Senate Hearing, 107TH Congress - The U.S. Economic Outlook

S. HRG.
107940
THE U.S. ECONOMIC OUTLOOK
HEARING
BEFORE THE
COMMITTEE ON
BANKING, HOUSING, AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED SEVENTH CONGRESS
SECOND SESSION
ON
THE CURRENT ECONOMIC OUTLOOK IN THE SHORT- AND LONG-TERM;

PREDICTIONS CONCERNING THE ROBUSTNESS OF THE ECONOMIC
RECOVERY; EFFECTS OF INCREASED UNEMPLOYMENT; CONTINUED
WEAKNESS IN THE GLOBAL ECONOMY; AND RECOMMENDATIONS FOR
MONETARY AND FISCAL POLICY
MARCH 12, 2002
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
PAUL S. SARBANES, Maryland, Chairman
CHRISTOPHER J. DODD, Connecticut PHIL GRAMM, Texas
TIM JOHNSON, South Dakota RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York WAYNE ALLARD, Colorado
EVAN BAYH, Indiana MICHAEL B. ENZI, Wyoming
ZELL MILLER, Georgia CHUCK HAGEL, Nebraska
THOMAS R. CARPER, Delaware RICK SANTORUM, Pennsylvania
DEBBIE STABENOW, Michigan JIM BUNNING, Kentucky
JON S. CORZINE, New Jersey MIKE CRAPO, Idaho
DANIEL K. AKAKA, Hawaii JOHN ENSIGN, Nevada
STEVEN B. HARRIS, Staff Director and Chief Counsel
WAYNE A. ABERNATHY, Republican Staff Director
AARON D. KLEIN, Economist
MARTIN J. GRUENBERG, Senior Counsel
THOMAS LOO, Republican Senior Economist
JOSEPH R. KOLINSKI, Chief Clerk and Computer Systems Administrator
GEORGE E. WHITTLE, Editor
(II)
C O N T E N T S
TUESDAY, MARCH 12, 2002

Page
Opening statement of Chairman Sarbanes ........................................................... 1
Opening statements, comments, or prepared statements of:
Senator Carper ................................................................................................. 2
Senator Bennett ................................................................................................ 20
Senator Reed ..................................................................................................... 26
Senator Corzine ................................................................................................ 30
WITNESSES
Robert M. Solow, Nobel Laureate in Economics, 1987; Professor of Economics,
Massachusetts Institute oF Technology ............................................................. 2
Prepared statement .......................................................................................... 39
Joseph E. Stiglitz, Nobel Laureate in Economics, 2001; Professor of Economics
and Finance, Columbia University ..................................................................... 5
Alan B. Krueger, Bendheim Professorship in Economics and Public Affairs;
Professor of Economics, Princeton University ................................................... 10
David R. Malpass, Chief Global Economist, Bear Stearns & Co., Inc. ................ 14
(III)
THE U.S. ECONOMIC OUTLOOK
TUESDAY, MARCH 12, 2002
U.S. SENATE,
COMMITTEE ON BANKING, HOUSING,
URBAN AFFAIRS, AND
Washington, DC.
The Committee met at 10:15 a.m. in room SD538 of the Dirksen
Senate Office Building, Senator Paul S. Sarbanes (Chairman of the
Committee) presiding.
OPENING STATEMENT OF SENATOR PAUL S. SARBANES
Chairman SARBANES. The hearing will come to order.
I am pleased to welcome before the Committee this morning this
distinguished panel: Robert Solow, Professor Emeritus of Econom-
ics at MIT and a Nobel Laureate in Economics; Joe Stiglitz, Pro-
fessor of Economics and Finance at Columbia, and recipient last
year of a Nobel Prize in Economics; Alan Krueger, the Benheim
Professor of Economic and Public Affairs at Princeton; and David
Malpass, Chief Global Economist for Bear Stearns & Co., Inc.
Actually, all of these witnesses are well-known to the Committee
and to Washington. Professor Solow, of course, has testified before
Congress many times. Joe Stiglitz served as Chairman of the Coun-
cil of Economic Advisers under President Clinton, Chief Economist
at the World Bank. Alan Krueger served as the Chief Economist
at the Labor Department in the mid-1990s. And David Malpass
was at the Department of the Treasury under Presidents Reagan
and Bush. He was also the Staff Director of the Joint Economic
Committee of the Congress.
I want to thank all the witnesses for appearing today and for the
care and effort they took in preparing their written remarks. Your
full statements will be included in the record.
I was going to make a few comments about the current economic
situation, but I think I will save that until the question period.
Before yielding to Senator Carper, though, I do want to note with
great sadness and with very deep respect the passing yesterday of
James Tobin, really one of our Nations preeminent economists, a
man who I knew. I knew him well and he was a man of extraor-
dinary ability and great civility, and very fundamental decency. He
had very strong views about public policy, but he put them forth
in a way that led to really a very rational and reasonable debate
I think with others. And I think he had a profound influence on
the thinking in this country.
I actually was Administrative Assistant to Walter Heller when
he was Chairman of the Council of Economic Advisers under Presi-
(1)
2
dent Kennedy. Jim Tobin was a Member of that Council, perhaps

one of the most distinguished, certainly amongst the most distin-
guished that we have had.
Senator Carper.
COMMENTS OF SENATOR THOMAS R. CARPER
Senator CARPER. Thank you, Mr. Chairman. I had not heard of
Dr. Tobins passing until this moment. He was one of those people
who could disagree with you without being disagreeable.
Chairman SARBANES. That is for sure.
Senator CARPER. Any number of times, I remember him sitting
in forums in the House and the Senate like this and providing his
guidance and counsel to those of us who were fortunate enough to
be in the room with him.
I just want to thank our witnesses today for joining us. I had a
chance to welcome you individually and would do so collectively.
David Malpass, who used to work for Bill Roth, my predecessor
from Delaware, we are especially glad that you are here today.
I will be slipping out in a little bit. We are taking up the energy
bill, as we wrestle with developing a comprehensive energy policy
for our country and we are anxious to make progress on that today
and certainly this week starting this morning at 10:30 a.m.
You are here really right after we passed an economic stimulus
package last Thursday. Some have said that it is a day late and
a dollar long.
[Laughter.]
Time will tell if we have, indeed, spent money that we did not
have for a recession that is over. Maybe you will have some
thoughts on that today.
We are glad you are here and we look forward to your testimony.
Thanks very much.
Chairman SARBANES. Thank you, Senator.
Dr. Solow, we would be happy to hear from you and then we will
go right across the panel.
STATEMENT OF ROBERT M. SOLOW
NOBEL LAUREATE IN ECONOMICS, 1987
PROFESSOR OF ECONOMICS
MASSACHUSETTS INSTITUTE OF TECHNOLOGY
Dr. SOLOW. Thank you very much, Senator Sarbanes.
I want to add my word about Jim Tobin, whom I worked at the
Council when Senator Sarbanes was Walter Hellers Assistant. He
was a role model for all of us from my generation and others, and
a person of remarkable integrity. Someone once asked me whether
he would be a suitable person for a very delicate and responsible
job. My response was that whenever I find myself having to make
a hard decision as between right or wrong, my universal method
is to ask myself what Jim Tobin would do, and do exactly the same.
It is too bad that you cannot be hearing from him today.
I am going to just comment briefly on a couple of important
points that were raised in the written statement that I turned in,
without trying to read it all.
This is, after all, a Senate Committee. We should be thinking
about fiscal policy.
3
There is a problem with fiscal policy. It takes too much time to

make decisions. It is hard to avoid getting those decisions mixed
up with the search for political advantage. The decisions that are
made in fiscal policy are often not easily reversible if the facts
change. And that creates a problem in using fiscal policy devices
in the business cycle context in the short run, just as was men-
tioned by Senator Carper.
The current stimulus package is an excellent example. The bill
that finally passed last Thursday was an okay bill, though it could
have been better and it should certainly have been much quicker.
If it had been a term paper, I would have graded it a B, but I
would have penalized it for being handed in late.
The contrast with monetary policy is, of course, very strong.
Monetary policy is much more flexible, at least in some hands, at
least in the United States in some hands. It is more reversible
when facts change, when our reading of the economic situation
changes. And so, monetary policy is generally accepted to be a more
suitable way to do tactical economic policy, short-run-oriented tac-
tical policy. I had hoped that we were getting to the point where
we could call more on fiscal policy, but the recent episode is not an
optimistic indication on that point.
We used to get a lot of help from what are called automatic stabi-
lizers, from the built-in tendency for the Federal budget to move
sharply toward surplus in a strong boom and to move just as
sharply toward deficit in a sharp slump. The automatic stabilizers
were a very important part of fiscal policy 30 years ago, or 40 years
ago. They are especially important because no one has to act and
no one has the opportunity to obstruct. They happen automatically.
The strength of the automatic stabilizers in our economy has
been weakened over the years, not on purpose, not as a deliberate
decision, but because the mechanisms on which those automatic
stabilizers rest have changed. Cyclical transfer payments are a
smaller part of our economy now than they used to be. State and
local governments are a larger part of government purchases of
goods and services these days than they used to be, and State and
local governments are statutorily not able to conduct their own fis-
cal policy in a counter-cyclical way. The general reduction in tax
rates and the diminishing importance of corporate profit tax reve-
nues in the total budgetI am not now speaking about whether
that is a good thing or a bad thingonly that those are the mecha-
nisms that used to make the Federal budget very sensitive to eco-
nomic conditions and make it less sensitive now. The automatic
stabilizers are not likely to get stronger, so we are not going to be
able to rely on them in the way that we used to.
One possibilitythis is a theoretical possibility that appealed to
Jim Tobin and to me 40 years agowould be for Congress to legis-
late once and for all a standard stimulus package which would be
effective and temporary and politically neutral; the same package
could work in reverse as a standard sedative package. Congress
could then turn this package, and only this package, on and off by
straight up-or-down votes when the situation called for it.
You could arrange such a package at a number of levelsweak,
moderate, strong. It could be triggered by events or proposed by the
President and then subject to an up-or-down vote by the Congress.
4
I realize that wont happen. I know that. But it is what would

be needed as a substitute for the automatic stabilizers if we are to
turn fiscal policy into a tool for countering the business cycle.
The next point I want to make is a very different kind. Think
how uncertain we have been over the past few months about
whether there was or wasnt a recession. If there was one, when
did it begin? When will it end? Where are the next few months
going to go? The four of us sitting here could go back and forth on
that for days, weeks.
That cannot be the right intellectual background for conducting
macroeconomic policy, especially fiscal policy. There is simply too
much noise and too much nonsense in trying on the basis of yester-
days data to predict next weeks economy. Here is an idea that will
be very familiar to Senator Sarbanes because Jim Tobin and Art
Oakun and I and others were talking about it when he was at the
Council of Economic Advisers.
It would make much more sense and be much more relevant to
look at the concept that we call potential output, potential GDP. It
is the number we come up with when we ask: What is the econo-
mys capacity to produce with reasonably full use of its resources?
Our focus should be to compare where we are now with where po-
tential GDP is. That would be a far better indicator of which way
fiscal policy should be pushing.
In the written statement that I have submitted to you, I point
out that real GDP now is right about within a percent or so of
where it was a year ago, the beginning of 2001, or 2000. And by
the standard estimates of what has been happening to potential
output on which the current Council of Economic Advisers and the
Congressional Budget Office and private economists like myself
tend to agreeby those standards, we have built up slack, room for
expansion in the economy of about 4 percent of GDP.
If the economy grows at 3 percent during the four quarters of
this year, which is what the standard forecast right now is, we will
not cut into that gap at all. We will still in the first quarter of 2003
have room for expansion amounting to 4 percent of GDP.
By the way, many people, including on Mondays, Wednesdays,
and Fridays met, thought that 2 years ago, when the unemploy-
ment rate was down to 4 percent, we were maybe a little too close
to the risk of inflation.
That is okay. One could make that adjustment in the kind of
thinking that I am suggesting, and still get a much clearer picture
of where the economy stands relative to where we should want it
to be, and to use that as an indicator of what we should do.
That is not a foolproof way of making fiscal policy or monetary
policy or anything else. Nothing is. But the raw materials are there
both within the Government and outside the Government. By going
back to thinking in those terms, we would avoid a lot of intellectual
wheel spinning.
That is why I was content to give the stimulus package a B.
Even having been handed in late, the stimulus package was a good
idea; and this has nothing particular to do with there never having
been a recession or the recession already having been over or being
the only one-quarter recession in the history of mankind or that
thing, but because there is room for the economy to expand.
5
I want to say just one last sentence: As I read Alan Greenspans

testimony before this Committee last week, it was not in contradic-
tion to what I have just been saying. Mr. Greenspan spent a lot of
time waffling over what happened last week and what will happen
next week. Waffling is what that kind of conversation calls for and
he is a master of it. But the general picture of where the economy
is relative to a reasonable standard we might set is certainly con-
sistent with what I have been saying. I think that what we have
to hope for from monetary policy is that we will get the same kind
of flexibility, nondoctrinaire flexibility, in dealing with the next
year or two that we did get to our great advantage over the past
4 or 5 years from the Fed.
Thank you very much.
Chairman SARBANES. Good. Thank you very much.
Dr. Stiglitz.
STATEMENT OF JOSEPH E. STIGLITZ
PROFESSOR OF ECONOMICS AND FINANCE
COLUMBIA UNIVERSITY
Dr. STIGLITZ. Thank you, Mr. Chairman.
I want to begin by seconding what Professor Solow just said, that
the critical issue is not the one that has been focused upon, but
whether the recession is over or not.
The real point is that the economy for the last year has been per-
forming substantially below its potential. I think that there is abso-
lutely no doubt about it. And if we go from minus one-half a per-
cent to plus one-half a percent, it is still performing substantially
below its potential. Even the most optimistic people do not see any
change in that prospect, that it was very likely to perform below
potential.
The numbers that I talked about in my written statement are
substantially more conservative than those of Professor Solow. I
talked about a 3 percent GDP shortfall. But one should try to re-
member what that entails. In a $10 trillion economy, a shortfall of
3 percent is $300 billion per year. If it goes on for 2 years, we have
lost $600 billion. That is an enormous wastage of resources.
The consequence also is that there is unemployment. Alan will
talk a little bit more about the unemployment problem. But even
as the economy in this recessionif it is trueends, long-term un-
employment has remained high. And the suffering that that causes
is significant.
The step that was made to finallyand again, too lateprovide
for extended benefits last week was an important step in the right
direction. But it only extends for 1 year and there is little prospect
that the long-term unemployment problem will be resolved in the
course of a year.
I wanted to move on and talk a little bit about the nature of this
current economic downturn and the reason why I am not optimistic
that there will be a robust recovery.
In my written testimony, I talk about the number of negative fac-
tors. I go through each of the major categories of expenditurecon-
sumption, capital expenditure, exportsand explain why I think
that the prospects of a robust recovery are limited.
6
I note that the one positive from a macroeconomic point of view

is the increased expenditures in military. That does help sustain
economic recovery. But I emphasize there that unlike investments
in education or roads, they do not contribute to long-term economic
growth. They are a utilization of resources that does not promote
the long-term economic strength of our economy. And one needs to
take that into account when one looks at the overall long-run pic-
ture. A lot of what I am going to be saying is focusing on the
medium- and long-term.
I want to move on in my discussion to address the sources of our
current problem.
I believe that if we are to formulate policies aimed at enhancing
the strength of the economy in the middle- to long-run, we must
understand better the sources of our current downturn, of the mas-
sive under-performance of the U.S. economy.
While every boom comes to an end, there are lessons to each.
Earlier booms and the busts that follow taught us the dangers of
inflation and the effects have been too hard on the brakes to stop
it. The recession of 1991 can ultimately be traced back to the weak-
nesses in the financial sector. Those in turn impart to the excessive
deregulation of the 1980s. I am not sure that we have learned the
lessons of excessive exuberance of the late 1990s.
In some ways, it is a familiar pattern. Deregulation in a sector
here telecommunicationsleading to excessive investment in that
sector, in this case, the problems exacerbated by breathtaking tech-
nological developments andI want to emphasize thisderegula-
tion in the financial sector.
The GlassSteagall Act was concerned with the problems raised
by the conflicts of interest. It was foolhardy to think that such be-
havior would not reappear with its repeal.
At the time I served on the Council of Economic Advisers, we
raised strong concerns about conflicts of interest and problems in
accounting standards and practices, particularly as they related to
derivatives and options. Our concerns have proved to be on the
mark. There were, of course, others who raised similar concerns.
Arthur Levitt was right in calling attention to these conflicts of in-
terest in accounting firms when they simultaneously provide con-
sulting services.
The FASB called for a changing of accounting practices to more
accurately reflect the costs of options given to executives.
I have devoted much of my academic life to the economics of in-
formation, and to the consequences of imperfections of information.
The proposed revisions would have improved the quality of infor-
mation. To be sure, some firms economic prospects might have
looked worse as a result, and its stock market price might have
fallen as a resultas well it should.
It was inevitable that a day of reckoning would come. Providing
misleading information only delayed the day of reckoning. But
worse, it led to a massive misallocation of resources, as overinflated
stock prices led to the excessive investment which is at the root of
the economic downturn.
Some contend that it is difficult to obtain an accurate measure
of the value of options. But this much is clearzero, the implicit
value assigned under current arrangements, is clearly wrong, and
7
leaving it to footnotes to be sorted out by investors is not an ade-

quate response, as the Enron case has brought home clearly.
If we are to have a stock market in which investors are to have
confidence, if we are to have stock markets which avoid the kind
of massive misallocation of resources that result when information
provided does not accurately report the true condition of firms, we
must have accounting and regulatory frameworks that address
these issues.
I am convinced that leaving it to the market will not work. I
served on an SEC commission on valuation on which Ken Lay also
served. Many on that commission believed that leaving it to the
market was the view of many of those, and I think we see perhaps
why and certainly the consequences.
As derivatives and other techniques of financial engineering be-
come more common, these problems too will become much more
pervasive. While headlines and journalistic accounts describe some
of the inequities, those who have seen their pensions disappear as
corporate executives have stashed away millions for themselves,
what is also at stake is the long-run well-being of our economy. The
problems of Enron and Global Crossing are part and parcel of the
current downturn.
So, I want to emphasize that, while typically, macroeconomics
focuses on macroeconomics, there are important microeconomic
foundations to the problems and, as is often the case, this is the
case today.
In the limited amount of time, I want to spend a few minutes
talking about a couple of particular issues. The first is the tax cut.
When we were talking about fiscal policy in the early 1990s,
1993, 1994, the economy was facing an economic downturn. We fo-
cused very much on the question of what was called a low-cost
stimulus. How to stimulate the economy using fiscal measures and
at the same time having a minimal budgetary impact.
My view is that the tax cut that was passed by Congress in the
spring was extremely badly designed. It provided very little stim-
ulus to the economy, at the cost of a substantial adverse effect on
the overall fiscal position of the United States. The result is that,
while short-term interest rates have come down significantly, long-
term interest rates have come down very little. And many people
believe it is the long-term interest rates which are more relevant
for investment.
One of the reasons that many people do not see a strong, robust
recovery is precisely because there has not been that decline in
long-term interest rates. That means, looking forward, that there
should be a certain degree of pessimism.
As I point out in my written testimony, there are tax reforms
that, for instance, would have done far more to promote investment
in the short-run with far lower budgetary costs, like the net invest-
ment tax credit, and better income-averaging provisions.
Both you and Professor Solow talked about the legacy of Jim
Tobin. One of his legacies was the investment tax credit. And that
was one of the sources of economic growth that began in the 1960s.
We now know how to even improve upon that through a net invest-
ment tax credit. That was not the stance that was taken. It was
really much more corporate giveaways rather than trying to design
8
a tax reform that would have been good for the overall performance
of the economy.
I strongly side with those who believe that when one makes a
mistake, one should recognize it. It is not just the size of the tax
cut that was a mistake, but its design. Given the peculiar structure
of the tax bill, with provisions that expire in 10 years, it is inevi-
table that the issues will have to be revisited. It is better that that
be done sooner than later.
As you all know, I have spent a lot of time in the last 4 years
involved in foreign economic policy and I want to spend a few mo-
ments talking about that because it is related to our current macro-
economic situation.
One of the sources of strength of the U.S. economy during the
1990s was increased export to emerging markets. This was partly
a result of trade opening, partly a result of the robust economy in
those regions.
Mismanagement of international economic policy by the IMF has
contributed significantly to a worsening of prospects, and I think
that will have adverse effects not only on the political position of
the United States and how it is perceived around the world, but
also on our economic prospects.
It is also the case, let me emphasize, that the problems that we
face in our exports are caused largely by the strength of the dollar.
And the strength of the dollar, in turn, is caused by our macro-
economic stance.
In the early 1980s, a large tax cut was enacted, and that led to
a massive worsening of the fiscal situation. The trade deficit is sim-
ply the difference between what we invest and what we save. Na-
tional savingsincluding public savingshas gone down from
what it otherwise would have been. The trade deficit would have
been even worse, were it not that investment too has gone down.
But when our economy recovers, investment will increase, and with
it, there is a good chance that the trade deficit will worsen.
We should be clearit is not protectionist policies abroad or un-
fair trade practices or just the failed macroeconomic policies that
have caused our current trade deficit problems. Whether they get
reflected in the steel industry, the automobile industry or else-
where, it is our overall macroeconomic framework, including the
tax cut that was passed last May. And I suspect that the full ad-
verse effects of the tax cut on our international economic position
are yet to be fully felt.
You mentioned that you were going to have a vote on energy pol-
icy, and let me just make a few brief remarks. I think that this is
important for the long-run economic prospects of the economy.
There is a widespread agreement among economists that GDP
does not provide a good measure of economic well-being. At the
very least, we should take account of the degradation of the envi-
ronment and natural resources. Bad information systems can lead
to bad decisionmaking, as we have recently seen in the corporate
world, and I referred to that earlier.
Nowhere is this more true than in energy policy. Extraction of
oil and natural gases may increase our measured GDP, but it does
not increase our economic well-being commensurately.
9
We should take account of the depletion of our resource base and

the degradation of our environment as a result of carbon emissions.
An energy policy which focuses on drain America first is not even
good for our long-run national security, for it leaves us potentially
more vulnerable in the future. Long-run economic growth
correctly measuredand long-run security both suggest that we
should focus more on conservation. And basic principles of econom-
ics suggest that what is required is incentives. Why should we
think that moral suasion would be more effective in this arena
than it is in any other area of economic activity?
I want to conclude with a few remarks about one of our long-
term problemsour Social Security system.
That program has been an enormous success. We have brought
the elderly out of poverty and we have provided a new measure of
economic security to the aged. Transaction costs are low. Improve-
ments in the design of the program over the years have reduced
some of the unintended inequities, reduced any adverse effects it
might have on labor supply, and increased overall efficiency. There
is still a way to go to put it on sound financial grounds.
Economics is traditionally described as the science of choice. The
legacy of the Clinton years, a huge fiscal surplus, provided us with
an opportunity to make some choices. We could have used some of
these funds to put the Social Security system on sound financial
ground. We could have fully funded that system. We could have de-
cided on how to proceed in the future. We have largely squandered
that opportunity.
Proposals for partial privatization typically leave the fiscal situa-
tion of our Social Security system worse off. Any reform proposal
which does not begin by addressing the question of how current un-
funded liabilities are to be financed is irresponsible, and should be
a nonstarter.
Elsewhere, I described at greater length common myths concern-
ing Social Security. One that has recently received some attention
is the low return on Social Security accounts. We should be clear
Social Security funds are invested well, but conservatively. To the
extent that capital markets work efficiently, then any higher re-
turns that might be received would simply reflect higher risk.
It is imprudent for those approaching retirement to invest all, or
even most, of their assets in highly risky investments. If there were
a decision to undertake greater risk, the public Social Security sys-
tem could do so, again, at low-transactions costs.
Just to put things into perspective, the transaction costs in the
privatized part of the British system have been estimated to reduce
benefits by 40 percent from what they otherwise would have been.
This is how privatized systems work.
Part of the reason that in partial pay-as-you-go Social Security
systems, it appears that returns are low is that some of the returns
are used to bear the costs of the unfunded liabilities. The problem
of funding those unfunded liabilities does not go away with partial
or complete privatization. It will have to be borne elsewhere.
To assess the merits of any reform proposal, therefore, one must
know how, and who, will bear those costs. To do otherwise is dis-
honest. It may put in jeopardy the long-run prospects of our econ-
omy, for a day of reckoning will undoubtedly come.
10
Let me conclude by saying that I continue to believe that the

basic fundamentals of the U.S. economy remain strong. But I have
seen the fortunes of countries change quickly as a result of eco-
nomic mismanagement. The decisions, the choices, we take today
will affect not only economic performance during the next year, but
also our long-run prospects.
I believe that the tax cut that was enacted last spring was based
on a serious miscalculation of our economic situation. It is a deci-
sion which, however, is reversible. If we do not revisit the issue,
in the light of the new information which has come to light and the
new situation which has evolved, the damage which could be done
may itself be irreversibleor at least it will take a long time to
undo it. Much is at stake.
Thank you.
Chairman SARBANES. Thank you very much.
Dr. Krueger.
STATEMENT OF ALAN B. KRUEGER
BENDHEIM PROFESSORSHIP IN
ECONOMICS AND PUBLIC AFFAIRS
PROFESSOR OF ECONOMICS, PRINCETON UNIVERSITY
Dr. KRUEGER. Thank you, Senator Sarbanes. I appreciate the op-
portunity to talk about the economy this morning.
Let me begin by seconding Joe Stiglitz and thirding Bob Solow
by saying it is not very productive to debate whether there was a
recession. It is quite clear looking at the labor market that the
labor market turned down in 2001 and March marked the turning
point in the labor market.
The unemployment rate reached a 30 year low of 3.9 percent in
April 2000. It hugged pretty close to 4 percent until the end of
2000. March 2001, the unemployment rate stood at 4.3 percent.
Then it increased to 4.9 percent by August 2001, before the Sep-
tember 11 attacks, and reached a recent high of 5.8 percent 2
months ago. The last 2 months, the unemployment rate has ticked
down a bit to 512 percent.
I think it is a bit too premature to celebrate the recovery in the
labor market. In terms of employment, 1.4 million jobs were lost
in the 11 months since March 2001, and 1.8 million jobs were lost
in the private sector. If we compare that to the recession in the
early 1990s, 11 months after the start of the recession in 1990, 112
million jobs were lost in both the private sector and in total.
This downturn has not been less mild as far as job losses is con-
cerned. In fact, if we compare the total job loss in the recession in
the early 1990s, even in the period after the recession ended when
jobs continued to drift down, total job loss in the private sector was
1.8 million jobs then and 1.8 million jobs now.
So in terms of job loss, as I said, this recession so far has been
about as severe as the one in the early 1990s.
This recession seems to me to have two distinct phases in the
labor market. The first phase was quite a surprise. Ordinarily, in
a downturn, less skilled workers and minorities are the hardest hit.
In the first 4 months of this recession, from March to July of
2001, the unemployment rate actually increased more for highly
skilled workers than for less skilled workers. So for college grad-
11
uates, the unemployment rate increased from 1.9 to 2.2 percent.

For high school drop-outs, the unemployment rate held steady at
6.8 percent.
I have to say that that was quite a surprise to those of us who
watched the labor market. By past history, we expected the labor
market to turn down more quickly for the less skilled and also be-
cause of welfare reform, I certainly expected that those last hired
would have been the first fired and thought we would see more dif-
ficulty among the less skilled at the beginning of the recession.
Well, since the summer, the typical pattern has emerged.
From July to February, the unemployment rate has risen much
more for the less skilled than for the highly skilled. And these
numbers are reported more fully in my written statement. But the
unemployment rate for high school drop-outs increased from 6.8
percent in July, up to 8.3 percent last month.
I should also add, while the overall unemployment rate went
down last month, an amount that was not statistically significant,
the unemployment rate did increase for high school drop-outs last
month. So the situation does not appear to have turned around for
the less skilled.
Meanwhile, the unemployment rate in the last 7 months in-
creased for highly skilled workers, but not by as much as it in-
creased for the less skilled.
So if you look over the whole period of the downturn, the unem-
ployment situation has worsened more for less educated workers
than for more highly educated workers, as is the typical pattern.
And we get a similar picture if we look by race. It looks like there
were two phases.
In the first phase, the unemployment rate increased for white
workers and actually fell for black workers, which was again quite
a surprise. And then in the second phase, the unemployment rate
has been rising more for black workers than for white workers.
Now the usual pattern is for unemployment to linger at a high
level after a recovery begins. If we go back to the experience in the
early 1990s, the unemployment rate stayed high and continued to
rise for 15 months after the recession officially ended.
There are several explanations for why jobs are slow to grow
after economic growth resumes. One is that employers are simply
uncertain how long the conditions will last. I think all of us here
are uncertain what type of a recovery we are about to have. That
naturally leads employers to be cautious in terms of hiring and re-
hiring workers.
Another explanation is called labor hoarding. During a recession,
firms will sometimes hold onto workers, particularly those who
they invested a lot in their training, because it would be costly to
rehire workers with such skills after the recession ends.
Another factor is called upskilling of positions. Employers often
will raise the standards for jobs in a recession and will hire highly
skilled workers to do the kind of work that previously was done by
less skilled workers, and not until demand increases rather smartly
will they adjust the standards and begin to hire the less skilled
workers again.
Then, finally, I would add that recessions give firms an oppor-
tunity to reorganize, to rethink the way they do things and change
12
the way they do things. And that often leads them to prefer to hire
more highly skilled workers than less skilled workers because more
highly skilled workers are more flexible. This also dovetails with
the purchase of new equipment, implementing new equipment,
which tends to go hand-in-hand with more highly skilled workers.
So, looking forward, my guess is that the soft labor market situa-
tion will linger for a while. That has been the past practice. Also,
if you look at the numbers and say, well, suppose the recession
ended in the fourth quarter of 2001, which is a reasonable guess
at this point. Well, then, it has been the case that unemployment
has continued to climb for the less skilled workers and climbed
overall since the recession ended because it is higher now than it
was in the fourth quarter of 2001. But I have to confess a fair
amount of uncertainty in this prediction that unemployment will
remain stubbornly high, even if we are in the midst of a recovery.
The first reason for my uncertainty is that the beginning of this
recession was unusual. I am somewhat heartened in the sense that
I see a familiar pattern in what has happened since the summer.
But one does have to admit that different forces do seem to be at
work in this recession, as Joe pointed out earlier.
Another difference is that productivity growth has remained
strong in this recession, stronger than is ordinarily the case in a
recession. And that might imply that there has been less labor-
hoarding, that firms might be leaner coming out of this recession
than is typically the case and they might be quicker to expand em-
ployment.
And that leads me to the third factor which might lead the labor
market to recover sooner than is usually the case.
It seems that we have gone through some fundamental changes
in the labor market, that the way in which employees find jobs has
changed over the last 10 or 15 years. Unfortunately, the data are
not terrific, but it looks like the number of vacancies at a given un-
employment rate is lower than it used to be, and there are several
hypotheses for why that is the case. One explanation is that tem-
porary help firms make the labor market more efficient, speedier
in terms of placing workers, make it easier for firms to adjust to
hire workers, and also make it easier for them to reduce their
workforce. There is also more outsourcing. And I suspect that the
web has changed things. A remarkably high number of people
search for work by looking at Internet job boards and using tech-
niques that did not exist even 10 years ago.
In spite of these factors, my best guess would be that the labor
market will remain soft, even if we are in the midst of a recovery.
What I think is probably most important to bear in mind for pol-
icy, at least in the short run, is that, to avoid a jobless recovery,
we should look at what kinds of options we have to increase em-
ployment for less skilled workers.
The unemployment rate is much higher for less skilled workers.
It is been growing for less skilled workers relative to more highly
skilled workers. And if we are to reduce unemployment further, I
think it will come mainly from reducing unemployment for less
skilled workers.
Now, Bob Solow mentioned that fiscal policy in this instance has
been slow to respond. I think I certainly agree with that. I remain
13
somewhat optimistic that if the recession was more severe, fiscal

policy might have been a bit quicker. But fiscal policy does come
with the types of problems that Bob mentioned.
And that leads me also to discuss automatic stabilizers. I com-
mend the Congress for extending unemployment benefits, although
I think Bob Solows is a softer grader than I am. I do not know if
I would have given a B. I think more could have been done in
this situation.
One thing would have been to expand benefits for workers who
seek part-time jobs. Part-time employees pay into unemployment
insurance. Yet, in most States, they do not qualify for benefits.
I think for stabilizing the economy, another more important point
is that the automatic stabilizers built in for extended benefits to
kick in are no longer realistic.
The insured unemployment rate in a State must exceed 5 percent
and then some other conditions have to be met for extended bene-
fits to turn on. The trigger used to be 4 percent in the 1980s. It
increased to 5 percent. Since then, the insured unemployment rate
relative to the overall unemployment rate has drifted down.
In other words, the unemployment insurance extended benefits
and the automatic triggers rely on the fraction of people who are
receiving benefits, receiving unemployment benefits relative to the
workforce rising, but the take-up rate for unemployment insurance
has declined and because of that, it makes it much harder to reach
the automatic triggers. Moreover, the national rate of unemploy-
ment appears to have declined, which also means that the triggers
are beyond reach, even with the fairly substantial increase in un-
employment.
I think one fairly straightforward thing to do would be to lower
the triggers for State benefits to turn on. That way, it wouldnt be
necessary for Congress to deliberate in a downturn whether it is
necessary to extend benefits. And I think that if extended benefits
were available more quickly, it would shorten the length of down-
turns and could also save money because it wouldnt be necessary
to extend benefits nationwide, but they could be targeted more to
the States which are suffering the most.
Some other changes in unemployment insurance which I think
would also be important would be to improve the experience rating
in the system. Employers are supposed to pay a higher tax rate if
they have had a worse record laying off workers. In a number of
States, experience rating has lapsed. There are very few rates.
Some States, only two rates.
In essence, what we are doing is subsidizing employers who lay
off workers. We are subsidizing them by providing benefits to their
workers when they lay them off and we are not charging the firms
for those costs.
Then I would also add that the taxable base for unemployment
insurance in many States is quite low. The taxable base in the ma-
jority of States is between $7,000 and $10,000, which means that
for higher-income people, they do not pay any unemployment insur-
ance tax after their first $10,000. This leads to very regressive fi-
nancing. And if we were to raise the tax caps, we would be able
to lower the rates, which I think would have a favorable impact on
employment demand.
14
Let me conclude by saying that I think this is a time to think

about how we can make Government policy respond more quickly
in the event of a downturn. One of the most important automatic
stabilizers we have now is the tax system, not by design, but just
the way it works.
Progressive taxes work as an automatic stabilizer. If income falls,
people fall into lower tax brackets. So, I think it is important to
bear in mind that this is one aspect of progressive taxation.
I think another policy to consider at this point would be job
training, how that connects with unemployment insurance. Fund-
ing sufficient job-training programs, especially for youth, which
were cut during the Clinton Administration and the Bush Adminis-
tration has proposed cutting even deeper.
Last, I would just add that I think it is important that we think
about these policies in the context of a budget that is sustainable
and a budget that is forward-looking and helps us to prepare for
the retirement of the baby boom generation.
Chairman SARBANES. Thank you very much.
We will now turn to David Malpass, the concluding panelist.
STATEMENT OF DAVID R. MALPASS
CHIEF GLOBAL ECONOMIST
BEAR STEARNS & CO., INC.
Mr. MALPASS. Mr. Chairman, I want to thank the Committee for
the opportunity to make a statement today. My written statement
covers the economic outlook and gives some thought on U.S. mone-
tary and fiscal policy. It also includes a final section dealing with
some foreign economic policy issues.
I am going to use some of the graphs from the written statement,
if you have one to look at while I go through.
I am the Chief Global Economist at Bear Stearns. So part of my
comments for the Committee today also relate directly to the finan-
cial markets.
One of the global economic features of the 1990s was the sharp
increase in the U.S. share of world GDP. Part of this is a tribute
to our economic system, but another part reflects the relatively
poor economic performance in Japan and many developing coun-
tries. As we count our many blessings and work to make our own
economy better for all, I think it is in our interest to also spend
considerable time and attention working on an appropriate U.S.
international economic policy.
The first graph in my statement shows the nominal world growth
rate in the 1990s. And what we can see is that in the first part
of the 1990s, world nominal dollar growth was strong. Then in the
latter half of the 1990s, it tailed off. Part of this is the strong dol-
lar, but part of it also is the weakness of economies, particularly
abroad.
As we think about the economic outlook, I expect a broad-based
U.S. recovery in 2002, with support from consumption, inventories,
Government purchases, and second-half strength in business in-
vestment. The U.S. economys natural tendency is to grow. The lat-
est improvement in the outlook over the last couple of weeks is jus-
tified, in my view, by the solid U.S. strengthsstrong productivity
growth and relatively full employment.
15
And I will go into that in a moment.

In recent months, Americans have shown their optimism and
their patience when confronted with adversity, traits that I think
auger well for the recovery.
After some recessions, growth accelerates to high levels early in
the recovery due to pent-up demand. I do not expect that pattern
in this recovery. The second graph in the statement shows the con-
sumption rate in this period versus the average recession. And
what we see is that you can barely see that there was a recession
if you just look at the consumption growth this time around. It did
not dip the way it normally does in a recession.
In many ways, the economy is reacting as if it is enjoying rel-
atively full employment. For perspective, we have today a 5.5 per-
cent unemployment rate. At the end of the 1991 recession, in
March, the unemployment rate was 6.8 percent. We are well below
that. So in many ways, the economy and the consumption growth
are responding to an unemployment rate that by longer-term his-
torical standards, is relatively full employment.
Of course, I would like to see the unemployment rate substan-
tially lower. Given the strong productivity growth, it is clear in my
mind that the U.S. economy can again be able to enjoy a sub5 per-
cent unemployment rate without it being inflationary.
I am going to skip the housing section here and turn to corporate
profits.
Even though the recession seems to be over, there are still in-
tense pressures in the economy. I think they reflect the aftermath
of a deflation caused by dollar strength in the late 1990s. We
should in this environment see a piece-by-piece recovery unfolding
in the economy, meaning that some industries, companies, and em-
ployee groups have absorbed most of the shock, while others are
still in its grip.
In my view, the intensity of the corporate adjustment is pushing
the economy quickly through the deflation process, that brings it
closer to completion. This ability to digest mistakes and move for-
ward is one of the hallmarks of the American system of business
and labor flexibility and is a key factor in our strong, long-term
growth rate.
The graph labelled Behavior of Profits in Recession shows that
in an average profits recession, corporate earnings decline. In this
profits recession, they have declined much more deeply than in an
average profit recession.
So this brings me to some cautions, not in the statement.
As we look at why those corporate earnings have gone down as
much as they have this time around, one of the reasons is that
nominal growth rate is weak. Economists typically deal in real
growth rates and that is appropriate for many times. But as we
move into a very low inflation environmentin fact, recall that the
GDP deflator in the fourth quarter was minus three-tenths of a
percent of GDP. And nominal growth rate was lower than the real
growth rate. So as we look at the nominal growth rate in this re-
cession, it has been deeper, the slow-down has been deeper than in
many previous recessions.
Another caution for us right now is that part of the strength in
real GDP is related to the weather and also to the increased secu-
16
rity costs that we have had after September 11, and the Govern-
ment spending that went along with them.
So these will all tend to be short-term or not long-term growth-
creating factors for the economy. Those are some cautions looking
forward.
I want to now turn to monetary policy, I offered a few thoughts
in my prepared statement.
As the U.S. recovery broadens, U.S. monetary policy will be faced
with the question: Is growth itself inflationary? And if not, does it
require monetary policy response?
The graph shows that over the 1990s, the range of the short-
term interest rates of the U.S. has been relatively wide as the Fed
tries to respond to these growth swings.
My view is that inflation and deflation are more related to
changes in the value of moneylets call it the strength of the dol-
larthan to economic growth. When a currency loses value, it puts
upward pressure on prices. Likewise, when a currency rises in
value, it puts downward pressure on prices. Since the dollar is very
strong right now, as judged by several factors, and the graph shows
the trade-weighted value of the dollar reaching a very high level
in most recent years, I think there is more likely to be downward
pressure on prices than upward pressure.
So even with a recovery, it looks as if CPI inflation will fall sub-
stantially in coming months and be low, relatively low, for the fore-
seeable future. This makes an argument against a rapid increase
in interest rates and bond yields. As a policy matter, I would like
to see a more explicit recognition of the connection between the
value of the currency and the inflation or deflation rate that is ex-
pected. I think it is important for us to achieve stability in the
value of the dollar as a step toward price stability.
In addition, I wanted to offer some thoughts on fiscal policy. It
is obviously a very complicated subject, both from an economic and
a political perspective. These are, therefore, very general thoughts.
It looks like the budget may now actually be in surplus or close
to it in fiscal 1902, and also in fiscal 1903. This is the result of sev-
eral positive factors. They includea shallower-than-expected re-
cession, the remarkable change in the interest rate policy in 2001,
strong U.S. productivity growth, and also Congress unusually well-
timed tax cut in 2001.
The Federal budget reflects tremendous growth in spending and
even faster growth in Federal receipts. The graph in the text shows
nominal spending and nominal revenues and you can see us trad-
ing back and forth between surplus and deficit.
Note that this graph is using CBOs February 1902 forecasts, the
ones that they made last month, and I imagine if they reestimated
the budget today, there would be a much smaller deficit showing,
if any, for the fiscal year 1902 budget.
The budget outlook is very sensitive to growth assumptions. No
one is very good at forecasting growth rates in either the near-term
or long-term. I am skeptical of the process of trying to calculate po-
tential GDP or using it as a rule or a guidepost for monetary policy
because of this difficulty in actually projecting short- or long-term
growth rates.
17
The bar graph in my statement shows the size of the miss by

both CBO and OMB in the 1990s versus the actual growth rate.
Year after year they systematically, under-estimated both the po-
tential and the actual growth rates for the U.S. economy.
I should note that in the 1980s it would show the flip side. There
was a systematic over-estimate of the growth rate by both agencies
during that period of time. I think it makes it difficult to use this
kind of projection as a guidepost for monetary policy.
If economic growth is as solid as I expect, then the glidepath for
the pay-down of the national debt will be rapid and would not be,
in my view, good economic policy. In effect, our current policy is to
levy a stiff level of taxation on workers and the profitable portion
of the private sector in order to pay off relatively low-cost Federal
debt. The effect is to improve the Federal Governments balance
sheet while putting pressure on the publics balance sheet.
Given the economic recovery, then, Congress will probably revisit
the 1990s debate about what to do with the fiscal surplus. In my
view, tax cuts would help maximize the growth rate and gains in
median incomes. In addition, I think a fiscal surplus, if it emerges,
should also provide an opportunity for an improvement in the
Social Security system.
Finally, I wanted to offer some thoughts on international eco-
nomic policy.
The U.S. economic recovery is good news for foreign economies.
It will probably spark a recovery in Europe and may even help
Japan break out of its deflation spiral. Some developing countries
will be able to participate in the global expansion, helping them
raise their living standards.
However, I am worried about the polarization of the world econ-
omy, meaning the wide gap between the U.S. growth rate and
growth rates abroad. With each new burst of U.S. growth in the
1990s, it became increasingly apparent that the United States was
producing and consuming an increasingly large share of world out-
put. It reached roughly 35 percent and it is climbing. In my view,
it is important that developing countries grow faster and begin to
narrow the gap in global living standards, but very few are.
Over the years, I have advocated a rethinking of our inter-
national economic policy and the international financial institu-
tions. I favor a vision of economic development based on stable cur-
rencies, lower tax rates, trade liberalization, and a firm belief that
people at the bottom of the economic ladder should be able to move
up. I do not think these principles are applied frequently enough
in our international economic policy. My worry is that world
growth may remain substantially below its potential, with the
shortfall coming disproportionately from the poor.
In conclusion, Mr. Chairman, the likely U.S. economic recovery
is very welcome, particularly given the war on terrorism and the
turmoil in international affairs. The recovery provides a real oppor-
tunity for thoughtful economic debate. My statement noted the im-
portance of monetary policy decisions relating to growth and infla-
tion; fiscal policy decisions in the event of renewed surpluses; and
the opportunity for constructive change in our international eco-
nomic policy.
Thank you.
18
Chairman SARBANES. Well, thank you very much.

There is a vote going on and I have to recess the hearing briefly
to go and vote. I think some other Members will also be joining us.
So, we will resume in short order. The Committee stands in recess.
[Recess.]
Chairman SARBANES. The hearing will come to order.
I want to ask a couple of almost preliminary questions. First of
all, the figure for the economic output in the fourth quarter origi-
nally came in at two-tenths of 1 percent. That was subsequently re-
vised to 1.4 percent. And we had a big change in the productivity
figure, too. Revised from an increase of 3.5 to 5.2 percent.
I have had an interest in these economic statistics infrastructure
of the Federal Government. My own view is that we do not invest
enough in it. We are talking about really small amounts of dollars.
But we could substantially improve the infrastructure. I do not
know if this is a good example of it or not. I guess that is the ques-
tion I am leading into. But we start thinking about policy decisions
off of one set of figures and then later we learn that the really ac-
curate set of figures is something substantially different.
How much of a problem do you see this as being and how much
attention should we give to it? That wasnt the purpose of todays
hearings, but I would like to elicit some response on that.
Dr. SOLOW. It is a problem. Here we are talking about policy and
the information on which our discussions and your decisions are
based, is changing under our feet as we talk. Part of that could,
I think, be helped by investing a little more in the data collection
process that underlies the national accounts. Not all of it, however,
can be helped that way.
For instance, part of the reason for the problem is that we rush
the process. We want those summary numbers as soon as possible,
or sooner. The quarter is barely over before we ask the Department
of Commerce to produce the figures.
We need, I think, to realize early in the game, that the first
numbers are going to be revised and can be revised substantially.
But there is a lag in the collection of some numbers that could be
shortened by spending, as you say, trivial sums of money by the
standards of the Federal budget.
Dr. STIGLITZ. Let me make a couple of comments.
First, I agree with what Bob says that part of the problem is the
fact that there are always going to be revisions. The first numbers
are going to come in are going to be different from what next will
be the case. At the same time, I think we have to recognize that
the point that you made, the investment in this area is inadequate
and that we could do better. When we get the revised numbers,
they could be reliable. We could do better samples.
So, I think there is enormous room for improvement.
You focused on numbers of GDP and productivity. The flip side
of that is the CPI, the cost of living, the inflation. It is very clear
that productivity, when we revise upward productivity numbers,
that revises downward the inflation and that means that the staffs
at the Fed should be more conservative, and less concerned about
inflation.
I always found it very interesting during the debates about revis-
ing the CPI in the context of Social Security, that while Greenspan
19
often talked about the implications that it had for the CPI, and for
Social Security, there was less attention for the implications for
monetary management. There were obvious implications, that we
needed to be far less concerned about inflation than he and many
of the other members of the board, Federal Reserve Board, seemed
to be. And so, I think that this is very important.
A third point I want to make very briefly, which is I think the
institutional framework for statistical collection should be changed.
I think it would be desirable to think about establishing an inde-
pendent statistical agency.
Chairman SARBANES. Like Canada?
Dr. STIGLITZ. Like Canada. Inevitably, the conflicts of interest
between an operating agency and a data collection agency can be
very great and lack separation.
At the international level, the problems are even greater. I think
that the numbers that are reported for growth, for instance, for
many countries by the IMF are simply made-up numbers to make
their programs work and have nothing to do with scientific, eco-
nomic-based forecasting, and that is not well known. I think that
moving the statistical responsibilities out of the IMF would be a
very important move in the right direction.
Chairman SARBANES. Alan.
Dr. KRUEGER. Let me mention, I started the survey center at
Princeton, so these are issues that I have thought about quite a bit.
I would add that the private sector, as well as the Government,
relies very heavily on the statistics that are coming out of the Bu-
reau of Labor Statistics and the Census Bureau and the BEA and
so on. And if you add up the costs of making mistakes for all those
who are involved in using these data for decisions, it is enormous
compared to the amount we are investing in collecting the data.
So, I have a couple of suggestions. I think there are some prob-
lems that could be solved by investing more to collect more infor-
mation. And one of the problems is the economy has become harder
to measure. The economy has become more diverse. Manufacturing
now is a much smaller share. We are investing more in collecting
the data, but the economy is getting harder to measure at the same
time. So it is kind of a race where we are left standing in place.
One suggestion I have is that we should be more aware of the
magnitudes of the revisions.
For example, in my written testimony, I pointed out that the em-
ployment growth last month was 66,000, according to the payroll
survey. The typical revision from the first report to the third revi-
sion, which is 2 months later, is on the order of magnitude of
around 50,000 jobs, plus or minus.
So when you think about these movements, you have to recognize
that you need a wide confidence band around them. There are some
numbers where you need a wider band than others. I think it
would be helpful if the numbers were reported more frequently
with those bands and if we think about those bands when we think
about using the numbers.
But there are some critical areas where I think we just do not
measure or we stopped measuring what is going on. One area has
to do with vacancies. Bob Solow and I co-edited a book together.
There is a lot of discussion on the relationship between vacancies
20
and the unemployment rate. We are forced to rely on help-wanted

ads as a measure of vacancies. There are big changes in newspaper
costs and in the way help-wanted ads are placed and so on.
The BLS has just revised or just started again a new survey on
vacancies. But I think that that was a critical gap, and there are
other areas where we are just not measuring enough.
Chairman SARBANES. David.
Mr. MALPASS. We maybe should have lower expectations of what
we are really getting out of the data, because it is so complicated
to actually measure what is going on in the economy.
Chairman Greenspan, in his testimony last week, mentioned
again what he calls conceptual capital. In part, it is the human
capital element of what is going into GDP. It is becoming more and
more important. It is very hard to measure what that actually is,
how productive it can be. So, I think we have to have some limits
on what we can really expect from the data.
We probably all have individual statistics that we dislike the
most. I will layout one domestic and one international that I think
are misleading.
Personal savings is a statistic that we see every month. It gives
us the impression that Americans are terrible at saving. That sta-
tistic produced by the Government is heavily biased. It keeps track
of all the expenditures that people make, but doesnt keep track of
all the income or cash flow savings.
For example, when someone refinances their home, say they save
$200 a month in their payment and spend $100 of that. The Gov-
ernment keeps track of the spending. If they then put $100 extra
every month into savings, we would think of it as their savings
rate going up. But the Governments going to conclude that their
savings rate actually went down by the $100 of spending. They do
not record it properly.
We have the impression of a terrible performance by the Amer-
ican saver and it actually wasnt nearly as bad as that statistic.
On the international front, people focus on foreign direct invest-
ment as the solution for foreign economies. But what we find is
that the data often comes from corporate reporting to a government
that they want to please. The government comes to corporations
and says, how much did you invest in our economy this year? And
the corporation, of course, has an incentive to say a large number.
It radically overstates the actual attractiveness. This is particularly
true in some developing countries.
I agreed with what Joe Stiglitz said on the IMF producing a lot
of data that really is just way off and is known to be off. That is
part of their job, I guess.
Chairman SARBANES. Thank you.
Well, I have a number of questions, but my time has expired. I
yield to Senator Bennett. I will come back.
STATEMENT OF SENATOR ROBERT F. BENNETT
Senator BENNETT. Thank you, Mr. Chairman. I appreciate your
holding this hearing.
I look around the room for the hordes of visitors and observers
and they are not here, which is too bad because I think the econ-
omy really is the starting place of virtually everything else.
21
One of the cliches that I repeat often and often again, and like
most cliches, it happens to be truemoney does not come from the
budget.
We here in Congress forget that. We think we can pass a budget
that creates a surplus or pass a budget that creates a deficit. We
are always surprised. Nobodys prediction of what the fiscal year is
going to produce is ever right or even close to right, except the one
that is issued with only 1 month left in the fiscal year, and that
is usually pretty close. But at the beginning of the fiscal year, we
are always either overly optimistic or overly pessimistic.
Money comes from the economy. If the economy is doing ex-
tremely well, then we get surpluses that we did not predict. If the
economy turns south, why, we get deficits that we did not predict.
And too many people blame the predictors and do not realize that
you are dealing with so many variables.
The example I like to use is a little like the weather forecaster.
There are some who say, well, the weather forecaster is never
right, so he cannot be any kind of a scientist. Actually, he can be
a very good scientist. He is just dealing with so many variables
that you have to cut him a little slack.
Economists get snorted at because their forecasts are never any
good. Actually, I think you are scientific and you do pretty well.
With that having been said, let me raise an issue that came out
of my exchange with Chairman Greenspan, when he was before us
last week, that has to do with the role of capital gains and the
amount of income that came from capital gains.
I made the observation to Chairman Greenspan that tax rates
are at historic highs. They have never been higher as a percentage
of GDP than they are now. He said, yes, that is true, except that
we have had a tremendous amount of tax revenue coming from
people cashing in on capital gains, and we have had some tax rev-
enue on people cashing in on stock options. If you go below those
to the income that comes from what one might consider more nor-
mal kinds of tax sources, the situation doesnt look quite so great.
Nonetheless, in macro terms, the tax burden on the economy is
very high and the question is raised whether or not the economy
over time can sustain a tax burden that is in excess of 20 percent
of GDP, which we have not had. Does that produce some kind of
a drag that will bring the economy down? And if it does bring the
growth rate of the economy downnothings going to bring the
U.S. economy down. We are not going to be Argentina. We are not
even going to be Japan. But if our growth rate slows, then we are
back into deficits rather than surpluses, however much we politi-
cians would like to think we can control whether we are in deficits
or surpluses.
If our growth rate slows, we are back into deficits rather than
surpluses. We have other kinds of problems. I would like you to ad-
dress that question of the overall 20 percent-plus tax burden that
we have had. Then, if you would, in that, lets talk about capital
gains because I view the capital gains tax as a tariff on money as
it moves from one purpose to another.
And just to put it into simple terms that I can understand, I
know an entrepreneurial type who is willing to invest his money
in relatively high-risk activities because he has learned that they
22
produce high returns, and he has enough experience to pick, he be-

lieves, the right kind of high-risk activities.
When he is successful, and one such investment becomes much
larger than it was when he got into it, he is loathe to unload it be-
cause if he takes his money out of investment A in an effort to put
it into investment B, there is a tariff on the movement of the
money, from A to B, in the form of the capital gains tax.
Now there is a widow who is most anxious to buy A because it
is now a mature investment that is producing a stable and reliable
7 percent per year income, and she thinks that is just nifty.
He is very anxious to get out of A and into B because, for him,
a mature investment that produces only 7 percent a year is a real
drag. But the capital gains tax stands as a tariff barrier to prevent
him from moving his money from A to B. And as we have lowered
that tariff barrier, we have seen more and more money move from
A to B, and in the process, produced the capital gains tax revenue
that Chairman Greenspan was talking about.
So, I would appreciate your comment on those two issues.
Dr. SOLOW. I guess I will start. I am the oldest one here by a
wide margin.
[Laughter.]
Senator BENNETT. As I am on this side.
[Laughter.]
Dr. SOLOW. I do not think that it makes sense to imagine that
there is some natural upper limit to the ratio of Federal revenues
to national income or GDP that we surpass temporarily or for a
longer time at great peril, or that if we fall short of it, something
else happens.
Much more depends on the nature of the taxes we levy, and the
uses of the revenue that we collect, than on any simple statistic
like the fraction of the national income that goes in taxes.
It is very important I think to focus on an obvious case: The need
for national defense. If the safety of the country, the security of the
country, requires expenditures that are naturally directed through
the Federal Government, we will make those expenditures and we
will tax for them if taxing is the rational way to finance them, and
we will borrow for them if by any chance, borrowing is the rational
method to finance them.
One problem with the illustration that Senator Bennett mentions
is that it under-estimates the ability of the financial engineer to
convert one form of income into another. In our tax system, we
favor capital gains as against other forms of income, and as a re-
sult, there is a thriving industry of converting large salaries into
asset transactions which appear as capital gains
Senator BENNETT. If I could interrupt you. I have always heard
the argument that, gee, you lower the capital gains tax and every-
body will transfer their income into capital gains. I have never
been able to do it. I have tried, and I have never heard of anybody
being able to do it.
Dr. SOLOW. You do not hire a fancy enough tax lawyer and ac-
countant. If, instead of being a poor but honest Senator, you were
a rich movie star, or a rock star, I assure you that clever people
would cluster around you who are anxious to do just that, for a
mere tiny fraction of what they are going to save you.
23
Senator BENNETT. Yes, I know. And very often, they end up put-
ting you into something that has wonderful upside protection and
turns out not to belike a percentage of your movie when you
would have been better off by taking it in salary. There is always
risk connected with the transaction.
Dr. SOLOW. Of course, there is always risk connected with any
asset transaction. I am merely saying that you cannot simply look
at the gross numbers without asking what incentives for the pri-
vate economy, as well as for public servants, are created by dif-
ferent forms of taxation.
Alan Greenspan was right that, if you look at the numbers, when
we passed through a period in which large asset gains are being
realized and therefore, taxed, even if they are taxed at low rates,
that will increase measured revenues. And they are not just meas-
ured revenues, they are real revenues of the Federal Government.
The lesson I would draw is that we should try, in thinking about
public finance, to pay attention, more attention than we actually
do, to the incentive effects of every tax increase, tax decrease, tax
change, that we make, incentives that bear on businesses, bear on
individuals, and to a certain extent, bear on the Government itself.
Senator BENNETT. Dr. Stiglitz.
Dr. STIGLITZ. Let me try to amplify a couple of points.
I agree with Bob that there are no magic numbers percent. It
really depends in part on what you are doing with the money. For
instance, we have done studies that show that the returns to in-
vestments in R&D by the Government have enormous returns, and
we have not been investing enough in that area. So, my view is
that if we spent more money on that kind of research, that would
be a high-yield return that would help the economy grow.
We were talking about investments in statistical infrastructure.
If the private sector is getting bad statistics, making bad decisions
as a result, and spending more public money, that can yield very
high returns.
The first point is what is the money going for? And we could ob-
viously waste money. I am not going to tell you how to do that as
well. But if we spend it well, it can yield high returns.
Second point, the design of the tax structure can make a great
deal of difference. We can design tax structures that give strong in-
centives to people who are creative. We can give strong incentives
to people who are engaged in tax shelters that are basically not
creating value. And so, much of the concern about the debate of tax
reform has been the design of tax structures that enhance produc-
tivity versus those who are advocating tax structures that help the
rich or help, unrelated to their activities with respect to enhancing
economic productivity.
So, I view a very strong part of the burden of the tax system as
having to do with the design. Again, we can have bad design and
good design and right now, I think we have been moving in the
wrong direction.
Third, with respect to capital gains itself, a relatively small frac-
tion of the capital gains comes from the picture of the innovative
activity that you have in mind. Most of capital gains comes from
real estate speculation.
24
I do not want to downgrade the importance of real estate as an

important sector of the economy, but I think most of us think of,
what is the strength of the new economy, the strength of the U.S.
economy over the last decade? It has been innovation. It has been
a whole set of activities like that and not building the kinds of
empty office building that led to the real estate crash in 1988,
1989, or in the 1990s.
Most of the capital gains goes to the real estate sector, not to in-
novation. I am more sympathetic with special treatment for capital
gains for innovation sectors than I am to real estate, but other peo-
ple do not believe in that kind of differentiation.
I think it does make sense.
The final point I want to make is to reemphasize the point Bob
made that the kind of financial engineering that one saw in Enron
has been well known and can be used forif you have special tax
treatment of capital gains, can be used to avoid taxes.
I wrote a paper a number of years ago detailing how that could
be done and how you could actually basically get rid of most of your
capital gains.
Chairman SARBANES. It is probably in the Enron files.
[Laughter.]
Dr. STIGLITZ. Over the years, the tax authorities have tried to
circumscribe one or the other of these kinds of devices and it ex-
plains a lot of the complexity of our tax code. And that complexity
is part of the downside cost of our tax system.
Unfortunately, a lot of the creativity of our economy is going not
into producing new products, but trying to circumvent the tax laws
and finding out loopholes, on accounting and in this area. I think
it is a mistake to try to provide them even more incentives to do
that. And afterwards, if you want to find some advice on how to
use our current tax system to avoid taxes, we can arrange for that.
Senator BENNETT. I am not talking about using the current tax
system to avoid taxes. I understand that perfectly.
I do object to the canard that I hear over and over again that
people will simply change their form of compensation to take ad-
vantage of the lower capital gains tax rate. And I hear that in the
debate often.
Michael Jordan doesnt take shares in the Wizards. Michael Jor-
dan takes cash. And if you say, we are going to give you shares in
the Wizards so that you can get capital gains advantage when the
price of the Wizards goes up and his knee goes out, he wishes he
did not take shares in the Wizards.
You cannot transfer income from normal income, ordinary in-
come, or earned income. To use the tax phrase, you cannot transfer
from earned income to capital gains income without risk. It is not
something that you just need a good accountant to do. Risk is al-
ways there and you are compensated for the risk. As Enron dem-
onstrated, stocks go down just as much as they go up, and options
become worthless just as often as they become valuable.
I was hired as the CEO of a company and was compensated in
options. And I did such a wonderful job in the company that the
options never ever exercised because the stock price never got as
high as it was on the day I was hired.
25
Dr. STIGLITZ. Can I just say, much of the paper that I wrote was
how you manipulate within the capital sector itself, borrowing
money, moving within that, and avoiding. But it is also the case
that there has been a lot of discussion, and I think some evidence,
that firmsone of the reasons they use stock options is for the fa-
vorable treatment.
What a number of corporations are doing as the stock goes down
of resetting the strike price, so implicitly, they are sharing the risk.
They are absorbing the risk.
And if you look at the studies that have looked at overall com-
pensation, what you see is that many executives do not bear the
risk that you would appear to see that they would bear from the
stock options because when things do not work out as well, there
are other ways of giving them money, either through resetting the
strike price or through other forms of compensation.
Chairman SARBANES. Does anyone else want to add anything be-
fore we move on?
Mr. MALPASS. I have a few points, if I may, Mr. Chairman.
Chairman SARBANES. Yes. Go right ahead.
Mr. MALPASS. In very rough terms, Federal revenues are $2 tril-
lion per year and State and local governments add another roughly
trillion dollars. So there is a lot of tax revenues.
Chairman SARBANES. Rates or revenues?
Mr. MALPASS. CBO, in its recent report, goes through some sce-
narios. Over the life of the budget, the 10 year life of the budget,
even with last years tax rate cut, they expect revenues from per-
sonal income taxes to rise from 12.8 percent of GDP now to 13.6
percent of GDP. And if we have a good economy, they will rise to
15.5 percent of GDP.
So even apart from the capital gains issue, we have the personal
income tax as a burdensome tax. Also, the Social Security tax is
a very burdensome tax on labor itself. It puts a wedge between the
employer and what the employee really receives.
Now, as far as capital gains taxes, we should note that each time
the rate is cut, the proceeds from capital gains are way above the
projections.
We have a systematic bias in the way capital gains are perceived
in the Government computer models. They dont fully account for,
the fact that, when the rate is cut, there is more activity and more
economic growth or simply transactions, and the total capital gains
receipts get a good bump.
One of the debates last year that was very confusing to me was
the assertion that if the capital gains tax rate had been cut, the
stock market would fall.
I believe that economists would by and large agree that if you
cut the tax on an exit from a given investment position, it adds to
the value of that position.
I think it is demonstrable and almost a certainty that if you had
a lower capital gains tax rate, you would see a big positive impact
on the value of capital assetsstocks, bonds, and real estate. So
that was a confusing debate to me on the sidelines last year.
A final point is the distribution of tax receipts from capital gains
taxes, the issue of who actually pays capital gains. What I am
struck by is that the rich actually can avoid much of the capital
26
gains tax by selectively taking gains. Also through the estate tax
system and through the charitable contributions system.
I was just at a dinner the night before last with a big group of
universities that receive a lot of charitable contributions. One of
the sizable tasks that they have is taking care of rich people as
they donate their appreciated property into the university before
their death.
The rich person avoids capital gains taxation and gets higher
current income from the charitable contribution. The whole process
is driven by the heavy taxation of capital gains.
On the other side of it, the small business owner really doesnt
have those mechanisms in order to avoid or work around the cap-
ital gains tax.
I think that the distribution of capital gains taxation falls very
heavily on the middle class and entrepreneur, precisely the people
that you would really rather leave the proceeds with.
Chairman SARBANES. Now as I understood Chairman Green-
spans response to this question that Senator Bennett put at the
hearing last week, he made the observation that the capital gains
tax revenues are factored into the numerator. But there is not an
item that is factored into the denominator.
Therefore, the percentage of tax revenues compared with the
gross product will, by virtue of that, be higher. And if you are get-
ting more capital gains, the figure will look higher because you do
not put any comparable item into the denominator. You get, in a
sense, an overstated figure when you are trying to make these com-
parisons or something that certainly should be taken into account.
Of course, the point is that we have had a lot of capital gains
in recent years with all of what has been going on in the market
and that that had an impact on these percentages.
He was, I thought, very careful to try to make that point in the
response.
Senator Reed.
COMMENTS OF SENATOR JACK REED
Senator REED. Thank you, Mr. Chairman. Thank you, gentlemen,
for your testimony and your presence here today.
Dr. Stiglitz, you seem to have an urge to say something, and I
do not want to deny that.
[Laughter.]
Dr. SOLOW. It is always the case, Senator.
[Laughter.]
Chairman SARBANES. What else is new?
[Laughter.]
Dr. STIGLITZ. Very briefly, let me just say that the Social Secu-
rity tax, since the contributions that people make under the Social
Security system are reflected in the benefits and move basically
commensurate with the benefits, doesnt have the distortionary
effect of other kinds of taxes. It is really like an investment. So
viewing it that way I think is fundamentally misguided.
Second, it is the case that cutting capital gains taxes leads in the
short run to increases in revenues because people worry that this
is a temporary benefit and they want to take advantage while
there is a sale going on.
27
The econometrics, the statistical evidence shows that over the

long run, cutting the capital gains tax is like cutting any other
taxit leads in the long run to lower revenue and a worsening of
the fiscal position of the United States.
I will stop at those two points. I have concerns about the other
points, too, but let stop there.
Senator REED. Thank you, Dr. Stiglitz.
It seems to me that the proponents of tax cuts, and this in some
respects seems to be the Administrations Swiss army knife for eco-
nomic policyit can do everythingbase some of their judgments
on a bet that productivity will increase at very prodigious rates for
the indefinite future.
I wonder if Dr. Solow and everyone, if you might comment on
your views on productivity increases.
Dr. SOLOW. Yes, I would be glad to. I should begin by saying that
these quarter-to-quarter numbers that are reported are intrinsicly
unreliable and volatile. Productivity has a numerator and a denom-
inator. They can both change unpredictably. They can both change
dramatically, and particularly when a denominator changes. It can
change the value of the fraction very much. Quarter-to-quarter
numbers are not an indicator of very much at all.
Over the longer run, in the quarter-century after the end of the
Second World War, we had very rapid productivity increase, re-
flected directly in the rise in the standard of living of the country.
For mysterious reasons, for reasons which are not fully under-
stood by anyone, the following 25 years, from about 1970 to about
1995, had extraordinarily low productivity increase. We thought, at
first, that productivity was growing 1 percent a year. It turns out
to be nearer a percent and a half a year after the data are revised.
Beginning in 1995, we had very rapid productivity increase
again, and much of that is undoubtedly information technology re-
lated. A lot of it is related to other things, including organization
innovations by businesses, and still other things.
It is very hard to extract from numbers like that what part is
business-cycle-relatedthere is a normal pattern of productivity
change in the business cycleand what part is durable. What we
really need to know is what is durable over the next 5 or 10 years.
I have put some time into studying that question in detail indus-
try by industry, in fact, and so have many other people. I think a
consensus is emerging that we probably have a durable benefit
from accelerated technological change in the United States, espe-
cially in telecommunications and information technology, but that
the period from 1995 to 2000 exaggerates considerably what we can
hope for over the longer run.
The longer run forecasts, naturally uncertain, that make most
sense to me are those that suggest that we can look ahead at some-
thing like 2 percent a year annual productivity increase, taking the
private economy, the private business economy as a whole.
Two percent a year aint hay. A number that rises at 2 percent
a year doubles in about 35 years. So doubling the productivity of
American workers in the course of a little over a generation is not
a negligible thing. This is nothing like the 3, 312, 4 percent in-
creases that we saw during that 5 year period, which almost cer-
tainly cannot be repeated regularly.
28
The 2 percent a year is a little less than we got between 1950

and 1975, which were very good years for productivity. It is more
easily explicable why we did so well in those years than why we
did so poorly in the 25 years.
Senator REED. Thank you.
Dr. Stiglitz.
Dr. STIGLITZ. Just to add one thing. I agree with everything that
he said. One point is that there has been a lot of research, a lot
of thinking over the last 20 years of how you make decisions under
uncertainty. These numbers are inherently uncertain. One of the
principles is you do not spend money before you have it. And you
revise policies as new information comes in.
So if you made a decision to spend a certain amount of money
when you thought you had a surplus of $5 trillion, or whatever the
number is, when it was a mistake to have spent as much as was
spent, given the uncertainty. But when you have new information
that comes in and that says it is much less than you thought, it
calls for revising the policy decisions that were made under that
framework.
Senator REED. Thank you, Dr. Stiglitz.
Dr. Krueger.
Dr. KRUEGER. I agree completely with what Joe and Bob said.
One point I would add is that one of the things that helps pro-
ductivity growth and it has helped historically has been increases
in education, increases in the human capital of the workforce. In
the post-World War II period, we had very rapid increases in col-
lege attendance and high school graduation and so on. That source
seems to have slowed down considerably.
So that is one of the reasons why I think it is very hard to pre-
dict going forward. The technological changes that Bob pointed to
I think probably are durable, although the probably should be un-
derscored, not the durable, in that sentence.
I also think there is a tremendous amount of uncertainty, even
looking over the next 5 years, for what the productivity growth
numbers will be. That is why the budget projections are so variable
and often so far off. And given that reality, I think what Joe said
is absolutely right, that one wants to adjust when one gets new in-
formation about what productivity growth looks like.
Senator REED. Mr. Malpass.
Mr. MALPASS. Senator Reed, very briefly, in my opening state-
ment I went through the policy implications of this question. I
think it is, indeed, worthy of a lot of thoughtful discussion. Could
the productivity growth be as high as we have been recently wit-
nessing? If it is anywhere close to that, as Dr. Solow says, even if
it is 2 percent, that compounds rapidly.
From the monetary policy standpoint, it means that we may have
a period where the inflationary impact of a given growth rate is a
lot less than what we are used to. That means that the potential
growth of the economy, or the possible growth of the economy, is
higher than what we have thought in the past.
From the fiscal policy standpoint, it means that we may have
surpluses rather than deficits. As I laid out in my statement, it is
worthwhile for Congress to begin thinking about what we would do
29
if we really had a sizable surplus, to begin thinking about the

glidepath.
Chairman Greenspan laid out a year or two ago the idea that if
we run surpluses, if we have the higher productivity growth that
we think we do, then the glidepath in the pay-down of the national
debt will be uncomfortably rapid. He went through that in a rather
detailed way.
Senator REED. But that was at the point that we had a projected
surplus of several trillion dollars, which is much less now. It is not
a glidepath. It is a cliff, I think.
Dr. STIGLITZ. Can I make one more remark which is a point that
I had in my written testimony having to do with the short-run?
Whenever you have a recession, a down-turn, even a shortfall
below potential, one of the impacts is that profits go down, and as
his testimony pointed out, they have come down considerably in
this economic down-turn. And when profits go down, firms cut back
on their R&D. The cut-back in long-term R&D is even more in the
short-term. Long-term R&D being focused on real productivity in-
creases rather than just making sure that you can compete with
the competitor.
I have been at some recent meetings with people who have been
involved very strongly in the high-tech area. They say that there
has been dramatic cut-backs in R&D in their firms and in their
industry in the last year, last year and a half. And that portends
very strongly for a slowing down of the pace of productivity over
the medium-term, at least in that particular sector.
Senator REED. Well, you can correct me. My sense is that produc-
tivity is not at the levels that we saw in the late 1990s, at 2 per-
cent. That, as a result, GDP will not grow as fast as it tended to
grow. With the declining GDP and even a constant obligation by
the Federal and State and local governments to spend money, the
likelihood will be in deficit, not surplus. Is that your judgment?
Dr. SOLOW. It is not clear that we will be in deficit rather than
surplus. But any surplus we generate will be much smaller than
the very optimistic numbers that we had before.
You are quite right that with roughly 2 percent productivity
growth and roughly 1 percent employment increase over the long
run, the long-term growth rate for real GDP is likely to be of the
order of magnitude of 3 percent, 3.1 percent, thereabouts. That is
the number that I come up with. That is the number given in the
Economic Report that the President issued a month ago. There is
a fairly good consensus on that.
That is not, I think, going to generate large surpluses, nor is it
going to give us much protection against inflation. Incomes tend to
rise along with productivity. What was so fortunate about the pe-
riod from 1995 to 2000 was that there was an unexpected splurge
in productivity, and as a result, an awful lot of it was fed into cost
reduction rather than into increases in earnings and other non-
profit forms of income.
I do not think that is likely to happen again. This works the
other way, too. The double-digit inflation of the early 1970s that
scared us so much came in part from the fact that wages and other
incomes were rising as if productivity were to continue to go up as
30
fast as it did in the years after 1950. It did not, and prices went
up instead.
Dr. STIGLITZ. Let me just make one more point, which is that the
numbers that are often cited include the Social Security system.
We should be putting away money for those obligations we have.
In addition, we have the long-term problem of Medicare. There
are estimates of what is going to be happening to health care costs,
that it will go up to 17 percent of GDP. And that is typically not
fully accounted in the forecast.
So there is a real risk on that side, as well as on the GDP side
that we have not really taken into account. I think it is irrespon-
sible to spend the money before we have it and before we know
what these expenditures are going to be.
Senator REED. Thank you very much. My time is expired.
Thank you, Mr. Chairman.
Chairman SARBANES. Senator Corzine.
COMMENTS OF SENATOR JON S. CORZINE
Senator CORZINE. Thank you, Mr. Chairman. I apologize to the
witnesses for attending another hearing first. This is a remarkable
panel and I intend to read all of your testimony.
Let me ask a question that relates to something that seems to
come up on the floor in our debates fairly frequently with regard
to tax policy. And that is the permanent repeat of the estate tax,
which seems to get tacked onto every piece of legislation that gets
presented to us that has any economic bearing. Would you all give
some of your perspectives on its impact into the economy long-run
capital formation? I hope this question has not been asked, Mr.
Chairman.
I would start with Mr. Malpass and then work the other way, or
vice-versa.
Mr. MALPASS. You put me on the spot first.
[Laughter.]
The one observation I would make on the estate tax is that it
places huge costs on the economy. I think it is very hard to quan-
tify those costs or be aware of how large they are.
I do not really want to go farther into exactly how it should be
revised. But we should recognize the gigantic number of workers
within the economy and systems within the economy that are de-
voted to dealing with the estate tax, from lawyers to accountants
to the university systems, which have staffs and whole processes
involved in helping people deal with the estate tax system.
We should be aware of those costs and also aware of the distor-
tions that are brought on by the system that we have right now.
Dr. KRUEGER. My own view is that the estate tax is largely an
issue of equity. Different people will have different views about
what constitutes equitable taxation.
I think one issue that David raised which is important is the
loopholes. What seems to upset people is having to spend money
on lawyers to avoid the estate tax. I think they would probably be
happier to give that money to the Government than to their attor-
neys. My own sense is that part of the outrage over the estate tax
in the public has to do with the loopholes which they consider to
be unfair.
31
I do think in terms of the economic impacts, there would be im-

pacts in terms of charitable giving. I think from the standpoint of
universities, for example, they will get fewer donations with the
repeal of the estate tax.
Dr. STIGLITZ. Let me make a couple of points.
First, I think one has to think about the repeal of the estate tax
in a broader context. In particular, in the context of the issue of
the step-up of basis of capital gains tax, step-up basis for payment
of the capital gains taxes. The step-up of basis, I believe that, as
our previous discuss, we said that there should be a capital gains
tax and that without that, there can be enormous tax evasion or
avoidancetax avoidance, I am sorry. And that without fully deal-
ing with the problems of step-up of basis, repealing of estate tax
is bad tax policy, both from efficiency and equity points of view.
The second point, a lot of the criticisms that have been raised
against estate taxes have focused on small businesses, farms, and
all those people who have to sell their property in order to pay the
tax. I think there is a legitimate concern about that. But that could
have been dealt with in a variety of ways other than the repeal.
For instance, giving people an extended period of repay, increas-
ing the exemption level maybe to $5 million, but not the complete
repeal. I think that was going far beyond what was necessary to
deal with those problems.
I think there is very little evidence that the repeal will increase
the efficiency. The core issue is the one that Alan pointed out, the
issue of equity and what kind of society that we want to have.
There are going to be significant impacts on charitable giving. I
think the evidence on that is fairly clear. One of the strengths of
the American society and the American economy is based on the
nonprofit sector. And I think that in some sense could be some of
the most serious adverse effects of the repeal.
I do not think it is a bad thing that people are encouraged to give
money to nonprofit organizations. But I have to admit that I have
some self-interest in that particular perspective because I have
been one of the beneficiaries of the nonprofit sector.
Mr. MALPASS. But the cost of that in the efficiency, or I wanted
to ask your point on efficiency. Why dont we have to go through
that, in the efficiency of extraction within the tax system?
Dr. STIGLITZ. I think the net cost of that is negligible compared
to what happens more broadly in trying to evade a whole variety
of taxes or to take advantage of special capital gains provisions,
real estate provisions, and so forth. I think this is really second-
order effect.
Dr. SOLOW. I think everything has been said here. I will take 30
second and emphasize a couple of points. There have been studies
of the incentive effects on business entrepreneurs of the existence
of the estate tax. And generally, they come up with very small
numbers.
The key technical matter is constructive realization of capital
gains at death. Under the present system, without the estate tax,
there are large capital gains that escape taxation forever. And that
cannot be appropriate as long as we are taxing capital gains else-
where in the system.
32
This is primarily a matter of equity. There is no danger that

well-off parents will be unable to create advantages for their chil-
dren by educating them properly and endowing them one way or
the other.
To return some portion of an estate at death to society or in an-
ticipation of death to charitable organizations does not seem to me
to be a bad thing at all. It seems to be a good thing.
The evidence is that, well, here we are, the most entrepreneurial
society in the world. You would think that we had been stifling en-
trepreneurship for generations by having this tax. In fact, Route
128 and similar centers are crawling with businesses like that,
somehow. People with the creativity to create enterprises will do it.
Chairman SARBANES. We will go around again, but lets move
more quickly. We have four panelists and it takes a lot of time to
get an answer. I am just going to ask a couple of questions and
Dr. SOLOW. Five, counting Joe.
[Laughter.]
Chairman SARBANES. Maybe if I can get a yes or no or a short
answer.
What is your view of the argument that the projections out that
we would shift from a strong surplus position either to a weak sur-
plus in the budget or even a deficit, because of the extensive tax
cuts that were made, has had an impact in keeping up long-term
interest rates? And that therefore, some of the stimulus that could
have come to the economy by lower long-term rates was lost be-
cause we did this extensive tax cut and then people looked out into
the future and they saw this.
So that was one way that the tax cut fed back into the current
situation and, in effect, detracted from moving the economy for-
ward. What is your view of that argument?
Dr. SOLOW. You wanted a yes or no answer. My answer is, yes,
that has to be the case. Something in the capital markets has been
lifting up expectation of interest rates in the future and it is at
least in part the expected supply-demand balance for funds in the
future. And that cannot help but be affected by the fiscal policy of
the Government.
Dr. STIGLITZ. I agree. I have actually written that. One other fac-
tor is the uncertainty that all of us have been talking about gets
reflected in the risk premium that is reflected in turn in the
medium- to long-term interest rates.
And so, it is not just the average numbers we are talking about.
It is the uncertainty by this commitment, seeming commitment we
have made to a tax cut when we are not sure if we can afford it.
Dr. KRUEGER. I tend to share those views.
Mr. MALPASS. You asked four economists, so that often means six
opinions. I will give you a different opinion.
It is pretty clear from the evidence that the fiscal deficit doesnt
have much impact on bond yields. We have the experience from the
1980s. It is discussed in detail in my statement with a graph show-
ing the bond yields versus the size of the fiscal deficit. As the ex-
pectations of the fiscal deficit and the actual fiscal deficit grew,
bond yields actually came down heavily in the 1980s.
We have had the experience of last week. As it became clear that
the U.S. fiscal deficit was going to be much smaller than people ex-
33
pected, or perhaps a surplus, yet bond yields are going up. The rise
in yields is reflecting the expected growth of the economy, the infla-
tion outlook, and I also think the currency outlook. Those are the
dominant variables in a bond yield.
Chairman SARBANES. Now what about the argument that doing
this extensive tax cut provided a stimulus to address the shortfall
that we were experiencing here?
I take it this really goes to the question of whether, somehow,
you can borrow frontwards or move frontwards tax cuts projected
out into the future in order to provide a stimulus now. Does it work
that way, or can it work that way?
Dr. SOLOW. I do not think it had or did. The Economic Growth
and Tax Relief Reconciliation Act of 2001 was not passed in antici-
pation of a recession and it is not mainly an antirecessionary act.
I am sure that the early stages of that tax reduction did have
the usual effect in supporting the demand for goods and services
in the economy.
Chairman SARBANES. You mean the early stages, what happened
in the current or the next fiscal year.
Dr. SOLOW. In the current fiscal year. But the notion that tax re-
ductions scheduled for 5 or 6 years from now, or 4 or 5 years from
now, can have a major effect on the current consumption expendi-
tures of the population seems to me to be far-fetched.
Chairman SARBANES. Does anyone disagree with that?
Dr. STIGLITZ. No. The only other factor is the point made earlier
that the anticipation of the worsening fiscal position has had a neg-
ative effect through interest rates.
Dr. KRUEGER. I was going to make the point also that rate cuts
in the future should cause people to delay their labor supply today.
To the extent that there is some substitution in the way people
work, it would work in the opposite direction, the future cuts. The
rebates might have had some effect, I suspect. When the history of
this period is written, it will probably be a small impact. But the
future cuts, I suspect, were probably having no effect or a small
negative effect.
Mr. MALPASS. People spend from their lifetime income expecta-
tions, the after-tax expectations of how much money they are going
to have over their lifetime. So if the Government changes its view
of how much taxes it is going to extract from people, that certainly
has an effect on peoples confidence about their near-term outlook.
If they see that their long-term after-tax income is going to be
more, then that gives them confidence in what they are doing. I
really think that it has to be the opposite of the points of view that
we have just heard.
Dr. SOLOW. Even a believer in something like the permanent in-
come theory of consumption, like me, for instance, understands
that permanent income is discounted like other incomes and incre-
ments to anticipated permanent income 5 years down the line will
not generate very large amounts of consumptions. I am perfectly at
home and comfortable with that way of looking at consumption.
But it cannot have any substantial quantitative impact, I think.
Dr. STIGLITZ. The work that I did in connection with the Nobel
Prize emphasized the importance of credit rationing. And it is one
of the reasons why you cannot borrow against income that you are
34
going to get in 5 years. The evidence in this particular episode is

very strong that it has not had any effect.
Chairman SARBANES. Senator Bennett.
Senator BENNETT. Thank you.
I have to return to the estate tax for just a minute.
I agree with you, Dr. Stiglitz, that the stepped-up basis is a stu-
pid idea. And it came because it was an attempt to ameliorate the
impact of the death tax, which I think is another stupid idea. The
problem with the death tax is that death is not a voluntary deci-
sion. It should not be an economic event. When I decide to sell a
stock, I decide to sell a stock based on my analysis of my needs,
the stock market, where things are. I make a rational decision, tak-
ing into account all factors. When my father dies, there is no such
options. He dies because of uneconomic circumstances.
If his entire estate is cash, that is one thing. If his estate is a
business, his death may occur at the worst possible economic mo-
ment for the survival of that business. But the Government pays
no attention to that, assumes that it is cash, and demands payment
within 9 months.
And so, in an effort to get around the arbitrariness of death, we
get all of the battalion of lawyers, tax accountants, and others that
you have talked about.
I have lived through a number of deaths. The most spectacular
one from an economic point of view was Howard Hughes. I was
working for Howard Hughes when he died, and I watched the gyra-
tions that everybody went through in an effort to preserve his as-
sets, not necessarily for his heirs because none of his heirs expected
to receive any of his assets. We spent a frantic amount of time try-
ing to find a signed copy of the will that left everything to charity,
which was Mr. Hughes intention.
Mr. Hughes, being Mr. Hughes, never bothered to sign the will.
And so, it did end up going to his relatives, none of whom expected
a dime on his death.
I watched the gyrations that people went through to write down
for assessment purposes the value of his assets, in many instances,
to preserve those assets because they represented businesses that
were not at that point in their lives where they could afford to liq-
uidate into cash.
So, I would much prefer a circumstance that says, death is not
a taxable event.
If Howard Hughes paid $10 for an asset, on his death, that basis
stays unchanged. There is no step-up in basis. When the asset gets
sold, no matter who sells it, it then produces a capital gain that
is taxed at the existing capital gain tax rate, whether it is 20 per-
cent or 28 percent or 25 percent or 15 percent, wherever it might
be. And that means the people who own the asset can make an in-
telligent economic decision that the time has come to sell it and
pay the tax, instead of an involuntary decision that says, uh oh,
Mr. Hughes died 10 years before we expected him to. This business
is not in shape to liquidate. But the Government said to come up
with the money, as if it were cash.
Now comment on the economic impact of saying, okay, death is
not going to be considered a taxable event. Therefore, there will be
no stepped-up basis, and whoever gets the asset by virtue of some-
35
bodys death is facing a capital gains tax on the original basis, just
as the individual would have faced it if he had survived.
That, by the way, is exactly what would happen if the asset were
given to a corporation at the very beginning when the corporation
decides to sell it, and the corporation can live for 150 years before
it decides to sell it. It pays the capital gains on the original basis.
Chairman SARBANES. I am going to have to excuse myself be-
cause of another engagement for which I am now quite far behind.
Senator Corzine will take over and conclude the hearing. But I did
not want to leave without thanking the panel for your contribution.
We really very much appreciate it. And I have looked through the
statements and obviously, a good deal of work went into these
statements as well.
This has been a fascinating session. It could go on indefinitely.
And I apologize to Senator Bennett.
Thank you all very much.
Dr. SOLOW. Since I am closer to this taxable event than any of
my colleagues
[Laughter.]
I will take the first crack at it. If it is good public policy that
unrealized gains on capital assets should escape taxation for time
periods measured in generations, in five, six, seven, eight genera-
tions, then I might agree with the direction of Senator Bennetts
comments. I do agree with him to the extent that I think it is a
little odd that death should be such an important taxable event.
I would think that a reasonable way of dealing with that, to say
that, at the very least, death is a transaction or the passing on of
assets at death is a transaction. And there is something very pecu-
liar about different treatment of someone who sells an asset 10
minutes before he or she dies and someone who forgets to do that
and holds the assets for 10 minutes more.
It would be my choice in view of the equity considerations and
the kind of society that I at least like to think of us as having, I
could be happy if the transfer of an asset at death, which is, after
all, from one person to another person, were treated as a trans-
action and what in the modern vocabulary is stepping up the basis,
or what I learned to call constructive realization of capital gains
took place. Then assets would be treated as if death constituted a
sale to heirs. By the way, not all of those heirs have to be members
of the family. They can be others.
Senator BENNETT. But it is an involuntary transaction.
Dr. SOLOW. No, it is not an involuntary transaction. That trans-
action could have taken place earlier, had anyone wanted to make
it, and might have taken place if the tax laws were different. And
not to sell something is as much a voluntary action as to sell it.
Dr. STIGLITZ. Let me just make a couple of points.
First, I think that smart businesses tend to buy insurance that
can pay the capital gains taxesthe estate taxes. So, we have a vi-
brant insurance industry, so the issue for most individuals can be
covered.
Senator BENNETT. You are assuming that the cost of insurance
is a minor issue to the business. There is a cost.
Dr. STIGLITZ. There is a cost.
Senator BENNETT. There is no cost-free way out of this.
36
Dr. STIGLITZ. But you have to understand, it is also the case that
in a competitive market, with the tax preferences associated with
the insurance industry, on average, it is not really a cost.
I really do think that the stepped-up basis is very distortionary.
It is also the case, though, that not forcing a constructive realiza-
tion in one form or another leads to this problem that is well docu-
mented, called the locked-in effect, that it discourages the turnover
of assets. And it is very important to address that issue.
I think that there are a number of ways in which one can try
to facilitate, help people who are facing the kinds of situations that
you describe.
I think that, for instance, under current law, they can, I believe,
have, if they are small businesses, extend the payments over a
number of years. I could imagine extending that more generally
with an interest charge that reflects the cost of the deferred receipt
of the Government. I do not think that is unreasonable.
Finally, in the end, I do think that, as I look at it from the point
of view of the efficiency effects, not talking about the equity. I
would make a trade-off in which I would have a step-up of basis,
constructive realization and a somewhat lowering of the estate tax
from what it was, but clearly not the elimination of the estate tax.
Senator BENNETT. We could debate this, but my time is gone.
Just one last thing. Dr. Solow, if Howard Hughes had decided to
put his initial stock in a corporation rather than in his own name,
it would have stayed in that corporation for generation after gen-
eration after generation and you wouldnt object to that because it
wasnt an individual. And the people who ran the corporation
would decide when to dispose of those assets and they wouldnt
have had the cost of any insurance firm to do it. They would make
intelligent business decisions on the disposition of the assets and
they would pay the capital gains tax when it came. You are treat-
ing individuals different than corporations.
Dr. SOLOW. I would regard that as a loophole and if I were a leg-
islator, I would consider closing that loophole.
Senator CORZINE. Okay. Let me change subjects here.
Mr. Malpass, being an old washed-up bond trader, I thought you
picked the timeframes for increases in debt associated with the rise
in interest rates at a rather interesting time. You picked the 1980s
and you apparently were picking 1982 or 1983, when we were at
the peak of interest rates and debts had continued to go on.
If you had just turned the clock back 6 years, I think we were
at very low rates, roughly where we are now, 512, 6 percent on
long-term rates. And the expectations of growing deficits took us to
13 or 14 percent, if my memory serves me correctly, about 1982 or
1983, and a clear sense at least of when I was sitting at the desk
buying and selling bonds, that supply had something to do with the
level of anticipated interest rates.
I think that those levels stayed very high throughout the 1980s.
There were some dips as people thought we were going into reces-
sions or had different problems. But I do not see that correlation
that you pointed out.
Then I wonder about the analysis even under the circumstances
that we see a little stronger economy. No one is revising down dra-
matically the kinds of changes in borrowing arrangements that we
37
are going to have over the next decade and certainly not as they
look out beyond the ending of this tax cut and the demands that
we are going to have with regard to Social Security and Medicare
and Medicaid.
I actually draw almost the opposite conclusion with regard to my
own personal experience of looking at the correlation of anticipated
debt financing relative to interest rates. It is not a one-to-one cor-
relation. But I would have a hard time explaining what happened
in the late 1970s and in the early 1980s with regard to the expan-
sion of debt.
I do not know whether you want to comment.
Mr. MALPASS. Well, there was a huge change in the value of the
dollar in the 1970s. I think what was going on in the 1970s was
a mis-estimate by the bond market of the amount of inflation that
was coming out. And so, the yields stayed low. I imagine that peo-
ple lost a lot of money being long bonds in the 1970s because there
ensued a very high inflation rate, not because of the fiscal deficit,
but because of the change in the value of the dollar and the infla-
tion that came out of it.
As I look at the graph of the 1980s, it looks to me that as the
fiscal deficit went bigger and bigger and bigger, you had a steady
decline in the 10 year bond yield falling from 10 percent in 1981
all the way down to 7 percent by the late 1980s. And then we have
the reverse process, of course, in the 1990s, as we moved toward
fiscal surplus. We actually ended up with an 8 percent interest rate
in 10 year bond yields in the year 2000. Even as we had moved
into a solid fiscal surplus, the bond yields were actually going up.
I think that was related to the growth rate that we had going at
that time.
Dr. STIGLITZ. Can I say something?
Senator CORZINE. It certainly did not stay there very long,
though. It came crashing back down to lower levels when people
thought they were going to be sustainable pay-downs in debt.
Mr. MALPASS. It is hard to find the fiscal correlation. We were
moving into a recession and we moved toward rate cuts by the Fed-
eral Reserve.
Senator CORZINE. Dr. Stiglitz.
Dr. STIGLITZ. The general point that I think you raised is that
interest rates reflect demand and supply for bonds. That is basic
economics. That demand and supply are affected by a number of
variables. In economics, we call it multivariant analysis. We do re-
gressions. Looking at one variable is likely to be misleading.
The appropriate question is, given everything else, what is the
impact of increased deficits? And viewed that way, I think it is un-
ambiguously the case that increased deficits mean that the Govern-
ment is going to have to borrow more. Reduced surpluses means
that the Government is not buying back as many bonds as it other-
wise would, the same basic story.
When that happens, the interest rates, those will be reflected in
the interest rates relative to what would have happened in the ab-
sence of that action? Lots of other things are going on in the world.
We cannot control them all. But that clearly is the dominant factor.
Senator CORZINE. There are studies out that show those correla-
tions, I take it.
38
Dr. STIGLITZ. Yes.

Senator CORZINE. We probably should cite those for the record at
some point and try to get them in because I think this is one of
those debates. It is like the estate tax that we have on a daily basis
around here.
It would be great to have some objective evidence.
I appreciate it. This is the first time I got to chair a hearing and
I will close it.
Thank you.
Dr. STIGLITZ. Thank you.
Dr. SOLOW. Thank you.
Mr. MALPASS. Thank you, Mr. Chairman.
Dr. KRUEGER. Thank you.
Senator CORZINE. This hearing is adjourned.
[Whereupon, at 12:55 p.m., the hearing was concluded.]
[Prepared statements supplied for the record follow:]
39
PREPARED STATEMENT OF ROBERT M. SOLOW
PROFESSOR OF ECONOMICS, MASSACHUSETTS INSTITUTE OF TECHNOLOGY
MARCH 12, 2002
I want to thank the Committee for the opportunity to testify today on the eco-
nomic outlook. This initial statement will be short and pointed, because I believe
that a lively discussion will get us closer to where you want to go.
The current economic situation is a living example of the reason why most econo-
mists think of monetary policy as the tool of choice for short-run economic stabiliza-
tion purposes. We have been told by the National Bureau of Economic Research that
a recession began exactly a year ago. The Council of Economic Advisers, in its An-
nual Report, seems to think that the recession began on September 12. But then,
to everyones surprise, including mine, the first revision of data for the fourth quar-
ter of 2001 showed that real aggregate output actually rose nontrivially, and gained
back everything it had lost in the third quarter. The preliminary tea leaves suggest
that the current quarter will show a further gain in real GDP, probably faster than
the quarter before.
So with maybe only one down quarter, was it worth calling this a recession? Per-
haps more to the point: Is that really the right question to ask? I think the answer
is No, and focusing on that questions leads to unnecessary confusion. There are
some good reasons to fear that the current upswing will be weak, at least for a
while. Corporate profits and business fixed investment are still falling. Unemploy-
ment will continue to rise for a while. Much of the strength in the fourth quarter
came from consumption spending, but more than half of that was on automobiles,
and thus very likely borrowed from later quarters, enticed by temporary incentives.
Europe and Japan have been stagnant or worse, and do not seem to be turning
around as rapidly as the United States. They will not be good markets for American
producers; on the contrary, they will be trying very hard to sell in the United
States. All in all, I was going to conclude that only God knows how the next few
quarters will turn out; but it may be that God has not yet decided.
In this kind of environment, it is hard to know what to do now. The Federal Re-
serve doesnt know any better than you or we do. The fundamental difference is that
the Fed can act quickly and then, if it soon changes its mind, it can reverse itself
quickly. It would be helpful if fiscal policy could be mobilized in tandem with mone-
tary policy, but you can not reverse yourself.
This lack of maneuverability in fiscal policy explains why the so-called automatic
stabilizers are so valuable; they do adapt to events, without requiring you, or any-
one, to take action. But they have been allowed to get weaker, for various special
reasons. They are not likely to be revitalized. Maybe it would be useful if you could
enact a standard stimulus package (which, worked in the other direction, could
serve as a standard cooling-off package). It could be triggered automatically by
eventsat one of several levelsor even proposed by the President, and subject to
a straight up-or-down vote. I realize that no such thing is likely to happen; maybe
you have a better idea.
There should be a more appropriate basis for making stabilization decisions than
wondering if there is or is not a recession, and when it will end. In fact, I think
it would still be a good idea to pass a stimulus package in spite of the current lack
of clarity about which way the economy is headed. I will explain why, briefly, be-
cause that may help untangle fiscal policy from the inevitable uncertainties of fore-
casting that Congress is too ponderous to deal with, unlike the Fed.
Real GDP in the fourth quarter of 2001 was only about 1 percent higher than it
was in the second quarter of 2000 when the clearly visible slowdown began. Two
years ago the unemployment rate was about 4 percent, compared with 5.8 percent
now. Capacity utilization in industry was then measured at 8384 percent, com-
pared with 7475 percent now. Suppose that early 2000 was a desirable state of the
national economy. (Some thought it was a little too prosperous for peace of mind
about inflation; but that requires only a small change in what I am about to say.)
We have to presume that the economys aggregative productive potential has been
increasing fairly smoothly since then, because that is how it usually behaves. The
Council of Economic Advisers estimates that the rate of increase of productive po-
tential is a hair over 3 percent a year. In that case, full utilization of our economys
potential this spring would entail a real GDP about 6 percent higher than current
output. By this time next year, even if the economy grows by 3 percent this year
(which is slightly faster than the Councils forecast in the Economic Report), there
will still be a 6 percent gap of unused economic potential. The gap will be larger
if the economy grows more slowly, and smaller in the opposite case.
40
That gap cannot be safely closed in a single year. The Fed would certainly fear
that an upswing fast enough to do that is fast enough to exceed the inflation-safe
speed limit, and would choke it off. But it would certainly be safe to grow fast
enough to close some of that gap. That is why I think there is still room for a mod-
est stimulus package, if you are capable of enacting a sensible one. By sensible I
mean effective, temporary, and free of partisan sacred cows. The House bill started
off as a ghastly mockery. And it has gotten better, just not enough better to be ac-
ceptable. Accelerated depreciation is not the best way to promote capital spending,
and it fails the test of being temporary.
I mention all this for a broader reason. All this talk about whether there is or
is not a recession, when did it begin and when will it end, leads to confusion be-
cause nobody knows. Anyway, it concentrates on the wrong thing. The CEA can
make approximate calculations of economic potential; in effect it already does so.
The Congressional Budget Office does something similar. Focusing on that would
force debate on the right issue, which is where we stand relative to potential, and
would provide a better guide to policy.
I should say that I am one of those who thinks the Economic Growth and Tax
Reduction Reconciliation Act of 2001 was a big mistake. Part of the surplus it gave
away has already evaporated, as we knew it would as soon as the economy weak-
ened. And we have converted the rest mostly into future consumption instead of the
future saving and investment that the country urgently needs as it looks ahead to
an aging population. You should resist any suggestion that stimulus should take the
form of advancing the date at which an ill-advised decision comes into effect.
Like most observers, I think that monetary policy has done very well in coping
with the past five quarters. Long-term interest rates have not fallen very much.
Nevertheless, if the Fed had behaved more traditionally the housing sector would
not have held up as well as it has, the auto industry would have had a harder time
providing those successful incentives, and business investment might have fallen
even faster.
Some people complain that the Fed stuck with its contractionary stance a bit too
long in 2000. Maybe it did; hindsight is usually 2020. But perfection is the wrong
benchmark against which to judge Alan Greenspan and the Federal Open Market
Committee. They are not omniscient; I have already said that they are, like the rest
of us, uncertain about what will happen next month. What distinguishes the Fed
is the flexibility with which it handled the boom of the late 1990s. If you want to
see how well they have performed, take a look at the record of the much more doc-
trinaire central banks of Japan, the U.K., and Europe.
What we have a right to hope for is that the Fed will exercise the same kind of
informed flexibility in the course of the coming upswing, whatever shape it takes.
If the recovery is indeed anemic, then the gap between current and potential output,
which is already ample, will be widening; there will be no need to move short-term
interest rates higher. Anecdote is piling up that lenders are being extra-cautious,
as a reaction to the Enron swindle. Suspicion falls especially on smaller, less well-
known companies without much of a track record, and they find it hard to get
credit. Other things equal, this state of affairs should incline the Fed toward main-
taining liquidity and credit ease. (It is this kind of circumstance that makes me sus-
picious of even a reasonable formula like the so-called Taylor rule: Why should the
central bank ignore this kind of market fact?) But if the economy picks up enough
speed, the margin of slack will narrow. In that case, we have to expect the Fed to
begin positioning itself for the inevitable palaver about soft and hard landings, and
interest rates will rise pretty quickly. Having a flexible monetary policy means
learning to live with a certain number of tentative and even reversible steps. Right
now I imagine wait-and-see is the right attitude.
All of the above was written before I saw Alan Greenspans statement to this
Committee last week. It contained no surprises, unless you count his strengthened
conviction that the third quarter of last year would be the only down quarter. At
this late date, I would not count it as a surprise.
There is only one point I would like to call to your attention. Mr. Greenspan
agrees that the upswing now launched is likely to be subdued, and he gives the
standard reasons for suspecting a slow increase. He waffles a bit, but a little of waf-
fle is justifiable. He reports that the FOMC forecast is for real output to increase
by 2.5 to 3 percent during the four quarters of 2002. That forecast is 6 weeks old,
and thus possibly already out of date. Anyway this pace is just a bit slower than
the estimate I quoted from the Economic Report that potential output is growing
at about 3.1 percent a year. The last decimal place in such estimates is not to be
taken as doctrine, of course. The underlying point is that in this scheme of things,
the gap between actual and potential output will not narrow during the rest of this
year. That is what matters, not just whether the movement is up or down. The
41
implication is that a somewhat faster path for the economy would be desirable; a
slower path definitely would not.

PREPARED STATEMENT OF JOSEPH E. STIGLITZ
PROFESSOR OF ECONOMICS AND FINANCE, COLUMBIA UNIVERSITY
MARCH 12, 2002
It is a pleasure to appear before you to provide my assessment of the outlook for
U.S. economic growth and employment and the appropriate public policies to pro-
mote those objectives. I will divide my remarks into seven sections. In the first, I
will discuss the overall prospects for the short and medium term. In the remaining
sections, I shall address specific policy concerns.
The Overall Prospects
While economists always look into the future with cloudy crystal balls, they are
particularly cloudy when it comes to forecasting turning points. The question that
is repeatedly asked is, is the recession over? I think, however, that that is the wrong
question. There is little doubt that for the past year, the economy has been per-
forming substantially below its potential. The potential growth rate of the economy
clearly improved through the 1990s, and even if the robust growth of the late 1990s
could not be sustained, there is a widespread consensus that the economy has a po-
tential for growth of between 3 to 4 percent. Taking the mid-point in that range of
3.5 percent, even a positive growth of .5 percent would represent a shortfall of $300
billion in our 10 trillion economyan enormous wastage of resources, even if we
were to ignore the tribulations imposed on those forced into unemployment. More-
over, we should remember that Americas unemployment insurance program is one
of the poorest in the advanced industrial countries. It is unconscionable that bene-
fits be terminated after 26 weeks. The argument that providing extended benefits
would attenuate search incentives is nonsense: The problem is a lack of jobs, not
the lack of job seeking. I shall return to this later.
While a great deal of pleasure is being taken in the fact that the rate of job de-
struction has been reduced, our economy needs to create a couple hundred thousand
jobs a month to just break even, to ensure that employment keeps pace with the
growing labor force. It is not a mark of success if the unemployment rate comes
down because workers have become discouraged from working, so the number of job
seekers is reduced.
Broadly, there are three types of recessionsthose associated with inventory cy-
cles, overinvestment in capital and housing, and financial crises. The current down-
turn is a combination of the first two. Some of the downturn was associated with
a decrease in the stock of inventories. There were reasons to believe that with the
New Economy, inventory cycles would be attenuated and become less important as
a source of economic volatility, as better control mechanisms kept inventories better
in control, as production methods (just in time production) reduced the required size
of inventories, and as the overall size of manufacturing in the economy declined. As
the economy nears the end of the period of inventory retrenchment, this source of
negative drag on the growth of the economy will be eliminated. This, by itself, would
suffice to bring an end to the recession; but it will not be enough to restore the econ-
omy to robust growth.
The overinvestment in certain key sectors of the economy has left an overhang,
which will take some time to redress fully. The good news is that some of these
areas are those in which technological advances have been proceeding at a rapid
pace, so that much of the old IT equipment will become obsolete relatively quickly,
before the equipment wears out, and this will help restore demand for new IT.
There are a number of other negative forces which suggest that the economy will
continue to operate substantially below its potential, and which represent a substan-
tial risk for a strong recovery.
Consumer Spending
Robust consumer spending has sustained the economy. The U.S. savings rate re-
mains dismally low, which is not good for the long-run prospects for growth. Part
of the explanation for the sustained spending is the mortgage refinancing which
resulted from the lowering of interest rates, part from the special deals that auto-
mobile dealers were offering. Given that consumption has not fallen in the way that
it does in a typical downturn, it is unlikely that an increase in consumption will
provide a strong impetus for growth in the short run. Moreover, there are several
42
reasons to believe that the forces which have sustained consumption could weaken.
(i) Mortgage rates may well rise; as it is, they have fallen far less than the short-
term interest rates have fallen, partly for reasons that I will discuss later. (ii) Simi-
larly, it is not obvious that the special deals on automobiles will continue. (iii) The
heavy indebtedness of the consumer may impose an important dampener on spend-
ing, one which will become especially important if interest rates rise. As it is, by
some estimates, consumers are spending 14 percent of their income on debt service.
(iv) If the unemployment rate is not soon brought down significantly, fears of job
security may increase, and given the poor unemployment insurance system, workers
may be induced to save as a precautionary measure. (v) One of the primary reasons
for the low savings rate is that through the nineties, households saw their wealth
increase through capital gains, even without putting aside money out of disposable
income. But with stock prices down or increasing slowly, it will gradually dawn on
consumers that their wealth is less than it once was, or than they thought. The
switch to defined contribution pension systems may exacerbate the resulting insta-
bility. Today, individuals must bear the risk of stock market fluctuations.
Capital Spending
Long-term interest rates have not come down anywhere near as much as short-
term interest rates. One of the reasons for this may be the increasing uncertainty
about the countrys long-term fiscal position, caused in part by the large tax cut,
where we seemed to be spending money before we got it. In addition, there is con-
tinuing worry about problems of valuation in the corporate sector. I served on the
SEC Commission on Valuation, which focused on the difficulties of valuation in the
new economy. While there was general recognition that old accounting principles
might be ill-suited for providing accurate pictures of the economic prospects of firms,
many on the Commission believed that the market should be relied upon. Enron and
Global Crossing confirmed the suspicions of the skeptics, and today, many if not
most investors feel high levels of uncertainty about the numbers that many corpora-
tions are reporting. This may dampen stock market prices, at least for a while.
Exports
The strong dollar and the weak international situation suggests prospects for
exports remain diminished.
Technology
A source of some concern is that the economic downturn has led many firms to
decrease significantly their investments in R&D. And investments in long-term
researchthe kind that is likely to result in productivity increases down the line
has been particularly hard hit, in ways that are hard to assess from the numbers
alone. This is likely to be one of the lingering costs of not having responded to the
economic downturn earlier, with stronger measures. (I do not include the House or
Administration so-called stimulus package among the stronger measures that would
have made a big difference.)
The one positive (from a macroeconomic perspective) is the increased military
expenditure; but such expenditures detract from resources that could be used to in-
crease long-term productivity, and hence to not contribute to the long-term strength
of the U.S. economy.
It will be noted that I have not listed the tax cut as a major positive factor. Its
net impact on the economy is in fact ambiguous. It was not designed to stimulate
the economy, and its regressive features and other elements of its design suggest
that the bang for the buck is likely to be quite low. On the other hand, the quickly
diminishing surplus (and, in some years, the emerging deficit) that resulted lead to
upward pressures on interest rates. The Fed only controls the short-term interest
rates. What firms care about far more is the longer-term interest rates that they
have to face, and the tax cut has changed the yield structure adversely, and in ways
which are quite dramatic: There has been an almost 4 percent reduction in short-
term interest rates, with less than a 25 basis reduction in some long-term interest
rates. And while this weakens the prospects for a robust short-term recovery, its im-
plications for the longer term are even more bleak.
Tax Cut
This brings me naturally to the subject of the tax cut. The tax cut was not only
ill-designed for stimulating the economy in the short run; it was also badly designed
for promoting long-term economic growth. (I put aside for the moment broader con-
cerns about equity.) There are tax reforms, for instance, that would have done far
more to promote investment in the short run with far lower budgetary costs, like
the net investment tax credit and better income averaging provisions. I strongly side
with those who believe that when one makes a mistake, one should recognize it. It
43
is not just the size of the tax cut that was a mistake, but its design. Given the pecu-
liar structure of the tax billwith provisions which expire in 10 yearsit is inevi-
table that the issues will have to be revisited. It is better that that be done sooner
rather than later.
Foreign Economic Policy
One of the sources of strength of the U.S. economy during the 1990s was in-
creased exports to emerging markets. This was partly a result of trade opening,
partly a result of the robust economy in those regions. Mismanagement of inter-
national economic policy by the IMF has contributed significantly to a worsening of
prospects. Much of Latin America today faces stagnation, recession, or depression.
As people in these countries look at the performance of their economies over the so-
called reform decade, they see growth rates that are half those that prevailed in the
much criticized pre-reform period (the so-called import substitution era), though, to
be sure, better than during the lost decade of the 1980s. There is a growing disillu-
sionment with the IMF, and with the United States, which is seen as responsible
for its policies. While there was consensus in the United States that in the face of
an economic downturn, there should be a fiscal stimulusthe debate was only over
how to design the most effective stimulusthe IMF was seen as pushing for con-
tractionary policies. The question is being asked everywhere, why? The asymmetries
associated with trade liberalization of the past have increasingly come to be a source
of resentment, and recent actions in steel have only heightened a perception of hy-
pocrisy. The European initiative of unilaterally eliminating trade barriers for the
poorest countries (Everything but arms) is one of the few positive developments,
but the United States, by failing to take corresponding actions, is increasingly losing
standing. Unless the United States does something, both to ensure that the IMF
pursues policies which are more in accord with the economic well-being of the devel-
oping countries, and especially the poor in those countries, and to ensure that there
are movements toward a more balanced trade agenda, it is hard to see a renewal
of the kind of growth in exports to these countries that has played such an impor-
tant role in our own countrys growth in the future. (There are even more important
consequences for global economic and political stability.)
We won World War II, but we also won the Peace that followed. The Marshall
Plan was not only magnanimous, but it also won lasting allies in the struggle for
peace and democracy. We stand on the threshold of winning the War against ter-
rorism, but will we win the Peace? Though the link between terrorism and poverty
is complicated, this much is clear: Unemployment and poverty, especially among
young males, provide fertile feeding grounds. The United States has neither pro-
vided aid nor trade; among the major more advanced developed countries, it is the
stingiest in providing assistance to the less developed. The contention that aid does
not work is simply wrong, and those who assert this must neither have looked at
the evidence nor gone into the field. I have seen aid work: Small irrigation projects
that double or triple the incomes of desperately poor, education projects that have
brought literacy and meaning to those who otherwise would not have had it, health
projects eradicate river blindness and other diseases that have plagued some of the
poorest countries of the world. Statistical studies at the World Bank have shown
that aid, when appropriately directly, has significant effects in increasing growth
and reducing poverty. To be sure, not every dollar of aid is well spent, but the same
thing could be said for any other category of expenditures, whether in the public
or the private sector. The Monterey meeting in Mexico on finance for development
is an occasion on which we could make a commitment both to increased assistance
and to explore innovative ways of helping the developing countries more. It is our
moral duty; it is also in our self-interest.
The continuing large trade deficit of the United States represents a potential
source of instability, not only for the United States, but also for the world. If an
objective outsider were to conduct the kind of review of the U.S. economy that is
regularly conducted for other countries around the world, the grades would be
mixed: The abysmally low savings rate, the high trade deficit, the worsening fiscal
situation. The problems are all related, and the prospects are that some could even
get worse in the short run. The reason that we have a large trade deficit, as I noted,
in part is due to the strong dollar. As in the early 1980s, a large tax cut has led
to a massive worsening of the fiscal situation. The trade deficit is simply the dif-
ference between what we invest and what we save. National savings (including pub-
lic savings) has gone down from what it otherwise would have been. The trade def-
icit would have been even worse, were it not that investment too has gone down.
But when our economy recovers, investment will increase, and with it there is a
good chance that the trade deficit will worsen. We should be clear: It is not protec-
tionist policies abroad or unfair trade practices that have caused our problems,
44
whether they get reflected in the steel industry, the automobile industry, or else-
where; it is our overall macroeconomic framework I suspect the full adverse affects
of the tax cut are yet to be felt.
Addressing the Sources of Our Current Problem
If we are to formulate policies aimed at enhancing the strength of the economy
in the middle to long run, we must understand better the sources of our current
downturn, of the massive underperformance of the U.S. economy. While every boom
comes to an end, there are lessons to each. Earlier booms and the busts that fol-
lowed taught us the dangers of inflation, and of the Fed stepping too hard on the
brakes to stop inflation. We have learned the dangers of excessive inflation; and
inflation was not the cause of the current downturn. The recession of 1991 can
ultimately be traced back to weaknesses in the financial sector, those in turn in part
to the excessive deregulation of the 1980s. I am not sure that we have learned those
lessons, or the lessons of the excessive exuberance of the late 1990s.
In some ways, it is a familiar pattern: Deregulation in a sector (here telecommuni-
cations) leading to excessive investment in that sectorin this case the problems
exacerbated by breathtaking technological developments and deregulation in the fi-
nancial sector. The GlassSteagall Act was concerned with the problems raised by
conflicts of interest. It was foolhardy to think that such behavior would not reappear
with its repeal.
At the time I served on the Council of Economic Advisers, we raised strong con-
cerns about conflicts of interest and problems in accounting standards and practices,
particularly as they related to derivatives and options. Our concerns have proved
to be on the mark. There were others who raised similar concerns. Arthur Levitt,
of course, was right in calling attention to the conflicts of interest in the accounting
firms, when they simultaneously provide consulting services. FASB called for a
changing of accounting practices to more accurately reflect the costs of options given
to executives. And I strongly agreed. The Secretary of the Treasury and the Sec-
retary of Commerce, however, violated basic principles of good governance, which
call for the independence of FASB, and intervened to squash the proposed revisions.
They succeeded.
I have devoted much of my academic life to the economics of information, and to
the consequences of imperfections of information. The proposed revisions would have
improved the quality of information. To be sure, some firms economic prospects
might have looked worse as a result, and its stock market price might have fallen
as a resultas well it should. It was inevitable that a day of reckoning would come.
Providing misleading information only delayed the day of reckoning, but worse, it
led to a misallocation of resources, as overinflated stock prices led to the excessive
investment which is at the root of the economic downturn.
Some contend that it is difficult to obtain an accurate measure of the value of the
options. But this much is clear: Zero, the implicit value assigned under current ar-
rangements, is clearly wrong. And leaving it to footnotes, to be sorted out by inves-
tors, is not an adequate response, as the Enron case has brought home so clearly.
At the Council of Economic Advisers, we devised a formula that represented a far
more accurate lower bound estimate of the value of the options than zero. Moreover,
many firms use formulae for their own purposes, in valuing stock options (charging
them against particular divisions of the firm). However, Treasury, in its opposition
to the FASB concerns, was singularly uninterested in these alternatives. I leave it
to others to hypothesize why that might have been the case.
If we are to have a stock market in which investors are to have confidence, if we
are to have stock markets which avoids the kind of massive misallocation of
resources that result when information provided does not accurately report the true
condition of firms, we must have accounting and regulatory frameworks that ad-
dress these issues. As derivatives and other techniques of financial engineering be-
come more common, these problems too will become more pervasive. While head-
lines and journalistic accounts describe some of the inequitiesthose who have seen
their pensions disappear as corporate executives have stashed away millions for
themselveswhat is also at stake is the long run well-being of our economy. The
problems of Enron and Global Crossing are part and parcel of the current downturn.
Energy Policy
There is a widespread agreement among economists that GDP does not provide
a good measure of economic well-being. We should, at the very least, take account
of the degradation of the environment and natural resources. Bad information sys-
tems can lead to bad decisionmaking (as we have seen recently in the corporate
world.) Nowhere is this more true than in energy policy. Extraction of oil and nat-
ural gases may increase our measured GDP, but it does not increase our economic
45
well-being commensurately. We should take account of the depletion of our resource
basis, and the degradation of our environment as a result of carbon emissions. An
energy policy which focuses on drain America first is not even good for long-run
national security, for it leaves us potentially more vulnerable in the future. Long
run economic growth (correctly measured) and long-run political strength both sug-
gest that we should focus more on conservation. And basic principles of economics
suggest that what is required is incentives, carrots and sticks. Why should we think
that moral suasion would be more effective in this arena than it is in any other area
of economic activity?
Social Security
I want to conclude with a few remarks about one of our long-term problems, our
Social Security program. Our Social Security program has been an enormous suc-
cess. We have brought the elderly out of poverty, and we have provided a new meas-
ure of economic security to the aged. Transactions costs are low. Improvements in
the design of the program over the years have reduced some of the unintended in-
equities, reduced any adverse effects it might have on labor supply, and increased
overall efficiency. There is still a way to go to put it on sound financial grounds.
Economics is traditionally described as the science of choice. The legacy of the
Clinton years, a huge fiscal surplus, provided us with an opportunity to make some
choices. We could have used some of these funds to put the Social Security system
on sound financial grounds. We could have fully funded the system, and we could
have then decided on how to proceed in the future. We have largely squandered that
opportunity. Proposals for partial privatization typically leave the fiscal situation of
our Social Security worse off. They do not provide additional funds to fill in the
gap; some proposals simple force current and future beneficiaries to take a cut in
benefits. Any reform proposal which does not begin by addressing the question of
how current unfunded liabilities are to be financed is irresponsible, and should be
a nonstarter.
Elsewhere, with Peter Orszag, I have described at greater length 10 myths con-
cerning Social Security that have been widely circulated. One that has recently re-
ceived considerable attention is the low return on Social Security accounts. We
should be clear: Social Security funds are invested well, but conservatively. To the
extent that capital markets work efficiently, then any higher returns that might be
received would simply reflect the higher risk. It is imprudent for those approaching
retirement to invest all, or even most, of their assets in high-risk investments. If
there were a decision to undertake greater risk, the public Social Security system
could do so, again at low transaction costs. (The transaction costs in the privatized
part of the British system have been estimated to reduce benefits by 40 percent
from what they otherwise would have been!)
Part of the reason that in partial pay-as-you go Social Security systems, it ap-
pears that returns are low is that some of the returns are used to bear the costs
of the unfunded liabilities. The problem of funding those unfunded liabilities does
not go away with partial or complete privatization. It will have to be borne else-
where. To assess the merits of any reform proposal, therefore, one must know how,
and who, will bear these costs. To do otherwise is dishonest. It may put in jeopardy
the long-run prospects of our economy, for a day of reckoning will come.
Concluding Remarks
I continue to believe that the basic fundamentals of the U.S. economy remain
strong. But I have seen the fortunes of countries change quickly, as a result of eco-
nomic mismanagement. The decisions, the choices, we make today will affect not
only economic performance during the next year, but also our long-run prospects.
I believe that the tax cut that was enacted last spring was based on a serious mis-
calculation of our economic situation. It is a decision which, however, is reversible.
If we do not revisit the issue, in the light of the new information which has come
to light and the new situation which has evolved, the damage which could be done
may itself be irreversibleor at least it will take a long time to undo. It will take
political courage. Much is at stake.
46
PREPARED STATEMENT OF ALAN B. KRUEGER
BENDHEIM PROFESSORSHIP IN ECONOMICS AND PUBLIC AFFAIRS
PROFESSOR OF ECONOMICS, PRINCETON UNIVERSITY
MARCH 12, 2002
Good morning, Mr. Chairman and distinguished Members of the Senate Banking,
Housing, and Urban Affairs Committee. My name is Alan Krueger and I hold the
Bendheim Professorship in Economics and Public Affairs at Princeton University. I
appreciate the opportunity to share my views on recent economic developments, par-
ticularly as they relate to the labor market.
The Labor Market Situation and Short-Term Outlook
Although some debate the exact meaning of the subjective definition commonly
used to define a recession, there is little doubt that the labor market started to turn
down in the beginning of 2001, and that March 2001the official beginning of the
recession according to the National Bureau of Economic Researchmarked a turn-
ing point. After reaching a 30 year low of 3.9 percent in April 2000, the unemploy-
ment rate fluctuated in a narrow range between 3.9 and 4.1 percent for the remain-
der of 2000, amid signs that economic growth was weakening.1 The unemployment
rate increased from 4.3 percent in March 2001 to 4.9 percent in August 2001, and
reached a recent peak of 5.8 percent in December 2001. The rate fell to 5.6 percent
in January and fell again in February to 5.5 percent.
Because, other things being equal, the unemployment rate increases when the
discouraged workers decide to actively search for work, economists often prefer to
examine employment growth from the establishment survey, and the employment-
to-population rate from the household survey, in addition to the unemployment rate.
These data tell a similar story. The employment-to-population rate reached an all-
time high of 64.8 percent in April 2000, stood at 64.3 percent in March 2001, and
fell to 63.4 percent as of August 2001. The employment rate continued to fall to 62.6
percent in January 2002, and increased to 63.0 percent in the latest employment
report, which pertains to February 2002. Unlike the unemployment rate, the em-
ployment rate fell in January 2002, suggesting that the improvement in the un-
employment rate that month resulted from labor force withdrawal rather than an
increased rate of job finding. In February, the small decline in the unemployment
rate and the rise in the employment rate both pointed in the same direction.
Total payroll employment peaked at 132.7 million jobs in March 2001, and was
down to 132.4 million in August 2001. It fell to 131.2 million in January 2002, and
increased by 66,000 in February, an amount that is close to the average monthly
absolute revision to the series. (The January and February figures are preliminary
and subject to future revisions.) In the 11 months since March 2001, the month the
recession began, total employment has fallen by 1.4 million jobs. Private sector em-
ployment is down by 1.8 million jobs in this period. By comparison, 11 months after
the 1991 recession began, private sector employment was down 1.5 million jobs, and
total employment was also down 1.5 million jobs. So, looking over a comparable
interval, job destruction was somewhat greater in the private sector in the latest
recession than in the previous one. Employment continued to drift downward after
the recovery began in March 1991, and reached bottom in February 1992, with pri-
vate sector employment down a total of 1.8 million jobs from the peak and total em-
ployment down 1.6 million from the peak.
The latest GDP news suggests that the economy began to turn around late in
2001 and that the recession likely has ended. I think it will take more months of
data before one can reach the conclusion that the labor market has reached bottom
and is on the upswing, however. I also suspect that employment growth will remain
sluggish for a time to come, especially for the less skilled. Employment and unem-
ployment tend to be lagging indicators when the economy begins to improve. This
point was made by Alan Greenspan in his prepared testimony before the House
Committee on Financial Services on February 27. Even if the economy is on the
road to recovery, he said, the unemployment rate, in typical cyclical fashion, may
resume its increase for a time.
Historically, the lingering effects of high unemployment in the first stages of a
recovery tend to be concentrated among the less skilled and minorities. This seems
to be the case despite the fact that recessions are becoming more egalitarian in
terms of who they affect.
Such a pattern was clearly evident in the early 1990s. When the recession offi-
cially ended in March 1991, the unemployment rate was 6.8 percent. The rate con-
1 All reported estimates are seasonally adjusted, unless stated otherwise.
47
tinued to rise for another 15 months, however, and did not settle below 6.8 percent
again until the end of 1993. Moreover, the unemployment rate rose from 12.3 to
13.5 percent for high school dropouts in the year after the recession ended, while
for college graduates it held steady at 2.9 percent. The jobless recovery mainly in-
volved the less skilled.
The current recession started out in a very unusual fashion. As the following table
makes clear, from March to July of 2001, unemployment rose more for college grad-
uates and those with some college education than it did for high school dropouts.
Since July, however, unemployment has increased more for high school dropouts
and high school graduates than for more highly educated workers, as is the usual
pattern in a downturn. It is also worth noting that the unemployment rate ticked
up for those with a high school degree or less last month, despite falling overall.
Table 1: Seasonally Adjusted Unemployment Rate by Education
Age 25 and Older
Education March 2001 July 2001 February 2002
Less than High School ............... 6.8 percent 6.8 percent 8.3 percent
High School ................................. 3.8 percent 4.1 percent 5.3 percent
Some College ............................... 2.7 percent 3.1 percent 4.1 percent
BA or higher ............................... 1.9 percent 2.2 percent 2.9 percent
Source: Bureau of Labor Statistics.
A similar picture holds by race. From March to July of 2001 the unemployment
rate increased from 3.7 to 4.1 percent for whites, and, uncharacteristically, fell from
8.4 to 8.1 percent for blacks. From July 2001 to February 2002, however, the rate
increased from 8.1 to 9.6 percent for blacks, and increased more moderately, from
4.1 to 4.9 percent, for whites. The unemployment rate for Hispanics was also
uncharacteristically stable in the beginning of the recession (standing at 6.2 percent
in March and July), and then increased sharply to 8.1 percent by January 2002, be-
fore quixotically falling by a percentage point in February.
The broad nature of the first phase of the latest recession came as a surprise, but
is consistent with the more-than-usual egalitarian tilt to the early 1990s recession,
and probably resulted from the plunge in capital investment that apparently precip-
itated the downturn, the implosion of many dot-coms, and the fact that the cyclically
sensitive manufacturing sector is much more skill intensive than it was 20 or 30
years ago. In any event, it is likely that the egalitarian phase is over.
There are many theoretical reasons to suspect that job growth would be slow at
the beginning of the recovery.
First, at the beginning of a recovery employers are not sure if improved conditions
will persist, so they expand work hours rather than hire new employees.
Second, many employers also hoard skilled workers (for example, particularly
those with specific training) during a recession because if they let them go it would
be costly to hire and train replacements when conditions improve. Neither of these
reasons, however, accounts for why job growth is particularly sluggish for the less
skilled when the economy begins to turnaround, which seems to regularly occur. In
fact, because of labor hoarding of skilled workers one might expect that employers
are relatively overstaffed with skilled workers when the recession ends, and would
therefore be less likely to hire skilled workers.
Third, as Melvin Reder suggested in a 1955 article, in a downturn many employ-
ers raise skill requirements for a given job, rather than cut pay.2 Upskilling of po-
sitions is common in a recession and probably at the beginning of a recovery as well.
Consequently, the less skilled find their job options even more limited until demand
picks up smartly, while skilled workers take positions further down the job ladder.
Finally, Lawrence Katz of Harvard suggests another reason: Think of a recession
as a time when firms reorganize. Reorganization tends to increase demand for
skilled workers, who are more flexible, over less skilled workers. Furthermore, when
companies introduce new technology as part of a reorganization they tend to hire
skilled workers to operate the equipment and release unskilled workers whose jobs
are made redundant.
To some extent, the lingering pattern of unemployment, especially among the less
skilled, after growth resumes is probably inadvertently reinforced by interest rate
cuts by the Federal Reserve. With a lag, rate cuts stimulate demand for new capital
2 See Melvin W. Reder, A Theory of Occupational Wage Differentials, American Economic

Review 45(5), 1955, pp. 83352.
48
and consumer durables. But this is a two-edge sword for workers. On the one hand,
a general rise in economic activity increases the demand for all factors of produc-
tion, including workers. On the other hand, because machinery is cheaper than it
used to be, in many industries companies replace some workers with machines, or
hire fewer workers than they otherwise would have, because the machines can do
the work at lower cost.
Also notice that capitalespecially high-tech equipmentand skilled labor are
generally considered complementary inputs in production, while capital and un-
skilled workers are substitutes.3 In other words, high skilled workers are hired to
operate and service the new machines, while less skilled workers are let go because
the machines can do their work.
This leads me to the conclusion that the best way to avoid another jobless recov-
ery is by stimulating demand for less skilled workers and by raising the skills of
the unemployed. I think the interest rate cuts and the recently passed accelerated
depreciation allowance will stimulate demand for more highly skilled workers. In
looking forward, I would recommend policies that would increase employment of less
skilled labor, such as job training.
Another important aspect of the labor market concerns wages. Table 2 (at the end
of this testimony) reports real hourly wages by decile of the wage distribution each
year since 1973 based on Current Population Survey Data.4 As is well-known, real
wages fell considerably for lower paid workers from 1979 to the mid-1990s. (This
table uses the BLSs new research series CPI to deflate wages, so the decline in real
wages in the 1980s was not as great as it is with the conventional CPI deflator.)
Real wage growth was very strong after 1996, however. Notably, most of the ground
that was lost for those at the bottom in the 197995 period was regained in the last
5 years. The weakest wage growth in the last decade was for those in the middle
of the distribution, a phenomenon that I previously called the sagging middle.
Most research finds that real wages have moved slightly procyclically since 1970,
although I agree with Katharine Abraham and John Haltiwanger that the cycli-
cality of real wages is not likely to be stable over time. 5 The exceptionally low un-
employment in the late 1990s, combined with two minimum wage increases,
spurred the impressive wage growth in the second half of the 1990s, especially for
the least paid workers.6 In the latest downturn, nominal wage growth slowed down,
but inflation slowed even more, so real wages continued to grow.7 This factor has
probably bolstered consumer spending, which was surprisingly robust during the
downturn.
A rising tide continues to lift all boats, and the late 1990s provides ample evi-
dence that strong economic growth greatly helps all segments of society. But the
effect of a rising tide on employment does not appear to occur immediately. In the
early 1990s, weak employment growth lingered long after the national economic
tide began to rise. Moreover, research suggests that a given change in economic con-
ditions has a more gradual effect on labor demand in a recovery than in a reces-
sion.8 As Edward F. McKelvey, a Senior Economist at Goldman Sachs observed after
the latest unemployment report, It would be premature to say that there is going
to be heavy net hiring soon.
Unemployment Insurance
Because I expect unemployment to linger at relatively high levels in the beginning
of the recovery, I think it is important and appropriate that last week both Houses
of Congress passed, and the President signed, a bill to extend unemployment insur-
ance (UI) benefits for an additional 13 weeks.
But I think recent history highlights the importance of making additional reforms
to make unemployment insurance a more efficient and more effective automatic sta-
bilizer. First, the automatic triggers that temporarily turn on extended benefits
3 For a survey of evidence on capital-skill complementarity, see Daniel Hamermesh, Labor

Demand, Princeton University Press, 1996. For evidence on high-tech equipment and skill up-
grading see David Autor, Lawrence Katz, and Alan Krueger, Computing Inequality: Have
Computers Changed the Labor Market? Quarterly Journal of Economics, 113(4), November
1998, pages 11691213.
4 These data were kindly provided by Jared Bernstein.
5 Abraham, Katherine and John Haltiwanger. 1995. Real Wages and the Business Cycle.
Journal of Economic Literature 33, no. 3, pp. 121564.
6 See, e.g., Lawrence Katz and Alan Krueger, The High-Pressure U.S. Labor Market of the
1990s, Brookings Papers on Economic Activity. 1999:1, pp. 187.
7 See Jared Bernstein, What Drove Low Wages Up in the 1990s? Mimeo., Economic Policy
Institute, 2002.
8 See James R. Hines, Hilary Hoynes, and Alan B. Krueger. Another Look at Whether a Ris-
ing Tide Lifts All Boats, The Roaring Nineties: Can Full Employment Be Sustained, edited by
Alan B. Krueger and Robert Solow, New York: Russell Sage and Century Fund, 2001.
49
without Congressional action should be set at more realistic levels. The State trig-
gers are connected to the insured unemployment rate; that is, the fraction of covered
workers who receive benefits. The insured unemployment rate must exceed 5 per-
cent for extended benefits to be provided, and must be 120 percent above the rate
in the corresponding period in each of the prior 2 calendar years. Because insured
unemployment has drifted down relative to the BLSs total unemployment rate, and
because the natural rate of unemployment has declined, it is very unlikely that a
State will automatically trigger extended benefits. In practice, the automatic trig-
gers have become beyond reach, and we rely on Congress to vote for extended bene-
fits during a downturn.
It should not be necessary for Congress to have to agree to ad hoc extended UI
benefits when it is clear that the economy has deteriorated in a specific region. Real-
istic automatic triggers would be much more expedient and more efficient. Funds
would be saved if extended benefits were more closely targeted to specific States ex-
periencing severe economic distress, rather than applied nationwide. Furthermore,
if extended benefits turned on more quickly in contracting areas, consumption would
be smoothed and the downturn would be less severe.
Second, the financing of UI could do more to stabilize the economy and discourage
layoffs. To pay for benefits, the UI system builds up reserves during prosperous
times and draws them down during slack times. A common measure of the health
of trust funds is the reserve ratio: The ratio of accumulated trust fund balances to
annual payroll. A higher reserve ratio provides more protection in an economic
downturn.
Unfortunately, the UI reserve fund in several Statesmost notably, New York
and Texaswere quite low even before September 11.9 Phillip B. Levine, an econo-
mist at Wellesley College, calculates that to remain solvent through a severe reces-
sion, like the one experienced in the early 1980s, unemployment insurance funds
would require a reserve ratio of at least 1.25 percent.10 Using this standard, 16
States were at risk of insolvency in a severe recession based on their reserve funds
as of the first quarter of 2001. In New York the reserve ratio was 0.28 percent and
in Texas it was 0.22 percent.
This predicament arose because many States did not build up their funds during
the 1990s, and because experience ratingthat is, the extent to which a businesss
payments increase with its past record of laying off workersis poorly implemented.
If the funds become insolvent, they will borrow from the Federal Government at
close to market rates, and probably tighten eligibility standards to stem the short-
fall. I would recommend considering that the States be required to implement real
experience rating and maintain ample fund balances within 3 years (for example,
after the economy improves sufficiently). This would shore up the long-run financing
of the State programs. In addition, a study by Phillip B. Levine and David Card
of U.C. Berkeley estimates that the unemployment rate would decline by six-tenths
of a percentage point if industries were fully experience ratedthat is, if employers
in an industry were required to pay the full additional costs of unemployment bene-
fits for layoffs in that industry.11
The Federal Government sets minimum standards for State unemployment insur-
ance programs and has a history of encouraging experience rating. This is a unique
aspect of the American system of UI, and may in part help to account for the
relatively low unemployment in the United States compared to other economically
advanced countries. Better experience rating could be accomplished by increasing
the 5.4 percent maximum tax rate on high-layoff employers, and by requiring the
States to have at least 10 different rates. Some States currently only have two rates:
0 or 5.4 percent. In addition, I would recommend that the per employee taxable
earnings capwhich range from $7,000 to $10,000 in most Statesbe raised, which
would allow better experience rating at lower tax rates and make the financing of
the program less regressive. Raising the caps and lowering the rates would also in-
crease demand for less skilled workers. Improved experience rating would discour-
age employers from laying off workers, and help to internalize the externalities lay-
offs impose on society.
Third, unemployed workers who are otherwise eligible for UI but are searching
for a part-time job (that is, because of family obligations) are ineligible for benefits
in most States. These workers pay into the system, but they are prevented from
9 See Alan B. Krueger, Economic Scene; Now is the time to reform unemployment insur-
ancebefore it is really needed. The New York Times, January 4, 2001, p. B2.
10 Phillip B. Levine, Cyclical Welfare Costs in the Post-Reform Era: Will There Be Enough
Money? Mimeo., Wellesley College, December 28, 2000.
11 David Card and Phillip B. Levine, Unemployment Insurance Taxes and the Cyclical and
Seasonal Properties of Unemployment, Journal of Public Economics, vol. 53, February 1994.
50
receiving benefits. States could be required to expand eligibility. Workers who would
be made eligible for UI benefits as a result of this reform would be primarily single-
parent, female, and low-income workers.
I realize that Congress is likely to be reluctant to make additional changes to UI
having just voted to expand benefit payments, but perhaps a commission could be
established to study longer-term issues in UI, including the automatic triggers,
financing, and eligibility requirements of the State programs.
Conclusion
Since the summer of 2001 the downturn has looked more like a typical downturn,
with the labor market softening more for the less skilled and minorities than for
highly educated, white workers. Recessions typically last longer and are more severe
for the less skilled and minorities. Job growth early in a recovery is typically weaker
for these groups as well. My guess is that the typical pattern will continue in the
near future, but I have to confess a great deal of uncertainty as the recession ini-
tially was unusual in terms of the breadth of groups of workers affected. Addition-
ally, the temporary help sector is much larger than it was in the early 1990s, and
it is possible that employment adjustment over the business cycles will be quicker
because the option of hiring from temporary help firms enhances labor market flexi-
bility.12 If this is the case, employment growth on the upswing may not lag eco-
nomic growth as much as it has in the past. Nevertheless, it is probably more likely
than not that higher unemployment will linger for less skilled and minority workers
in the beginning of the recoveryand such a process has already begun if the reces-
sion ended in the fourth quarter of 2001.
To have a balanced recovery I would argue that policy has to be balanced as well.
Fiscal and monetary policies are in place to lower the costs of capital and stimulate
growth. Because of the phenomenon of capital-skill complementarity, this will likely
increase demand for employment of skilled workers and reduce demand for employ-
ment of less skilled workers in the future. Policies are also in place (that is, ex-
tended UI benefits) to maintain consumption. To the extent that further policy ini-
tiatives are sought to stimulate job growth, I would expect that policies geared to
stimulate demand for hiring less skilled workers would be most effective. Such poli-
cies could include job training, the Targeted Jobs Tax Credit, and a temporary re-
duction of payroll taxes. But I think it is also important to recognize that there will
be pressures on the Federal budget as the baby boom cohort retires because of Medi-
care and Social Security commitments, so policies to address short-run cyclical ad-
justments should be careful not to weaken the long-run budget outlook.
12 See, e.g., Lawrence Katz and Alan Krueger, The High-Pressure U.S. Labor Market of the
1990s. Brookings Papers on Economic Activity. 1999:1, pp.187.
51
Table 2: Real Hourly Wages by Decile of the Wage Distribution
(2000 Dollars)DECILE:
Year 1 2 3 4 5 6 7 8 9
1973 .... $6.03 $7.28 $8.65 $10.06 $11.53 $13.23 $15.36 $17.57 $22.07
1974 .... 5.96 7.15 8.49 9.83 11.26 12.96 15.02 17.31 21.84
1975 .... 5.80 7.09 8.38 9.72 11.27 13.13 14.86 17.31 21.86
1976 .... 6.25 7.26 8.44 9.76 11.34 13.20 15.13 17.59 22.11
1977 .... 6.18 7.16 8.36 9.72 11.40 13.09 15.19 17.95 22.02
1978 .... 6.27 7.40 8.62 10.05 11.77 13.50 15.59 18.42 23.09
1979 .... 6.55 7.47 8.77 10.32 11.68 13.53 16.00 18.65 22.90
1980 .... 6.19 7.32 8.59 9.97 11.55 13.43 15.59 18.47 22.62
1981 .... 6.29 7.17 8.54 9.76 11.26 13.31 15.52 18.30 22.66
1982 .... 6.06 7.06 8.44 9.82 11.44 13.35 15.72 18.52 22.93
1983 .... 5.87 6.93 8.27 9.69 11.38 13.27 15.89 18.41 23.29
1984 .... 5.74 6.97 8.22 9.67 11.45 13.31 15.78 18.78 23.64
1985 .... 5.65 7.04 8.28 9.70 11.56 13.47 15.69 18.92 23.44
1986 .... 5.64 7.21 8.52 10.05 11.78 13.83 16.19 19.13 24.17
1987 .... 5.62 7.15 8.55 10.12 11.78 14.01 16.13 19.17 24.62
1988 .... 5.63 7.10 8.50 10.12 11.71 13.92 16.22 19.35 24.81
1989 .... 5.62 6.99 8.38 10.02 11.64 13.60 16.18 19.35 24.44
1990 .... 5.70 7.06 8.47 9.98 11.63 13.48 15.99 19.24 24.55
1991 .... 5.81 7.12 8.49 9.93 11.69 13.52 15.92 19.11 24.69
1992 .... 5.79 7.05 8.43 9.85 11.78 13.45 15.93 19.24 24.33
1993 .... 5.76 7.03 8.42 9.89 11.68 13.67 16.09 19.41 24.70
1994 .... 5.70 6.96 8.27 9.70 11.47 13.51 16.05 19.54 25.12
1995 .... 5.68 6.95 8.30 9.77 11.37 13.46 16.04 19.42 25.09
1996 .... 5.65 7.00 8.38 9.78 11.31 13.36 16.09 19.45 25.16
1997 .... 5.84 7.21 8.50 9.90 11.58 13.58 16.14 19.66 25.57
1998 .... 6.16 7.44 8.71 10.36 11.91 14.00 16.65 20.07 26.31
1999 .... 6.25 7.60 9.01 10.44 12.27 14.40 17.01 20.60 26.92
2000 .... 6.31 7.77 9.08 10.51 12.26 14.51 17.19 20.91 27.50
2001 .... 6.51 7.85 9.36 10.73 12.52 14.65 17.46 21.14 28.25
Source: Economic Policy Institute analysis of CPS data.
Note: Hourly wages were deflated by the BLS Research Series CPI deflator.
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S. HRG.

THE U.S. ECONOMIC OUTLOOK

THE CURRENT ECONOMIC OUTLOOK IN THE SHORT- AND LONG-TERM;

MARCH 12, 2002

U.S. GOVERNMENT PRINTING OFFICE

For sale by the Superintendent of Documents, U.S. Government Printing Office

TUESDAY, MARCH 12, 2002

TUESDAY, MARCH 12, 2002

dent Kennedy. Jim Tobin was a Member of that Council, perhaps

There is a problem with fiscal policy. It takes too much time to

I realize that wont happen. I know that. But it is what would

I want to say just one last sentence: As I read Alan Greenspans

I note that the one positive from a macroeconomic point of view

leaving it to footnotes to be sorted out by investors is not an ade-

We should take account of the depletion of our resource base and

Let me conclude by saying that I continue to believe that the

uates, the unemployment rate increased from 1.9 to 2.2 percent.

somewhat optimistic that if the recession was more severe, fiscal

Let me conclude by saying that I think this is a time to think

And I will go into that in a moment.

The bar graph in my statement shows the size of the miss by

Chairman SARBANES. Well, thank you very much.

and the unemployment rate. We are forced to rely on help-wanted

produce high returns, and he has enough experience to pick, he be-

I do not want to downgrade the importance of real estate as an

The econometrics, the statistical evidence shows that over the

The 2 percent a year is a little less than we got between 1950

if we really had a sizable surplus, to begin thinking about the

I do think in terms of the economic impacts, there would be im-

This is primarily a matter of equity. There is no danger that

going to get in 5 years. The evidence in this particular episode is

Dr. STIGLITZ. Yes.

1 All reported estimates are seasonally adjusted, unless stated otherwise.

Education March 2001 July 2001 February 2002

2 See Melvin W. Reder, A Theory of Occupational Wage Differentials, American Economic

3 For a survey of evidence on capital-skill complementarity, see Daniel Hamermesh, Labor

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