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 THE GLOBAL FINANCIAL SYSTEM: PERSPECTIVE AND CHALLENGES TREASURY ASSISTANT SECRETARY FOR INTERNATIONAL AFFAIRS EDWIN M. TRUMAN REMARKS AT THE FEDERAL RESERVE BANK OF ATLANTA ATLANTA, GEORGIA


10/12/2000

FROM THE OFFICE OF PUBLIC AFFAIRS

LS-950


 

It is a great pleasure to be with you this evening. I take some comfort that, despite my having strayed from the central bank fold almost two years ago, I can be invited back on occasion, at least to Federal Reserve gatherings that are generally open. I have not completely lost the caution I acquired while serving under four Chairmen of the Federal Reserve Board. Thus, I have a desire this evening to be interesting, but hopefully not too provocative.

My remarks cover three areas: globalization, the international financial system, and international economic cooperation. In each area, I will attempt, first, to provide a bit of my own perspective based upon my nearly three decades now in Washington and, second, to offer some comments on what I see as some of the challenges ahead.

Globalization

It has become almost obligatory that remarks by a public official who operates in the international arena start with comments about globalization, especially someone who has been in two of the three recent hot spots -- Seattle last November, Washington in April, and Prague in September. (I was also in Chaing Mai, Thailand in May for the annual meeting of the Asian Development Bank where there were also mild anti-globalization, anti-IFI demonstrations.) However, aside from political correctness, globalization is an important and complex issue.

One reason for the complexity is the lack of clarity about the core issue. The term "globalization" means different things to different people. Broadly speaking, however, concerns appear to be rooted in two conflated phenomenon: the rapid expansion of world trade and an apparent acceleration in the pace of economic change -- technical change to economists -- which is principally a domestic phenomenon. You put trade and technical change together and you have a potent mixture.

Economists have not been able to disentangle the relative influence of these two phenomenon on such sensitive matters as income distribution. Policy makers tend to be equally fuzzy or confusing. The fact is that trade is growing more rapidly than aggregate income or output and has been doing so since the end of World War II. Since 1950, world trade has grown over twice as fast as global output; in 1950 world merchandise trade was seven percent of global GDP. By 1999, merchandise trade was 18 percent of GDP. Initially this rise was explained by a catch up following the war. More recently the explanation lies, I believe in part, in the fact that trade is measured gross and GDP is measured on a valued added basis. With the increase in intra-industry trade and increased trade in components, facilitated in part the declining weight of many tradeable goods -- see the collected comments of Alan Greenspan -- goods that cross borders, return, and may cross borders again, get counted three times while the GDP with which they are compared is counted only by the valued added that occurs in each location. However, the rest of the explanation lies in the broad expansion of global choice.

A parallel phenomenon involves international capital flows that have been increasing even more rapidly than trade and are perceived by many to be at best capricious and at worst predatory.

Economists since Adam Smith have not done a good job in convincing people of the proposition that unilateral free trade based on underlying comparative advantage means that people will be better off. Moreover, economic change is threatening to most people whether induced by trade or technology. In addition, we as a society have not historically done a good job in cushioning affected groups against the adverse effects of economic change. Even economists do not believe that no one can be hurt or disadvantaged by increased trade, or more precisely imports; we only believe that those who are made better off can compensate those who are made worse off with some left over. The problem is that, at best, we do not have efficient compensation mechanisms, and, at worst, we forget about this aspect of the problem entirely. Basic education and continuing education are often the best answer, but education itself is a controversial matter. Finally, when it comes to capital flows we do an even worse job of linking such flows that we depict as part of a search for higher returns to the economic well being of either the country of origin or destination.

Turning to the challenges posed by globalization, Secretary Summers recently said that it is too easy to frame the issue as a false choice "between unfettered global capitalism, on the one hand, and autarky and protectionism on the other." He likes to point out that it is the rare country in the post-war period that has experienced rapid growth without also experiencing an even more rapid expansion of manufactured exports -- the one special exception is Botswana which is particularly well endowed with diamonds (and also has a small, ethnically homogenous population). If trade, technical change and capital flows are inevitable and basically good, then the challenge lies, again to quote Summers, "in developing the right broader institutional framework in which global integration can take place."

Successful globalization requires a parallel international process of harmonization of rules, including rules governing the financial system, a process that has been going on largely silently for many years in the central banking community -- witness the Basel capital accord of 1988 that is now being revised. More recently, in the wake of the Mexican and Asian financial crises of the 1990s, this harmonization process has accelerated -- witness the focus on the role of international standards and codes in the international financial architecture discussion.

I think most of us would probably agree that a common set of rules that everyone generally obeys is a good idea. However, the additional challenge involves who makes the rules: should it be the United States, the Group of Seven countries, more inclusive groupings of countries such as the new Group of Twenty that will have its next meeting in Montreal in two weeks, or universal groups such as the International Monetary Fund? In addition, who sits at the table, the experts or people with somewhat greater political accountability? Issues of sovereignty are piled on top of issues of competence and accountability. As a result, it is not surprising that we find many people in many lands questioning the system -- with a capital S. The challenge is to find solutions that not only satisfy technicians around the world, which is difficult enough, but also are perceived to be fair by informed public opinion. I think progress is being made. What is important, in my view, is to understand better some of these issues when we are trying to manage a global process of change and to incorporate better such understanding into our decision-making processes.

The International Financial System

In 1972, when I joined the staff of the Federal Reserve Board, just after the collapse of the Bretton Woods system of fixed exchange rates, a central focus of attention was the international monetary system: the set of rules and conventions that govern official financial relations among countries. Today, in the wake of the Asian financial crisis, the focus is on the international financial system: the set of rules and conventions (standards and codes in today's parlance) that govern a wide range of financial transactions that primarily involve private sector agents.

The reason for this change in focus is well known: the shift in the relative importance of financial flows from official flows to private flows. In the global context, official flows represented more than 40 percent of financial flows to developing countries in the early 1970s; in the late 1990s, official flows accounted for less than a quarter of financial flows. This phenomenon is not limited to developing countries. For the United States, in 1972, for example, the net increase in foreign official claims on the United States was $10.5 billion while the net increase in foreign private claims was only slightly larger at $11 billion. In 1999 there was a net increase in foreign official claims on the United States of $42.9 billion and a net increase in foreign private claims on the United States of $710 billion.

This greater role of private international financial flows, in turn, has impacted the international monetary system. We have moved progressively from a world primarily of fixed exchange rate regimes thirty years ago to a world increasingly of managed floating exchange rate regimes today; in just the past four years, 14 countries have moved away from regimes of pegged exchange rates. Many people bemoaned the demise of the Bretton Woods exchange rate regime and tried for half a dozen years to put it back together. Moreover, some today, for example Paul Volcker, advocate a return to a more rigid regime that they see as less prone to misalignments and exerting more discipline on macroeconomic policies. These two phenomenon -- floating rates and the nature of international capital flows -- are, of course, related. With the greater volume of private international capital flows, it becomes more difficult to manage exchange rates, to say nothing of trying to hold them fixed. It is highly unlikely, and I would argue undesirable, that we will see a turning back of the clock with respect to capital flows. It is, therefore, equally unlikely that we will see a turning back of the clock to fixed exchange rates.

Thus, the focus has shifted from issues of exchange rate management and macroeconomic policies, which was the case during debates on the reform of the international monetary system in the 1960s and 1970s, toward issues of sound financial management during more recent debates about the international financial architecture. This is not to suggest that exchange rate regimes, and macroeconomic policies as well, are not relevant to today's world of international finance; they just may not be as exclusively relevant as they were three and four decades ago.

The more recent debates have centered on international financial crises and the twin challenges of crisis prevention and crisis management. The challenge in crisis prevention involves, first, recognizing that crisis prevention, like fire prevention, can never be perfect. Moreover, as with banking supervision, we probably do not want it to be perfect because if it were, we would have eliminated all risk taking from the system. If there were no risk taking, there would be no progress, no change, and little growth. However, because negative externalities are associated with financial crises, we have an obligation to try to limit their virulence.

The place to start on crisis prevention, in my view, is still with economic policies -- macroeconomic policies, and, increasingly, microeconomic policies -- what some refer to as the fundamentals. There is no substitute for a prudent monetary and fiscal policy as protection against the uncertain world of international finance. Similarly, there is no substitute for strong microeconomic policies, for example, in the area of the supervision and regulation of banking and securities markets. Both areas, macro and micro policies, have received a great deal of attention in the context of developing international standards and codes aimed at establishing more clearly defined rules of the game and at creating more robust economic and financial regimes that are better able to withstand disturbances.

Complementing this work has been the drive toward increased transparency. This activity ranges from greater clarity about the rules and eschewing implicit government guaranties of private liabilities to such matters as central bank audits and what information central banks release about their balance sheets (and off balance-sheet obligations) and how often and what lag they release such information.

All of this is material for the international surveillance process. That process, in turn, has both public and private dimensions. We tend to focus on the public sector side, for example, reviews of policies and prospects, risks and vulnerabilities by international organizations like the IMF. However, equally important, in my view, is the private sector side, which involves rating agencies, financial institutions, and organizations of financial institutions. If the international financial system is to avoid crises occurring without warning, the system cannot and should not rely solely or, I would argue, primarily on surveillance by public sector bodies because that process raises severe potential moral hazard problems.

As noted earlier, crises will happen and in a sense should happen -- at least small crises. In this event, the principal issue with regard to managing the crisis is how best and how much to involve private investors in the workout process, in light of the fact that private international capital flows have often played a role in the origins of the crisis and how best to strike a balance with the availability or public sector resources.

One challenge in crisis management is to position the international financial institutions, primarily but not exclusively the International Monetary Fund, to play an appropriate role. This, inter alia, means providing them with adequate financial resources, which we accomplished for the IMF in 1998. It also means providing them with instruments to use in pre-crisis, crisis, and post-crisis situations. With the recent consensus established on reforms of IMF lending facilities, we have largely accomplished this task as well. These reforms will better position the IMF in those select circumstances where it's appropriate to lend larger amounts of money, at higher interest rates, for shorter periods, at least for its members that are emerging market economies and normally enjoy substantial access to international capital markets.

Another challenge in crisis prevention involves the establishment of greater consensus not about private sector involvement, but about public sector involvement. How much official money should be used to help address these inevitable crises. Some argue that there should be strict limits. I would argue that it is dangerous, and potentially irresponsible, to contemplate strict limits on the amounts of international financial assistance potentially to provide countries through the international financial institutions in a crisis situation, which is not the same thing as saying that financing should be freely available without either limits or conditions. However, it is impossible to anticipate the economic and financial circumstances that may prevail in the country or globally when a crisis might hit. Moreover, the financing is not intended principally to "bail out" (if I may use that term) either the borrowing country or the investors (domestic or foreign) in that country. The purpose, as under the Bretton Woods system, is to help strike a balance between financing and adjustment that encourages authorities in the country in crisis to adopt adjustment measures that achieve the desired objective of restoring stability while limiting the collateral damage to the international economy and financial system. Again, I think progress is being made on these issues, but it is an evolutionary not a revolutionary process.

International Economic Cooperation

Turning to international economic cooperation, the striking feature of the international economy today is what I like to call "the changing shape of the globe." Thirty years ago, international financial crises exclusively involved crises in the major industrial countries, the so-called Group-of-10 countries, such as France, Italy, the United Kingdom, and the United States. It was these countries' balance-of-payments crises that had the potential to impact on the global economy. This is not to say that other countries did not experience balance-of-payments problems; they were just less likely to have a fallout on the global economy. In the 1990s, the crises that threatened global prosperity did not involve the major industrial countries. They involved countries such as Mexico, Thailand, Indonesia, Korea, Russia and Brazil, but they did pose potential threats to the overall health of the global economy, threats from which we are still recovering.

The fact that threats to global prosperity today can originate in a larger number of countries means that representatives of a larger number of countries need to be involved in trying to anticipate those threats and to deal with them. Almost thirty years ago, after the United States closed its official gold window in August 1971 and signaled the end of the Bretton Woods system, the fixed exchange rate system was (temporarily) put back together by the G-10 countries, meeting at the Smithsonian Institution. The G-10 was a grouping of countries that had been formed in the early 1960s to deal primarily with balance-of-payments crises of the G-10 countries; it was not then regarded as a creditor-country caucus. The United States was not pleased by the process that led to the Smithsonian meeting because of the dominance of Europeans in the G-10 group -- eight out of eleven countries. When it came time to assemble a group of countries to consider the future of the international monetary system, the United States favored broader representation, and the Committee of Twenty (on the Reform of the International Monetary System and Related Issues) was formed.

The C-20 evolved into the IMF Interim Committee, but that body proved to be insufficiently action-oriented. More recently, in the wake of the Asian financial crisis and the fresh look at the international financial architecture, the Interim Committee has been transformed into the International Monetary and Financial Committee; it has been somewhat invigorated in terms of the format of its meetings and the creation of a deputies-level group. At the same time, the Group of Twenty finance ministers and central bank governors representative of the major countries of the world has been formed. To some extent, the G-10 central bankers were ahead of their finance ministry brethren in recognizing the changing shape of the world. The Bank for International Settlements expanded its membership in 1996 and the G-10 central bankers began (cautiously) to reach out well before then to non- G-10 central banks.

My point in reciting this history is to emphasize that the world has changed. A larger number of countries are players, and an even larger number of countries think they should be players. The challenge is to have a group of countries, or more likely groupings of countries, that have the capacity both to reflect responsibly upon potential problems and to convincingly deal with actual problems. We will not know whether the configurations we have now are sufficiently effective until the next crisis occurs, but I am confident that we have gone a long way toward establishing a more inclusive system for international economic cooperation.

One traditional arena of international economic cooperation has involved exchange rates and the evolution of exchange rate regimes. As I noted earlier, in recent years there has been a further drift toward more flexible regimes. At the same time, we have had the Europeans creating the euro, and eliminating ten currencies from the global system, and countries like Ecuador adopting the dollar as its currency. I believe that it is at least possible that in the years ahead we will witness a dramatic decline in the number of independent currencies in the world. Exchange rate stability is positive and can contribute to the freer flow of goods and services, but such stability is difficult to maintain in the face of large global capital flows. At the same time, the advantages of the greater independence of monetary policy that has traditionally been associated with more flexible exchange rate regimes may be diminishing due to the increased scale and sensitivity of capital flows. I would not like to put a time frame on an evolution to a world with substantially fewer currencies, but I am sure you have noted that the president elect of Mexico, Vincente Fox, has suggested a long-term evolution toward a North American currency area. Such trends may lead to new challenges and institutions in the area of international economic cooperation.

In conclusion, the basic challenge that faces citizens, financial leaders, and policy makers going forward with respect to all three areas that I have touched upon -- globalization, the international financial system, and international economic cooperation -- is to recognize that we live in a shrinking world. If some are to prosper in that world, all must have the opportunity to prosper. This will require a quantum increase in global economic and financial cooperation.

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