Timothy F Geithner: Further investments to strengthen the financial system
Remarks by Mr Timothy F Geithner, President and Chief Executive Officer of the Federal Reserve
Bank of New York, before the Economic Club of Washington, Washington, 9 February 2005.
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Good evening. I am honored to be here. It's good to be back in Washington and to have a chance to
talk with such a distinguished group.
Much of our nation's financial history and the history of our central bank is a story of contest for
influence and over ideas between political leaders in Washington and the financial center of New York.
I think it is important that ideas shuttle back and forth between our cities, and I am pleased to have a
chance to share a few tonight.
My overall argument this evening is this. We face a delicate balance between genuinely positive
near-term economic conditions, and some fundamental challenges. If we are to increase the likelihood
of continued strong growth in living standards, we should use this time of relative prosperity to address
the imbalances that hang over our economy. Even with good policy choices, and with considerable
luck, these imbalances will take time to unwind. During this time we face some risk of a more volatile
and less benign overall financial environment. This makes it important that we continue to invest in
making our financial system stronger and more resilient.
Markets now reflect a fairly positive view about overall economic prospects. Global growth is
reasonably strong and broad-based. Underlying inflation is low. Estimates of structural productivity
growth in the United States remain high. The global economy has weathered the oil price shock and
other recent shocks quite well. Most of the major emerging market economies look stronger than they
have in some time. Overall volatility in output and inflation has moderated significantly in the United
States and, to a lesser extent, in other economies as well.
These favorable fundamentals are reflected in low risk premia of many forms - low credit spreads, low
and quite stable inflation expectations, and low actual and implied volatility. Market participants appear
to believe that future macroeconomic shocks will be more moderate, less frequent, and less damaging
than past shocks have been. To say this another way, the price of insurance against a less benign
world is now quite low.
We face a number of significant challenges that threaten this positive outlook. I want to touch on the
two that appear to me most important.
The first is the growing imbalances at the center of the global economy.
Fiscal policy in most of the major economies is on a path towards rising debt-to-GDP ratios; this
trajectory gets dramatically worse as demographic changes reduce the ratio of workers to retirees.
At the same time, external imbalances have reached unprecedented levels, most dramatically in the
case of the U.S. current account deficit, which is on a path to exceed six percent of GDP. These
imbalances - fiscal and external - cannot be sustained indefinitely. Each magnifies the risk in the
other.
The second broad challenge involves the rise of China and the other major emerging market
economies. The process of integrating China and India into the world economy offers tremendous
gains in global living standards. But the greater adjustment pressures that come with integrating the
two most populous economies in the world will put a greater burden on the political sustainability of
open trade policies. The framework of international institutions and arrangements for cooperation we
now have will need to change to reflect the emerging importance of these economies.
One important dimension of this process of integration will be a necessary evolution in the global
exchange rate system. The present system, where the major currencies adjust against each other, but
many large emerging market economies tie their currencies to the dollar or shadow it closely, creates
an awkward asymmetry. This system carries with it the seeds of future stress for the global economy.
These challenges - the challenges of unwinding large fiscal and external imbalances and of managing
the integration of emerging market economies - are likely to dominate the economic policy agenda for
a considerable period of time. If they are not managed well, we risk lower and less stable future growth
and unwelcome shocks to financial prices.
These are two different types of risks. One is the risk of lower average rates of future growth in living
standards if, for example, rising deficits and debt levels are left on a path that reduces future
investment and productivity growth. Another is the risk of higher volatility in financial and economic
outcomes, which could also limit future growth in investment and in living standards.
What are some of the things policy makers can do to mitigate the risks and challenges on the horizon?
Let me begin with monetary policy. In the present context, the Fed's most important contribution to
sustaining the expansion is to preserve confidence that we will act to keep inflation and inflation
expectations stable, at low levels.
Preserving the credibility of our commitment to price stability is vital. It is important because price
stability is critical to giving enterprises confidence to invest in the future. It is more important at a time
when we are running very large external deficits, because countries investing their savings here must
remain confident that their investments will not be eroded by future inflation. And it is important
because confidence in our commitment to price stability affords us more flexibility to act aggressively
in the event of future shocks.
If the economy follows the present forecast of slightly above-trend growth, then it would be appropriate
for monetary policy to continue to move the real fed funds rate higher. The pace at which we move
and the distance we move will depend, of course, on how the economy performs and how the forecast
evolves. But we need to be careful to give the world confidence that we will conduct policy in a manner
that will keep inflation expectations stable, at low levels.
Second, to fiscal policy. We now face a substantial and unsustainable gap between our fiscal
commitments and our resources, not just over the longer term with respect to Social Security and
Medicare, but also with respect to budget projections for the coming ten years. Reducing this gap to a
more sustainable level is vital. The decisions we make this year and over the next few years will be
important to building more confidence that we have the will to act in a manner commensurate with the
challenge.
Achieving a substantial and sustainable reduction in our fiscal imbalance is important to decrease the
risk of lower future growth in private investment which could dampen future productivity gains.
Reducing our fiscal imbalances is also important for reducing the risk of adverse shocks to financial
markets, and for maintaining the willingness of investors to invest in our economic future. Improving
the credibility of our commitment to this fiscal challenge is the most important contribution we can
make towards improving the chance of a more benign adjustment in our external imbalance.
Third, the U.S. and the major economies have an important role to play in guiding further evolution in
the international monetary system. Policy makers in Asia are well aware of the complications and
costs involved in sustaining their current regimes. Many are moving toward more flexibility in their
exchange rate regimes. The challenge ahead is to help manage the transition to a monetary system
that provides flexibility in the exchange rates of all the major economic areas, and this has to be
handled with care.
Even with good policy choices here and in other countries, bringing these imbalances down to a more
sustainable level will take time. During this period of adjustment, despite our fundamental economic
strengths, we will be vulnerable to an elevated risk of volatility in financial markets.
This prospect makes this a good time to examine the health of the financial system. The strength of
the financial system is a major factor in determining how well economies respond to shocks - weak
financial systems amplify the damage to growth.
The stronger the financial system, the more effective policy - monetary policy in particular - can be in
cushioning the effects of those shocks and helping to restore expansion.
We are fortunate in the United States today to have a strong financial system. This system has a
tremendous capacity to match capital to ideas, reward innovation, and channel savings to the highest
return. And it has demonstrated a capacity for very considerable resilience and stability in face of
shocks.
What are the main sources of these strengths? Our banks are stronger than they have been in the
past. Their larger earnings capacity, higher capital cushions, and the greater diversity of their activities
help shield them from a broader range and greater magnitude of shocks than in the past. Capital
markets play a comparatively larger role in our financial system. As a consequence, shocks get
diffused more broadly, and weakness in traditional intermediation channels can be offset by the
strength in other channels.
Here in the United States, financial innovation has advanced farther and more rapidly than elsewhere.
This reflects a regulatory model that is more supportive of competition, of financial innovation, and of
market-driven improvements in risk management. The U.S. financial system has embraced
opportunities for risk transfer much more rapidly and extensively than other systems.
Finally, we have larger and more developed venture capital, private equity, and hedge fund segments
within our financial system. These are important sources of liquidity, they add depth and breadth to
capital markets, and they play a valuable arbitrage role in reducing or eliminating mispricing in the
financial markets.
However, no system is invulnerable to stress and crisis. Recent U.S. financial history is not a history of
the uninterrupted achievement of ever higher returns. The stock market crash of '87, the stress that
surrounded the Russian default and the collapse of Long Term Capital Management, and the more
recent fall in equity prices that came with the collapse of the technology boom all posed significant
potential threats to financial stability. In each case, however, with a swift monetary policy response
and other actions the process of recovery and repair was reasonably quick.
The relative ease with which we managed through these events has reinforced confidence in the
stability of the system. This confidence is justified. But one of the consequences of the resilience of the
system in the face of past shocks is a higher degree of confidence in a benign and stable future. And
this confidence itself can increase the risk of future instability.
It is critically important, then, that we continue to strengthen our financial system. The most important
dimension of this challenge is to ensure that the size and the quality of the cushions maintained by
financial institutions against the risk of adverse outcomes are sufficiently strong.
This is particularly important in the case of the relatively small number of bank-centered financial
institutions that now play a much more central role in our financial system. Their extraordinary size and
diversity diminishes their vulnerability to shocks. However, it also exposes them to a broader array of
potential shocks, and magnifies the potential damage to the system should one of these institutions
stumble or fail.
We need to ensure that the level of insurance these core institutions maintain against risk - insurance
in the form of their capital and liquidity cushions, their operational resilience, and the quality of their
risk management and control systems - are calibrated to reflect their greater systemic significance
and the greater complexity of the challenges they face in managing more diverse businesses.
This is true not only for the largest banks, but also for GSEs like Fannie Mae and Freddie Mac, and
also for those non-bank financial institutions that play a critical role in the wholesale financial markets.
The payments system we live with today is a complex mix of national and cross border systems
originally designed for a safer, slower, less complex, more segmented financial world. While many
improvements have been made to this system over time, it is important that we work to strengthen
further the core infrastructure of the payments system.
We also need to promote further evolution in the framework of supervision and regulation of our more
complex and integrated global financial system. To paraphrase Bob Rubin in a different context, we
need a framework for supervision and regulation that is "as modern as the markets" and that stays
abreast of the pace of change and innovation.
Perhaps the greatest challenge we face - in macroeconomic policy and in financial supervision - is a
challenge of imagination: How do we best prepare for the low probability of an extreme event; a crisis
not captured by past experience? How do we generate the will today to build a greater degree of
insurance against a more uncertain future, particularly if the risk of adversity seems remote and the
immediate future looks strong?
We can take considerable reassurance from apparent moderation in overall macroeconomic volatility
recently, and from the ease with which our system has handled recent stress.
Prudent macroeconomic policy actions will increase the likelihood that these beneficial circumstances
will continue. But we cannot know with confidence that the future will bring an enduring reduction in
volatility and risk, and it would be imprudent to plan for such a world.
All this suggests we should complement sensible macroeconomic policy choices with further
investments to strengthen the financial system.
Let me end by thanking Vernon Jordan and the Economic Club of Washington for providing a forum
for thinking about the economic agenda of the country, and for giving me the opportunity to share a
few thoughts with you tonight.
Thank you.