William C Dudley: US economic policy in a global context
Remarks by Mr William C Dudley, President and Chief Executive Officer of the Federal
Reserve Bank of New York, at the Foreign Policy Association Corporate Dinner, New York,
7 June 2011.
* * *
It is a pleasure to have the opportunity to speak here this evening and I would like to thank
the Foreign Policy Association for inviting me. The Association has served for decades as a
catalyst for developing awareness and understanding of global issues and for providing
nonpartisan forums for informed discussion. Your mission is clearly a worthy one - now more
than ever.
In this discussion I will highlight how the recent financial crisis and its aftermath have
accelerated the shift in the relative importance of the so-called developed and emerging
market economies.
I will then discuss how the global economic system needs to adapt in light of the growing
relative importance of the EMEs in the global economy. I will explore the implications of
these changes for U.S. economic policy and I will also touch on some of the challenges the
EMEs face as they seek to consolidate their gains and sustain their success.
I will argue that the developed countries and the EMEs need to adjust in mutually supportive
ways. In my view, the current relationship between the EMEs and the United States is not
sustainable for either side. Not only has an unusually wide divergence in cyclical positions
opened up that creates immediate strains, but there are also important structural imbalances
that have developed that must be addressed.
I will close by turning my attention to what can be done to address these cyclical and secular
challenges. Although I will discuss the role of U.S. monetary policy in this context, I will also
discuss what other steps can be taken to strengthen the relationship and make it more
sustainable.
As always, what I have to say reflects my own views and not necessarily those of the Federal
Open Market Committee or the Federal Reserve System.
Over the past few decades, the most salient feature of the global economy has been the
growing importance of the emerging market economies and the ever-deepening integration
of these economies into the global economic system. A shift toward more market-based and
outwardly oriented development on the part of the EMEs has enabled hundreds of millions of
people across the emerging world to become integrated into the global economy for the first
time. The outcome has been a rapid rise in living standards and a reduction in poverty on a
scale that is without precedent in human history.
These changes have been most evident in China, with a historic transformation that began
with the economic reforms of Deng Xiaoping and continues to this day. But the EME story is
much broader than China. Over the past decade,1 excluding China, the emerging world has
grown at a 4.7 percent annual rate - its fastest rate on record.
The EME world is, of course, not monolithic. There are the dynamic large economies, EMEs
that are broadly complementary to them, and some countries that are both less
complementary and less competitive than their peers. Happily, for the most part, EME
success is proving mutually reinforcing, as witnessed by growing intra-EME trade.
As EME output has grown rapidly, their share of the global economy has increased
markedly. EMEs now account for 38 percent of global gross domestic product (GDP), up
from 23 percent in 1990. And it is the EMEs, not the developed economies, that have been
the engine of global growth in recent years. For example, during the 2000s, EME growth
accounted for 59 percent of global growth, up from 33 percent and 25 percent, respectively,
in the two preceding decades.
By other measures, the EMEs have been even more important. For example, EME growth
has been very commodity intensive. Thus, while China is still only two-fifths the size of the
United States in GDP terms, it dwarfs the United States in terms of its demand for some key
commodities.
The growth momentum among the EMEs is the result of years of tough choices and sound
decisionmaking across the emerging world. Policymakers learned from the mistakes of past
crises and capitalized on globalization and technological change. However, while the rise of
the EMEs is due mainly to the efforts of the EMEs themselves, the reaction of the developed
countries in maintaining an open global trading system and resisting calls for protectionism
has also been essential.
Even before the financial crisis, the sustained dynamism of the emerging economies was
bringing about a profound shift in the role of the EMEs within the global economy. The
traditional distinction between the industrialized "core" of the system and the emerging
"periphery" was becoming harder to justify as an analytical construct - still less an organizing
framework for policy - as the periphery took on more weight and became a much more
important driver of global economic developments.
However, the crisis and its aftermath accelerated this transition. Although many emerging
market economies contracted sharply following the peak of the financial crisis in late 2008,
economic activity in the EMEs has since rebounded powerfully. In contrast, the recovery for
the developed economies has been anemic. Economic output for the BRICs this year will be
about 31 percent higher than it was in 2007; for the G7 just 1 percent higher.2
The rapid rebound of the EMEs occurred mainly because the locus of the financial crisis was
elsewhere and that helped limit the damage to their financial system and balance sheets. But
many EMEs also recovered quickly because they had the capacity and credibility to pursue
countercyclical policies in response to large external shocks to aggregate demand for the
first time.
On many fiscal metrics, some economies in the emerging world now look in better shape
than many of those in the advanced world. This challenges the traditional distinction between
developed country and emerging market sovereign creditworthiness. Where the developed
world still stands apart is in the quality of its institutions, legal and policy frameworks, and the
sophistication of its technologies and markets. But even here the gap is narrowing.
The story of the EMEs has generally been an extraordinarily positive one for the world as
hundreds of millions of people have lifted themselves out of poverty.
Nevertheless, even before the crisis, it was evident that the relationship between developed
and emerging economies was becoming strained and needed to be adjusted; the status quo
would clearly be unsustainable. Consider, for example, the economic relationships between
the United States and China that prevailed over the past decade or so.
Some experts have summarized the arrangements as follows. The United States bought
Chinese exports at low prices, which bolstered U.S. living standards and held down U.S.
inflation. The United States did not take extreme steps to try to force China to revalue the
renminbi upward against the dollar, and China, in turn, invested its trade surplus and capital
inflows into U.S. Treasuries in order to keep the renminbi from appreciating too rapidly. The
U.S. terms of trade improved as the cost of imported goods dropped, and U.S. interest rates
stayed relatively low as China recycled its trade surpluses back into U.S. financial assets.
For China, the benefits included strong economic growth, technology transfer and the
creation of many manufacturing jobs. These developments, in turn, helped foster rising living
standards and political stability in China.
These outcomes were by no means all the result of a deliberate grand strategy. But I think
this is a reasonable, albeit overly simplistic, description of what happened.
Although the pre-crisis arrangements worked reasonably well for a while, the flaws became
increasingly evident over time. Looked at from the lens of the developed world, the
combination of rapid gains in production capacity and relatively repressed consumption in the
EME world helped foster a global deficiency of demand relative to supply. In these
circumstances, the United States and many other industrialized economies had to sustain
domestic demand at elevated levels in order to achieve "full employment" and prevent
deflation.
For the United States, the consequence was elevated consumption facilitated by asset price
inflation, easy underwriting standards for credit and structural budget deficits. Of course, this
particular outcome was not preordained or caused by the EMEs. There were multiple
combinations of domestic demand consistent with full employment in the United States
during the pre-crisis period. For example, if the United States had adopted different policies,
it might have shifted the composition of growth toward more business investment and less
consumption and housing. But in a disinflationary global environment amid chronic EME
trade surpluses, the United States could not achieve a high level of employment with a high
level of national saving.
Looked at from the lens of the emerging world, sustained consumption demand in developed
nations induced the EMEs to continue to emphasize investment and exports. This meant that
still poor populations did not reap the full benefit of their labors in the form of increases in real
income and consumption commensurate with the gains achieved in productivity and output.
Also, this system led, in many cases, to poor returns to EME savers. This resulted, in part,
from the cost of sterilizing reserves accumulated in the process of managing exchange rates
and the use of the banking system as a tool of industrial policy.
While it is tempting to draw a line of causation from actions in one part of the global system
to the other, this is overly simplistic. Rather, we have to think of the global economy as a
single system, with outcomes based simultaneously on all the choices and preferences
throughout the system. What is new is that the so-called periphery is now weighty enough to
have a large impact on the pattern of economic activity in the core, as well as vice versa.
Although the outcomes were not caused by currency arrangements per se, it is hard to avoid
the conclusion that regimes with limited exchange rate flexibility linked to the dollar at
undervalued exchange rates frustrated one channel through which relative prices might
otherwise have adjusted in a way to induce more balanced global growth.
It is clear that the pre-crisis formula for global growth was not sustainable. This is obvious in
the case of industrialized nations where private consumption and fiscal deficits reached
unsustainable levels and needed to be cut back.
Less obviously, this is also the case for EMEs, as growth strategies that rely on excessive
consumption elsewhere in the system are no longer viable. Put simply, we now have a
problem of arithmetic - particularly for China as the largest and most dynamic EME.
As China becomes increasingly weighty in the global economy, it will not be able to sustain
export growth in the high teens annually3 in a world that is growing (ex China) at less than
4 percent a year on average. For China, the business fixed investment side of the ledger also
appears unsustainably high as a share of GDP. In this context, China's ongoing rapid
accumulation of foreign exchange reserves, which carries real economic costs, seems less a
sign of strength than an indication of how difficult it is to shift to a different growth path.
The financial crisis did not cause the old growth patterns to become unsustainable. They
already were. But its aftermath forces us to confront the need for adjustment with greater
urgency, due to the added imposition of extreme cyclical pressures on what were already
unsustainable structural relationships.
There are now two additional dimensions to the problem: (1) the stress created by exchange
rate regimes that link the monetary conditions of economies at very different stages in the
business cycle, and (2) the need for far-reaching fiscal adjustment in the crisis-hit economies
of the developed world in the coming years.
Again, to simplify, take the case of the United States and China. The Chinese economy is
experiencing the pressures of rapid economic growth that threaten to lead to overheating.
Chinese wages - especially in the coastal regions are rising rapidly and consumer prices, on
a year-over-year basis, are rising at about a 5 percent annual rate. In contrast, U.S. inflation
is considerably lower, growth is subdued, and the United States is still 7 million jobs short of
the peak reached in 2007.
An extreme cyclical imbalance exists between the EME world and the United States. The
monetary policy appropriate for the United States is increasingly inappropriate for the vast
majority of EMEs and vice versa. This creates for EME authorities a dilemma that cannot be
resolved entirely via macro-prudential regulatory policies, regardless of their merit.
An EME faces the choice: let its currency appreciate more rapidly and risk losing
competitiveness in international markets, or restrain the rise in its currency through
intervention and risk inflation. The steps required to mitigate the inflation risk through
sterilization can involve big fiscal costs.4 Neither option is attractive, though the former
strategy of currency appreciation is much less problematic if other EMEs are acting in a
similar manner.
Meanwhile, we all have to bear in mind that current circumstances put stress on the support
for open global markets in the developed world.
On the U.S. side, the recovery remains distinctly subpar in spite of aggressive monetary and
fiscal stimulus. On the monetary policy front, short-term rates remain near zero and the
Federal Reserve is just about to complete its $600 billion Treasury purchase program. On
the fiscal policy front, the U.S. government has engaged in large stimulus program. This
supported demand and employment while the private sector shifted its saving balance into
surplus in an effort to repair balance sheets.
However, the large size of the fiscal deficit and the rapid increase in the country's federal
debt-to-GDP ratio means that this is not sustainable for much longer.
Ultimately, the composition of economic activity in the United States needs to be rebalanced.
There are two issues here. First, the consumption share of GDP may still be too high.
Second, the need for U.S. fiscal consolidation implies that there will have to be offsetting
increases in investment and the U.S. trade balance as the recovery proceeds.
To illustrate this second point consider the following accounting identity: The public sector
balance + the private sector balance = the current account balance
Right now the identity holds as roughly: -10 percent of GDP public sector balance
+ 7 percent of GDP private sector balance = -3 percent of GDP current account balance.5
If the public sector balance must over time move from around -10 percent to around
-3 percent to stabilize the federal debt-to-GDP ratio at tolerable levels, then the private
sector balance and the current account balance must move by roughly 7 percentage points
of GDP to take up the slack.
Assuming that the consumption share of GDP still needs to fall over the medium term, the
adjustment in the U.S. private balance will have to occur primarily in terms of rising
residential or business fixed investment.
There does seem to be room for business investment to expand significantly when firms
become more confident in the economic outlook, provided that the United States remains a
competitive location for investment. But residential investment is unlikely to climb very much
for some time given the chronic overhang of unsold homes.
If these two sectors cannot take up all the slack created by necessary fiscal retrenchment in
the years ahead - as seems likely - then the U.S. trade balance will need to improve as well.
This implies that EMEs will no longer be able to rely on expanding U.S. demand as a key
driver of their own economic growth.
Of course, this is not just an issue of U.S. and EME adjustment. Adjustments will be required
in other industrialized countries, too - and not just the deficit countries. There has to be
recognition on all sides that global rebalancing in terms of the composition of activity and
growth and in terms of global capital flows is necessary.
Fortunately, this is not a zero-sum game: it is in the interests of all sides. However, it is still
very difficult to accomplish because it is not in the short-term interests of some interest
groups in many nations. This means that there are likely to be considerable political
obstacles to adjustment in many parts of the global economy.
In this process, the United States needs to show leadership in contributing to a smooth
adjustment. In this regard, I think there are a number of actions that the United States can
take - unilaterally and in its own interest - that will make this rebalancing process easier and
less prone to disruption.
As discussed earlier, no issue is more important than a credible commitment for getting our
fiscal house in order, but at a pace that does not forestall a sustained economic recovery.
What is needed here is fiscal consolidation that begins slowly, builds over time to substantial
magnitude, and is difficult to dismantle - i.e., it requires the commitment of both political
parties. The decision of how big the U.S. government should be and what functions it should
perform is a political decision that I leave to the voters and our legislators. However, as a
nation we need to acknowledge that we must be willing to pay for whatever government
services and transfers we want to have. We should not assume that an excess of global
savings will always be available to easily finance our public deficits.
The choice of fiscal sustainability is not a political one, it is an economic one and if we do not
act voluntarily and preemptively, the market will inevitably force the outcome later - most
likely in a much more difficult and messy fashion.
Moreover, we must recognize that the rest of the world is closely monitoring our ability as a
nation to come to grips with our long-term fiscal challenges, and to pay our debts when they
come due. This is an important litmus test of our credibility and ability to exercise global
economic leadership.
But the challenges extend far beyond fiscal policy. We, as a nation, have to take steps that
facilitate the needed structural adjustment of U.S. economic activity that will position us to
thrive in the next chapter of global economic transformation. We need to make sure the next
business cycle will be more sustainable than the last, which was built on an unstable
foundation of asset price gains, easy credit and outsized financial-sector profits.
This will require a shift in orientation from consumption to export and investment-led growth.
As EMEs have shown us, comparative advantage and global competitiveness are not
inevitable consequences of factor endowments - they are the result of the choices we make
as nations.
There are no easy answers or quick-fix solutions. But in this regard, ensuring broad access
to educational opportunity and improving opportunities for people to retool their skills
mid-career so they can compete in a rapidly evolving global economy are important.
So too is ensuring that regulation is calibrated such that it achieves public policy goals in the
most efficient manner possible, with the least compliance costs and unnecessary delays. A
continued commitment to open markets and free trade is essential. Enlightened immigration
policies can play a role - making sure that U.S. companies doing business here in the United
States can augment the skill sets of workers here with those attracted from abroad.
Tax reform, energy policy, and housing policy also have crucial roles to play - as does
financial reform, a subject to which I will return later in the speech.
Leveraging the comparative advantage that the United States has in higher education also
makes sense. This should include encouraging foreign students to come here to study. Also,
closer partnerships between universities and business could leverage the technological
discoveries and advances that occur in university research so that the benefits accrue to a
greater degree to U.S. firms and workers.
These are fundamentally structural issues - not cyclical issues. They cannot be tackled
primarily through monetary policy. Instead, monetary policy is mainly a tool for stabilizing the
macroeconomy and keeping inflation expectations well-anchored.
Nevertheless, monetary policy has an important role in supporting the transitions that need to
take place, consistent with our dual mandate of full employment and price stability. As we do
so, we must take international developments fully into account.
The integration of the EMEs into the global economy has been associated with some major
shifts in relative prices. For a number of years, the United States and other industrialized
nations benefited from disinflation in manufactured goods produced in EMEs. This shift in
relative prices - a positive terms of trade gain - helped contain inflation.
More recently, the disinflationary tailwind in traded manufactured goods imported from China
may have come to an end, at least for a period, as more of the increase in productivity there
is captured in wage gains.
Meanwhile, growing prosperity and urbanization in highly populous countries such as China
and India has been the principal driver of a major, multiyear upward shift in the relative price
of commodities. This move - a negative terms of trade hit for the United States - has pushed
up the overall rate of inflation, at least temporarily.
There are good reasons to believe that commodity prices will not continue to increase at the
explosive rate of recent months. Households and businesses will adjust their activities in
response to higher prices, and there will be a supply response to higher prices that will
gradually build over time.
In any event, a shift in relative prices, even if spread out over a number of years, should not
to be confused with the onset of an ongoing inflation problem. But the uncertain future path
of commodity prices does make the task of the central banker harder.
It is the job of central bankers to ensure that changes in relative prices do not infect the
general trend in prices. In the United States - unlike in many EMEs that are appropriately
tightening policy - a large amount of slack and low unit labor cost increases provide a
disinflationary counterbalance to commodity price gains. Of course, as I noted in a speech
earlier this year, we will have to monitor inflation expectations closely to ensure that they do
not become unanchored.
We also need to keep a close eye on the degree to which unit labor cost increases in EMEs
and real exchange rate appreciation abroad are passed through into U.S. import prices and
consumer inflation. Although the historic evidence is that pass-through has been limited in
the United States, we cannot be complacent about this.
Meanwhile, we have to recognize that monetary policy works somewhat differently in a world
in which a large share of global GDP is part of a de facto dollar block. In particular, we must
take into account the feedback loops this creates - how U.S. monetary policy influences
financial conditions elsewhere and, how these changes, in turn, influence activity and prices
in the United States.
At the same time, other nations should recognize that we cannot and do not seek to make
monetary policy for the world. Responsibility for ensuring that financial conditions in other
nations are appropriate for their own circumstances appropriately lies with their national
authorities, and they have a wide range of fiscal, monetary, exchange rate and other policy
tools available for this purpose.
I do not see any fundamental conflict between U.S. domestic economic objectives and the
interests of the global system as a whole. But the existing system of global currency and
monetary arrangements does render effective pursuit of these objectives more difficult.
I believe that we would all be better off if the system evolved toward more flexible exchange
rates and greater monetary independence in the EME world.
Notwithstanding this, we can and do pursue our monetary policy objectives in the United
States ever mindful of how our policy choices affect other parts of the global economic
system, recognizing that these impacts will, in turn, influence U.S. economic outcomes.
For the Federal Reserve, pursuing the dual mandate of full employment and price stability
allows us to make an important contribution to global stability and growth. Ensuring low and
stable inflation preserves the purchasing power of the dollar and sustains its attractiveness
as a medium of exchange. Supporting maximum sustainable employment means that we
have an important growth mandate.
This remains the case even when we are at the so-called zero bound with respect to
shortterm rates. In this context, I believe that our large-scale asset purchase programs were fully
consistent with our global responsibilities. For example, our recent program to purchase
$600 billion of Treasury securities sought to prevent a relapse into recession and to lessen
the risk of deflation - outcomes that would have been very damaging to global economy.
I do not mean to dismiss lightly the concerns raised by some EMEs about the program. By
removing long-duration Treasury assets from private investors' hands, we encouraged those
investors to purchase other assets, including foreign assets. This eased U.S. financial
conditions and, thus, boosted U.S. demand for both domestically and foreign-produced
goods. The portfolio rebalancing also may have encouraged greater gross capital outflows. It
is at least possible that this amplified the fundamentally driven rise in EME asset prices and
put some upward pressure on some EME currencies.
But, in my opinion, it would have been irresponsible for us to allow the risk of a deflationary
outcome in the United States to persist without decisive policy action. If the United States
had slipped back into recession, the global economy and financial system would have been
destabilized in unpredictable ways, and capital flight to the EMEs and upward pressure on
EME currencies would have likely increased rather than diminished.
The Federal Reserve is fully committed to keeping inflation in check and maintaining the
purchasing power of the dollar. This is important for U.S. economic stability and growth. It is
also critical if the United States is to retain foreign investor confidence, which, as an importer
of capital, we should never take for granted.
In fact, we recognize that the United States, as the issuer of the global reserve currency, has
singular responsibilities within the global system. The central role of the dollar and dollar
assets rests on several pillars:

confidence in the credibility and coherence of U.S. monetary policy, which preserves
the long-run purchasing power of the dollar;

the unimpeachable credit quality of the public debt that anchors our system;

the resilience and vibrancy of our financial system; and

the efficiency and security of our payments system.
These are strengths that we must constantly maintain.
Ensuring financial stability is essential to advancing the common interests of the global
economic system. We have much work still to do in the developed world. But the EMEs also
need to be active participants in this conversation, given their rising weight in the world
economy, already large contribution to global savings and growing importance in the creation
of financial assets. Everyone benefits if the EMEs can liberalize and deepen their financial
systems in ways that avoid some of the mistakes that we in the United States and others
have made.
To sum up, the rapid ascendancy of the EMEs in the world economy and the widespread
improvement in living conditions associated with globalization are to be applauded. But
aspects of this process have occurred in a manner that has led to strains on both a cyclical
and secular basis. The current relationships in terms of capital flows and composition of
growth are not likely to prove sustainable on a long-term basis.
The issue of global rebalancing has received plenty of attention elsewhere. My goal today is
not to play the blame game. We all share responsibility for addressing our current set of
challenges. Rather, it is to lay out the reasons why it is imperative that the United States and
the EMEs collectively move toward arrangements that put us on a mutually sustainable path.
I hope I have been convincing.
The United States must provide leadership in this global process. This is in our own national
interest. The policy response we need combines fiscal and structural adjustments that would
enable the United States to prosper in the next phase of global economic transformation.
These issues cannot be addressed primarily thorough monetary policy. However, monetary
policy has a role to play in supporting the necessary transitions, and it too needs to be
conducted mindful of its global context.
As we step up to our responsibilities, we should look to the leading nations of the EME world
to provide leadership too, commensurate with their growing importance in the global system,
in rebalancing demand and increasing currency flexibility. If we lead together, with mutually
supportive actions, we can achieve better outcomes than any of us can achieve on our own.
Thank you for your kind attention.