William C Dudley: The challenges ahead
Remarks by Mr William C Dudley, President and Chief Executive Officer of the Federal
Reserve Bank of New York, at the Center for the New Economy 2010 Economic Conference,
San Juan, Puerto Rico, 19 February 2010.
* * *
Thank you very much and good morning. Although this is my first visit to Puerto Rico in my
current role, I have been here a number of times, going way back to a childhood visit with my
parents. It's a beautiful and special place, but I must admit that coming in February has some
special advantages.
I welcome this opportunity to talk with business leaders, workers and educators. My goals
are to hear what issues are on the minds of people here and to let you know what the
Federal Reserve has been doing to help improve the economy. So I'm very grateful to the
Center for the New Economy (CNE) for giving me the opportunity to speak to - and learn
from - you. 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.
I want to start by talking about the implications of the close economic ties between the
mainland and Puerto Rico. Since the economies of the mainland and the Commonwealth are
very tightly linked, what happens on the mainland has important consequences for Puerto
Rico, as well. In the aftermath of the financial crisis, we anticipate that the mainland recovery
will prove to be sustainable, and that this will ultimately benefit the economy here. But Puerto
Rico faces some significant challenges beyond its ties to the weaknesses in the broader U.S.
economy, including problems in its own financial sector. Dealing with these problems
forcefully and expeditiously is crucial to ensuring that Puerto Rico benefits fully from the
expected economic recovery over the next few years. The Fed is assisting in several ways:
by setting the stage for a resumption of world economic growth, by helping to resolve
problems in the U.S. mainland and Commonwealth financial sectors and by partnering with
Puerto Rican groups to make meaningful contributions toward resolving some of the
Commonwealth's other underlying issues.
Puerto Rico's special economic relationship with the mainland
Puerto Rico has what economists often call an "open economy." What this means is that
Puerto Rico is especially dependent on external trade, so what happens to the Puerto Rican
economy is greatly affected by what is going on with its major trading partners. When
demand from Puerto Rico's export customers is weak, then sales and prices for the
Commonwealth's products fall, so jobs and incomes on the island suffer.
In the recent recession - as in many financial crises - global trade declined even faster than
output. As a result, the shock generated by the financial crisis spread quickly throughout the
world. Economies and regions far from where the problems began suffered. This was
especially true for economies dependent on trade, such as Puerto Rico's. In fact, Puerto Rico
suffered much more than most because the Puerto Rican economy was already in recession
when the financial crisis struck.
While Puerto Rico interacts with many other economies, one partner looms especially large
for the Commonwealth. For generations, the mainland United States and Puerto Rico have
had a special economic relationship in many dimensions. One of the most obvious of these
ties is the free flow of people between the mainland and the island. Indeed, according to the
U.S. Census, about one half of the people who identify their origin as Puerto Rican lived on
the mainland in 2008. The active migration, return migration and remittances to family
members reflect and reinforce the close personal and economic ties between Puerto Rico
and the mainland.
Another link is our common use of the dollar. This means that tourists from the mainland can
visit without worrying about changing currencies. In addition, businesses can make long-term
investments in Puerto Rico without worrying that currency fluctuations against the dollar will
undermine their competitiveness. It also means that when the U.S. dollar falls in value,
Puerto Rico's exports become more competitive around the world, although not, of course, in
the United States.
Somewhat less obvious are the consequences of the mainland's role as Puerto Rico's
largest trading partner. The mainland accounts for half of the island's imports and
threequarters of its exports. With such heavy trade flows, when the mainland economy does
poorly - as during the past year - Puerto Rico's economy and job growth suffer.
Financial regulation also represents an important linkage. Of course, my presence here
representing the New York Fed is one example of that particular connection - Puerto Rico is
part of the Second District of the Federal Reserve System, along with New York, the U.S.
Virgin Islands and parts of New Jersey and Connecticut. I'll return to the theme of financial
regulation shortly. For now, let me just say that we share, along with the rest of the world, a
commitment to taking the necessary steps to prevent the type of financial crisis that we just
experienced from recurring in the future.
The Fed's role in coping with the crisis and the outlook for the United States
The close ties with the mainland means that the broader outlook for the United States is very
important for Puerto Rico. The U.S. economy has been through a terrible period, having
suffered the worst financial crisis in 70 years. Extensive study of banking crises shows that
they tend to be "protracted affairs" with surprisingly similar, if unpleasant, contours.
Downturns average four years, during which the unemployment rate rises an average of
7 percentage points. The peak-to-trough decline in output averages 9 percent.
Those statistics point out the risks that we faced. Well aware of the threat of a second Great
Depression, U.S. policymakers took very aggressive actions to support economic growth in
2008 and 2009. The Fed provided liquidity facilities and took many other actions to contain
and reduce pressures in financial markets, while the U.S. Treasury supported the banking
system and provided cash and incentives to households, businesses, and state and local
governments to support spending during 2009.
The Fed's "lender of last resort" interventions - including facilities such as the Term
Securities Lending Facility (TSLF) and the Primary Dealer Credit Facility (PDCF), as well as
programs such as reciprocal currency agreements - are examples of the rapid application of
central banking tenets to the unique challenges we faced as this crisis evolved. Indeed, in
many ways, the crisis has underscored why the Federal Reserve was created almost a
century ago: to provide a backstop for a banking system prone to runs and financial panics.
Where it proved necessary and feasible, the Fed also used its emergency lending authority
to forestall the disorderly failure of systemically important institutions. These actions truly
were extraordinary - well outside the scope of our normal operations - but our judgment was
that not taking those actions would have risked a broader collapse of the financial system
and a significantly deeper and more protracted recession. Faced with the choice between
these otherwise unpalatable actions and a broader systemic collapse, the Fed, with the full
support of the Treasury, invoked its emergency lending authority and prevented the collapse
of certain institutions previously considered to have been outside the safety net.
Make no mistake: these necessary moves were unprecedented and controversial. The U.S.
government's financing of Treasury's actions required federal debt to rise sharply, and
stabilizing the financial system temporarily boosted the size of the Fed's balance sheet.
The final numbers aren't in yet, but it now appears that the downturn in real gross domestic
product (GDP) in the United States lasted about a year and a half, much shorter than the
typical banking crisis downturn. Peak to trough, output fell about 4 percent, less than half the
typical decline seen in past financial crises. While there are still some significant downside
risks to the economy, in general, the outlook is improving. Of particular note, the capital
markets - except for certain securitization markets - are now generally open for business. In
addition, the big banks in the United States have been able to raise a large amount of equity
capital to put themselves in a stronger position. I believe that Federal Reserve actions over
the last year and a half have contributed very substantially to this improvement.
But there still is a lot of work to do. Smaller banks - especially those with large commercial
real estate exposures - are under pressure, while households and smaller businesses find
that their access to credit is still constrained.
Moreover, regulatory reform is essential to prevent this type of financial crisis going forward.
We need to ensure that no financial institution is "too big to fail." This means we need
Congress to enact a resolution mechanism that allows large, complex financial firms to be
wound down smoothly, without the need for extraordinary interventions. In addition, we need
to take steps to make the financial system as a whole more resilient and robust. This
requires many steps - some already in train - including higher capital requirements for large
banks, bigger liquidity buffers, and changes to ensure that compensation practices are
consistent with safety and soundness and financial stability. It's a long list - there is no single
silver bullet - and it will take time, but the regulatory community and the political leadership
will fail to meet our shared responsibility as stewards if we do not implement the necessary
reforms in a timely and effective manner.
Outlook for the recovery and risks from the financial sector
The U.S. economy has begun to recover. Growth in the second half of 2009 was a bit
stronger than expected and the pace of layoffs has diminished. We currently expect that the
economy will keep expanding, but at a somewhat slower growth rate than during the second
half of 2009 as the temporary boost from the inventory cycle fades and the effects of the
stimulus bill gradually weaken. With modest growth, we expect price pressures to remain
well contained.
Nonetheless, it's far too early to pop the champagne corks. While the U.S. economy is
growing, unemployment remains unacceptably high and certain impediments could restrict
growth in the near term. One set of challenges are current conditions in the financial system.
The initial stages of the financial crisis have been widely attributed to a rapid rise in
residential mortgage defaults. Many large financial institutions turned out to have direct
exposure - and often indirect exposure through complex linkages - to residential real estate,
and found themselves facing severe funding problems as the value and liquidity of their
assets sharply diminished.
As the real economy slipped into recession in 2008 and unemployment began to rise, other
financial instruments came under stress, including commercial real estate loans and
instruments based on these loans. Commercial real estate loans are frequently originated by
medium-sized regional banks that have significant expertise in their local areas and are often
held in the lending bank's portfolio.
In many parts of the United States, including Puerto Rico, these commercial real estate loans
have now soured, and many banks are seeing the value of their assets decline and their
revenues shrink. In extreme cases, some banks have become insolvent. Finding ways to
address problem assets and the health of the exposed banks is fundamental to restoring the
banking industry to the firm footing that is needed to properly support economic growth.
To bring this point home, let me step back and offer some observations on the importance of
a well-functioning financial system. A healthy banking sector is crucial for economic growth
because banks and other parts of the financial system play a key role in determining how
savings are allocated among competing projects and users of credit. If households and
businesses cannot get credit on reasonable terms, then the economy sputters. To underline
this point, the Fed and Treasury did not intervene during the recent crisis to save the
financial system (and with it, some big financial firms) for its own sake. We intervened
because a collapse of the financial system would have done irreparable harm to Main Street.
With the limited tools at hand, we made our choices (often between unattractive options) with
the goal of supporting the economy, households and small businesses.
A well-functioning financial system is also crucial in fostering economic development. History
shows that substantial risks to the economy come from a persistently weak banking sector.
Economists have debated whether healthy banks drive real economic growth, or vice-versa,
but a wealth of recent evidence suggests that the causality runs at least partly from banks to
growth, and not just the other way around. So, from my perspective, getting Puerto Rico's
banking system back onto solid footing is "job one" for supporting growth here.
Preparing Puerto Rico to benefit from recovery in the world economy
Of course, that isn't the whole story. Growth may also be impeded by factors that are specific
to particular regions or policies.
I work in New York and live in New Jersey, where we know a thing or two about fiscal
problems. Puerto Rico's large public debt has the potential to reduce its growth prospects as
the world economy recovers. Puerto Rico's fiscal situation has deteriorated sharply over the
last five years as the Commonwealth's recession has deepened. Throughout this period,
public debt has risen quickly as revenues that are sensitive to economic activity - such as
income taxes - have declined.
But the fiscal problem in Puerto Rico pre-dates the current crisis. Even when the economy
was growing, public debt was growing even faster. This structural imbalance is difficult to
sustain in the long run, and requires attention if Puerto Rico is to prosper.
A critical factor here is ensuring that the Commonwealth's tax system is designed to
generate the revenue required to sustain government operations. Furthermore, any good tax
system should satisfy three important criteria: simplicity, fairness and neutrality. The current
system suffers from some problems that make it difficult to meet these tests and generate
adequate revenue. In particular, high rates are levied on a narrow tax base.
One of the key public services funded by these taxes is education. Workers need skills to
produce the complicated technological products of the future. There is clear evidence that
workers with the sort of flexible thinking skills not easily duplicated by computers have seen
their productivity and earnings rise, a trend that is likely to persist in the future. Thus,
technology and skills are essential for healthy economic growth and for the financial health of
workers and their families.
As the economy and financial system become more complex, financial literacy is also
increasingly central to family financial well-being. Improved understanding of budgeting,
saving, financial products and planning for retirement is not only a high priority for people in
their own lives, but also for the Fed with its responsibility for monetary policy.
Education thus plays a key role in fostering upward mobility for future generations. All of this
underscores the importance of achieving the best possible education for all of Puerto Rico's
young people and making lifelong learning and skills development a part of everyone's
future. Yet, about half of Puerto Rico's low-income students drop out of high school.
Reducing this dropout rate will not be easy, but should also be a priority for the
Commonwealth.
The private and public sectors both need accurate, timely and comprehensive economic
statistics to perform effectively. It is impossible to make good decisions without a solid factual
basis for those decisions. For example, the government needs good economic information to
develop effective fiscal, economic development and regulatory policy. Likewise, to make the
best production, investment and pricing decisions, businesses need accurate and timely
information on things such as wages, income and prices. Poor quality information increases
uncertainty and this uncertainty inhibits well-considered risk-taking and investment decisions.
Although Puerto Rico's statistical system was once a model for other countries, now there
are major opportunities for improvement in comparison with the mainland and other
countries. In recognition of this need, the government of Puerto Rico recently established the
Institute for Statistics to work with its statistical agencies.
One key example of these efforts concerns the Consumer Price Index (CPI) as a measure of
inflation. A recent study by the Institute, aided by the Department of Labor, found that the
island's official inflation rate was overestimated by more than double between 2001 and
2006. Overestimating inflation can have tangible consequences, such as excessive wage
increases in certain sectors that can damage the island's global competitiveness and cause
unnecessary job loss.
Also thanks to the Institute, the government of Puerto Rico now has a release schedule,
called the "calendario", for its statistical publications. This basic tool helps people,
businesses and investors by ensuring that they use the latest available data for their
decisions. It also boosts confidence in the data, which reduces economic uncertainty.
How the Fed is helping
There are many challenges ahead, and we are committed to being an active partner in
confronting them. The Fed's most important roles in helping Puerto Rico, of course, emanate
directly from our responsibilities for economic growth, stable prices and a resilient financial
system. We continue to take the actions required to promote maximum sustainable growth in
the U.S. economy. These efforts have and will continue to benefit the mainland and the
Commonwealth.
In addition, we are working very closely with all of the banking supervisors and other key
parties to facilitate an effective resolution to the current problems facing the island's banking
sector. Some consolidation is likely needed to produce stronger, healthier institutions more
able to make the sound lending decisions that support economic growth.
Let me also tell you a bit about how we are contributing "on the ground" here in Puerto Rico.
I mentioned financial literacy a few minutes ago. The Federal Reserve System and the
New York Fed have taken a great interest in economic education and financial literacy and
will continue to do even more in the future. I, personally, believe that financial literacy is
essential so that households can make the type of good financial decisions that help to
ensure better futures.
The New York Fed, along with many financial institutions and foundations in Puerto Rico, has
created and supported the Economic and Financial Education Alliance of Puerto Rico. Over
the past ten years, the Alliance has trained more than 400 high school teachers in economics
and financial literacy. I would like to personally thank all the institutions whose devotion to
this Alliance has made these education efforts possible.
These teachers take what they learned back to the classroom and many of their students
enter the Federal Reserve Economics Competition. The students apply analytical skills to a
local problem of their choosing and work as a team to create a presentation outlining their
solution and responding to questions. The winning team develops skills - in analysis,
presentations and teamwork - that will help them in their future studies and careers in the
knowledge economy.
The New York Fed is also supporting the Office of the Commissioner of Financial Institutions
in its two-week expo, where last year 20,000 people saw presentations and received
financial counseling.
We have also had a productive relationship with our good friends at the Puerto Rico Bankers
Association. Each year during "Community Reinvestment Act Week," our staff highlights new
ideas and products especially suited to the Puerto Rican market.
For example, this November we held a forum for Puerto Rican and U.S. Virgin Islands
financial institutions, state and local governments, and nonprofit organizations to introduce
"Bank On," a financial product proven to attract under-banked people into the financial
mainstream. Since then, several local banks have formed a group to explore how to best
implement it here.
Another example of collaboration is our work with the Bankers Association and local
universities. During the fall, we held a "Financial Awareness Video Contest" for college
students. This pilot project explores building peer-to-peer financial awareness among young
adults by having contestants create a 90-second video. We look forward to hosting the first
place winners during their trip to New York in the spring.
To improve our understanding of the Puerto Rican economy, the New York Fed has joined a
group of local businesses - including some represented here - to sponsor and fund a
household survey, undertaken by the Center for the New Economy, our hosts today, to
benchmark Puerto Rican consumer finances. As of today, the data have been collected and
Fed economists are collaborating with the CNE to provide technical assistance, to make the
results of this study public and to make these data available for further research.
To help businesses and government in Puerto Rico, we have also been providing technical
assistance to Puerto Rico's new Institute for Statistics. We recognize the importance of this
work and applaud its efforts to improve Puerto Rico's inflation measures, national income
accounting and business activity measures, just to name a few.
All of these activities, from monetary policy and financial regulation to fostering community
development and economic literacy and measurement, complement and reinforce each
other. Our policy actions are most effective when people understand how financial markets
work. Our decisions are always better when we are well informed about the concerns of
families and businesses. Thus, outreach to the region and communities we serve is an
important part of my job. Thank you for your kind attention. I would be happy to take a few
questions.