Archive Press Releases

TESTIMONY

TO

THE HOUSE COMMITTEE ON BANKING AND

FINANCIAL SERVICES

JANUARY 30, 1998

DR. LAWRENCE CHIMERINE
SENIOR VICE PRESIDENT AND CHIEF ECONOMIST
ECONOMIC STRATEGY INSTITUTE

My name is Lawrence Chimerine. I am Senior Vice President and Chief Economist at the Economic Strategy Institute in Washington, D.C. I am pleased to testify before the Committee on Banking and Financial Services on the economic and financial crisis in Asia.

In sum, my views are as follows:

• While many factors have combined to cause the crisis which is engulfing much of Asia, including shoddy banking practices, excessive reliance on debt (especially short term debt) to finance long term investment, currencies which became overvalued because they were tied to an appreciating U.S. dollar, etc., these are all part of a bigger force, namely that most Asian countries are simultaneously pursuing export-led growth strategies. In virtually all cases, macro and micro economic policies, and other elements of their economies, are structured to produce high levels of domestic investment, largely to support a high and rising level of exports. Unfortunately, the rest of the world, especially the United States, which is the only truly open economy, is not large enough to absorb all of these exports. The resulting overcapacity has created many of the problems that now exist in the Far East.
• While the crisis in Asia will generate spillovers onto the U.S. economy, principally in the form of a sharp increase in the already huge and persistent U.S. trade deficit, it is not likely to cause a downturn in the U.S. This reflects the fact that most other fundamentals, including the forces which drive consumer spending, interest rates, inventory levels, etc., remain favorable. However, many industries, particularly capital goods producers that are significant exporters to Asia, and industries which compete with imports from Asia, will be significantly impacted. Pricing pressure is also likely to reduce the growth in profits throughout the economy, and losses in Asia will likely hurt profits in the banking industry. Furthermore, it should be noted that the risks are on the downside – weaker than expected economic conditions in Asia could cause larger negative effects on the U.S. economy.
• I believe that properly structured International Monetary Fund (IMF) financial assistance packages are essential to stabilize the Asian situation in the short term, and to help prevent a recurrence in the future. A "good" bailout would reduce the spillovers onto the U.S. and the global economies, reduce the risk of substantial social unrest in Asia, and reduce the risk of international tensions.
• The conditions attached to IMF support should adhere to the following guidelines:

  -the old, cookie cutter approach should be modified to take into account specific conditions on a country-by-country basis;

  -they should aim to stabilize, and even strengthen, many Asian economies in the short term, rather than exacerbate current economic weakness;

  -they should, to the extent possible, produce shared burdens;

  -most importantly, they should include long term structural reforms that would move these countries away from excessive dependence on exports. These reforms include market opening, deregulation, banking reform and tax policies designed to stimulate consumption.

• It is vital that both Japan and China play major roles in dealing with the crisis in Asia. Japan should not only stimulate its economy, and deal with its banking problems, but should aggressively introduce policies that would lower extremely high domestic consumer prices in order to substantially raise consumption in the long term. China should not devalue its currency because this would likely lead to additional currency weakness in other Asian countries, and cause more instability.

• U. S. policy measures should include the following:

-Approve funding for the IMF, assuming that IMF bailouts are consistent with the guidelines laid out above.

-Do everything possible to encourage Japan to make the structural and economic changes necessary to stimulate higher levels of consumer spending.

-Make it clear to China that any currency devaluation would risk its accession to the WTO.

-Gear macroeconomic policy towards improving U.S. competitiveness by increasing funding for selective trade and competitiveness oriented programs, and running budget surpluses to the extent possible to keep interest rates down.

-The Federal Reserve should not only refrain from raising interest rates, but, given the high level of real short term interest rates, and the extremely low probability of any acceleration in inflation any time in the foreseeable future, should cut interest rates at the earliest opportunity.

CAUSES OF THE ASIAN CRISIS

The causes of the current problems in Southeast Asia, and the rest of Asia, have been much discussed. While they vary somewhat from country- to- country, in general they include the following:

Overvalued currencies - In hindsight, it is now clear that many of the Asian currencies became significantly overvalued in recent years, reflecting several events. First, the Chinese yuan was devalued by nearly 50 percent in 1994, giving China a significant competitive advantage relative to countries such as Thailand and Malaysia, which are among its major competitors in global markets for many products. Second, many of these currencies have been tied to the dollars; the sizable appreciation in the value of the dollar against virtually all major currencies in recent years has caused a further overvaluation in Asian currencies. Finally, the Japanese yen has been extraordinarily weak -- many Asian countries, most notably Korea, compete aggressively with Japanese companies in industries such as semiconductors, consumer electronics, autos, etc.. The net effect is that many of the emerging Asian countries began to suffer a loss of competitiveness as a result of the overvaluation of their currencies, causing slowing exports and rising trade imbalances.

Weakness of the Japanese Economy - The long period of economic stagnation in Japan has had a major impact throughout Asia. In particular, it has caused additional weakness in the exports of many Asian countries, since Japan is a significant market for many of them.

Poor Banking Practices - It is also now clear that the banking systems in most Asian countries are captives of governments and large corporations - - this so-called "crony capitalism" has resulted in a huge number of loans, primarily to large industrial corporations and commercial real estate developers, that would not pass the tests of risk assessment and expected returns, under normal banking practices. The result has been a huge accumulation of nonperforming loans, which is not only threatening the solvency of the banking system in many Asian countries, but is now sharply curtailing the availability of new credit, which in turn is acting as another drag on economic activity.

Widespread Overcapacity- The resulting overinvestment in industrial capacity and commercial real estate has created huge overcapacity in many Asian countries. This is not only causing widespread bankruptcies, but is exacerbating the weakness in the banking systems.

While these may be among the specific triggering events of the Asian crisis, they are all part of a much bigger problem. The fact is that, to one degree or another, virtually every Asian country has been attempting to grow primarily through exports, in many cases directly patterning themselves after the Japanese model which created rapid growth in Japan during the 1960’s, 1970’s and 1980’s. Thus, virtually all of the emerging countries in Asia have adopted tax, macroeconomic, and other policies designed to hold down consumption and generate a high level of personal savings; to funnel most of these savings through the banking system; to encourage banks to channel these savings into loans to corporations in order to finance the building of new capacity in a wide range of manufacturing industries to support higher levels of exports; to encourage foreign investment and lending to further support industrial capacity expansion; and to protect domestic industries from foreign competition. The fundamental problem, however, is that while one or even a few countries can be successful with such a strategy, it has now become clear that the rest of the world, particularly the United States, is not large enough to absorb all of the exports from all of these countries at the same time. In fact, it is now obvious that many Asian countries are increasingly competing amongst themselves for a share of these export markets. Thus, when China devalued its currency in 1994, it gave Chinese manufacturers a competitive advantage against those in Thailand, Malaysia, and other Southeast Asian countries, ultimately displacing some of the exports of those countries to the United States and other foreign markets. Similarly, South Korea’s problems partly stem from a loss of market share to Japanese semiconductor, auto, and other producers as a result of the competitive advantage that Japanese companies have gained through the effects of the weak Japanese yen and stronger Korean won. There simply is not enough to go around for all of these countries, especially since the United States remains the only truly open market among the large industrial countries, and is already running a huge trade imbalance.

In sum, most Asian countries have been employing export-led growth policies, that have created widespread overcapacity throughout Asia; the heavy reliance on debt to finance such capacity, especially short-term, dollar-dominated loans, is now causing widespread bankruptcies and distress throughout Asia. This, in my judgment, is at the heart of the economic and financial crisis in Asia.

EFFECT ON THE U.S. ECONOMY

It is clear that the U.S. economy will be negatively impacted in several ways by recent events in Asia. Most likely, the magnitude of these effects is likely to be modest, far from enough to bring about an end to the current expansion, even through this expansion is already nearly seven years old. This conclusion reflects the following:

-Probably the most significant direct effect of the crisis in Asia will be on trade. However, short term movements in economic activity in the United States are still largely determined by domestic forces, despite the increased integration of the United States into the global economy. In fact, total exports still account for only 12% of U.S. GDP. Furthermore, despite the phenomenal growth of that region in recent years, exports to Asia in total account for only about a quarter of all U.S. exports, and therefore for only about 3 percent of U.S. GDP. Therefore, even a near twenty percent decline in total exports to Asia would reduce total U.S. output by only .5 percent. Furthermore, while imports from Asia will rise in response to the appreciation of the dollar with respect to most Asian currencies, some of this will displace imports from other countries. In total, the impact of the crisis in Asia on U. S. trade will be to reduce 1998 GDP by about ¾ of one percent, significant, but not devastating.

-The huge currency swings will have another effect, namely they will reinforce the trend of reduced pricing flexibility and disinflation in the U.S. This could cause a squeeze on profits in some industries, and some cuts in domestic business investment, reducing GDP growth by perhaps another .2% in 1998.

-U. S. commercial banks are likely to incur some losses on loans to Asian companies and governments – however, because U. S. banks are currently highly profitable and well reserved, this is not likely to reduce the availability of credit to U. S. borrowers, and will thus have essentially no effect on overall economic conditions.

-The increase in the trade deficit and cuts in investment spending will have multiplier effects on other sectors of the U. S. economy, amounting to perhaps another .5% on GDP.

-On the positive side, recent declines in long term interest rates appear to partly reflect these expected negative effects of the Asian crisis on U. S. output, and the positive effect on U. S. inflation. Lower long term rates will offset some of the factors discussed above.

On balance, the net impact of these forces should be to reduce growth by about 1% in 1998. There are other reasons to believe that the economy will continue to experience modest growth, perhaps in range of 2%, despite this drag. First, while erratic on a month-to-month basis, sales and order rates remain strong in most industries, with no sign of any significant deceleration. And the Christmas retail season, while far from the best ever, ended on a positive note, with sales up modestly over the previous year. Finally, housing activity continues to exhibit strength in most parts of the country. Thus, there are no signs of recession in the current economic statistics. Second, not only is activity still at a high level, but the forces which will drive the economy in the near future, other than trade, remain positive. In particular, real incomes continue to rise in response to the recent modest acceleration in wages and low inflation; household balance sheets are in good shape as a result of the strong gains in the value of financial assets in recent years; jobs are available for virtually all who want them; and consumer confidence remains at or near record levels. Moreover, as mentioned earlier, the recent decline in long term interest rates will provide a powerful dose of stimulus by making big ticket items less expensive, and by permitting more mortgage refinancing, which will reduce mortgage payments for millions of American families and free-up purchasing power. In addition, the high level of corporate cash flow will continue to help the financing of new purchases of business machinery and equipment.

It should be noted, however, that while the effects of the Asian crisis on the U. S. economy are likely to be manageable, and a recession is not the most likely forecast, the risks are clearly on the downside. In particular, greater weakness in Asian currencies, and/or steeper recessions in Asia, would obviously cause an even larger U. S. trade imbalance, which in turn would slow growth even more. Furthermore, any sizable negative effects on confidence in the U. S., or on U .S. financial markets, would hurt the U. S. economy.

It is also clear that the effects of the crisis across the U. S. economy will be highly uneven. Obviously, the industries that are highly export-dependent, especially capital goods producers which are large exporters to Asia, and those which are import-sensitive, will feel the brunt of the crisis, not only because of the direct trade effects, but because of the added pricing pressure that is likely to result from the huge shift in exchange rates in recent months. These are important industries for future economic growth, and the decline in their competitiveness could cause significant longer term effects on the performance of the U. S. economy as well.

IMF SUPPORT IS NEEDED

Many analysts are espousing the view that, despite the severity of the financial and economic crisis in Asia, the International Monetary Fund should play no role in trying to stabilize the region. Many, in fact, argue that IMF programs have been counterproductive in similar situations in the past, and are likely to be so again at present.

I take a different view. In my judgment, IMF financial aid, if properly structured, can play a very constructive role in dealing with the current crisis, and in fact can not only help stabilize the situation in the short term, but can bring about major long term reforms that will reduce the risk of a recurrence in the future, and at the same time help address some of the trade imbalances and other global economic problems which now exist. In so doing, the risk of major social unrest in many Asian countries, and of a build-up of international tensions and global security problems, would also be reduced.

From the U. S. perspective, all of the above are extremely important. First, it is essential that major economic downturns in Asia be avoided in order to limit the spillover effects of the crisis on the overall U. S. economy, on key U. S. industries, and on U. S. financial markets. Second, to the extent possible, it is necessary to avoid even deeper currency declines in Asia because this would further harm the long term competitiveness of many U.S. companies by in effect negating many of the measures that these companies have adopted in recent years to become more competitive. Third, a properly structured IMF package should include reforms that would help open many of the Asian markets that are now essentially closed to U.S. exports. Fourth, anything that jeopardizes the security of the Pacific region, or heightens tensions in that region, would not be in the best interests of the United States, and in fact, could result in the need for increasing the defense budget in the years ahead, undermining the progress that has been made toward eliminating the huge budget deficits of the 1980s and early 1990’s.

Thus, in my judgment, IMF financial support is not only necessary from a United States perspective, but also may be the best opportunity that currently exists to bring about structural reforms in Asia that are very strongly in the interest of the United States in the long term.

CONDITIONS FOR IMF SUPPORT

The terms of IMF bailouts must reflect the economic conditions which exist in each individual country, whether in Asia or anywhere else. The cookie cutter approach, in which the requirements and conditions are essentially the same across all countries, is no longer appropriate. This is especially true in the current Asian crisis – most Asian economies do not have large budget imbalances; loose monetary policy; high or rising inflation; poor international competitiveness; overconsumption; low domestic savings; etc., as was the case, to a great extent, in Mexico and many countries bailed out by the IMF in the past.. Quite the contrary, the problem in Asia has not been overconsumption, but overinvestment, as indicated earlier. Furthermore, there is no sign of overheating in virtually any Asian country -- most, as discussed earlier, have widespread overcapacity. Thus, the excessive austerity measures that characterized many IMF financial assistance packages in the past do not seem appropriate in the current situation, and could unnecessarily exacerbate the sharp economic slowdowns that are already occurring. Furthermore, it is important that the burden of the adjustments that will take place in Asia be shared as equally as possible. Finally, as mentioned earlier, it is also important that the packages be structured in a manner that will avoid future reliance on the IMF -- in particular, structural reforms that will prevent a recurrence of the conditions which now exist in Asia, and which will also be best for the world economy, are essential.

With these broad guidelines in mind, I would suggest the following general approach with respect to short term conditions, keeping in mind that the specific conditions for aid will have to be adjusted based on the economic and financial conditions which exist in each individual country:

-Fiscal policies aimed at reducing consumption in the short term would in general not be appropriate – if anything, measures to stimulate consumer spending are needed, especially since the extremely weak Asian currencies will themselves act to slow consumption by squeezing real incomes. Asian countries should be allowed to run budget deficits in the short term while their economies are weaker, provided they do not have a sizable long term structural budget deficit. Thus, to the extent that spending reductions are needed, particularly the elimination of wasteful programs or inappropriate subsidies, they should be matched by consumption-oriented tax cuts. This will offset the drag from cuts in government spending, will offset some of the decline in purchasing power caused by import inflation, and will stimulate consumption and help eat into the huge excess capacity that exists in many industries. Tax increases may be necessary in those cases in which there is a sizable long-term structural budget imbalance, but these should be phased in slowly over time in order to prevent additional short-term fiscal drag. Finally, any tax increases, spending cuts, or other austerity measures should be aimed at reducing investment, not consumption.

-It is essential that foreign lenders be encouraged to roll over their existing loans to Asian countries, at reasonable interest rates. This is a matter of fairness, because without economic stabilization, lenders will likely suffer huge loses. It is also very important for the Asian economies in the short term -- the more foreign money that is pulled out, the bigger the increase in interest rates that will be needed to attract new capital. This could create more downward pressure on the Asian economies in the short term, and larger spillovers to the rest of the global economy. Furthermore, the more foreign money that is pulled out, the more likely that Asian currencies will weaken further, creating even bigger trade imbalances in the future.

-It is important that IMF funds not be used directly to help those companies that have created the overcapacity, or they are in the process of adding new capacity. With respect to the long term, the key objective should be to introduce reforms that would move the Asian countries away from export-led growth. This can only be accomplished with measures designed to lift the level of consumer spending over time, and by eliminating the industrial policies that are at the heart of the export-led growth strategies now in place. Thus, as mentioned earlier, the IMF should make it clear that in return for financial support, Asian countries must put in place aggressive measures designed to open markets to foreign competition, to encourage more domestic competition by deregulating domestic industries in a way that would encourage more consumer spending, and reform banking and financial systems, etc. In addition, the IMF should insist that subsidies which give Asian exporters an unfair competitive advantage be phased out over time. Other polices designed to stimulate consumer spending, including the phasing out of saving-oriented incentives that exist in many Asian countries, should also be considered. It is also essential that other structural aspects of these economies that create a bias towards overcapacity be eliminated over time. Finally, it is important that an effective monitoring process be put in place to ensure that the Asian countries which receive IMF support carry out the reforms that are agreed to.

To be fair, the IMF appears to recognize that the problems now in Asia are not the same as those in many previously bailed-out countries, and is now attempting to structure its packages to reflect these differences. This is a big step forward. But it is in the interest of the U. S. to make certain that this continues -- one way to do so might be for the Congress to approve U. S. funding for the IMF only under the understanding that the IMF will continue to move in this direction in the future.

In sum the crisis in Asia actually represents an opportunity for the U. S., by working through the IMF to help bring about structural and other reforms in Asia that would clearly be in our short and long term interests. These reforms and policy measures could:

-prevent additional excess capacity in many key industries that could significantly damage many U. S. companies.

-reduce the risk of an implosion in Asia that would put the U. S. expansion at risk

-prevent rising social unrest and military tensions that would jeopardize global stability.

-prevent deeper currency declines in Asia that would hurt the competitiveness of many U. S. companies for years to come.

-help us achieve our major trade objective of increased market access in Asia, which is essential for reducing our huge trade imbalance with Asia.

WHAT SHOULD JAPAN DO?

As mentioned earlier, the economic stagnation in Japan has been a significant contributing factor to the current problems in the rest of Asia. It is also clear that a complete solution cannot take place unless the Japanese economy itself is revitalized. The Japanese economy is more than twice as big as the rest of Asia combined, and is strongly intertwined with the rest of Asia -- thus, the rate of economic growth in Japan, the openness of its markets, the value of the Japanese yen, etc., all have potentially large effects on the other Asian economies.

The Japanese government recently announced several measures designed to stimulate its weak economy, including tax cuts and an infusion of public money to shore up the banking system. Unfortunately, these actions are nowhere near enough. The starting point is acceptance of the fact that, after more than six years of stagnation, it should be clear that Japan can no longer export its way to sustained prosperity. In fact, the collapse of some of its major export markets throughout Asia, coupled with the backlash that is now developing in the United States and other industrialized countries against large and persistent trade imbalances with Japan, will make it more difficult to achieve export-led growth. And, the likelihood of an eventual decline in the dollar despite Bank of Japan efforts to keep propping it up will only compound the problem. Only a sustained pick-up in consumer spending can restore economic growth back to the rates that the Japanese experienced on a regular basis in the 1970’s and 1980’s.

Unfortunately, this seems virtually impossible without dramatic changes in Japan. In particular, the Japanese save too much -- while saving is a virtue, like for anything else, the law of diminishing returns eventually sets in. Simply put, excessive saving rates (the national saving rate still hovers around 30% in Japan) become counterproductive in the non-linear world that we live in. This very high saving rate reflects government policies designed to promote thrift, and an extremely high price structure that, combined with the unavailability of consumer credit, requires consumers to accumulate large amounts of savings before they can purchase big ticket durable goods.

The problem is so deep rooted that some of the traditional remedies being put forth are too little, too late. For example, the income and other tax reductions now being proposed are virtually useless. First, because of concern over current and future deficits, they have been limited to less than one percent of GDP, not even enough to offset the tax increases that went into effect earlier this year. Second, not only is the average propensity to spend in Japan very low, but the rate of spending at the margin far lower, even under the best conditions. Furthermore, in today’s environment of growing uncertainty, declining confidence, and the perception that tax cuts will be reversed in the future, it is likely that hardly any of the added consumer income resulting from tax cuts would be spent. Thus, neither consumer spending nor overall GDP will be raised to any measurable degree.

By contrast, even a modest reduction in prices of consumer goods and services, now estimated to be at least 30 percent higher on average than in the United States and other OECD countries, would raise the volume of consumer spending over time by 5 percent or more, and, with multiplier effects, would increase real GDP by at least 7 percent. This can be brought about only by opening markets to imports in order to bring competition to the entrenched monopolistic producers of many goods and services in Japan, coupled with land reform, anti-trust enforcement and other deregulation. Moreover, it is vital that Japan not only finally face up to its severe banking problems in order to permit Japanese banks to start lending again, but modern consumer lending practices must be introduced to the Japanese banking system in order to further support consumer spending. Finally, some of the other policies which encourage thrift in Japan should be scaled back or phased out over time.

These changes are not only needed for Japan itself, but to help set an example for the rest of Asia, and to help revive the entire Asian region. Unfortunately, it is far from clear that the Japanese are willing to make these changes – in fact, they seem willing to let the prolonged weakness of the yen be its major short term stimulant. The appreciation of the dollar from approximately 80 yen to about 130 yen in recent years, coupled with deflation and widespread cost cutting in Japan, have given most Japanese companies at least a 20 percent cost advantage relative to even highly efficient U.S. competitors in both the U.S. and Japanese markets.

If the dollar-yen exchange rates remains at current levels, ESI estimates that the U.S. - Japan trade imbalance will likely balloon to at least $68 billion in 1998, and to $75 billion in 1999, from an estimated $57 billion in 1997. This is clearly unacceptable. It will not only exacerbate the already huge and growing overall U.S. trade deficit, it would also likely create an increasing backlash against free trade in the United States, and result in trade frictions. And, of course, if the dollar were to keep appreciating against the Yen, the problem would become even worse -- for example, at an exchange rate of 150 Yen to the dollar, the bilateral imbalance will skyrocket to as much as $85 billion by 1999.

To prevent this, the U.S. government should consider joining the Japanese in a program of coordinated intervention in order to strengthen the yen. This would resemble the joint intervention between the United States and Japan in the Spring of 1995 designed to reverse the rising yen when it was already super strong. It would also be a strong signal to the Japanese that the United States will no longer tolerate a continuation of closed markets and other mercantilist practices in Japan, which are the root cause of our persistent bilateral trade imbalance, and that Japan will not be permitted to export its way out of stagnation.

U. S. POLICY

A number of policy measures should be considered in the U. S. to both reduce the potential spillovers from the turmoil in Asia in the short term, and to deal with longer term issues as well. These include the following:

1. As mentioned earlier, I strongly urge the Congress to approve U. S. funding for the International Monetary Fund, provided that the IMF structures bailout packages in a manner that is in both our short and long term interest. This would include measures designed to stabilize the Asian economies in the short term, rather than creating even deeper recessions, and which could force market opening and other reforms in the longer term which will increase the access of U.S. companies to Asian markets, and prevent Asia companies from competing unfairly in U. S. markets.
2. The United States government should put the maximum pressure possible on Japan to restructure its economy in order to reduce its high saving rate, and to stimulate domestic demand and higher rates of economic growth. This must include measures designed to open markets to imports from the United States and elsewhere, and other measures which could reduce domestic prices. In addition, if the yen begins to weaken again, the U.S. government should consider intervening in foreign exchange markets, in coordination with the Bank of Japan.
3. As mentioned earlier, the devaluation of the Chinese yuan several years ago contributed to the onset of the financial and economic problems in Southeast Asia. A new devaluation of the yuan in response to the sharp declines in the value of other Asian currencies would be counterproductive, by likely causing additional downward pressure on these other currencies. This would lead to even higher interest rates in Southeast Asia and intensify the downward pressure on many Asian economies. We should make it clear that we will not support Chinese accession to the WTO if China does devalue its currency.
4. The biggest threat to the economic expansion in the United States is the adverse effect on U.S. competitiveness and trade of the collapse in Asian currencies, the extreme weakness of the Japanese yen and other industrialized country currencies, and the looming recession in much of Asia, on U.S. competitiveness and trade. It is now all but certain that the already huge and persistent U.S. trade imbalance will skyrocket off the charts in the next several years in response to these events, significantly reducing economic growth and the demand for high wage jobs. In addition, currency shifts and global overcapacity will hurt the competitiveness of many U.S. companies over the longer term as well.

   In my view, budget policy in the next several years should be geared to address this problem. This suggests that we should run budget surpluses as much as possible in order to keep interest rates down, and free up our savings, to stimulate private investment in new equipment, and research and development. In addition, expenditure increases for selective programs, such as export promotion and financing, dual-use technology programs, expanding the Office of the Trade Representative to better monitor and enforce existing trade agreements, and job retraining, would be in order -- even substantial increases in outlays on these programs would have only a small impact on overall expenditures, and thus would use up only a small part of projected surpluses. Yet, by improving our competitiveness and reducing our trade deficit, they would have a payoff on overall economic activity far beyond the cost. Some targeted pro-investment tax cuts also deserve consideration.

   The worst thing to do would be to give back the surpluses in the form of large across-the- board tax cuts, which would stimulate consumption rather than investment; would have little or no supply-side effects; would jeopardize the budget in the longer term when the baby boomers start to retire in large numbers, pushing up the cost of the health and pension entitlements; and would do nothing to help trade and competitiveness.

5. Finally, it absolutely essential that the Federal Reserve not only avoid any interest rate increases in the near future, but consider cutting rates. As I have previously testified to this committee, rate increases are unnecessary because the outlook for inflation is still very favorable. Even the recent concern about accelerating wages is overblown, since the acceleration is very selective and gradual, and is being offset by productivity growth in most industries. The crisis in Asia will reinforce the trend towards disinflation that has been in place in the United States for several years and, coupled with already high real short term interest rates, makes interest rate increases unnecessary. In fact, if the economy slows in response to rising trade deficits, the Fed should consider lowering rates, not raising them. Without such a reduction, it is likely that long term interest rates will begin to back up again, negating the stimulus from the recent decline in long term rates that will offset some of the drag from bigger trade deficits.