Transcripts of the monetary policymaking body of the Federal Reserve from 2002–2008.

Thank you, Mr. Chairman. We seem to be entering phase 2 of the fight against the downturn. Phase 1 involved bringing in all the fire trucks—fiscal expansion, monetary accommodation, and language such as “considerable period.” The fire is out now, the economy is growing at a healthy rate, and the pattern of vigorous growth is spreading throughout the economy. Earlier, most of the strength involved household and government spending; now the strength has broadened to investment and exports. It is not inevitable but fortunate that inflation has stayed very low in this expansion, and it is still bumping along the bottom edge of our target range and pointing down in its most recent numbers. On the other side, we are just beginning to hear talk of new asset bubbles such as we discussed previously. In these circumstances, to bring this all together I personally think it is time for policy to start pulling back the fire trucks gradually. For monetary policy, we should start unwinding our rhetoric by moving toward a more flexible set of words. We can deal with interest rates later on.

Fiscal policy should do likewise. Now, I’m talking here about the general fiscal outlook. Larry Slifman discussed a chart earlier today that shows one period of sharp decline in fiscal impetus, but in general the trend is for a series of large deficits. Making the Administration’s preferred assumption that the tax cuts will be extended, the CBO declared two days ago that the outlook is for a $300 billion yearly deficit as far as the eye can see. A former colleague, Alice Rivlin, is convening a Brookings conference that has the deficits rising to twice that level. These numbers are much too large, and we should gradually be removing the fiscal fire trucks as well. Not doing so will drain funds from capital formation, waste tax revenues on excessive interest costs, and put the country in poor shape to deal with the upcoming retirement crunch stemming from aging baby boomers.

There is an interesting, if difficult to understand, impact on the foreign side. Under the normal Mundell–Fleming model, gradual fiscal tightening should lower the dollar and lead to a gradual reduction in our current account deficit. Part of that has actually happened. There has been a dollar reduction that according to the Greenbook has resulted in a current account deficit that is smaller by a percentage point of GDP than it would otherwise have been. But the current account deficit is still very large—5 percent of GDP through the Greenbook horizon and possibly even larger beyond that horizon. The net external debt implied by all of this—it was zero as late as 1985—is 25 percent of GDP right now, and it could easily be as high as 40 percent of GDP in three years. We are putting a lot of dollar instruments on the international markets, and it’s reasonable to ask who is going to hold them all. So far, the Asian central banks have been huge buyers and are now holding more than a trillion dollars of foreign exchange reserves, largely in dollar form. They seem to be motivated more by the desire to keep their exports competitive than by traditional rate-of-return considerations. As other currencies bear the brunt of the adjustment, it is not impossible that this kind of behavior will spread to other central banks. Suppose many of the world central banks gang up to support the dollar. Can they pull it off? I don’t know. We know that it is physically impossible for central banks to intervene indefinitely to support their own currencies, but they may be able to keep printing money to support some other currency. The question is whether they will exhaust their ability to sterilize these interventions and whether this monetary expansion ultimately will lead to rapid inflation.

We’re into the realm of unfamiliar economics, a realm that we have visited often since I’ve been on the Board. [Laughter] Is such intervention desirable? To me the answer is clearly “no.” If the support just goes on for a finite period, the central banks are overriding the normal exchange rate adjustment process. The current account deficit remains too high, too much external U.S. debt is being created, and inevitable adjustments only become more difficult down the road. The world economy would be better off with small and gradual adjustments now. In the limiting case, where the support goes on forever, one must be less definitive; but as I just said, I seriously question whether this limiting case is possible. Politicians have an old saw called the law of holes, which says that, when in a hole, the first thing to do is to stop digging. I think the world macroeconomy would be a safer place if the economic authorities around the globe would follow this rule. The United States should be gradually tightening its fiscal policy. Foreign central banks should get out of the business of export promotion, finding domestic ways to stimulate their economies if necessary. The Fed can, and I trust will, pull back its fire truck; but now is the time to pull back all the fire trucks.

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