires to make further progress.
Thank you very much. I look forward to your questions. [Applause]
PETERSON: Mr. Chairman, let me kick this off. Weve asked a few people to ask questions. I take it you agree with most economists that it would be a pretty good thing to increase the net national savings rate. As you point out, the personal savings rate has plummeted in recent times. Im interested in a couple of things.
First, I keep hearing from economists that our current tax incentive to increase savings have rather limited and ambiguous effects, because weve become very consumption obsessed. Some people think we may have reached the point where if were really serious about increasing personal savings, it may be necessary to use the Singapore, Chile, Australian model of mandatory savings. Do you have a point of view about that?
GREENSPAN: I do, Pete. And it really reflects remarks I made earlier. Namely, that the most extraordinary thing about our savings investment conflicts is that we are able to get such an extraordinarily high real rate of return out of the capital investment financed by both domestic and borrowed savings from abroad. And, as a consequence, directly related to this, weve had an extraordinary rise in productivity. One of the reasons for this is we have a remarkable flexibility of financial markets. And as a consequence, savings, as little as it is, gets extraordinarily efficiently used because of the flexibility and vitality of our markets.
Im concerned that if we start putting government rigidities and laws around various different types of actions, in other words prevent people from doing what they otherwise would have done, in effect, remember, forced savings is a tax. You will undermine the efficiency of the flow and adjustment pump, and I think while it seems to be a highly desirable thing to do because we want savings, mandate it, if you want economic growth, mandate it, if you want the world to be better, mandate it; the only problem is, something happens between the mandate and the conclusion, and thats really what bothers me.
PETERSON: Thank you. [Applause] All right. David Rubinstein.
DAVID RUBINSTEIN: You refer to the improvement in information technology. Since you became Chairman of the Fed in 1987, how has the improvement of information technology enabled the Federal Reserve to get better information when it makes its decisions compared to what the case was in 1987; and how has the improvement in technology enabled you to work more closely with central bankers around the world; and, finally, how has the improvement in technology affected your golf and your tennis games?
GREENSPAN: With respect to the latter, it is remarkable how many years new technology can take off your life. I find it remarkable, and Im just wondering when theyre going to invent the golf ball which I can hit 400 yards.
Obviously, theres been an extraordinary change over this period. We, like everybody else over this period, have moved to information technology at unbelievable speed. I recall when I first arrived at the Fed, in order to get a stock price or a bond price or an exchange rate, I had to pick up the phone and call the desk up in New York, or some brokerage firm, and it was a major activity. Today, as you well know, almost all sorts of information are at your fingertips.
We have got a huge amount of data available to us, and I do not deny that it assists us in making judgments, but only at the margin, and the margin may be very narrow, and the reason is that good policy depends on good judgment. And that judgment does depend on facts and how easy they are achieved, and compiled and analyzed, but all that does is add a little time to the evaluation process, but it doesnt fundamentally alter the quality of the decisions. It may have taken us three days to come to a conclusion 15 years ago, and now it would take us a day. We can still act as we always have given 15 minutes notice, that isnt the issue.
I would say that I cannot perceive that the quality of the decision making process at the Federal Reserve has improved as a consequence of the technology, but it has made us individually far more capable of getting what we need to know more rapidly. It may appear that the next time we have a 1987 type stock market crash, which was something in which information was critical, it may well be were that type of event to occur with todays technology, it really would matter. We would know whether the Chicago Options Exchange was shut down, or not shut down. We know the bid/ask prices of a great number of securities, and fetishes, and be able to judge the degree of liquidity far better today than we were able to on October 19, 1987. But those are the rare events.
The most general answer I can give you is, its made us work harder, but the outcome has not been materially different.
PETERSON: David, it would not have escaped your attention that he avoided your question about the effect on his golf score, because Im sure he was worried about the possible effects on future negotiations on the first tee, so I admire that, Mr. Chairman, dramatically. We now have Adam Levinson.
ADAM LEVINSON: Chairman Greenspan, are you concerned that because of the currency regime in China that the Fed effectively sets monetary policy in China despite the fact that its designed for the U.S. And, does Chinas recycling of their current account surplus back into U.S. Treasuries in part undermine the efficacy of that same policy in the U.S.?
GREENSPAN: There has been, as you imply, considerable concern about the size of the flows that have occurred with respect to China in the United States. And, indeed, obviously, locking their currency against ours effectively makes Federal Reserve policy their monetary policy. And if monetary policy really made a big difference, as it does, in all fully market-oriented economies, then much of the concerns, I think, would be valid. But remember we are still dealing with a centrally planned system that only recently have they employed interest rates to address imbalances in the system, and in not an extended way. They still are using the administrative controls. And so that the impact of what, for example, our impact on Hong Kong is far greater than it is on mainland China.
There is no question in my mind that were they to perceive that the ultimate development, which I believe will occur, perceive that when they get a financial system in which the adjustment process occurs as a consequence of interest rates, various different types of prices, rather than administrative controls, they will not be locking themselves into the U.S. exchange rate because the impacts would be very destabilizing.
The issue of the sequencing back and forth, as you put it, of their very large holdings of U.S. dollars, which they have effectively accumulated almost wholly in the context of supporting their exchange rate, would be a large issue if its impact on U.S. long-term interest rates were very large. As best we can figure out, while there is some impact from an aggregate amount of holdings by foreign monetary authorities of U.S. Treasuries on Treasury interest rates, its really modest, it varies at various different times, but were talking about something in the area of 50 bases points, sometimes less, maybe sometimes more. And, as we have seen in recent days, you can get move in a 10-year Treasury note without anything very significant going on of those orders of magnitude.
So, at this stage, the thing which is surprising everybody and is causing some concerns is the newness of this relationship, and its dramatic change in size. And I think we will all be somewhat concerned until China develops a full market economy, which it ultimately seems to be moving interest he direction of, which will then integrate into the international financial system in a far more effective way than it does today. And well be far more familiar with what their interest rates are doing, their exchange rates are doing, how the system as a whole is doing. It will look more like everybody else. At the moment, of course, its not, but theyre working in that direction, and I think quite successfully.
PETERSON: Kim White, please.
KIM WHITE: Mr. Chairman, you take a very sanguine view of the current account deficit, and I guess that youve stated that market pressures would stabilize and over the longer run possibly decrease the current account deficit, and its a pending financing requirement. However, due to the increase just in interest payments on external debt, the non-factor line in the current account deficit will rise according to some studies by $200 billion. This takes us from a surplus a few years ago into a deficit. With this tailwind turning into a headwind, do you believe that the financial markets will be able to manage this without requiring a significant adjustment in the value of the dollar?
GREENSPAN: Well, Ive been trying to stay out of the dollar forecasting business for quite a long while, and I trust to maintain that this evening. Let me just say what it is we know about these types of imbalances and what their ultimate resolution is.
We have got, as I indicated before, what appears to be an extraordinarily flexible system and the one thing that flexible systems tell us is that markets adjust imbalances before we are aware that they exist. And to the extent that we have, as I put it in my prepared remarks, seeming Adam Smith type invisible hands in the international markets, theres every reason to believe that we will get the set of adjustments that will replicate what the two studies I mentioned, the Federal Reserve studies, on developed countries.
Let me just say this, we do have a model of balance of payments adjustments, and you might even say budget deficit adjustments occurring in the context of a fixed exchange rate system, which is 50 states of the United States. We, of necessity, have imbalances in capital flows between states, we have imbalances with respect to labor forces moving in and out, we have interest rates adjusting to those imbalances, and price differentials do the rest. Yet, we have not had for generations significant serious balance of payments problems.
We did back in the 19th Century, some states did default, and indeed a number of companies within states defaulted and we did have essentially a balance of payments problem. But, in the post-World War II period, especially in the last 10 years, with the advent of derivatives, specifically credit derivatives, and the remarkable ability arbitrage almost anything, we have responses in the marketplace, which balance most everything. While Im not going to say that therefore we will have no difficulties. I did have a very large caveat in that argument talking about serious questions that emerge when people get overly exuberant, and bubbles emerge, and usually unwelcome currents following that. Aside from that, the system works extraordinarily flexibly.
All I can say is, we would not be, with some of the ratios we now have and which we are concerned about, if the markets werent sufficiently flexible to allow us to get there. The fact that we are there, and we do not see any significant evidence of problems leads me to conclude that we are probably not in bad shape. I dont want to say, I shouldnt say that everything will happen in a benevolent form, the reason is history sometimes suggests that that may not be the case. I think he probabilities are pretty high that well come out of this okay.
MR. PETERSON: Jacob Frenkel, please.
JACOB FRANKEL: You described various deficits, household deficits, budget deficits, the future of Social Security, current account deficits, which really normally should have created tremendous anxiety, and then you described in a very convincing way why the unique characteristics of the American system, flexibility, deregulation, competitiveness, and the globalization, why they extend the limits of tolerance. Normally, extending the limits of tolerance means they provide a breathing space for policymakers in markets to take care of what normally is non-sustainable.
The real question that I have is, do you feel that this breathing space is being used in the right way? The reason why Im asking is that, being an outsider, one cannot but be impressed with the lack of attention that is given definitely outside of this country in Europe, with its discussion of the stability and growth, and the fiasco of previous commitments, about the budget solvency, and the budget deficit spending. G7 discussions are focusing on exchange rates, much less on the fundamentals. So, again, I know that you are not sanguine about it, but are they sanguine?
GREENSPAN: You mean, is the G7 sanguine, is that what youre saying? I have a tendency to, as my wife says, think that the glass is half full over time. So I will reinterpret your remarks in a positive manner. I would really be worried if nobody else were worried. Were beginning to see a movement from what I would call budget policy tranquility to real serious debate. And while it may be nervous making, its a symptom that we may be on the cure for this problem.
Indeed, unless we address it, as Ive said on many occasions, theres a major disruption out there, there is essentially an unsustainable fiscal budget paradigm, which means that we have to alter the path, which essentially becomes a significant problem in 2015 and beyond. Obviously, to alter that path you have to start very significantly earlier to get on the right track.
I am chagrined at the level of disagreement in American discussions, but it may very well be a factor to help move us further to the types of compromises, and the types of policy which will divert us from a path which is not favorable.
PETERSON: On a related issue, some of your colleagues have noted that the low level of savings, of interest rates globally, related to the big increase in current account surpluses among emerging market countries, a big increase in the supply of savings from these countries, and this low level interest rates is also contributing to the low level of savings in the U.S. Do you subscribe to the notion that this emerging market savings bulge is contributing to the low level of interest rates?
GREENSPAN: Doesnt that sound like a Federal Reserves question, as a former alumnus? I tried to examine that issue a while back, a couple of weeks ago, and you go through you know that we have an extraordinary, or at least back then, something that was at least in my experience, utterly unprecedented. The central bank pushes short-term interest rates up, and long-term interest rates proceed to go down. Now, that is not necessarily impossible, as indeed events have proved it not to be impossible. And to be sure, when rates get when youre in a central bank tightening mode, on the tail end you usually find that long-term rates begin to move lower, but not at this stage were in.
So we looked at everything else, including the savings demand imbalance, its hard to judge. Its possible. Im sure that there is some element to that, indeed, Ive suggested as much in my remarks. The problem is, we have no sense of broader reason.
PETERSON: One final question.
QUESTIONER: I wanted to directly address the question of inflation, and its really a two-part question. The first is rather technical, the Fed has routinely directed those of us in the financial markets towards measures of core inflation. As you know, we have two of those measures. One, the core personal consumption expenditure [PCE] deflator, and the other the core consumer price index [CPI]. We have a big of a divergence right now, so I was wondering if I could get your thoughts on the divergence, and the merits of the two.
The second part relates to slack in the labor force. Weve seen the labor force participation rate decline from its peak in 2000 fairly substantially. Were now running participation rates similar to the late 1980s. My question there is, are those declines secular or are they cyclical? Weve seen the unemployment rates fall rather substantially with relatively few jobs created. Can we expect that ton continue in the future.
GREENSPAN: With respect to the CPI PCE core, as you know we have decided that the CPI is not a particularly good price index. The problem with it is that its got fixed rates, its never revised, and as a consequence cannot bring to bear the quality, sensitivity that the so-called PCE core brings to it, which has flexible weights, far more prices, covers far more in the ways of consumers purchase.
These two indexes will tend to diverge. I should put it this way. The rate of change of the core PCE almost always is less than the CPI, essentially because the CPI is a fixed rate, and as you know, a fixed rate does not adjust for the fact that when prices go up, invariably people buy less, and that is not captured in the CPI. So you get an abnormal upward bias. But, the two indexes fluctuate, and the spreads do change, and its not something I pay terribly much attention to.
Others do. They conceive of the spread as being an indicator of something. Im not certain whether that is indeed the case. But we obviously look at both. The problem is that the vast proportion of the prices in the PCE core come from the CPI. So it has nothing to do with the individual equations, its got to do with the process of putting them together. Im not sure I read terribly much into that particular equation.
Let me just answer this other thing. The labor force participation issue can be constructed, if you disaggregate it into cohorts of not only what ages, but when were you born. If you trace the patterns of labor force participation by, say, people born between 1950 and 1955, from the age of 20 forward, youll get a certain pattern, which will differ slightly form those who were born 1960 to 65. So if you adjust for the year born, and the age, you pretty much can forecast what the participation rate will do. And indeed, as you know, its been going down, a goodly part of that is explained exactly by this process, which I am addressing. I havent projected it out terribly much further, but if youre trying to figure out how to do it, thats the best way that I know to do it.
Thank you very much, ladies and gentlemen. [Applause]
PETERSON: Mr. Chairman, I look forward to two events, Im anxious to hear your rendition of the U2 song, With or Without You, and I cant wait to hear it. Secondly, we look forward to having you back again. Thank you, sir, very, very much.
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