Ms. Rivlin discusses the state of the world economy and its implications for
Remarks by Vice-Chair of the US Federal Reserve System,
the United States
Ms. Alice M. Rivlin, at the State University of New York-Brockport and Buffalo State College
in Buffalo, New York on 22/10/98.
I am delighted to be here today and to have this opportunity to talk with you. I am
particularly pleased to be here with my friend Congressman John LaFalce, who brings such
energy and good sense to the Congress, especially to the hard work of the Banking Committee,
which is where I see him most frequently.
I want to talk with you this morning about the turmoil in the world economy and
what it might mean for us here in the United States. Why should people in upstate New York
care about the economy of Thailand or Russia or Brazil? What can we do to keep our own
economy strong?
We are all used to the cliche that the world is getting smaller, that the electronic
age has brought us closer and put us in instant touch with remote parts of the globe. We know
that cross-border trade and investment have increased enormously in recent years, bringing both
greater prosperity and greater interdependence.
Still, when bad news from Asian economies began flashing across our screens in
the summer of 1997, it didn't seem to have much to do with us. Currencies with odd names, like
the baht and the ringgit were said to be plunging, stocks prices on the Hang Seng or the Nikkei
were falling, by the end of the year Korean banks were negotiating with their creditors. But here
at home the economy was doing better than it had in a generation. The news from Asia seemed
like a small dark cloud appearing on the horizon in the middle of a sunny day at an outdoor
festivity. It might mean rain, but with any luck it would go away.
We have been enjoying a truly extraordinary performance of the US economy.
Since the beginning of the 1990s, we have had a long period of growth that didn't seem to be
sputtering out. In fact, growth accelerated in 1997 and early 1998, which is not the usual pattern
for a "mature" business cycle. We have seen few signs of strain or imbalance. Although some
areas, including Upstate New York, have lagged, we have experienced mostly good growth
across the country and across sectors of the economy.
Unemployment has been very low - lower than most economists thought it could
remain for long without igniting inflation. Wages have been increasing, but not so fast that the
rise caused rapid escalation of costs. The slowdown in the rise of health benefit costs has held
total compensation increases to moderate levels. Productivity increases have been offsetting
compensation growth, keeping profits growing, at least until quite recently. Most remarkable of
all, inflation has been falling and not showing any clear evidence of accelerating again.
Even the Asian crisis at first seemed an ill-wind whose timing was actually
blowing us some good. Some Americans felt the negative impact early, especially manufacturers
whose exports to Asia declined and farmers who saw their prices drop on world markets as Asian
demand fell off. At the national level, however, our economy was clearly growing at an
unsustainable rate, and some slowdown was actually welcome. We were in danger of running out
of workers. Sooner or later cost pressures would lead to inflation. The primary economic risk
seemed to be overheating, not slow growth.
Indeed, the Federal Reserve was concerned enough to tap the brakes by raising the
short term interest rate in March 1997 before the Asian crisis hit that summer. We would
probably have felt called on to raise rates again later in 1997, but by then it seemed likely that
slower growth in Asia would cut US net exports, and restrain our economy enough to avoid
inflation and any pressures. Good productivity performance, falling commodity prices, combined
with low inflation expectations and the high value of the dollar, all made it less risky to wait and
reduced the necessity of the Federal Reserve taking preemptive action against inflation by raising
rates again.
The stock market's remarkable rise both reflected and perpetuated the general
good feeling about the US economy. Even the Asian crisis raised the price of US stocks, as
investors took their money out of Asian markets and bought US securities instead. To be sure,
US equity values were outrunning reasonable expectations of profits, especially if, as many
forecasters expected, the economy slowed down. But increased wealth of consumers stimulated
consumption and the low cost of equity stimulated investments, so chances of future profits were
enhanced. Some worried that high equity values were a bubble that would inevitably burst, but
this concern was mitigated by: (1) lack of strong evidence that stock prices were part of a wider
speculative phenomenon that included real estate and other assets, as in some previous boom
periods; (2) the apparent new maturity of small investors, who talked and acted as though they
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 the US
was in "new era" in which all the old rules had been suddenly repealed, or whether there was a
"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. There are
lots of reasons why the economy might be both more productive and less inflation prone than it
used to be:
• more global competition
• deregulation of airlines, trucking, telecommunications; decline of barriers among
financial services
• the computer and telecommunication revolution (finally) making cost savings
possible, not just in manufacturing, but in services
more flexibility and incentives built into wages, less unionization, out-sourcing of
•
specialized services, use of temporary and part-time employees
• high levels of investment, including human investment - on-the-job and other skill
training.
In economists' terms, there was hope that productivity might have moved onto a
higher growth trend. Faster productivity growth would mean a higher standard of living for
Americans in the future. It would mean that growth could be faster without setting off inflation
(perhaps closer to 3 percent a year than 2 percent) and that unemployment could be lower
without inflationary consequences. That would be very good news.
It was too soon to be sure that the apparent productivity trend increase would hold
up or that less inflation was becoming the norm. It was certainly true that some elements of the
unusual combination of favorable inflation factors were likely to reverse. Health cost increases
might accelerate again; the dollar might weaken and cause import prices to rise; oil and
commodity prices might go up again. Still, the US economy seemed to be performing remarkably
well.
Then ill-wind from Asia turned to a gale, sweeping through currency and asset
markets all around the world and affecting our own financial markets as well. The stock market
dropped 5 percent in one day in August, then bounced wildly around. A general "flight to
quality" drove long-term interest rates down on Treasuries, but rates on riskier financial
instruments went up. The market mood changed to pessimism and risk aversion.
Meanwhile, across the Atlantic, the initial storm warnings from Asia, were also
first dismissed by many Europeans as far away and not their problem - distant thunder on another
shore. European economies are less heavily involved with Asia than we are and, besides, the
ill-wind was blowing them some good in the form of lower oil and other commodity prices. The
major countries on the continent were working hard on the details of monetary union and
organizing a multi-national central bank; they were struggling earnestly to get deficits and
inflation down. The basically simple idea of having a common currency and a common central
bank proved very difficult to achieve technically and politically, but they had done it. Growth
rates were finally picking up and even high French and German unemployment rates were
beginning to recede. Europeans were optimistic that the common currency, and the increased
competition and deepening capital markets it was likely to engender, would energize their
economies even more and lead to higher growth. This unpleasant weather on the horizon seemed
at first a minor distraction. But the lightening bolt in Russia was more difficult to ignore; it was
right there on their borders.
In Japan, the Asian crisis had a much greater impact and came at a much worse
time. Japan is closely involved with other Asian countries and suffered both financial reversals
and loss of markets for Japanese goods. They were already struggling with slow growth, a
banking system in need of overhaul and a political party structure in need of rejuvenation. The
Asian crisis precipitated deep recession in Japan. The world economic turmoil could not have
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 an
increasingly interdependent world that it is important to remind ourselves that the upside is
enormous. Increasing volumes of trade and cross-border investment have raised the standard of
living in many emerging countries at an astonishing rate. Trade and foreign investment have
moved the countries of southeast Asia in less than a generation from traditional agriculture to
modern industrial societies with far less poverty, much more skilled work forces and rising
standards of living. At the same time, we and other industrial countries have benefited from
growing markets for our exports, higher profits on our capital and lower prices for the wide
variety of goods we import.
When things are going well in an interlinked world, one country's prosperity
reinforces another's. The rapid growth of emerging market countries, especially in Asia, in the
last couple of decades, led to greatly increased trade among them as well as with industrial
countries. The self-reinforcing growth seemed so positive that investors began to view investing
in emerging markets as not much more risky than investing in their own more familiar industrial
country markets. Capital flowed freely to finance projects in emerging market countries with
lenders demanding only slightly higher interest rates than they would have required to lend at
home.
But the downside of interdependence is that when something goes wrong, the
impact also spreads quickly from one country to another, through trade channels, prices and asset
markets. Asian countries in trouble quickly cut their imports from each other and from the
industrial world. The reduced Asian demand for food, oil and raw materials was felt by farmers
in the US and Canada, Australia and New Zealand; by producers of oil in Mexico and Venezuela,
Nigeria and Russia and the Middle East; by copper producers in Chile and exporters of industrial
raw materials in Africa and elsewhere. Companies in Rochester and Buffalo found their sales
falling.
As the contagion spread, investments in many emerging market countries began to
look less promising. Investors became generally more cautious and began looking for safe places
to put their money - like buying US government bonds - even at low rates of return. As they saw
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 loss of
confidence in an interlinked world. The meltdown in Russia was the clearest case. Russia is not
an important economic and trading power in itself. Losses to major money center banks, here and
in Europe, though magnified by unexpected interrelations with hedge funds and other operations,
were not in themselves destabilizing. But what apparently mattered was the surprise, both of the
suddenness and unpleasantness of the Russian default and of the fact that the Western "powers"
were so powerless. No one thought the US and its allies would take the political risk of letting
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 who
had borrowed to invest in Russia had to sell assets in other markets to cover losses. Others
simply said to themselves, "If it can happen in Russia, it can happen anywhere; I had better get
my money to a safe place." The result was plummeting markets in Latin America, South Africa,
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 summer of 1997
- and seemed like a remote event of no great significance to most Americans - has set off a chain
reaction reaching around the world. Much of Asia is in deep recession, the Russian economy has
collapsed with negative repercussions for many of its neighbors, growth is slowing in Latin
America. Risk aversion of investors has made it difficult for any country, company or venture
perceived as at all risky to get capital or to borrow, even at high rates. Countries like Brazil,
Mexico and Argentina, considered quite strong a few months ago, are under mounting pressure.
Brazil has had to raise interest rates, use much of its foreign exchange reserves to keep its
currency from depreciating; the high interest rates, in turn, have greatly exacerbated Brazil's
budget deficit, and the deteriorating outlook has led to fears that investors will pull their capital
out and bankers refuse to roll over debts. Economic collapse in Brazil, which is Latin America's
largest economy, could precipitate serious trouble in other Latin American countries and then
reverberate back around the globe to deepen the trouble of Asia, including Hong Kong, China
and Japan. Another round of deepening deterioration would surely put intense downward
pressure on the US economy by cutting our exports, depressing equity markets and weakening
investor and consumer confidence. As Chairman Alan Greenspan has said, we cannot expect to
be an "oasis of prosperity" in a deteriorating world economy. Even if we could stay prosperous
alone, we should not want to take the risk that deteriorating economies in the rest of the world
would augment unrest, terrorism and international conflict that could engulf the United States.
What's to be done? In the near term there are clearly two priorities:
⇒ Stop the contagion so that emerging market countries can begin to get back on their feet.
⇒ Keep the world's largest economy from slowing down too much - for our own sake and
the world's.
There is no easy, simple answer to stopping contagion, if indeed there is any
answer. What would be the elements of a plan?
First, countries most in danger of being the next to fall have to be willing to face
up to their vulnerability quickly. (There is no point in moaning, "It's not our fault, we didn't do
anything wrong; we just got caught in the world backwash." That's partly true, but not helpful.)
They have to be willing to call in their creditors to negotiate rollovers, ask the IMF for
conditional loans, offer significant and credible internal reforms in return. Nowhere is this easy.
Second, private creditors have to see their long-run interest in hanging in, even on
concessional terms, rather than joining a stampede for the exits.
Third, the international financial institutions and the industrial countries have to
find more funding to tide these countries over the crises if they give evidence of willingness to
accept strict conditions. Congress' passage of the IMF quota increase and the New Arrangements
to Borrow remove a major uncertainty about the effectiveness of collective action and should do
a lot to restore confidence that the chain reaction of economic deterioration can be stopped.
Keeping our own economy growing would be important even if the rest of the
world were not depending on us so much. Slower growth and rising US unemployment would
mean fewer opportunities for Americans to earn income and move to higher skilled and better
paid jobs, less chance for families to move out of poverty and from welfare to work. Slow
growth or recession in US would also have serious consequences for the rest of the world,
reducing our ability to buy and invest abroad and exacerbating economic downturn everywhere.
At present, the chance of recession in the US does not seem high. Recent growth
has been strong and balanced with few indications of strains and speculative excesses that
typically go with boom/bust cycles. Most forecasters expect the US economy to slow; the hope is
that it will not slow too much.
The Federal Reserve, recognizing that the balance of risks has shifted from
overheating to cooling off, has cut short term interest rates twice. Other industrial countries may
follow our lead (Canada already has); although the major continental European countries feel
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 - to stop
being part of the problem and be part of the solution - as Americans and Europeans have been
pointing out, none too politely, for months.
The Japanese were not shy, when they were riding high in the '70s and '80s, to
offer advice to the Western industrialized countries about modernizing our manufacturing and
management practices, working harder, getting budget deficits down. So there may be a payback
element to the US and European shrillness about how important it is for the Japanese to use
aggressive fiscal stimulus to get their economy going again and to restore confidence by drastic
and immediate restructuring of their banking system. Neither is going well. A series of stimulus
announcements, mostly focussed on increasing government spending for public works has not
yet succeeded in stemming the economic slide. A next step might be a significant tax cut, but
with Japanese consumers and investors both feeling anxious about the future, there is no
guarantee that even a large tax cut would result in much near term spending.
Japanese banking system restructuring is going slowly, although it does seem to
be moving toward resolution. We are fine ones to talk, since we let our much smaller savings and
loan crisis fester for a long time before facing up to it. With hindsight, the Japanese could have
restructured their banks much more easily three or four years ago. The worst time to restructure
failing banks is when macroeconomic conditions are reducing the value of their assets even
further. Drastic action now may make the recession worse in the short run, but it may also be the
only hope for restoring confidence and financial health in the future. Let's suppose this crisis
turns around: the contagion is stopped, Asian and other emerging market countries begin to grow
again; Japan pulls out of recession and begins to contribute with its recovery to recovery of its
neighbors; North America and Europe sustain healthy economies. Then the big question is: how
to avoid such a costly episode happening again. The real costs are not monetary; they are
disrupted human lives and hopes. Millions of people in emerging market countries are suddenly
without jobs, food, basic necessities, children are not going to school, young people are not
learning skills, and are facing uncertain futures.
We won't be able to avoid crises altogether. But in the new era of huge capital
flows and instant communication, the amplitude and severity and cross border reach of crises are
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 economies
that don't trade or invest in each other. The simple reason is: we'd all be a lot poorer. That
solution is like saying: We don't like power failures, so let's all stop using electricity or make
sure that everyone has a generator in the backyard, so we don't have to depend on the power
company.
What we can strive for is more cautious better informed investing and lending,
better early warning systems and ways of heading off deepening trouble once it begins.
Better information would help:
⇒ All countries giving complete information on their foreign exchange reserves in as close
to real time as possible.
⇒ Better information on budgets and government finances, eg, what real deficits are.
⇒ Companies and banks revealing more clearly what their assets, liabilities and profits are.
More effective, better supervised financial systems are essential:
⇒ Prudential regulation of banks.
⇒ More carefully supervised securities markets.
⇒ Accounting standards, enforced.
One idea is that a country's financial systems could be graded by its peers in other
countries; somewhat in the manner that universities or hospitals are accredited in the United
States and the results published.
The concern should not be just with borrowing countries and their institutions, as
though making emerging market countries' financial structures more like the structures in
industrial countries would solve all the problems. For every borrower there is a lender. Industrial
countries, creditor countries, have to be more sure their banks are managing their risks
appropriately, and are prepared to deal with situations when a lot of things go wrong at once.
Finally, we must strengthen international financial institutions so they are better
able to assess the health of member countries, give timely warnings of trouble ahead, and provide
short term assistance to countries that need to make repairs.
All of this will take sustained effort to learn from past and build a stronger
international financial community for future. The process ought to create some interesting,
rewarding jobs and challenges for those with an interest in how the economic world works and
how to make it better.