Janet L Yellen: Improving the international monetary and financial
system
Speech by Ms Janet L Yellen, Vice Chair of the Board of Governors of the Federal Reserve
System, at the International Symposium of the Banque de France: Regulation in the Face of
Global Imbalances, Paris, 4 March 2011.
* * *
Improving the international monetary and financial system
Nearly four decades have elapsed since the demise of Bretton Woods, and during that time,
the international monetary and financial system has undergone a significant transformation.
The changes that have occurred reflect deliberate policy choices by the official sector as well
as the organic interactions of investors, institutions, and advancing technologies. Judging by
the standards of global economic growth, stable prices, and financial stability, the
international monetary and financial system, in its current incarnation, has a decidedly mixed
record. Wrenching crises and economic distress, notably including the difficult experience of
the past several years, have punctuated periods of solid growth, low inflation, and financial
stability. Thus, the subject of today's discussion is vitally important, and I am pleased to
contribute my thoughts on steps we can take to improve our international economic order.1
In evaluating our policy priorities, I find it helpful to distinguish between the international
monetary international
system and the financial system.2 The international monetary system
is the set of rules, conventions, and institutions associated with monetary policy, official
capital flows, and exchange rates. It also includes mechanisms to provide official sector
support to countries facing funding pressures. The international financial system is much
broader, encompassing both private and official participants in global financial markets. I
consider this distinction important in thinking about how to reduce the incidence and severity
of future crises while preserving a prosperous global economy.
In the case of the recent global financial crisis and recession, I would apportion responsibility
to inadequacies in both the monetary and financial systems. With respect to the international
monetary system, the basic story is now quite familiar: Strong capital outflows from countries
with chronic current account surpluses - in part reflecting heavily managed exchange rates,
reserve accumulation, and other shortcomings in the operation of the international monetary
system - put downward pressure on real interest rates, in turn boosting asset prices
(particularly for housing) and enhancing the availability of credit. These developments
contributed significantly to the buildup of financial imbalances, but they were not, on their
own, sufficient to have engendered the massive financial crisis we experienced.
Had the additional domestic credit associated with these capital inflows been used
effectively, the imbalances need not have led to financial ruin. In the United States and other
countries with current account deficits, however, borrowing too often supported excessive
spending on housing and consumption, rather than financing productive investment. Most
important, declines in underwriting standards, breakdowns in lending oversight by investors
and rating agencies, increased use of opaque financial products, and more-general
inadequacies in risk management by private financial institutions helped foster a dangerous
and unsustainable credit boom. With the financial system evolving rapidly, supervisors and
regulators, both in the United States and in many other countries, failed to recognize and
address the mounting vulnerabilities. In short, these failures rooted in the financial system
interacted with weaknesses in the global monetary system to create stresses and instabilities
that eventually triggered - and amplified - the recent financial crisis and subsequent
recession.
Other economic crises can similarly be traced to the interaction of weaknesses in the global
monetary and financial systems. For example, the Asian financial crisis of the late 1990s was
rooted in failures to prudently allocate capital to productive investments - failures of financial
intermediation. But these problems were made worse by characteristics of the international
monetary system, as heavily managed exchange rates encouraged excessive foreign
currency borrowing. The collapse of the Thai baht in mid-1997, which marked the beginning
of the crisis, resulted in substantial balance sheet losses - particularly for that country's
banks - and triggered a widespread reappraisal of risk in the entire region. As investors lost
confidence, capital fled these economies, precipitating a severe downturn. As in the recent
experience of the United States, better management of domestic financial systems in the
emerging Asian economies would have greatly limited, if not prevented, the financial
vulnerabilities that ultimately resulted in the crisis, but policies regarding exchange rate
regimes and capital flows were also an important part of the story.
The conclusion I draw from these and other financial crises is that we must strengthen both
the financial system and the monetary system to create a more stable and less crisis-prone
global economy. Improving the international financial system requires better management of
national financial sectors and also enhanced international cooperation and coordination,
because in a globalized economy with strong, complex, cross-border linkages, even
domestic financial stresses can have serious international repercussions.
Countries need to work together to ensure that weaknesses in the global financial system are
recognized and addressed. I am encouraged by the progress we have made in strengthening
the banking sector through the capital and liquidity requirements of Basel III. We have also
made important strides in improving international cooperation and coordination in the
supervision of systemically important financial institutions, whose operations and exposures
span numerous jurisdictions. That said, we need to continue working toward viable resolution
mechanisms for these institutions. Further work is also needed to improve our
macroprudential approach to managing vulnerabilities. And we must collaborate to ensure
that risky activities do not migrate to the shadows of the financial system in an attempt to
circumvent regulatory authorities.
We must also strengthen the international monetary system. We need a system
characterized by more open capital accounts, flexible exchange rates, and independent
monetary policies. Open capital accounts, supported by appropriate financial supervision and
regulation, channel savings to their most productive uses, thereby enhancing welfare.
Exchange rate flexibility improves domestic macroeconomic management, allowing countries
to pursue independent monetary policies tailored to their individual needs, and limits
unwelcome spillovers to other economies. Such a system can also flexibly adapt to changing
economic and financial realities as countries develop, technology progresses, and shocks
buffet the global economy.
Our current international monetary system does not yet fulfill these objectives. We now have
a hybrid arrangement in which some economies have flexible exchange rates, maintain open
capital accounts, and pursue independent monetary policy - a sensible reconciliation of the
so-called impossible trinity. But other countries heavily manage their exchange rates, with
varying mixes of capital mobility and monetary policy independence.
Inflexible exchange rates in these countries have tended to inhibit adjustment of
unsustainable global imbalances in trade and capital flows. Indeed, as I noted, such
imbalances appear to have fostered the buildup of vulnerabilities in the run-up to the recent
financial crisis. Countries with current account surpluses and restricted capital flows have
been able to resist currency appreciation for prolonged periods, even when justified by
underlying fundamentals. In principle, adjustment of imbalances could occur if countries
permitting relatively limited movements in nominal exchange rates allow their national price
levels to adjust over time. But sterilization operations and other policy tools can, and often
have, restrained such adjustment. Meanwhile, countries with current account deficits should
take steps to increase national saving, including by putting in place credible plans to reduce
their fiscal deficits in the longer run.
The international monetary system, in effect, still suffers from the same asymmetry that
bedeviled the Bretton Woods system - namely, a marked differential in the pressures facing
surplus and deficit countries to permit automatic adjustments or to undertake policy to reduce
persistent global imbalances. Surplus countries can resist adjustment by restricting capital
flows and exchange rate movements, but deficit countries are forced to adjust when they run
out of international reserves or lose access to external borrowing. This asymmetry has
served to inhibit the global rebalancing process, and it could threaten the ongoing recovery: If
deficit countries curtail spending without offsetting spending increases in the surplus
countries, aggregate demand would decline, with adverse consequences for the global
economy.
Thus, in my view, we need to continue working toward an international monetary system
characterized by more-flexible exchange rates, open capital accounts, and independent
monetary policies that will facilitate the adjustment of global imbalances. But we must
recognize that countries face diverse challenges in such a transition. For countries with
undervalued currencies, the adoption of more-flexible exchange rates requires an internal
shift in resources across sectors - a transition that takes time. As noted earlier, the recent
crisis has also uncovered numerous flaws in the functioning of regulation of our financial
system, and these, too, will take time to correct. Finally, although I have not addressed this
concern in my remarks today, the expansion of public-sector deficits and debts in many
countries poses very serious medium- to long-run risks for both the international monetary
and financial systems that will need to be addressed.
Against the background of these longer-term issues, we must also support countries' efforts
to address their more immediate challenges. Some advanced economies struggle with weak
demand, high unemployment, and disinflation. Many emerging market economies face
increasing inflationary pressures and capital inflows amid strong growth. In light of these
differing challenges, a cooperative spirit among policymakers is essential to ensure
prosperity of the global economy.