Mr. Greenspan's remarks to the Economic Club of New York Remarks by
the Chairman of the Board of the U S Federal Reserve System, Mr. Alan Greenspan, at the
Economic Club of New York in New York City, on 02/12/97.
Dramatic advances in the global financial system have enabled us to materially
improve the efficiency of the flows of capital and payments. Those advances, however, have
also enhanced the ability of the system to rapidly transmit problems in one part of the globe to
another. The events of recent weeks have underscored this latter process. The lessons we are
learning from these experiences hopefully can be applied to better the workings of the
international financial system, a system that has done so much to foster gains in living standards
worldwide.
The current crisis is likely to accelerate the dismantling in many Asian countries
of the remnants of a system with large elements of government-directed investment, in which
finance played a key role in carrying out the state's objectives. Such a system inevitably has led
to the investment excesses and errors to which all similar endeavors seem prone.
Government-directed production, financed with directed bank loans, cannot
readily adjust to the continuously changing patterns of market demand for domestically
consumed goods or exports. Gluts and shortages are inevitable. The accelerated opening up in
recent years of product and financial markets worldwide offers enormous benefits to all nations
over the long run. However, it has also exposed more quickly and harshly the underlying
rigidities of economic systems in which governments -- or governments working with large
industrial groups -- exercise substantial influence over resource allocation. Such systems can
produce vigorous growth for a time when the gap between indigenous applied technologies and
world standards is large, such as in the Soviet Union in the 1960s and 1970s and Southeast Asia
in the 1980s and 1990s. But as the gap narrows, the ability of these systems to handle their
increasingly sophisticated economies declines markedly.
In western developed economies, in contrast, market forces have been allowed
much freer rein to dictate production schedules. Rapid responses by businesses to changes in
free-market prices have muted much of the tendency for unsold goods to back up, or unmet
needs to produce shortages. Recent improvements in technology have significantly compressed
business response times and enhanced the effectiveness of the market mechanism.
Most Asian policymakers, while justly proud of the enormous success of their
economies in recent decades, nonetheless have been moving of late toward these more open and
flexible economies. Belatedly perhaps, they have perceived the problems to which their systems
are prone and recognized the unforgiving nature of the new global market forces. Doubtless, the
current crises will hasten that trend. While the adjustments may be difficult for a time, these
crises will pass. Stronger individual economies and a more robust and efficient international
economic and financial system will surely emerge in their wake.
While each of the Asian economies is unique in many important respects, the
sources of their spectacular growth in recent years, in some cases decades, and the problems that
have emerged are relevant to a greater or lesser extent to nearly all of them.
Following the early post-World War II period, policies generally fostering low
levels of inflation and high rates of savings and investment -- including investment in human
capital through education -- contributed to a sustained period of rapid growth. In some cases this
started in the 1960s and 1970s, but by the 1980s most economies in the region were expanding
vigorously. Foreign net capital inflows grew, but until recently were relatively modest. The
World Bank estimates that net inflows of long-term debt, foreign direct investment, and equity
purchases to the Asia-Pacific region were only about $25 billion in 1990, but exploded to more
than $110 billion by 1996; less comprehensive data suggest that inflows rose to a still higher rate
earlier this year.
Sustained, spectacular growth in Asian economies fostered expectations of high
returns with moderate risk. Moreover the global stock market boom of the 1990s provided the
impetus to seek these perceived high returns. As that boom progressed, investors in many
industrial countries found themselves more heavily concentrated in the recently higher valued
securities of companies in the developed world, whose rates of return, in many instances, had
reached levels perceived as uncompetitive with the earnings potential in emerging economies,
especially in Asia. The resultant diversification induced a sharp increase in capital flows into
those economies. To a large extent, they came from investors in the United States and western
Europe. A substantial amount came from Japan, as well, owing more to a search for higher
yields than to rising stock prices and capital gains in that country. The rising yen through
mid-1995 also encouraged a substantial increase in direct investment outflows from Japan.
In retrospect, it is clear that more investment monies flowed into these economies
than could be profitably employed at reasonable risk. It may have been inevitable in those
conditions of rapid growth, ample liquidity, and an absence of sufficient profitable alternatives,
that much investment moved into the real estate sector, with an emphasis by both the public and
private sectors on conspicuous construction projects that had little economic rationale. These
real estate assets, in turn, ended up as collateral for a significant proportion of the assets of
domestic financial systems. In many instances, those financial systems were already less than
robust, beset with problems of poor lending standards, weak supervisory regimes, and
inadequate capital.
At the same time, rising business leverage added to financial fragility. Businesses
were borrowing to maintain high rates of return on equity and weak financial systems were
poorly disciplining this process. In addition, explicit government guarantees of debt or, more
often, the presumption of such guarantees by the investment community, encouraged insufficient
vigilance by lenders and hence greater leverage. But high debt burdens allow little tolerance for
rising interest rates or slowdowns in economic growth, as recent events have demonstrated.
Moreover, the rapidly growing foreign-currency-denominated debt, in part the
result of pegged exchange rates to the dollar, put pressure on companies to earn foreign
exchange. But earning it became increasingly difficult. The substantial rise in the value of the
dollar since mid-1995, especially relative to the yen, made exports of the Southeast Asian
economies less competitive. In addition, in some cases, the glut of semiconductors in 1996 and
the accelerated drop in their prices suppressed export earnings growth, exerting further pressures
on highly leveraged businesses.
In time, the pressures on what had become fixed-exchange-rate regimes mounted
as investors, confronted with ever fewer profitable prospects, slowed the pace of new capital
inflows. Fearing devaluation, many domestic Asian businesses sought increasingly to convert
domestic currencies into foreign currencies, or, equivalently, slowed the conversion of export
earnings into domestic currencies. To counter pressures on exchange rates, countries raised
interest rates. For fixed-exchange-rate, highly leveraged economies, it was only a matter of time
before slower growth and higher interest rates led to difficulties for borrowers, especially those
with fixed obligations.
Particularly troublesome over the past several months has been the so-called
contagion effect of weakness in one economy spreading to others as investors perceive, rightly
or wrongly, similar vulnerabilities. This is an age-old phenomenon. When investors are unsettled
by uncertainties and fears, they withdraw commitments on a broad front; the finer distinctions
between countries and currencies are lost. There is a flight to safe-haven investments, many of
which are in developed nations.
Perhaps, given the circumstances, it was inevitable that the impressive and rapid
growth experienced by the economies in the Asian region would encounter a temporary
slowdown or pause. I say temporary because there is no reason that above-average growth in
countries that are still in a position to gain from catching up with the prevailing technology
cannot persist for a very long time, provided their markets are opened to the full force of
competition. Nonetheless, free-market, even partially free-market, economies do periodically
run into difficulties because investment mistakes invariably occur. And, as I noted earlier, many
of these mistakes arose from government-directed or influenced investments. When this
happens, private capital flows may temporarily turn adverse. In these circumstances, individual
companies should be allowed to default, private investors should take their losses, and
government policies should be directed toward laying the macroeconomic and structural
foundations for renewed expansion. New growth opportunities must be allowed to emerge.
Although the economies of the troubled Asian countries were usually
characterized by a combination of current account deficits, large net foreign currency exposures,
and constraints on exchange rate fluctuations, one cannot generalize that these are always signs
of impending difficulties.
Large current account deficits, per se, are not dangerous if they result from direct
investment inflows that are not subject to rapid withdrawal and that generate an increase in
income sufficient to compensate the investors. Foreign currency exposures need not be a
problem if positions are properly managed and the risks are recognized. Fixed exchange rates,
also, are not necessarily a problem. Indeed, if they can be sustained, they yield extensive benefits
in lower risk and lower costs for all international transactions. But a small open economy can
maintain an exchange rate fixed to a hard currency only under certain conditions. Both Austria
and the Netherlands, for example, have been able to lock their currencies against the Deutsche
Mark because their economies are tightly linked through trade with Germany, they mirror the
Bundesbank's monetary policies, and they are perceived to engage in prudent fiscal policies.
Were it not for issues of national identity and seignorage, they could just as readily embrace the
DM as their domestic currency without any economic disruption. Other economies, such as
Argentina and Hong Kong, have fixed their exchange rates essentially through currency boards.
Changes in dollar reserves directly affect the monetary base of those economies.
But when exchange rates are fixed, with or without currency boards, should
monetary and fiscal policies diverge significantly from those of the larger economy, the currency
lock of the smaller economy would be difficult to hold irrespective of the size of reserves. Large
reserves can delay adjustment. They cannot prevent it if policies are inconsistent, or prices in the
smaller country are inflexible.
A well-functioning international financial system will seek out anomalies in
policy alignments and exchange rates and set them right. In such a system, the exploitation of
above-normal profit opportunities, that is, arbitrage, will force prices to change until expected
returns have been equalized. To policymakers in the country whose currency is not appropriately
aligned, capital outflows are too often seen as attacks by marauding currency speculators. There
have no doubt been some such attempts on occasion. But speculators rarely succeed in
dislodging an exchange rate that is firmly rooted in compatible policies and cost structures. More
often, speculation forces currencies through arbitrage into a closer alignment with underlying
market values to the benefit of the international economic and financial system as a whole. We
used to describe capital flight as "hot money". But we soon recognized that it was not the money
that was "hot", but the place it was running from.
The prodigious expansion of cross-border financial transactions in recent years
has tightened and refined the arbitrage process significantly. But, to repeat, the inestimable
advantages that it brings to trade and standards of living also carry a price. The inevitable
investment mistakes and governmental policy failures are more rapidly transmitted to other
markets by this process than was the case say twenty, or even ten, years ago. Moreover, there is
little evidence to suggest that the rate of increase of financial transactions will slow materially in
the years immediately ahead.
Technology will continue to reduce the costs of finding and exploiting perceived
differences in risk-adjusted rates of return around the world, helping to direct capital even more
to its most efficient use. Already, covered rates of return on actively traded interest-rate
instruments have been equalized among many industrial countries.
But the broader merging of world savings and investment markets, clearly, has
not been achieved, largely because investors are fearful of investing in countries they do not
understand to the extent that they do their own, or are uninformed of the opportunities.
One measure of this so-called home bias in world investments is the degree that
portfolios remain substantially local. Foreign investments, on average, represent less than
10 percent of U.S. portfolios, for example. The percentage of Japanese portfolios is only slightly
higher, and 15 percent of German portfolios is in foreign assets. The partial exception is Great
Britain, where, with a longer history of global financial involvement, one-third of portfolios is
invested in foreign assets.
Home bias in investments is considerably less than it was ten years ago, but we
are still far from full globalization. Unless government restrictions inhibit the expansion of ever
more sophisticated financial products that enable savers in one part of the world to reduce risk
by investing in another, the bias will continue to diminish and the size of the international
financial system will continue to expand at a significant pace. It is this overall diversification,
and hence lowering of risk, that an effective international financial system offers. It facilitates
the ever more efficient functioning of the global economic system and, hence, is a major
contributor to rising standards of living worldwide.
Nonetheless, there are those who ask whether the price of so sophisticated a
financial system is too high. Would it not be better to slow it down a bit, and perhaps achieve a
system somewhat more forgiving of mistakes, even recognizing that such a slowing may entail
some shortfall in long-term economic growth?
Even if we could implement such a tradeoff, with only minor disruption, should
we try? For centuries groups in our societies have railed against, and endeavored on occasion to
destroy, new inventions. Fortunately for us the Luddites and their ilk failed, and recent
generations have enjoyed the fruits of those technologies.
Moreover such a slowdown may not even be possible -- at least without major
disruption and cost. Newer technologies, especially advanced telecommunications, make it
exceptionally difficult for open markets, with associated opportunities, to be suppressed. Price
and capital controls, which might have been feasible a half century ago, would be very difficult
to implement in today's more technologically advanced environment. Tinkering at the edges of
our system in order to produce a less frenetic pace of change would be easily circumvented.
Arguably, it would take massive government controls to substantially slow the advance toward
greater efficiency of our systems. This would surely produce a far more negative impact on
economic growth than would be acceptable to even the most ardent advocates of reining in the
rapid expansion of our international financial system.
If, as I suspect, it turns out after due deliberation and analysis, that slowing the
pace of financial modernization is not in fact seen as a feasible alternative, what policy
alternatives confront the international financial community to contain the periodic disruptions
that are bound to occur in any free market economy?
A financial system, like all structures, is as strong as its weakest link. As the
international financial system has become even more complex, the particular areas of weakness
to be addressed have changed. At the risk of oversimplification, let's examine some of the key
links of our current infrastructure.
Today, the organized exchanges and over-the-counter markets of industrial
countries can handle massive volumes of transactions. Even in emerging countries exchanges are
developing and expanding. In contrast, during the world-wide stock market crash of October
1987, the transactions systems were under severe stress and, indeed, some broke down,
incapable of handling the enlarged volumes. At that time, the Hong Kong stock exchange could
not open for several days. The New York Stock Exchange was straining badly under the near
400 million daily share volume of late October 1987, with long reporting delays creating
uncertainties that, doubtless, exaggerated the price declines. Those weaker links have since been
strengthened by large infrastructure investments. Almost 1.2 billion shares traded on the NYSE
on October 28 of this year, three times the 1987 volumes with no evident problems or delays.
Our equity, debt, and foreign exchange trading systems, and their peripheral
futures and options markets have functioned well under stress recently. These systems are not
weak links in the developed economies, nor, for the most part are they in other economies.
Neither is the payment system, that complex network, which transfers funds and
securities in huge and growing volumes domestically and internationally, rapidly and efficiently.
The private and public sectors across the globe have endeavored diligently for years to expand
the capacity of the system to meet the increasing demands put upon it. And they have initiated
and strengthened procedures for reducing risk in settling transactions, and diminishing
uncertainties. That they have generally succeeded is evident from the smoothness with which
huge volumes of funds produced under recent stressed market conditions were transferred and
settled with finality, through various netting and clearing arrangements.
Banks are another matter. These are highly leveraged institutions, financed in part
by interbank credits and, hence, prone to crises of confidence that can quickly spread. In most
developed nations banking systems appear reasonably solid. Japan has been somewhat of an
exception, but there have been some positive signs there, as well. Banks have been recognizing
losses, and the government seems finally to be appropriately addressing their problems. In a
large number of emerging nations, as I indicated previously, banks are in poor shape. Lax
lending has created a high incidence of non-performing loans, supported by inadequate capital,
leaving banks vulnerable to declines in collateral values and non-performance by borrowers.
How can such deficient institutions be elevated to a level that would allow their
economies to function effectively in our increasingly sophisticated international financial
system? Certainly, improved cost and risk management and elimination of poor lending
practices are a good place to start.
But these cannot be accomplished overnight. Loan officers with experience
judging credit and market risks are in very short supply in emerging economies. Training will
require time. The same difficulties confront bank supervision and regulation. Important efforts
in this area have been underway for several years through the auspices of the Bank for
International Settlements, the International Monetary Fund, and the World Bank. But again, it
will take time to develop adequate systems and trained personnel.
Moreover, robust banking and financial systems require firmly enforced laws of
contract, and transparent, market-oriented systems of corporate reporting and governance. The
current crisis in Asia is, to a much greater extent than many previous crises, one of private, not
public, debts, at least de jure. Arguably, the absence of efficient and transparent work-out
arrangements for troubled private borrowers makes the problems more difficult to deal with.
Efficient bankruptcy arrangements reduce disruptions to economic activity that often arise when
losses have to be imposed on creditors. Many developing countries do not have good work-out
arrangements for troubled debtors, and, as a result, governments in these countries often feel
compelled to bail them out rather than accept the consequences of defaults.
The most troublesome aspect of many banking systems of emerging countries, to
expand on the issue I raised earlier, is the widespread prevalence of loans driven by "industrial
policy" imperatives rather than market forces.
What is wrong with policy -- that is, politically-driven -- loans? Potentially
nothing if they were made to firms to finance expansions that just happened to coincide with a
rise in consumer or business or overseas demand for their newly-produced products. In these
circumstances, the loan proceeds would have been profitably employed and the loan repaid at
maturity with interest. Unfortunately, this is often not the case. Policy loans, in too many
instances, foster misuse of resources, unprofitable expansions, losses, and eventually loan
defaults. In many cases, of course, these loans regrettably end up being guaranteed by
governments. If denominated in local currency, they can be financed with the printing
press -- though with consequent risk of inflation. Too often, however, they are foreign-currency
denominated, where governments face greater constraints on access to credit.
Restructuring of financial systems, while indispensable, cannot be implemented
quickly. Yes, the potential risks to the banking systems of many Asian countries and the
potential contagion effects for their neighbors, and other trading partners, should have been
spotted earlier and addressed. But flaws, seen clearly in retrospect, are never so evident at the
time. Moreover, there is significant bias in political systems of all varieties to substitute hope
(read, wishful thinking) for possibly difficult pre-emptive policy moves, both with respect to
financial systems and economic policy. There is often denial and delay in instituting proper
adjustments. Recent propensities to obscure the need for change have been evidenced by
unreported declines in reserves, issuance by the government of equivalents to foreign currency
obligations, or unreported large new forward short positions against foreign currencies. It is very
difficult for political leaders to incur what they perceive as large, immediate political costs to
contain problems they see as only prospective.
Reality eventually replaces hope, and the cost of the delay is a more abrupt and
disruptive adjustment than would have been required if action had been more pre-emptive.
Increased transparency for businesses and governments is a key ingredient in fostering more
discipline on private transactors and on government policymakers. Increased transparency can
counter political bias in part by exposing for all to see the risks of current policies to stability as
they develop. Under such conditions, failure to act would also be perceived as having political
costs.
We should strongly stress to the newer members of the international financial
system -- the emerging economies -- that they should accelerate the restructuring of their
financial systems in their own interests. But having delayed timely restructuring, many now find
themselves with major shortfalls in bank liquidity and equity capital that put their systems at
severe risk of collapse before any full restructuring is feasible. The IMF, the World Bank, and
their major shareholders, the developed countries, may wish to facilitate adjustment through
temporary loans to governments and the encouragement of private equity infusions to these
banking systems. Since any severe breakdown can have contagion effects on a world-wide basis,
it is in our interest to do so.
These loans must be judged in their entirety. They transform short-term
obligations into medium-term loans, but they do so contingent on the country using the time to
reform financial systems as well as adopt sound economic policies. Such conditionality
accelerates the adjustments in financial systems needed to lay the foundation for resumption of
robust, sustainable, growth, while cushioning to some degree the economic effects of the
immediate crisis. Assistance without further reform of financial systems and economic policies
would be worse than useless since it would foster expectations of being perpetually bailed out.
That, in turn, could induce perverse behavior on the part of emerging nations' governments and
of private sector investors in emerging nations. Believing that the international financial
community will support these economies, in part by backstopping the obligations they incur,
induces investors to commit more than they would otherwise. This has tended in the past to push
the expansion of investment beyond prudence -- given the limit of profitable opportunities.
As the international financial system becomes ever larger and more efficient, the
size of the financial response -- whether to help banks or to add to foreign currency
reserves -- may have to be correspondingly larger per unit of crisis, if I may put it that way
-unless we alter our approach. While it is precarious to generalize from one observation, it is
likely that the Mexican financial crisis of the 1980s was broader than in 1994-95, but the size of
the assistance program, to set things right, was much larger in the latter than in the former case.
The reason appears to be that the increased efficiency of the financial system created a larger
negative spillover, which had to be contained. Among other developments, the marked shift
from bank credits in the earlier crisis, to a more securitized, anonymous, set of liabilities made
workouts far more complex.
It is, hence, all the more essential that the weaker links in our international
financial system, the banking systems of the emerging nations, be strengthened. Preventive
programs should be accelerated sufficiently far in advance of the next crisis to effectively thwart
or contain it.
Moreover, it is incumbent on governmental policymakers to insure that unstable
economic environments do not induce or exacerbate international financial disruptions. But
governments and international financial institutions should be brought on the scene only rarely.
To do otherwise risks the perverse incentives I spoke of earlier. Markets should be allowed to
work.
Recent events in Asia have sharpened our understanding of the complexity of
today's international capital flows and, presumably, of similar episodes that may emerge in the
future.
The rapid integration of national financial systems has fostered the growth of
trade and standards of living worldwide. It has also forced a review of the soundness and
viability of our burgeoning financial systems. We should welcome such pressures even as they
impose challenges to all of us. The end result is very worthwhile having.