cost of production, firms tend, where possible, to substitute capital and labor for energy consumption. in the 1970s and 1980s, such substitution greatly reduced the amount of energy consumed in the business sector per unit of output. i'd expect to see a similar response to the latest price run - up in the years ahead. some portions of the business capital stock may be made obsolete by higher energy costs. facilities that are no longer profitable will be shut down. we already see an example of this in the airline industry, where increasingly airlines are eliminating unprofitable routes. we may see more such adjustments in other industries. firms that use natural gas seem especially vulnerable at this time. many plants that use natural gas as a feedstock were not designed to be profitable at the current level of natural gas prices. we have a limited capacity to increase our imports of liquefied natural gas at present. hence, some companies are talking about moving their production facilities to overseas locations where the price of natural gas is lower than in the united states. studies have shown that adjustments by households and businesses in response to higher energy prices reduce the long - run level of potential output in the economy. this reduction mainly reflects the tendency of production to become more labor intensive in response to the increase in the relative price of energy. in essence, labor productivity grows more slowly after an energy price shock and that effect lowers the trajectory for potential output. if higher energy prices induce scrappage of parts of the business capital stock, this would lower the growth of capital services and further lower the path for potential output. up to this point, i have spoken qualitatively about how a permanent change in the relative price of energy affects the economy. now i'd like to report on some simulations of the board's frb / us econometric model that attempt to quantify some of these effects. as with any model simulation, the results will be depend on the structure of the model and a host of ancillary assumptions. however, in my view, the results are illustrative of the magnitude of the shock that we've experienced. we simulated frb / us using the path for crude oil prices that futures market participants in december 2003 expected to prevail over the following three years. we also simulated the model with the revisions to futures prices that occurred subsequently over 2004 and through mid - september of this year. based on a comparison of these simulations, we estimate that real gdp growth was held down 1 /

##flows 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 these remarks solely reflect my own views and not necessarily those of any other member of the federal open market committee. i appreciate the assistance of trevor reeve of the board ’ s staff in the preparation of these remarks. for a further discussion of this distinction, see edwin m. truman ( 2010 ), “ the international monetary system and global imbalances ” ( washington : peterson institute for international economics, january ). bis central bankers ’ speeches 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