Ms. Rivlin discusses the state of the world economy and its implications for the United States  (Central Bank Articles and Speeches, 22 Oct 98)
Central bank: fed | Type: speech | Date: 1998-10-22

Ms. Rivlin discusses the state of the world economy and its implications the United States Remarks by Vice-Chair of the US Federal Reserve System, Ms. Alice M.

Rivlin, at the State University of New York-Brockport and Buffalo State in Buffalo, New York on 22/10/98.I am delighted to be here today and to have this opportunity to talk with y particularly pleased to be here with my friend Congressman John LaFalce, who brings energy and good sense to the Congress, especially to the hard work of the Banking Com which is where I see him most frequently.I want to talk with you this morning about the turmoil in the world econom what it might mean for us here in the United States.

Why should people in upstate Ne care about the economy of Thailand or Russia or Brazil?

What can we do to keep our economy strong?We are all used to the cliche that the world is getting smaller, that the age has brought us closer and put us in instant touch with remote parts of the globe. that cross-border trade and investment have increased enormously in recent years, brin greater prosperity and greater interdependence.Still, when bad news from Asian economies began flashing across our screen the summer of 1997, it didn't seem to have much to do with us.

Currencies with odd nam the baht and the ringgit were said to be plunging, stocks prices on the Hang Seng or were falling, by the end of the year Korean banks were negotiating with their creditors at home the economy was doing better than it had in a generation.

The news from Asia like a small dark cloud appearing on the horizon in the middle of a sunny day at an festivity.

It might mean rain, but with any luck it would go away.We have been enjoying a truly extraordinary performance of the US econom Since the beginning of the 1990s, we have had a long period of growth that didn't se sputtering out.

In fact, growth accelerated in 1997 and early 1998, which is not the u for a 'mature' business cycle.

We have seen few signs of strain or imbalance.

Althoug areas, including Upstate New York, have lagged, we have experienced mostly good gro across the country and across sectors of the economy.Unemployment has been very low - lower than most economists thought it cou remain for long without igniting inflation.

Wages have been increasing, but not so fa rise caused rapid escalation of costs.

The slowdown in the rise of health benefit cos total compensation increases to moderate levels.

Productivity increases have been o compensation growth, keeping profits growing, at least until quite recently.

Most rema all, inflation has been falling and not showing any clear evidence of accelerating againEven the Asian crisis at first seemed an ill-wind whose timing was ac blowing us some good.

Some Americans felt the negative impact early, especially manufac whose exports to Asia declined and farmers who saw their prices drop on world markets a demand fell off.

At the national level, however, our economy was clearly growing unsustainable rate, and some slowdown was actually welcome.

We were in danger of runnin of workers.

Sooner or later cost pressures would lead to inflation.

The primary econ seemed to be overheating, not slow growth.Indeed, the Federal Reserve was concerned enough to tap the brakes by raisi short term interest rate in March 1997 before the Asian crisis hit that summer.

W probably have felt called on to raise rates again later in 1997, but by then it seeme slower growth in Asia would cut US net exports, and restrain our economy enough to inflation and any pressures.

Good productivity performance, falling commodity prices, c with low inflation expectations and the high value of the dollar, all made it less risk reduced the necessity of the Federal Reserve taking preemptive action against inflation rates again.The stock market's remarkable rise both reflected and perpetuated the ge good feeling about the US economy.

Even the Asian crisis raised the price of US sto investors took their money out of Asian markets and bought US securities instead.

To US equity values were outrunning reasonable expectations of profits, especially if, forecasters expected, the economy slowed down.

But increased wealth of consumers stimu consumption and the low cost of equity stimulated investments, so chances of future pro enhanced.

Some worried that high equity values were a bubble that would inevitably bu this concern was mitigated by: (1) lack of strong evidence that stock prices were part speculative phenomenon that included real estate and other assets, as in some previo periods; (2) the apparent new maturity of small investors, who talked and acted as th were in the equity market for the long haul.

All in all, it was a sunny day at the fair.All of this good news generated an occasionally silly debate about whether was in 'new era' in which all the old rules had been suddenly repealed, or whether th 'new paradigm,' which usually seemed to mean 'no paradigm' or 'the sky's the limit'.The more sensible version of the discussion went something like this.

The lots of reasons why the economy might be both more productive and less inflation prone used to be:- more global competition- deregulation of airlines, trucking, telecommunications; decline of barriers financial services- the computer and telecommunication revolution (finally) making cost savi possible, not just in manufacturing, but in services- more flexibility and incentives built into wages, less unionization, out-so specialized services, use of temporary and part-time employees- high levels of investment, including human investment - on-the-job and other training.In economists' terms, there was hope that productivity might have moved on higher growth trend.

Faster productivity growth would mean a higher standard of liv Americans in the future.

It would mean that growth could be faster without setting off (perhaps closer to 3 percent a year than 2 percent) and that unemployment could be without inflationary consequences.

That would be very good news.It was too soon to be sure that the apparent productivity trend increase wo up or that less inflation was becoming the norm.

It was certainly true that some eleme unusual combination of favorable inflation factors were likely to reverse.

Health cos might accelerate again; the dollar might weaken and cause import prices to rise;commodity prices might go up again.

Still, the US economy seemed to be performing remar well.Then ill-wind from Asia turned to a gale, sweeping through currency and markets all around the world and affecting our own financial markets as well.

The stoc dropped 5 percent in one day in August, then bounced wildly around.

A general 'fl quality' drove long-term interest rates down on Treasuries, but rates on riskier instruments went up.

The market mood changed to pessimism and risk aversion.Meanwhile, across the Atlantic, the initial storm warnings from Asia, wer first dismissed by many Europeans as far away and not their problem - distant thunder o shore.

European economies are less heavily involved with Asia than we are and, besid ill-wind was blowing them some good in the form of lower oil and other commodity price major countries on the continent were working hard on the details of monetary uni organizing a multi-national central bank; they were struggling earnestly to get de inflation down.

The basically simple idea of having a common currency and a common ce bank proved very difficult to achieve technically and politically, but they had done rates were finally picking up and even high French and German unemployment rates w beginning to recede.

Europeans were optimistic that the common currency, and the inc competition and deepening capital markets it was likely to engender, would energiz economies even more and lead to higher growth.

This unpleasant weather on the horizon s at first a minor distraction.

But the lightening bolt in Russia was more difficult to right there on their borders.In Japan, the Asian crisis had a much greater impact and came at a much w time.

Japan is closely involved with other Asian countries and suffered both financia and loss of markets for Japanese goods.

They were already struggling with slow gro banking system in need of overhaul and a political party structure in need of rejuven Asian crisis precipitated deep recession in Japan.

The world economic turmoil could n come at a moment when the Japanese were less able to deal with it.In the last few months, we have learned so much about the downside of increasingly interdependent world that it is important to remind ourselves that the enormous.

Increasing volumes of trade and cross-border investment have raised the stan living in many emerging countries at an astonishing rate.

Trade and foreign investme moved the countries of southeast Asia in less than a generation from traditional agr modern industrial societies with far less poverty, much more skilled work forces an standards of living.

At the same time, we and other industrial countries have benef growing markets for our exports, higher profits on our capital and lower prices for variety of goods we import.When things are going well in an interlinked world, one country's prosp reinforces another's.

The rapid growth of emerging market countries, especially in As last couple of decades, led to greatly increased trade among them as well as with countries.

The self-reinforcing growth seemed so positive that investors began to view in emerging markets as not much more risky than investing in their own more familiar in country markets.

Capital flowed freely to finance projects in emerging market countr lenders demanding only slightly higher interest rates than they would have required t home.But the downside of interdependence is that when something goes wrong, impact also spreads quickly from one country to another, through trade channels, prices markets.

Asian countries in trouble quickly cut their imports from each other and industrial world.

The reduced Asian demand for food, oil and raw materials was felt by in the US and Canada, Australia and New Zealand; by producers of oil in Mexico and Venez Nigeria and Russia and the Middle East; by copper producers in Chile and exporters of i raw materials in Africa and elsewhere.

Companies in Rochester and Buffalo found thei falling.As the contagion spread, investments in many emerging market countries began look less promising.

Investors became generally more cautious and began looking for saf to put their money - like buying US government bonds - even at low rates of return.

As US companies affected, they became less eager to finance them as well.We've learned a lot in the last few months about the power of contagious l confidence in an interlinked world.

The meltdown in Russia was the clearest case.

Russ an important economic and trading power in itself.

Losses to major money center banks, in Europe, though magnified by unexpected interrelations with hedge funds and other ope were not in themselves destabilizing.

But what apparently mattered was the surprise, bo suddenness and unpleasantness of the Russian default and of the fact that the Western were so powerless.

No one thought the US and its allies would take the political risk Russia fall apart.

In the end, there was nothing they could do to stop it.The Russian collapse led investors to pull back just about everywhere.

Some had borrowed to invest in Russia had to sell assets in other markets to cover loss simply said to themselves, 'If it can happen in Russia, it can happen anywhere; I had my money to a safe place.' The result was plummeting markets in Latin America, South A Asia and elsewhere, more difficulties for the countries struggling to recover.It is now clear that the Asian crisis that started in Thailand in the summe - and seemed like a remote event of no great significance to most Americans - has set o reaction reaching around the world.

Much of Asia is in deep recession, the Russian econ collapsed with negative repercussions for many of its neighbors, growth is slowing America.

Risk aversion of investors has made it difficult for any country, company or perceived as at all risky to get capital or to borrow, even at high rates.

Countrie Mexico and Argentina, considered quite strong a few months ago, are under mounting pre Brazil has had to raise interest rates, use much of its foreign exchange reserves currency from depreciating; the high interest rates, in turn, have greatly exacerbat budget deficit, and the deteriorating outlook has led to fears that investors will pul out and bankers refuse to roll over debts.

Economic collapse in Brazil, which is Latin largest economy, could precipitate serious trouble in other Latin American countries reverberate back around the globe to deepen the trouble of Asia, including Hong Kong, and Japan.

Another round of deepening deterioration would surely put intense down pressure on the US economy by cutting our exports, depressing equity markets and weak investor and consumer confidence.

As Chairman Alan Greenspan has said, we cannot expec be an 'oasis of prosperity' in a deteriorating world economy.

Even if we could stay pr alone, we should not want to take the risk that deteriorating economies in the rest o would augment unrest, terrorism and international conflict that could engulf the UnitedWhat's to be done?

In the near term there are clearly two priorities:- GLYPH Stop the contagion so that emerging market countries can begin to get back on thei- GLYPH Keep the world's largest economy from slowing down too much - for our own sake a the world's.There is no easy, simple answer to stopping contagion, if indeed there answer.

What would be the elements of a plan?First, countries most in danger of being the next to fall have to be willi up to their vulnerability quickly. (There is no point in moaning, 'It's not our fault, anything wrong; we just got caught in the world backwash.' That's partly true, but not They have to be willing to call in their creditors to negotiate rollovers, ask t conditional loans, offer significant and credible internal reforms in return.

Nowhere iSecond, private creditors have to see their long-run interest in hanging in concessional terms, rather than joining a stampede for the exits.Third, the international financial institutions and the industrial countri find more funding to tide these countries over the crises if they give evidence of wi accept strict conditions.

Congress' passage of the IMF quota increase and the New Arran to Borrow remove a major uncertainty about the effectiveness of collective action and s a lot to restore confidence that the chain reaction of economic deterioration can be stKeeping our own economy growing would be important even if the rest of t world were not depending on us so much.

Slower growth and rising US unemployment woul mean fewer opportunities for Americans to earn income and move to higher skilled and paid jobs, less chance for families to move out of poverty and from welfare to wor growth or recession in US would also have serious consequences for the rest of the reducing our ability to buy and invest abroad and exacerbating economic downturn everywhAt present, the chance of recession in the US does not seem high.

Recent g has been strong and balanced with few indications of strains and speculative exces typically go with boom/bust cycles.

Most forecasters expect the US economy to slow; the that it will not slow too much.The Federal Reserve, recognizing that the balance of risks has shifted overheating to cooling off, has cut short term interest rates twice.

Other industrial follow our lead (Canada already has); although the major continental European countr easing is less appropriate for them as they consummate their monetary union.It is clearly important for the Japanese to get their economy moving again being part of the problem and be part of the solution - as Americans and Europeans ha pointing out, none too politely, for months.The Japanese were not shy, when they were riding high in the '70s and '80 offer advice to the Western industrialized countries about modernizing our manufactur management practices, working harder, getting budget deficits down.

So there may be a p element to the US and European shrillness about how important it is for the Japanes aggressive fiscal stimulus to get their economy going again and to restore confidence and immediate restructuring of their banking system.

Neither is going well.

A series oannouncements, mostly focussed on increasing government spending for public works has yet succeeded in stemming the economic slide.

A next step might be a significant tax with Japanese consumers and investors both feeling anxious about the future, ther guarantee that even a large tax cut would result in much near term spending.Japanese banking system restructuring is going slowly, although it does se be moving toward resolution.

We are fine ones to talk, since we let our much smaller sa loan crisis fester for a long time before facing up to it.

With hindsight, the Japanes restructured their banks much more easily three or four years ago.

The worst time to r failing banks is when macroeconomic conditions are reducing the value of their asse further.

Drastic action now may make the recession worse in the short run, but it may a only hope for restoring confidence and financial health in the future.

Let's suppose turns around: the contagion is stopped, Asian and other emerging market countries begin again; Japan pulls out of recession and begins to contribute with its recovery to rec neighbors; North America and Europe sustain healthy economies.

Then the big question i to avoid such a costly episode happening again.

The real costs are not monetary; disrupted human lives and hopes.

Millions of people in emerging market countries are s without jobs, food, basic necessities, children are not going to school, young peop learning skills, and are facing uncertain futures.We won't be able to avoid crises altogether.

But in the new era of huge flows and instant communication, the amplitude and severity and cross border reach of c magnified.

Can we at least make crises less frequent and mitigate the damage?What we should not try to do is retreat to isolation and self-sufficient e that don't trade or invest in each other.

The simple reason is: we'd all be a lot solution is like saying: We don't like power failures, so let's all stop using electr sure that everyone has a generator in the backyard, so we don't have to depend on th company.What we can strive for is more cautious better informed investing and le better early warning systems and ways of heading off deepening trouble once it begins.Better information would help:- GLYPH All countries giving complete information on their foreign exchange reserves in to real time as possible.- GLYPH Better information on budgets and government finances, eg, what real deficits are.- GLYPH Companies and banks revealing more clearly what their assets, liabilities and profMore effective, better supervised financial systems are essential:- GLYPH Prudential regulation of banks.- GLYPH Accounting standards, enforced.- GLYPH More carefully supervised securities markets.One idea is that a country's financial systems could be graded by its peers countries; somewhat in the manner that universities or hospitals are accredited in States and the results published.The concern should not be just with borrowing countries and their institut though making emerging market countries' financial structures more like the struct industrial countries would solve all the problems.

For every borrower there is a lender countries, creditor countries, have to be more sure their banks are managing th appropriately, and are prepared to deal with situations when a lot of things go wrong atFinally, we must strengthen international financial institutions so they a able to assess the health of member countries, give timely warnings of trouble ahead, a short term assistance to countries that need to make repairs.All of this will take sustained effort to learn from past and build a international financial community for future.

The process ought to create some int rewarding jobs and challenges for those with an interest in how the economic world wo how to make it better.