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so-called "daylight overdrafts," which is what occurs during the day. It is the type of credit which the central bank extends during the day as a system engenders these huge amounts of payments. What happens if there is a failure is that we are required either to allow the failure to exist, meaning not a failure of payment, but an insolvency, which has very major consequences in the payment system; or we give a loan to the institution at the end of the day through the discount window.

When we know how risky an individual institution is, we can contain our extent of "daylight overdraft" and discount window privilege so as not to risk taxpayer funds in bailing out individuals. who are less than creditworthy.

If there are organizations which gain access to that system and we do not know whether they are creditworthy or not, we don't know how to handle the "daylight overdraft" cap problem, as we call it, nor whether there should be access to the discount window. As a consequence, we think it is important that a certain minimum amount of evaluation be available to the Federal Reserve if institutions want to move funds for final settlement through the Fed payment system.

Mr. LEACH. I appreciate that. One of the debates that is going to be occurring in the development of this legislation is the question of functional regulation. Virtually everyone supports functional regulation, but then the question is, "Is there going to be only functional regulation?"

It strikes me if you postulate good actors and good times and not particular convergence of decision making, only functional regulation is relatively persuasive. But if you postulate the possibility of bad times, the possibility of bad actors, and the possibility of convergence of economic decisionmaking within multifaceted corporations, you almost have to have a Fed oversight role.

Now, does that strike you as valid or invalid?

Mr. GREENSPAN. No, I think it is valid, Mr. Chairman.

I used to be a strong supporter of functional regulation about 10 years ago. The reason I was, was that it was not clear at that time that there would be any quick evolution of consolidated activities within holding company institutions, and that, therefore, it was perfectly adequate to have individual entities within a holding company separately examined and not be terribly concerned about what the state of the parent was.

What has happened is a much more rapid degree of movement toward consolidated entities, where the decisionmaking process has increasingly moved from the subsidiaries, the individual activities, to the total, to the consolidated unit. So that now what happens is, in all of the major institutions, risk management is accomplished at the holding company level for all of the entities. That is where the crucial business decision is made.

If you do not have oversight of that particular decisionmaking process, then you are missing a very crucial part of supervision and regulation.

One may argue that you don't need to do very much, and I agree with that; I think that often we do far more regulation than is required and, indeed, as I mentioned in my prepared remarks, since it has become obvious to us how this structure has occurred, we are

moving rapidly to a new paradigm of regulation. We have been moving for the last couple of years, and we hopefully will arrive at a point where the degree of supervision, regulation, examination, and the whole panoply of structure we are involved with is very significantly reduced.

But at the end of the day, it is very difficult to get around the fact that we cannot subject the taxpayer to the types of losses which would exist if we did not have the full type of evaluation structure that is necessary with umbrella supervision.

Mr. LEACH. I thank the Chairman.

Chairwoman ROUKEMA. Congressman LaFalce.

Mr. LAFALCE. Thank you very much, Madam Chairwoman.

Dr. Greenspan, first I want to thank you and praise your staff. In December, you extended the courtesy of providing briefings by your staff on the various issues that are confronting our subcommittee, and you have undoubtedly the finest staff in the world, and you should be commended on that.

Mr. GREENSPAN. Thank you.

Mr. LAFALCE. Second, this year I begin my 23rd year on the committee and in Congress, and for the first time in that entire tenure, I am rationally exuberant about the prospects for financial modernization legislation passing. I was irrationally exuberant in the past, but this year I think I am rationally exuberant. So I hope it happens.

In the past, you and the other regulators, though, have not listened to the calls of some individuals in Congress for inaction in trying to bring Depression Era legislation to the marketplace realities of a cyberspace economy. You have been creative and the courts have ruled, invariably unanimously, that you have been correct in doing that. I commend you and the other regulators for doing that, but I encourage you to keep doing that, because it is always possible that even rational exuberance could turn into incorrect or inappropriate exuberance.

My first question is, having said all of this: Do I buy or sell on the Dow Jones today? No, you don't have to answer that question, since everybody is following your word so closely. Let me get serious for a second. This has little to do with financial modernization, but I always want to ask you the questions that are uppermost in my mind when I have the opportunity.

Lately there have been a lot of writings-something was just put out by an author under the auspices of the Institute for International Economics, George Soros just came out with a book, and so forth, and they have to do with the serious, serious problems of global capitalism.

We have been talking about the tremendously increasing global economy, and in your comments, you talked about how that is necessary to raise standards of living.

Those certainly do that, for some, and perhaps it does this in the aggregate, but it could also leave an awful lot of individuals much further behind.

Are you familiar with the writings and statements of Soros on this issue, the recent work that was done at the Institute for International Economics? Is somebody at the Federal Reserve Board looking into this?

Mr. GREENSPAN. Well, I think we obviously function in an international context, and since the dollar is the major reserve currency of the world, it is incumbent upon us, if we care about the interaction of the rest of the world on dollar holdings, which affects us, that we be very knowledgeable about what is evolving, at least as much as that is feasible.

I don't want to comment on individual notions, unless you want me to, but I would just say generally that what is driving this tremendous globalization is technology, largely, and the ability to create an ever smaller per unit weight of the gross domestic product, if I may put it that way. In other words, we are downsizing all various different types of products, so everything is very small.

Mr. LAFALCE. Maybe I didn't make my point clearly enough, so I would ask you to respond in writing. I am not looking at the overall, the macro. I am looking now at the micro, and there could be an awful lot of winners in this. It is the losers that we have.

Mr. GREENSPAN. I am addressing that subject.

Mr. LAFALCE. OK.

Mr. GREENSPAN. What I am saying is, as you get to increasing technology, which means that globalization is reflecting the expansion around the world of smaller and smaller physical things, which is the reason they are able to be moved, intellectual products are becoming of ever increasing importance everywhere.

What that means is that we are getting, as we have in recent years, a significant spread between those who have the type of knowledge that is required to deal in that society and those that do not. And this is reflected in the growing gap between the earnings of those who are college educated and those who are high school educated. And if you go from high school to high school dropout, the gap moves even more apparently.

What this suggests is, and one of the reasons why the income distribution in the United States has begun to spread is, it is an education problem that we are dealing with, and that is a problem that exists all around the world. It is not a function of any defect of capitalism, per se.

Mr. LAFALCE. I have heard you give that explanation before. I encourage you to read the most recent documents on it, because while I think your answer is partially correct, I think it is only partially correct, and I think there are a great many other causes that we must examine and look into.

So I do not dispute what you are saying, but I think that is only a piece of the pie. How large a piece, we could debate, but only a piece of it. Therefore, I find it inadequate.

Madam Chairwoman, let me ask unanimous consent to, number one, introduce into the record my opening statement. Number two, I have approximately a dozen questions dealing with two basic subjects: A, functional regulation; and B, banking and commerce, and I would like to submit them to all the regulators and ask for their written responses.

Chairwoman ROUKEMA. So moved.

[The prepared statement of Hon. John J. LaFalce can be found on page 430 in the appendix.]

Chairwoman ROUKEMA. Dr. Paul.

Dr. PAUL. Thank you, Madam Chairwoman.

Welcome, Mr. Chairman.

It has been reported in the media on occasion that sometimes your words are confusing.

Mr. GREENSPAN. I seem to work at that.

Dr. PAUL. But in reading over your testimony, there were a few items that I thought were very clear and very interesting. For instance, this concept of sovereign credit and your attack, or criticisms, of the expansion of subsidies. You say, "The use of sovereign credits in banking, even its potential use, creates a moral hazard that distorts the incentives for banks."

I find that very interesting and very pertinent.

Likewise, you also indicate some caution about the unsurpassable sovereign credit as an undesirable consequence of the system. I share your concern about the spreading of this subsidy, because this could be an undue burden placed on the taxpayer. Yet my question and my concerns are more directed toward the whole concept itself.

If there are moral hazards and there are concerns and undesirable consequences, shouldn't we rather not be just having a holding action, but questioning whether or not the system is a good system?

The system has been created, it is not created out of thin air as credit is. It is a creature of the Congress, and in many ways a creature of the courts. Yet if one were inclined to look at some guidelines that we are supposed to occasionally look at, and that is in the Constitution, there is very restrictive language there about what we can do with sovereign credit.

We don't read about sovereign credit in the Constitution. Article I and Sections 8 and 10 are very specific and limited as to what we can do. But we are at that point today where we are concerned about the spreading of the subsidy.

And I am delighted you used that word, because that is what it is, and I will be certainly on the side of preventing the spread of a subsidy.

But my question really in a way is philosophic to you. Can you conceive of a system that might be entirely different than the one we have where we don't grant the subsidy and we don't grant this ability for banks to have the wrong type of incentives, and maybe prevent the financial bubbles that have occurred continuously over the last 70 or 80 years? And yet today there are many concerned about some of the financial bubbles, the trillion dollar foreign debt we have. The amount of debt that our foreign central banks hold now is well over $600 billion, and we have a stock market that is soaring. This is a reflex, I believe, of this sovereign credit notion. So is there another system that, instead of going in the direction of trying to hold back the spread of the subsidy, saying, "Is this subsidy proper? Is it moral? Is it correct? Is it Constitutional?"

Mr. GREENSPAN. Well, I think you are correct, Congressman, in stipulating that the concept of the sovereign credit does not exist in the Constitution, and the reason is that it never entered anybody's mind at that time, because what the sovereign credit implies is fiat money. That is, we had no sovereign credit in this country in the early years because we were effectively on a gold and silver standard for a very significant part of the history of this country.

It is only when we chose to move off the gold standard and to a fiat money system that the concept of sovereign credit emerged. The issue is a debate between two major different forms of financial systems. The earlier system, which was essentially constrained by the existence of the gold standard, made the issuance of significant amounts of government debt rather difficult because they were convertible into gold, and obviously the amount of debt that you could issue would be a function of the gold reserves which the government had.

Therefore, you could not create the types of government deficits which we and other nations can, as well.

A judgment has been made in this country that the cost of the restraints of the gold standard was such that many, in fact, the vast majority of the Congress eventually concluded in the 1930's that that was an undue constraint on the system, and choices were made at that point to move to another system.

You cannot, however, look at a financial system independently of the values of the society, and you cannot separate the financial system from the economic structure itself. So it is a value judgment that a society makes, and the judgment that this country has made since the abandonment of the gold standard in 1933 is that a fiat money, sovereign credit system is a superior mechanism for fi

nance.

Dr. PAUL. Do you agree that that judgment was correct?

Mr. GREENSPAN. Well, I think that there are pluses and there are minuses. As I have said over the years, I have always had perhaps a nostalgic view for how the markets worked in those earlier years, but I would be naive to fail to recognize that that was a view that is held by the vast majority of my colleagues.

Dr. PAUL. Madam Chairwoman, may I follow up later on with written questions?

Chairwoman ROUKEMA. Yes. That is appropriate.

I was about to make the announcement that the Chairman has been very generous with his time, and we will go through the first round of questions, but further questions will have to be deferred, not only for those who were able to stay, but for those who have had to leave because of conflicts with other committee hearings.

So I make a motion that everyone will be able to submit their further questions for written responses from the Chairman. He has been very, very generous with his time.

Without provoking my colleague, Dr. Paul, I just want to make one comment. You may be nostalgic, Mr. Chairman, but I am hardly nostalgic for what led to the crash of 1929 and the financiers' activities in that. We will have that debate.

Dr. PAUL. Madam Chairwoman, I might remind you that occurred after 1913.

Chairwoman ROUKEMA. But I was responding to the Chair

man

Mr. GREENSPAN. 1913 is when the income tax was put in place. Dr. PAUL. And the Federal Reserve.

Chairwoman ROUKEMA. I have got it, but that is a debate that we might want to have some other time. There are various wide differences of opinion on that subject.

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