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Speech by Mr Roger W Ferguson, Jr, Vice Chairman of the Board of Governors of the US Federal Reserve System, at Vanderbilt University, Nashville, Tennessee, 5 February 2003.
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Roger W Ferguson, Jr: September 11, the Federal Reserve, and the financial system Speech by Mr Roger W Ferguson, Jr, Vice Chairman of the Board of Governors of the US Federal Reserve System, at Vanderbilt University, Nashville, Tennessee, 5 February 2003. * * * Thank you for the invitation to speak, and thank you all for being here. Certainly most of you have heard of the Federal Reserve and understand that it plays a role in the maintenance of our domestic economy. But that is not what I am here to discuss. I was invited here to speak to you about the actions of the Federal Reserve after the terrorist attacks on September 11, 2001. As the central bank of the United States, the Federal Reserve seeks to establish through the implementation of monetary policy, an economic environment that encourages stable prices over time, a high level of employment, and moderate long-term interest rates. Additionally, the Fed shares, with a few other regulatory bodies, the duty of overseeing the banking industry. In a broader context, the Federal Reserve also shares the responsibility of maintaining the stability of the financial system and containing systemic risks that may arise in financial markets. And in carrying out that responsibility, we have never been confronted with a situation remotely resembling the grave reality of September 11, 2001. On that morning, sitting in my office in Washington, I watched television with horror as the second plane crashed into the World Trade Center. Not long after, I could see thick smoke billowing above the trees in the direction of the Pentagon. As events were unfolding, one could easily envision the risks that confronted the United States - and especially the risks to which the Federal Reserve, as the nation’s central bank, would have to respond. It was clear that the loss of so many key resources at the core of the financial capital of the United States would strain markets. If allowed to mount, those strains could prompt a chain reaction drying up liquidity, which, unchecked, could lead to real economic activity seizing-up. The shocks to the financial system and the economy that were possible could have been disastrous to the confidence of businesses and households in our country and, to a significant degree, the rest of the world. Besides these very visible external risks, the Federal Reserve System had to cope effectively in a threatening environment. The employees of the Federal Reserve Bank of New York, being a few blocks away from “ground zero,” had the exceedingly difficult challenge of maintaining operations in the midst of terrifying and chaotic surroundings. All parts of the Fed System, wherever located, faced the challenge of maintaining ongoing operations, including discount window lending and check clearing, in the period of heightened uncertainty that followed those horrific attacks. In short, on the morning of September 11, the Fed, as monetary authority, as payment system operator, as banking supervisor, and as employer, faced an unfolding crisis, and the risks were all to the downside. The outlook was at best uncertain, and potentially quite bleak. Against this background, the Federal Reserve System organized a response that emphasized three objectives. First, as central bank we needed to provide sufficient liquidity through as many means as possible to maintain stability. In doing so, we would further our obligation to the broader citizenry to maintain public confidence so that the crisis in New York and Washington, D.C. would not spread across the country. Second, as operator and overseer of key payment systems we had to ensure that our systems, as well as those in the private sector, were operational. Third, we worked with critical public- and private-sector participants to keep markets open or, if circumstances forced them to close, to return them quickly to normal operations. Obviously, we had to balance the need to perform these public functions with the need to be a sensitive and responsible employer. Recognizing these multiple challenges, we responded in several ways. We attempted to maintain confidence by indicating through our public statement that the Federal Reserve was open and operating and that we were ready to provide liquidity. We issued this statement after consultation with the Reserve Bank presidents, so that it represented a statement of the entire System. Why were we so concerned about maintaining liquidity in the financial system? Liquidity, as you know, serves as the oil lubricating the engine of capitalism to keep it from burning itself out. The efficiency of our financial system at maintaining adequate liquidity is often taken for granted. But on September 11, it could not be taken for granted. The bottlenecks in the pipeline became so severe that the Federal Reserve stepped in to ensure that the financial system remained adequately liquid. In other words, our massive provision of reserves made sure that the engine of finance did not run out of oil and seize up. The massive damage to property and communications systems at the hub of financial activity in this country made it more difficult, and in some cases impossible, for many banks to execute payments to one another. The failure of some banks to make payments also disrupted the payments coordination by which banks use incoming payments to fund their own transfers to other banks. Once a number of banks began to be short of incoming payments, some became more reluctant to send out payments themselves. In effect, banks were collectively growing short of liquidity. We recognized this disturbing trend toward illiquidity in the pattern of funds movement among the accounts held by commercial banks at the Federal Reserve. Before September 11, banks held approximately $13 billion in their Fed accounts. In the days after September 11, these balances ballooned to more than $120 billion because some banks could not move funds out of their accounts. The large buildup of Federal Reserve account balances was limited to only a few banks, but it meant that a number of other banks were running huge negative positions in their Federal Reserve accounts and needed to find other sources of liquidity before the close of business. Further evidence of disruption in the flow of payments among banks at this time is quite clear from data for the Federal Reserve’s large-value electronic payment system, known as Fedwire. Banks use Fedwire to make payments to one another to settle their customers’ as well as their own transactions. Just before September 11, the number of transfers sent over Fedwire on a normal day was around 430,000, with a total value of $1.6 trillion. On September 11, the number of transfers was down more than 40 percent, with fewer than 250,000 transfers being sent over Fedwire, and the total value was down 25 percent. If liquidity had continued to dry up, both business and consumer confidence could have been severely affected. Imagine businesses unable to promptly withdraw funds from checks deposited in their banks, even though those checks paid for goods or services already provided. Imagine international banks running out of dollars, a serious impediment to international trade and finance. As we know now, the situation never reached those extreme conditions because, fortunately, the Federal Reserve System has numerous means providing liquidity. One tool used to provide needed liquidity was the discount window, through which the Fed lends in certain circumstances to help banks maintain smooth day-to-day operations. In essence, in more normal times the discount window serves a function similar to that of a pressure valve. During the crisis, as the volume of borrowing requests increased dramatically, the discount window served as something closer to the floodgates of a great dam. On September 12, lending to banks through the discount window totaled about $46 billion, more than two hundred times the daily average for the previous month. The flood of funds released into the banking system reduced the immediate need for banks to rely on payments from other banks to make the payments they themselves owed others. Open market operations were a second tool at our disposal for pumping additional liquidity into the system. Indeed, as you may know, open market operations are the chief tool employed by the Federal Reserve to affect the global supply of dollars in circulation. In these operations, our trading desk at the Federal Reserve Bank of New York enters the market daily to buy or sell Treasury securities. Contrary to one of the early fears, most of our counterparties in these transactions, the community of primary dealers, were generally functioning starting on September 12. Our trading desk in New York met all propositions at the intended funds rate from September 12 through September 17, and the System engaged in a record level of open market operations through overnight repurchase agreements. To accommodate these demands, the trading desk operated later in the day than normal, giving dealers an opportunity to assess their financing needs. Also, the Fed’s securities lending program expanded its provision of securities to the marketplace, and those securities in turn could be used as the collateral for private-sector liquidity arrangements. The staff of the Federal Reserve Bank of New York, having evacuated its main site and gone to its backup facility, performed heroically in running the open market operations. Despite the increased liquidity resulting from discount window lending and open market operations, some institutions still had difficulty exchanging payments and lending or borrowing funds because of connectivity problems and the closure of key markets. As a result, many depository institutions incurred larger-than-usual daylight overdrafts on their accounts at the Federal Reserve. To help in this situation, the Federal Reserve waived the overdraft fees it normally charges. Between September 11 and September 21, peak and average daylight overdrafts incurred by depository institutions were approximately 35 percent and 30 percent higher than normal levels, respectively. On September 14, daylight overdrafts peaked at $150 billion, more than 60 percent higher than usual, despite Federal Reserve opening account balances of slightly more than $120 billion. The destruction of infrastructure in Lower Manhattan meant that some foreign financial institutions might not be able to provide sufficient collateral to underpin funding from their usual counterparties and correspondent banks. These foreign firms turned to their national central banks for dollar-based liquidity. The Federal Reserve arranged for the availability of reciprocal currency facilities of up to $50 billion with the European Central Bank and $30 billion with the Bank of England, both in the form of thirty-day swaps. We also lifted the ceiling of a preexisting swap with the Bank of Canada to $10 billion. The Federal Reserve’s role as a provider of check collection services presented another opportunity for providing liquidity. Check collection relies on a fleet of airplanes to fly checks all around the country so that the checks can be presented to their home bank for payment. Though U.S. airspace was closed for several days after the attacks, the Federal Reserve Banks continued to provide credit for checks on the usual availability schedules. This accommodation allowed businesses and consumers that depended on the prompt availability of their check deposits to withdraw the proceeds of these check deposits as they expected. With other regulators and supervisors, the Federal Reserve issued a statement on Friday, September 14, encouraging state member banks and bank holding companies to work with customers affected by the events of September 11. The Board has a long-standing policy of encouraging bankers to work flexibly with customers affected by disasters. That policy recognizes the need for taking prudent steps to make credit available to sound borrowers and for adjusting terms and conditions of loans and transactions to take account of the stresses during a crisis. I am sure that several Reserve Bank Presidents and Directors of Supervision communicated this message directly to commercial bankers in their Districts. We also recognized that the banks’ balance sheets might expand as businesses and consumers turned to banks for funding. Through an interagency statement, we invited banks that experienced such an expansion of their balance sheets to contact their regulator to discuss ways to respond. Ultimately, to further increase liquidity, on the morning of September 17, the policymaking body of the Federal Reserve System, the Federal Open Market Committee, met by teleconference and then publicly announced a 50 basis point decrease in the intended federal funds rate from 3.5 percent to 3.0 percent. The Federal Reserve also worked with other regulators through the President’s Working Group on Financial Markets to monitor developments in financial markets. As you know, the government securities market postponed settlements for a few days, the commercial paper market experienced significant problems, and the New York Stock Exchange remained closed until September 17. We supported fully restoring financial markets to normal operations as soon as practical. However, in working with the Securities and Exchange Commission, the Department of the Treasury, market participants, and other stakeholders to reopen these markets, we had to balance the benefit of a prompt return to business against the risk that the supporting infrastructure would be unable to handle what would certainly be a record volume of trades. Paramount in that consideration was the safety of the men and women working in Lower Manhattan. The SEC and the New York Federal Reserve Bank, along with the leaders in these various markets, deserve a great deal of credit for ably managing the process of reopening, making judgments that allowed all markets to return to normal functioning quickly and effectively. As I look back, I am comforted that the financial and monetary effects of the horrible and tragic events on that day were less severe than one might have imagined. The aftershocks were less sizable than one might have feared they might be, largely because of the action taken by major market participants and the regulatory community, including the Federal Reserve System. The incidents of September 11 taught us many lessons relating to central banking and financial stability. First and foremost, they reinforced the importance of the Federal Reserve’s role as lender of last resort. Second, we again saw that the multiple roles the Federal Reserve plays - in this instance, central bank, supervisor and regulator, and payment systems operator - give us many tools to apply during a crisis. While I have been a member of the Board, I have from time to time heard some question the wisdom of our central bank’s being involved in supervision and regulation and continuing to provide payment services, particularly retail payment services. To my mind the events of September 11 should put such question to rest. From our experience, we should recognize the benefits of a central bank that can influence the economy and enhance financial stability through several mutually reinforcing tools. A third lesson is that having diversified forms of risk intermediation makes the financial system more robust. In this instance, having markets and banks that performed similar financial intermediation roles accounted for much of our financial system’s ability to withstand the shock of September 11. Fourth, the attacks remind us that operational risk, which is hard to quantify with any model, may at times be the paramount risk. We recognized this in the abstract in our planning for the Y2K centurydate change. Now we have seen the real results of a massive disruption in infrastructure. Fortunately, the preparations for Y2K helped the financial system of our country withstand the September 11 crisis. Even now, financial institutions are working hard to update their contingency plans on the basis of a new understanding of the risks that confront our country. Having layers of redundancy, each calibrated to a different level of emergency need, is one potentially successful strategy. A fifth lesson is the importance of ongoing communication and, when required, coordination among domestic authorities and across borders. The ability to communicate seamlessly with other members of the President’s Working Group and with fellow central bankers, in both cases on the basis of trust developed in the course of pre-existing relationships, proved to be very helpful. Obviously, even without those well-established relationships, we would still have reached decisions. The decisions may not have come as quickly nor been as well informed, however. The amount of trust needed to successfully coordinate in the midst of stressful situations is high, and coordinating with familiar colleagues is much easier than working with relative strangers. Finally, in the wake of those events, we must address the possibility of major disruptions in areas in which financial markets or operational centers are concentrated. We will not accomplish our task if one or two organizations strengthen their resilience and others do not. Instead, we need to work hard to adopt consistent strategies for reducing risks that together address prevention, management, and testing. In conclusion, I must admit that the farther we move away in time from the tragic events of September 11, 2001, the more the lessons come into focus. We in the United States are very fortunate to have created, through the efforts of private industry at times pushed by regulators, the most robust, most efficient financial system in the world. But at the same time, it is clear that the events should remind us to redouble our efforts to make our financial system even stronger. It has been a pleasure to address you all this afternoon. Thank you.
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board of governors of the federal reserve system
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Speech by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, before the Money Marketeers of New York University, New York, 3 February 2003.
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Ben S Bernanke: “Constrained discretion” and monetary policy Speech by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, before the Money Marketeers of New York University, New York, 3 February 2003. The references for the speech can be found on the website of the Board of Governors of the US Federal Reserve System. * * * What is the appropriate framework for making monetary policy? This crucial question has sparked lively debate for decades. For much of the period since World War II, at least until recently, the debate has been carried on mainly between those favoring the use of rules for making monetary policy and those arguing for reliance on discretion. Under a strict rules-based approach to monetary policy, advocated most prominently by Milton Friedman and his followers, the policy instruments of the central bank would be set according to some simple and publicly announced formula, with little or no scope for modification or discretionary action on the part of policymakers. For example, under Friedman’s most famous proposal, the so-called kpercent rule (Friedman, 1960), the central bank would be charged with ensuring that some specified measure of the national money supply increase by a fixed percentage each year, irrespective of broader economic conditions. Friedman believed that such a rule would have the important advantage of preventing major monetary policy errors, as when the Federal Reserve permitted the U.S. money supply to collapse in the 1930s - a blunder that contributed substantially to the severity of the Great Depression. In addition, Friedman argued, a rule of this type would have the advantages of simplicity, predictability, and credibility, and it would help insulate monetary policy from outside political pressures and what Friedman saw as an inherent tendency toward excessive policy activism. Neither the k-percent rule nor any comparably strict policy rule has ever been implemented, but “rulelike” monetary policy arrangements have existed in the real world. An important example is the international gold standard, the dominant monetary system of the late nineteenth and early twentieth centuries. Under the gold standard, at least in principle, the central bank’s responsibility regarding monetary policy extended only so far as ensuring that the value of the currency in terms of gold was stabilized at the legally specified value. In short, under a strict gold standard the monetary policy rule would be, “Maintain the price of gold at so many dollars per ounce.” Although the gold standard system malfunctioned and ultimately collapsed during the chaotic economic and financial conditions that followed World War I, many economic historians have credited it with promoting price stability and robust international trade and capital flows during 1870-1913, the so-called classical gold standard era. Another example of a rule-like monetary policy institution is a currency board, such as the ones currently employed by Hong Kong and several eastern European nations. On the other side of the debate, advocates of discretion have firmly rejected the use of strict rules for policy, arguing that central bankers must be left free to set monetary policy as they see fit, based on their best judgment and the use of all relevant information. Supporters of discretion contend that policy rules of the type advocated by Friedman are simply too mechanical and inflexible for use in real world policymaking; in particular, simple rules cannot fully accommodate special circumstances or unanticipated events. During the past few decades, for example, financial innovation and new transactions technologies have led to large and difficult-to-predict changes in the empirical relationship between money growth and the rates of growth of output and prices. If central banks had slavishly followed Friedman’s k-percent rule for money growth during this period, critics point out, substantial economic instability would have been the likely result; indeed, most central banks have deemphasized money growth as a policy target or indicator in recent years. More generally, opponents of rules have argued that, as a practical matter, policymakers can never credibly commit to abandoning The Bank of England’s capable “ management” of the pre-war gold standard was an important element in its success; after the war, Great Britain no longer had the economic and financial power needed to occupy a central position in the world monetary system. Proponents of discretion do not necessarily reject the use of “ rules” or formulas - such as the famous Taylor rule (Taylor, 1993) - as rough guides to policy, so long as policymakers remain free to deviate from the rule as they see fit. John Taylor himself advocates using his eponymous rule in this way. discretion in favor of supposedly “unbreakable” rules. The problem, this argument runs, is that the public will understand that the central bank always has the option of abandoning its rule, should the rule happen to dictate a policy action perceived at the time as counterproductive. Hence, an announcement by the central bank that it is adopting a strict policy rule would carry little credibility. Although a strict rules-based framework for monetary policy has evident drawbacks, notably its inflexibility in the face of unanticipated developments, supporters of rules in their turn have pointed out - with considerable justification - that the record of monetary policy under unfettered discretion is nothing to crow about. In the United States, the heyday of discretionary monetary policy can be dated as beginning in the early 1960s, a period of what now appears to have been substantial over-optimism about the ability of policymakers to “fine-tune” the economy. Contrary to the expectation of that era’s economists and policymakers, however, the subsequent two decades were characterized not by an efficiently managed, smoothly running economic machine but by high and variable inflation and an unstable real economy, culminating in the deep 1981-82 recession. Although a number of factors contributed to the poor economic performance of this period, I think most economists would agree that the deficiencies of a purely discretionary approach to monetary policy - including over-optimism about the ability of policy to fine-tune the economy, low credibility, vulnerability to political pressures, short policy horizons, and insufficient appreciation of the costs of high inflation - played a central role. Is there then no middle ground for policymakers between the inflexibility of ironclad rules and the instability of unfettered discretion? My thesis today is that there is such a middle ground - an approach that I will refer to as constrained discretion - and that it is fast becoming the standard approach to monetary policy around the world, including in the United States. As I will explain, constrained discretion is an approach that allows monetary policymakers considerable leeway in responding to economic shocks, financial disturbances, and other unforeseen developments. Importantly, however, this discretion of policymakers is constrained by a strong commitment to keeping inflation low and stable. In practice, I will argue, this approach has allowed central banks to achieve better outcomes in terms of both inflation and unemployment, confounding the traditional view that policymakers must necessarily trade off between the important social goals of price stability and high employment. In the rest of my talk, I will first define constrained discretion more precisely and argue that, to an increasing extent, this approach characterizes contemporary Federal Reserve policymaking. I will then explain why I think constrained discretion is the best operating framework for monetary policy, and in particular why it constitutes the best approach for achieving the economic goals that the Congress has set for the Fed. Finally, I will briefly discuss the close relationship between constrained discretion and the strategy for monetary policy known as inflation targeting. Before proceeding, though, I should note that my remarks today do not necessarily represent the views of my colleagues on the Board of Governors of the Federal Reserve System or the Federal Open Market Committee. What is constrained discretion? The approach to monetary policy that I call constrained discretion can be defined by two simple and parsimonious principles. First, through its words and (especially) its actions, the central bank must establish a strong commitment to keeping inflation low and stable. Second, subject to the condition that inflation be kept low and stable, and to the extent possible given our uncertainties about the structure of the economy and the effects of policy, monetary policy should strive to limit cyclical swings in resource utilization. In short, under constrained discretion, the central bank is free to do its best to stabilize output and employment in the face of short-run disturbances, with the appropriate caution born of our imperfect knowledge of the economy and of the effects of policy. However, a critical proviso is that, in conducting stabilization policy, the central bank must also maintain a strong commitment to keeping inflation - and, hence, public expectations of inflation - firmly under control. Because monetary policy For example, even the classical gold standard contained important elements of discretion in practice, as when countries took measures to prevent their domestic money supplies from being influenced by international gold flows. Moreover, the gold standard often was suspended during wars or national emergencies. To the best of my knowledge, this term was first used in connection with monetary policy by Bernanke and Mishkin (1997). influences inflation with a lag, keeping inflation under control may sometimes require the central bank to anticipate and move in advance of inflationary developments - that is, to engage in “preemptive strikes” on inflation. In my view, constrained discretion characterizes the current monetary policy framework of the United States. And it has done so to an increasing degree over time. First, since the Fed under Chairman Paul Volcker broke the back of inflation in the early 1980s, inflation in the United States has been both declining and becoming more stable. From a high of nearly 10 percent in 1980, inflation (as measured by the core PCE deflator, twelve-month rate of change) fell to 4 percent by the end of 1984 and to 3 percent by the end of 1992. Inflation breached the 2 percent barrier in the spring of 1996 and has remained consistently within the narrow range of 1.5 to 2 percent for the past six and a half years - for practical purposes, a good approximation to price stability. Likewise, expected inflation - as measured by financial-market indicators as well as surveys of both professional forecasters and consumers - has stabilized at a low level. Thus, the Fed in recent years has demonstrated a commitment to keeping inflation low and stable - the first principle of constrained discretion. The Fed’s commitment to low inflation has not, however, prevented it from being flexible in implementing policy in the short term; in particular, the Fed has not been precluded from responding to adverse shocks to the economy (the second principle). Since the taming of inflation by the Volcker Fed, the United States has faced two recessions, in 1990-91 and in 2001. In both cases, as you know, the Fed eased policy significantly to support real activity. In particular, in 2001 the Federal Open Market Committee lowered the federal funds rate target by 475 basis points in a period of just under a year. Importantly, inflation and inflation expectations seem to have been virtually unaffected by this large move - a direct benefit, I argue, of the Fed’s previous investment in establishing a commitment to price stability. Moreover, both output and employment have become considerably more stable in the past twenty years, relative to previous decades - a result I attribute in substantial part to improvements in monetary policy. The Fed has also responded aggressively and flexibly to crisis conditions in financial markets, in episodes ranging from the 1987 stock market crash to the 1998 Russian crisis to the aftermath of the September 11, 2001, terrorist attacks. In the United States, the Congress has assigned to the Federal Reserve the objectives of maintaining price stability, maximum employment, and moderate long-term nominal interest rates. Of course, the Federal Reserve System, and in particular the Federal Open Market Committee, treats each part of this congressional mandate with utmost seriousness. Because the Fed appears to an increasing degree to be following a policy of what I have called constrained discretion, one must ask: Is this policy approach consistent with the Congress’s mandate for monetary policy? My answer is absolutely yes. In my view, this policy framework achieves each of the goals set by the Congress with greater consistency and effectiveness than any alternative of which I am aware. Broadly, there are three reasons why successful monetary policy is built on a foundation of price stability, as implied by the framework of constrained discretion. First, of course, price stability is one of the objectives for monetary policy set by the Congress and, indeed, is highly desirable in its own right. And, of course, the price level is the macroeconomic variable over which a central bank exerts the most direct control in the long run. Second, in the long run price stability promotes high employment and low nominal interest rates - the other objectives set by the Congress - as well as productivity and Throughout this talk I follow a common Fed practice in using the core personal consumption expenditure (PCE) deflator to measure inflation. Relative to the more familiar consumer price index (CPI), the PCE deflator (1) has broader coverage, is believed to be based on more accurate expenditure weights, (3) is constructed in a manner that reduces so-called substitution bias, (4) is measured more consistently over time, and (5) arguably does a better job measuring medical inflation. The core PCE deflator excludes volatile components, notably the prices of food and energy. Core inflation measures in general are probably better indicators of the underlying rate of inflation, with which central banks are typically most concerned. Standard inflation measures probably overstate increases in true inflation by about 1.0 percentage point. For example, Lebow and Rudd (2002) estimate that measured inflation using the consumer price index overstates the actual change in the cost of living by about 0.9 percentage points per year, with a confidence interval ranging from 0.3 percentage point to l.4 percentage points per year. (The bias in the PCE deflator, which is chain-weighted, may be a bit less.) In addition, as I discussed in a previous talk, aiming for an inflation rate modestly above zero provides a useful buffer against deflation risk. Stock and Watson (2002) note that the standard deviation of annual growth rates in real GDP fell from 2.7 percent during 1960-83 to only 1.6 percent in 1984-2001. They attribute 20 to 30 percent of this reduction in volatility to improvements in monetary policy. Arguably, however, stabilizing factors that Stock and Watson treat as exogenous, such as the reduced variability of commodity prices (other than oil), are actually in part the result of more stable policies. economic growth. Third, and most subtly, in the short run a record of consistently low inflation increases central bank credibility and stabilizes inflation expectations, effects that in turn actually increase the flexibility of the central bank to respond to shocks to the economy. I will discuss each of these points, beginning with the importance of price stability in the long run and then turning to the short-run issues. Price stability and economic performance in the long run Constrained discretion, at its foundation, recognizes the critical importance of maintaining price stability, both in the long run and in the short run. The desirability of maintaining price stability in the long run is by now hardly a matter for dispute, with virtually all economists in agreement that, in the long run, low inflation confers many benefits on the economy. Most fundamentally, only when inflation is low do nominal - that is, dollar - values provide a reasonably stable measure of real economic values. We should not underestimate the importance of this simple point. Although economists are used to the idea of “real” or inflation-adjusted quantities, making inflation adjustments in practice requires significant information, expertise, and effort. Thus, instability in the price level significantly impedes the ability of the typical household to make long-term financial plans, for example, or to compare prices of goods and services separated in space and time. (In a high-inflation economy, price information grows “stale” more quickly than newly baked bread.) Planning, investment, and pricing decisions by firms are likewise complicated and often distorted by inflation. Because prices constitute the market economy’s fundamental means of conveying information, the increased “noise” that inflation adds to prices raises transactions costs and erodes the efficiency of the free market system. In a similar vein, as economist Martin Feldstein has frequently pointed out, price stability permits contracts, tax laws, accounting rules, and the like to be expressed in nominal (dollar) terms without concern about fluctuations in the value of money. If prices are instead variable and unpredictable, then contracts or laws written in dollar terms will produce unintended and probably undesired economic outcomes. Feldstein, for example, has emphasized how the interaction of inflation with the tax code leads to unintended increases in the real cost of capital, which inhibit investment and reduce economic growth. Likewise, because debt contracts are written in nominal terms, unanticipated inflation transfers wealth from creditors to debtors, adding to the risk of financial contracting and at times posing a significant threat to the financial system itself. For example, the savings and loan crisis of the 1980s, which cost U.S. taxpayers hundreds of billions of dollars, was to a substantial extent the result of the unexpected inflation of the 1970s, which greatly reduced the real value of mortgage loans made by the S&Ls in an earlier, low-inflation era. These losses effectively de-capitalized the savings and loans, setting the stage for the problems that followed. Given the Congress’s mandate to the Federal Reserve, the long-run relationship between price stability and employment is an issue of particular importance. Our understanding of this relationship has evolved considerably over the past forty years. During the 1960s, U.S. policymakers appeared to believe that a long-run tradeoff between these two objectives existed and that that tradeoff could be exploited for policy purposes (Samuelson and Solow, 1960). That is, it was thought that by accepting a modest increase in the inflation rate, policy could achieve a permanently lower rate of unemployment. Both economic theory and U.S. economic experience have shown this view to have been in error, and that no long-run tradeoff between inflation and unemployment exists is now widely accepted. Indeed, because price stability promotes efficiency, productivity, and capital investment, one can reasonably presume that low inflation actually increases employment and real wages in the long run. Because price stability also promotes moderate long-term nominal interest rates, a commitment to price stability clearly is fully consistent in the long run with the objectives set by the Congress. See Feldstein (1997) and references therein. In principle, indexation to the price level could remove or moderate the unanticipated consequences of inflation in laws and contracts. In practice, however, indexation can be costly and complex, as suggested by the fact that people seem reluctant to adopt indexation even when inflation is relatively high. The shortcomings of indexation as a solution to high inflation have been illustrated by the experience of many developing countries in recent years. Price stability and economic performance in the short run That price stability is beneficial to the economy in the long run is well established. As economists and policymakers have increasingly come to recognize, however, the benefits of a commitment to price stability in the short run are probably at least as significant. I think it worthwhile, before discussing the short-run benefits of price stability for the economy, to note the simple fact that, historically, periods of unstable prices have also tended to be periods of marked instability in output and employment. In the nine decades since the founding of the Federal Reserve System, the United States has experienced two large, sustained departures from price stability. The first was the precipitous deflation of 1929-33, during which prices fell at a rate of about 10 percent per year; the second was the prolonged inflationary period that began in the latter part of the 1960s and did not end until the early 1980s. Of course, each of these episodes was associated not only with instability of prices but also with exceptionally poor economic performance more generally. The 192933 deflation ushered in, and to a significant extent was the cause of, the broad economic collapse we now know as the Great Depression. The inflation that began in the United States in the second half of the 1960s was associated with slow growth, bouts of high unemployment, and instability in economic activity, including the two worst recessions of the postwar period in 1973-75 and 1981-82. What is the link between price instability and instability in output and employment in the short run? In a previous talk I focused on the risks, so evident in the 1930s, that uncontrolled deflation poses for the economy, and I doubt that many of my listeners today will require much convincing on that point. So that no misunderstanding occurs, however, let me state clearly that the commitment to price stability under constrained discretion entails strict avoidance of deflation as well as of inflation. That said, I will concentrate for the remainder of the talk on the risks that inflation creates for economic stability in the short run. For illustration, I will emphasize the U.S. “Great Inflation,” the experience of the late 1960s through the early 1980s. The primary cause of the Great Inflation, most economists would agree, was over-expansionary monetary and fiscal policies, beginning in the mid-1960s and continuing, in fits and starts, well into the 1970s. The fiscal expansion of this period had a variety of elements, including heavy expenditures for the Vietnam War and President Johnson’s Great Society initiatives. Monetary policy first accommodated the fiscal expansion, and then - for reasons I will note - began to power the inflationary surge on its own. The breakdown of the price stability that had characterized the 1950s and early 1960s was remarkably quick; inflation was perceived as a problem by the late sixties. Though temporarily restrained by the Nixon price controls, inflation (again as measured by the core PCE deflator) rose from 2.6 percent in February 1973 to 9.8 percent in February 1975. After the deep 197375 recession, inflation fell back to the range of 6 to 7 percent for several years before rising again to 9.8 percent in September 1980. Like inflation, the real economy was also highly volatile during this whole period. The civilian unemployment rate, below 4 percent throughout the second half of the 1960s, rose above 6 percent during the 1969-70 recession, declined briefly, then rose again to 9 percent in May 1975. Unemployment declined slowly from there, falling below 6 percent only in late 1978 and early 1979. But during the 1981-82 recession, unemployment peaked at 10.8 percent - a rate not seen since the 1930s - and remained above 10 percent as late as June 1983. Taking the inflation and unemployment performance together, one should not be surprised that a recent chronicler of the period called the Great Inflation the 1970s “the greatest failure of American macroeconomic policy in the postwar period” (Mayer, 1998, p. 1). Why was this episode so dismal? Critically, although Fed officials often mentioned the importance of keeping inflation low during the 1960s and 1970s, the record of inflation outcomes during that period shows that their commitment to maintaining price stability was spotty. Several factors contributed to the Federal Reserve’s inflationary policies, including the political pressures exerted by the Johnson and Nixon administrations (Mayer, 1998, chapter 5). Mistakes of analysis - among them a tendency to blame nonpolicy factors (such as union wage pressures) for inflation, a misplaced belief in the potential efficacy of wage-price controls, and overly optimistic assessments of the economy’s growth potential in both the 1960s (DeLong, 1997; Romer and Romer, 2002) and early 1970s (Orphanides, 2001) - also played a key role. See “ Deflation: Making Sure that ‘It’ Doesn’t Happen Here” , November 21, 2002,www.federalreserve.gov. Yet another miscalculation, particularly important in the early stages of the Great Inflation, was the already-mentioned idea of an exploitable long-run tradeoff, according to which policymakers supposedly would be able to achieve permanently lower unemployment by accepting a bit more inflation. Indeed, initially the tradeoff idea appeared to be valid, for unemployment fell while inflation rose only moderately during the latter part of the 1960s. However, as we now understand, in this early period the Fed was living off the capital of two previous decades of price stability, which had conditioned the public to expect low inflation. Because the period began with expected inflation under control, monetary expansion in the latter part of the 1960s stimulated real spending and production without leading immediately to wage and price pressures. As the public woke up to the new reality of high and rising inflation, however, inflation expectations began to rise as well. Within a few years, the Federal Reserve found itself in a situation in which inflation and inflation expectations had risen considerably, while the earlier gains in terms of lower unemployment and higher growth had dissipated. The high and erratic inflation of this period contributed to instability of output and employment in a number of ways. I will highlight two. First was the pattern of go-stop policies followed by the Fed. The Fed understood in principle that stabilizing inflation and inflation expectations was important, but knowing that a slowdown in spending and output (of a magnitude difficult to guess) would be an unwelcome side effect - it was extremely reluctant to tighten monetary policy enough to do the job. The resulting compromise has been appropriately described as “go-stop” policy. First, over-expansion led to inflation, the “go” phase. Then, periodically, when inflation became bad enough, the Fed would tighten policy (the “stop” phase), only to loosen again when the resulting slowdown in the economy began to manifest itself. The net result of this policy pattern was to exacerbate greatly the instability of both inflation and unemployment, while making little progress toward restoring price stability or reanchoring inflation expectations. This cycle ended only under Chairman Volcker, who (together with his colleagues on the FOMC) had the courage to keep policy tight until inflation and inflation expectations finally began to stabilize in the early 1980s. Of course, the cost of this critical stabilization was the high unemployment and lost output associated with the sharp 1981-82 recession. The second link between the instability of inflation and that of unemployment in the Great Inflation operated through the behavior of inflation expectations. As I have noted, when the episode began in the 1960s, inflation expectations were well anchored, in the sense that the public was conditioned by long experience to expect low inflation. Hence, the first expansionary policy moves of the 1960s did succeed in raising output and employment without much initial effect on prices. As demand pressures accumulated and inflation rose, however, the Fed’s credibility as an inflation-fighter was lost and inflation expectations began to rise. The unmooring of inflation expectations greatly complicated the process of making monetary policy; in particular, the Fed’s loss of credibility significantly increased the cost of achieving disinflation. The severity of the 1981-82 recession, the worst of the postwar period, clearly illustrates the danger of letting inflation get out of control. This recession was so exceptionally deep precisely because of the monetary policies of the preceding fifteen years, which had unanchored inflation expectations and squandered the Fed’s credibility. Because inflation and inflation expectations remained stubbornly high when the Fed tightened, the impact of rising interest rates was felt primarily on output and employment rather than on prices, which continued to rise. One indication of the loss of credibility suffered by the Fed by the time of the 1981-82 episode, and the difficulty of getting it back once lost, was the behavior of long-term nominal interest rates. For example, the yield on 10-year Treasuries peaked at 15.3 percent in September 1981 - almost two years after Volcker’s Fed announced its disinflationary program in October 1979 - suggesting that long-term inflation expectations were at that point still in the double digits. The 10-year Treasury yield did not fall below 10 percent until November 1985. Remarkably, 30-year Treasury yields were only slightly lower than 10-year yields throughout the episode, implying that the markets had no confidence that inflation would ever return to 1950s or 1960s levels. Romer and Romer (2002) make this argument and provide historical documentation. See also Taylor (1997) and Mayer (1998). In an important paper, Orphanides and Williams (2003) use a theoretical model to show that when the public forms its expectations of inflation behavior by observing the actual behavior of inflation, the importance of the central bank keeping inflation low and stable - and thereby “ anchoring” the public’s inflation expectations - is greatly increased. The behavior of long-term nominal interest rates in the early 1980s can be contrasted with that of more recent years. Today the 10-year Treasury yield is approximately 4 percent, suggesting substantial confidence on the part of financial market practitioners that inflation will remain low for the next decade. Indeed, we have the benefit of a developed market for indexed debt to make that inference more precise: The expected inflation rate inferred from the yield on 10-year inflation-protected Treasury bonds is now about 2.0 percent for CPI inflation. Also notable is the fact that the substantial easing of monetary policy during 2001 appeared to generate no concerns about future inflation, as evidenced by the record low long-term interest rates and stable survey-based inflation expectations that we are still seeing. You may have noticed that I have discussed the Great Inflation of the 1970s with an emphasis on Federal Reserve behavior but without mentioning oil prices. My reading of the evidence suggests that the role the conventional wisdom has attributed to oil price increases in the stagflation of the 1970s has been overstated, for two reasons. First, the large increases in oil prices that occurred in this period would not have been possible in an environment that was not already highly inflationary because of previous monetary expansion. In an important paper, Barsky and Kilian (2001) make this case in some detail. They note, for example, that prices of other industrial commodities and raw materials rose substantially at the same time as oil prices, suggesting that broader monetary forces - and not factors specific to the oil market - account for much of the rise in the oil price in 1973. Second, without Fed accommodation, higher oil prices abroad would not have translated into domestic inflation to any significant degree. To see this point, note that oil prices do not directly affect the measure of inflation that I have been using here - the change in the core PCE deflator, which excludes energy prices. Thus, any link of oil prices to inflation must be through so-called second-round effects, in which increased fuel prices push up wages and other costs. Comparison of the 1970s and the 1990s confirms the common finding in the literature that the degree of “pass-through” to core inflation from supply shocks, such as a rise in oil prices or a depreciation of the exchange rate, depends strongly on how well domestic expectations of inflation are anchored. Because inflation expectations were not well anchored in the 1970s, the oil price shocks were in fact associated with substantial passthrough, that is, increases in core inflation. As already noted, core PCE inflation rose by a whopping 7 percentage points in the years 1973-74, the period of the sharpest increase in oil prices. In the 1990s, by contrast, oil price changes seemed to have no noticeable effect on core inflation. For example, the price of oil at the end of 1998 was a little more than $11 per barrel; over the next two years the price of oil tripled, exceeding $34 per barrel late in 2000. Then, over the subsequent year, the price of oil suddenly reversed itself, dropping 40 percent. Despite these gyrations, core inflation remained firmly anchored throughout the period, registering between 1.5 percent and 2.0 percent on a twelve-month basis in every month. Although structural changes have occurred in the economy since the 1970s, including increased energy efficiency, this difference in the degree of pass-through from oil prices to general inflation can be explained, in my view, only by differences in the stability of inflation and inflation expectations. Overall, it is reasonable to conclude that macro policy, particularly monetary policy, was the most important single reason for the poor economic performance experienced during the U.S. Great Inflation. Constrained discretion and inflation targeting I mentioned at the beginning of the talk that constrained discretion characterizes at least to some degree the policy approach of many of the major central banks around the world. It is, in fact, closely related to the policy framework known as inflation targeting. Let me take a moment to explain the relationship between what I have termed “constrained discretion” and the more familiar concept of inflation targeting. It is useful, I think, to divide monetary policymaking into two parts - roughly, what you do and what you say about it. “What you do” covers the operational aspects of policy - the assessment of economic conditions and the setting of policy instruments (such as the federal funds rate in the United States). In related work, Bohi (1989) and Bernanke, Gertler, and Watson (1997) provide evidence that macroeconomic policy, rather than the behavior of oil prices, was the most important source of macroeconomic instability in the 1970s. In a study of OECD countries, Ball and Sheridan (2003) find that the effect of commodity price shocks on inflation in recent years has dropped by a factor of ten, relative to earlier decades. “What you say” is about how you talk to the public and relates to the issues of central bank transparency, communication, and accountability. “What you do” is certainly the more important of the two, though I think most central bankers understand that communication is a valuable tool. The details of inflation-targeting regimes vary by country and have evolved over time. Broadly speaking, however, the operational, or “what you do,” side of what I consider to be best-practice inflation targeting is well described as constrained discretion, as I have characterized it here. Specifically, most inflation-targeting central banks try to stabilize output and employment subject to the constraint that inflation remain low and stable - in the case of formal inflation targeters, of course, within the declared target range for inflation. As I have noted, constrained discretion also describes reasonably well the recent policy approach of the Federal Reserve, though of course the Fed does not have publicly announced inflation targets. Thus, on the operational side, the policy frameworks of the Federal Reserve and of the leading central banks with formal inflation targets are today rather similar. The second element of inflation targeting - the communication, or “what you say,” side - consists of not only a public announcement of a target range for inflation (the hallmark of inflation targeting) but also a variety of other mechanisms for talking to markets and the public. These include the regular publication of so-called Inflation Reports, release of forecasts, prompt release of minutes, and other measures. Here is the principal area in which the Federal Reserve - though it has certainly become markedly more transparent in the past decade - has not chosen to adopt the whole framework of inflation targeting. Many have concluded that central banks that have adopted the transparency and communication aspects of inflation targeting have strengthened their overall policy performance through enhanced communication to the public of their objectives and plans, improved management of expectations, greater consistency of policy, and heightened accountability. The Fed has much in common with other major central banks, but of course it also differs in important ways, including its history, legal framework, and institutional structure. Whether adopting any or all of these communication strategies would be useful for the Federal Reserve is an important issue about which I hope to say more in the future. Conclusion My objective today has been to lay out the advantages of using a framework of constrained discretion for making monetary policy. The essence of constrained discretion is the central role of a commitment to price stability. Not only does such a commitment enhance efficiency, employment, and economic growth in the long run, but - by providing an anchor for inflation expectations - it also improves the ability of central banks to stabilize the real economy in the short run as well. An important and interesting implication is that, under a properly designed and implemented monetary policy regime, the key social objectives of price stability and maximum employment tend to be mutually reinforcing rather than competing goals. Thank you very much for your attention. This BIS Review is available on the BIS website at www.bis.org. The Federal Reserve has a dual mandate, with responsibility for both employment and inflation. The formal mandates for inflation-targeting central banks vary, but in practice virtually all take employment and output into consideration as well as prices - that is, they practice what is sometimes referred to as “ flexible” inflation targeting. Among the steps taken by the Federal Reserve to increase transparency in recent years include immediate announcement of changes in the target for the policy rate, the issuance of a “ balance of risks” statement, and the publication of minutes and (with a five-year lag) the transcripts of each FOMC meeting. Case studies of several inflation-targeting central banks are presented in Bernanke, Laubach, Mishkin, and Posen (1999). Ball and Sheridan (2003) find that there has been substantial improvement in monetary-policy outcomes in OECD countries generally in the 1990s, a result that can reasonably be attributed to widespread adoption of what I have here referred to as constrained discretion. Ball and Sheridan also find that inflation-targeters improved by somewhat more than non-inflationtargeters, but they attribute this finding to the phenomenon of “ regression toward the mean” rather than to any benefits of formal inflation-targeting per se.
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board of governors of the federal reserve system
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Testimony of Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Committee on Banking, Housing, and Urban Affairs, US Senate, 11 February 2003.
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Alan Greenspan: Federal Reserve Board’s semiannual monetary policy report to the Congress Testimony of Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Committee on Banking, Housing, and Urban Affairs, US Senate, 11 February 2003. * * * Mr Chairman and members of the committee, I am pleased this morning to present the Federal Reserve’s semiannual Monetary Policy Report to the Congress. I will begin by reviewing the state of the US economy and the conduct of monetary policy and then turn to some key issues related to the federal budget. When I testified before this committee last July, I noted that, while the growth of economic activity over the first half of the year had been spurred importantly by a swing from rapid inventory drawdown to modest inventory accumulation, that source of impetus would surely wind down in subsequent quarters, as it did. We at the Federal Reserve recognized that a strengthening of final sales was an essential element of putting the expansion on a firm and sustainable track. To support such a strengthening, monetary policy was set to continue its accommodative stance. In the event, final sales continued to grow only modestly, and business outlays remained soft. Concerns about corporate governance, which intensified for a time, were compounded over the late summer and into the fall by growing geopolitical tensions. In particular, worries about the situation in Iraq contributed to an appreciable increase in oil prices. These uncertainties, coupled with ongoing concerns surrounding macroeconomic prospects, heightened investors’ perception of risk and, perhaps, their aversion to such risk. Equity prices weakened further, the expected volatility of equity prices rose to unusually high levels, spreads on corporate debt and credit default swaps deteriorated, and liquidity in corporate debt markets declined. The economic data and the anecdotal information suggested that firms were tightly limiting hiring and capital spending and keeping an unusually short leash on inventories. With capital markets inhospitable and commercial banks firming terms and standards on business loans, corporations relied to an unusual extent on a drawdown of their liquid assets rather than on borrowing to fund their limited expenditures. By early November, conditions in financial markets had firmed somewhat on reports of improved corporate profitability. But on November 6, with economic performance remaining subpar, the Federal Open Market Committee chose to ease the stance of monetary policy, reducing the federal funds rate 50 basis points, to 1¼%. We viewed that action as insurance against the possibility that the still widespread weakness would become entrenched. With inflation expectations well contained, this additional monetary stimulus seemed to offer worthwhile insurance against the threat of persistent economic weakness and unwelcome substantial declines in inflation from already low levels. In the weeks that followed, financial market conditions continued to improve, but only haltingly. The additional monetary stimulus and the absence of further revelations of major corporate wrongdoing seemed to provide some reassurance to investors. Equity prices rose, volatility declined, risk spreads narrowed, and market liquidity increased, albeit not to levels that might be associated with robust economic conditions. At the same time, mounting concerns about geopolitical risks and energy supplies, amplified by the turmoil in Venezuela, were mirrored by the worrisome surge in oil prices, continued skittishness in financial markets, and substantial uncertainty among businesses about the outlook. Partly as a result, growth of economic activity slowed markedly late in the summer and in the fourth quarter, continuing the choppy pattern that prevailed over the past year. According to the advance estimate, real GDP expanded at an annual rate of only ¾ last quarter after surging 4percent in the third quarter. Much of that deceleration reflected a falloff in the production of motor vehicles from the near-record level that had been reached in the third quarter when low financing rates and other incentive programs sparked a jump in sales. The slowing in aggregate output also reflected aggressive attempts by businesses more generally to ensure that inventories remained under control. Thus far, those efforts have proven successful in that business inventories, with only a few exceptions, have stayed lean - a circumstance that should help support production this year. Indeed, after dropping back a bit in the fall, manufacturing activity turned up in December, and reports from purchasing managers suggest that improvement has continued into this year. Excluding both the swings in auto and truck production and the fluctuations in non-motor-vehicle inventories, economic activity has been moving up in a considerably smoother fashion than has overall real GDP: Final sales excluding motor vehicles are estimated to have risen at a 2¼% annual rate in the fourth quarter after a similar 1¾% advance in the previous quarter and an average of 2% in the first half. Thus, apart from these quarterly fluctuations, the economy has largely extended the broad patterns of performance that were evident at the time of my July testimony. Most notably, output has continued to expand, but only modestly. As previously, overall growth has simultaneously been supported by relatively strong spending by households and weighed down by weak expenditures by businesses. Importantly, the favorable underlying trends in productivity have continued; despite little change last quarter, output per hour in the nonfarm business sector rose 3¾% over the four quarters of 2002, an impressive gain for a period of generally lackluster economic performance. One consequence of the combination of sluggish output growth and rapid productivity gains has been that the labor market has remained quite soft. Employment turned down in the final months of last year, and the unemployment rate moved up, but the report for January was somewhat more encouraging. Another consequence of the strong performance of productivity has been its support of household incomes despite the softness of labor markets. Those gains in income, combined with very low interest rates and reduced taxes, have permitted relatively robust advances in residential construction and household expenditures. Indeed, residential construction activity moved up steadily over the year. And despite large swings in sales, underlying demand for motor vehicles appears to have been well maintained. Other consumer outlays, financed partly by the large extraction of built-up equity in homes, have continued to trend up. Most equity extraction - reflecting the realized capital gains on home sales - usually occurs as a consequence of house turnover. But during the past year, an almost equal amount reflected the debt-financed cash-outs associated with an unprecedented surge in mortgage refinancings. Such refinancing activity is bound to contract at some point, as average interest rates on outstanding home mortgages converge to interest rates on new mortgages. However, fixed mortgage rates remain extraordinarily low, and applications for refinancing are not far off their peaks. Simply processing the backlog of earlier applications will take some time, and this factor alone suggests that refinancing originations and cash-outs will be significant at least through the early part of this year. To be sure, the mortgage debt of homeowners relative to their income is high by historical norms. But as a consequence of low interest rates, the servicing requirement for the mortgage debt of homeowners relative to the corresponding disposable income of that group is well below the high levels of the early 1990s. Moreover, owing to continued large gains in residential real estate values, equity in homes has continued to rise despite sizable debt-financed extractions. Adding in the fixed costs associated with other financial obligations, such as rental payments of tenants, consumer installment credit, and auto leases, the total servicing costs faced by households relative to their incomes are below previous peaks and do not appear to be a significant cause for concern at this time. While household spending has been reasonably vigorous, we have yet to see convincing signs of a rebound in business outlays. After having fallen sharply over the preceding two years, new orders for capital equipment stabilized and, for some categories, turned up in nominal terms in 2002. Investment in equipment and software is estimated to have risen at a 5% rate in real terms in the fourth quarter and a subpar 3% over the four quarters of the year. However, the emergence of a sustained and broad-based pickup in capital spending will almost surely require the resumption of substantial gains in corporate profits. Profit margins apparently did improve a bit last year, aided importantly by the strong growth in labor productivity. Of course, the path of capital investment will depend not only on market conditions and the prospects for profits and cash flow but also on the resolution of the uncertainties surrounding the business outlook. Indeed, the heightening of geopolitical tensions has only added to the marked uncertainties that have piled up over the past three years, creating formidable barriers to new investment and thus to a resumption of vigorous expansion of overall economic activity. The intensification of geopolitical risks makes discerning the economic path ahead especially difficult. If these uncertainties diminish considerably in the near term, we should be able to tell far better whether we are dealing with a business sector and an economy poised to grow more rapidly - our more probable expectation - or one that is still laboring under persisting strains and imbalances that have been misidentified as transitory. Certainly, financial conditions would not seem to impose a significant hurdle to a turnaround in business spending. Yields on risk-free Treasury securities have fallen, risk spreads are narrower on corporate bonds, premiums on credit default swaps have retraced most of their summer spike, and liquidity conditions have improved in capital markets. These factors, if maintained, should eventually facilitate more vigorous corporate outlays. If instead, contrary to our expectations, we find that, despite the removal of the Iraq-related uncertainties, constraints to expansion remain, various initiatives for conventional monetary and fiscal stimulus will doubtless move higher on the policy agenda. But as part of that process, the experience of recent years may be instructive. As I have testified before this committee in the past, the most significant lesson to be learned from recent American economic history is arguably the importance of structural flexibility and the resilience to economic shocks that it imparts. I do not claim to be able to judge the relative importance of conventional stimulus and increased economic flexibility to our ability to weather the shocks of the past few years. But the improved flexibility of our economy, no doubt, has played a key role. That increased flexibility has been in part the result of the ongoing success in liberalizing global trade, a quarter-century of bipartisan deregulation that has significantly reduced rigidities in our markets for energy, transportation, communication, and financial services, and, of course, the dramatic gains in information technology that have markedly enhanced the ability of businesses to address festering economic imbalances before they inflict significant damage. This improved ability has been facilitated further by the increasing willingness of our workers to embrace innovation more generally. It is reasonable to surmise that, not only have such measures contributed significantly to the long-term growth potential of the economy this past decade, they also have enhanced its short-term resistance to recession. That said, we have too little history to measure the extent to which increasing flexibility has boosted the economy’s potential and helped damp cyclical fluctuations in activity. Even so, the benefits appear sufficiently large that we should be placing special emphasis on searching for policies that will engender still greater economic flexibility and dismantling policies that contribute to unnecessary rigidity. The more flexible an economy, the greater its ability to self-correct in response to inevitable, often unanticipated, disturbances, thus reducing the size and consequences of cyclical imbalances. Enhanced flexibility has the advantage of adjustments being automatic and not having to rest on the initiatives of policymakers, which often come too late or are based on highly uncertain forecasts. Policies intended to improve the flexibility of the economy seem to fall outside the sphere of traditional monetary and fiscal policy. But decisions on the structure of the tax system and spending programs surely influence flexibility and thus can have major consequences for both the cyclical performance and long-run growth potential of our economy. Accordingly, in view of the major budget issues now confronting the Congress and their potential implications for the economy, I thought it appropriate to devote some of my remarks today to fiscal policy. In that regard, I will not be emphasizing specific spending or revenue programs. Rather, my focus will be on the goals and process determining the budget and on the importance, despite our increasing national security requirements, of regaining discipline in that process. These views are my own and are not necessarily shared by my colleagues at the Federal Reserve. * * * One notable feature of the budget landscape over the past half century has been the limited movement in the ratio of unified budget outlays to nominal GDP. Over the past five years, that ratio has averaged a bit less than 19%, about where it was in the 1960s before it moved up during the 1970s and 1980s. But that pattern of relative stability over the longer term has masked a pronounced rise in the share of spending committed to retirement, medical, and other entitlement programs. Conversely, the share of spending that is subject to the annual appropriations process, and thus that comes under regular review by the Congress, has been shrinking. Such so-called discretionary spending has fallen from two-thirds of total outlays in the 1960s to one-third last year, with defense outlays accounting for almost all of the decline. The increase in the share of expenditures that is more or less on automatic pilot has complicated the task of making fiscal policy by effectively necessitating an extension of the budget horizon. The Presidents’ budgets through the 1960s and into the 1970s mainly provided information for the upcoming fiscal year. The legislation in 1974 that established a new budget process and created the Congressional Budget Office required that organization to provide five-year budget projections. And by the mid-1990s, CBO’s projection horizon had been pushed out to ten years. These longer time periods and the associated budget projections, even granted their imprecision, are useful steps toward allowing the Congress to balance budget priorities sensibly in the context of a cash-based accounting system. But more can be done to clarify those priorities and thereby enhance the discipline on the fiscal process. A general difficulty concerns the very nature of the unified budget. As a cash accounting system, it was adopted in 1968 to provide a comprehensive measure of the funds that move in and out of federal coffers. With a few modifications, it correctly measures the direct effect of federal transactions on national saving. But a cash accounting system is not designed to track new commitments and their translation into future spending and borrowing. For budgets that are largely discretionary, changes in forward commitments do not enter significantly into budget deliberations, and hence the surplus or deficit in the unified budget is a reasonably accurate indicator of the stance of fiscal policy and its effect on saving. But as longer-term commitments have come to dominate tax and spending decisions, such cash accounting has been rendered progressively less meaningful as the principal indicator of the state of our fiscal affairs. An accrual-based accounting system geared to the longer horizon could be constructed with a reasonable amount of additional effort. In fact, many of the inputs on the outlay side are already available. However, estimates of revenue accruals are not well developed. These include deferred taxes on retirement accounts that are taxable on withdrawal, accrued taxes on unrealized capital gains, and corporate tax accruals. An accrual system would allow us to keep better track of the government’s overall accrued obligations and deferred assets. Future benefit obligations and taxes would be recognized as they are incurred rather than when they are paid out by the government. Currently, accrued outlays very likely are much greater than those calculated under the cash-based approach. Under full accrual accounting, the social security program would be showing a substantial deficit this year, rather than the surplus measured under our current cash accounting regimen. Indeed, under most reasonable sets of actuarial assumptions, for social security benefits alone past accruals cumulate to a liability that amounts to many trillions of dollars. For the government as a whole, such liabilities are still growing. Estimating the liabilities implicit in social security is relatively straightforward because that program has many of the characteristics of a private defined-benefit retirement program. Projections of Medicare outlays, however, are far more uncertain even though the rise in the beneficiary populations is expected to be similar. The likelihood of continued dramatic innovations in medical technology and procedures combined with largely inelastic demand and a subsidized third-party payment system engenders virtually open-ended potential federal outlays unless constrained by law. Liabilities for Medicare are probably about the same order of magnitude as those for social security, and as is the case for social security, the date is rapidly approaching when those liabilities will be converted into cash outlays. Accrual-based accounts would lay out more clearly the true costs and benefits of changes to various taxes and outlay programs and facilitate the development of a broad budget strategy. In doing so, these accounts should help shift the national dialogue and consensus toward a more realistic view of the limits of our national resources as we approach the next decade and focus attention on the necessity to make difficult choices from among programs that, on a stand-alone basis, appear very attractive. Because the baby boomers have not yet started to retire in force and accordingly the ratio of retirees to workers is still relatively low, we are in the midst of a demographic lull. But short of an outsized acceleration of productivity to well beyond the average pace of the past seven years or a major expansion of immigration, the aging of the population now in train will end this state of relative budget Unfortunately, they are incomplete steps because even a ten-year horizon ends just as the baby boom generation is beginning to retire and the huge pressures on social security and especially Medicare are about to show through. In particular, a full set of accrual accounts would give the Congress, for the first time in usable form, an aggregate tabulation of federal commitments under current law, with various schedules of the translation of those commitments into receipts and cash payouts. However, accrued outlays should exhibit far less deterioration than the unified budget outlays when the baby boomers retire because the appreciable rise in benefits that is projected to cause spending to balloon after 2010 will have been accrued in earlier years. Constraining these outlays by any mechanism other than prices will involve some form of rationing - an approach that in the past has not been popular in the United States. tranquility in about a decade’s time. It would be wise to address this significant pending adjustment sooner rather than later. As the President’s just-released budget put it, “The longer the delay in enacting reforms, the greater the danger, and the more drastic the remedies will have to be.” Accrual-based revenue and outlay projections, tied to a credible set of economic assumptions, tax rates, and programmatic spend-out rates, can provide important evidence on the long-term sustainability of the overall budget and economic regimes under alternative scenarios. Of course, those projections, useful as they might prove to be, would still be subject to enormous uncertainty. The ability of economists to assess the effects of tax and spending programs is hindered by an incomplete understanding of the forces influencing the economy. It is not surprising, therefore, that much controversy over basic questions surrounds the current debate over budget policy. Do budget deficits and debt significantly affect interest rates and, hence, economic activity? With political constraints on the size of acceptable deficits, do tax cuts ultimately restrain spending increases, and do spending increases limit tax cuts? To what extent do tax increases inhibit investment and economic growth or, by raising national saving, have the opposite effect? And to what extent does government spending raise the growth of GDP, or is its effect offset by a crowding out of private spending? Substantial efforts are being made to develop analytical tools that, one hopes, will enable us to answer such questions with greater precision than we can now. Much progress has been made in ascertaining the effects of certain policies, but many of the more critical questions remain in dispute. However, there should be little disagreement about the need to reestablish budget discipline. The events of September 11 have placed demands on our budgetary resources that were unanticipated a few years ago. In addition, with defense outlays having fallen in recent years to their smallest share of GDP since before World War II, the restraint on overall spending from the downtrend in military outlays has surely run its course - and likely would have done so even without the tragedy of 11 September The CBO and the Office of Management and Budget recently released updated budget projections that are sobering. These projections, in conjunction with the looming demographic pressures, underscore the urgency of extending the budget enforcement rules. To be sure, in the end, it is policy, not process, that counts. But the statutory limits on discretionary spending and the so-called PAYGO rules, which were promulgated in the Budget Enforcement Act of 1990 and were backed by a sixty-vote point of order in the Senate, served as useful tools for controlling deficits through much of the 1990s. These rules expired in the House last September and have been partly extended in the Senate only through mid-April. The Budget Enforcement Act was intended to address the problem of huge unified deficits and was enacted in the context of a major effort to bring the budget under control. In 1990, the possibility that surpluses might emerge within the decade seemed remote indeed. When they unexpectedly arrived, the problem that the budget control measures were designed to address seemed to have been solved. Fiscal discipline became a less pressing priority and was increasingly abandoned. To make the budget process more effective, some have suggested amending the budget rules to increase their robustness against the designation of certain spending items as “emergency” and hence not subject to the caps. Others have proposed mechanisms, such as statutory triggers and sunsets on legislation, that would allow the Congress to make mid-course corrections more easily if budget projections go off-track - as they invariably will. These ideas are helpful and they could strengthen the basic structure established a decade ago. But, more important, a budget framework along the lines of the one that provided significant and effective discipline in the past needs, in my judgment, to be reinstated without delay. I am concerned that, should the enforcement mechanisms governing the budget process not be restored, the resulting lack of clear direction and constructive goals would allow the inbuilt political bias in favor of growing budget deficits to again become entrenched. We are all too aware that government Office of Management and Budget, Budget of the United States Government, Fiscal Year 2004, Washington, D.C.: US Government Printing Office, p 32. In general, fiscal systems are presumed stable if the ratio of debt in the hands of the public to nominal GDP (a proxy for the revenue base) is itself stable. A rapidly rising ratio of debt to GDP, for example, implies an ever-increasing and possibly accelerating ratio of interest payments to the revenue base. Conversely, once debt has fallen to zero, budget surpluses generally require the accumulation of private assets, an undesirable policy in the judgment of many. spending programs and tax preferences can be easy to initiate or expand but extraordinarily difficult to trim or shut down once constituencies develop that have a stake in maintaining the status quo. In the Congress’s review of the mechanisms governing the budget process, you may want to reconsider whether the statutory limit on the public debt is a useful device. As a matter of arithmetic, the debt ceiling is either redundant or inconsistent with the paths of revenues and outlays you specify when you legislate a budget. In addition, a technical correction in the procedure used to tie indexed benefits and individual income tax brackets to changes in “the cost of living” as required by law is long overdue. As you may be aware, the Bureau of Labor Statistics has recently introduced a new price index - the so-called chained CPI. The new index is based on the same underlying data as is the official CPI, but it combines the individual prices in a way that better measures changes in the cost of living. In particular, the chained CPI captures more fully than does the official CPI the way that consumers alter the mix of their expenditures in response to changes in relative prices. Because it appears to offer a more accurate measure of the true cost of living - the statutory intent - the chained CPI would be a more suitable series for the indexation of federal programs. Had such indexing been in place during the past decade, the fiscal 2002 deficit would have been $40 billion smaller, all else being equal. At the present time, there seems to be a large and growing constituency for holding down the deficit, but I sense less appetite to do what is required to achieve that outcome. Reestablishing budget balance will require discipline on both revenue and spending actions, but restraint on spending may prove the more difficult. Tax cuts are limited by the need for the federal government to fund a basic level of services - for example, national defense. No such binding limits constrain spending. If spending growth were to outpace nominal GDP, maintaining budget balance would necessitate progressively higher tax rates that would eventually inhibit the growth in the revenue base on which those rates are imposed. Deficits, possibly ever widening, would be the inevitable outcome. Faster economic growth, doubtless, would make deficits far easier to contain. But faster economic growth alone is not likely to be the full solution to currently projected long-term deficits. To be sure, underlying productivity has accelerated considerably in recent years. Nevertheless, to assume that productivity can continue to accelerate to rates well above the current underlying pace would be a stretch, even for our very dynamic economy. So, short of a major increase in immigration, economic growth cannot be safely counted upon to eliminate deficits and the difficult choices that will be required to restore fiscal discipline. By the same token, in setting budget priorities and policies, attention must be paid to the attendant consequences for the real economy. Achieving budget balance, for example, through actions that hinder economic growth is scarcely a measure of success. We need to develop policies that increase the real resources that will be available to meet our longer-run needs. The greater the resources available - that is, the greater the output of goods and services produced by our economy - the easier will be providing real benefits to retirees in coming decades without unduly restraining the consumption of workers. * * * These are challenging times for all policymakers. Considerable uncertainties surround the economic outlook, especially in the period immediately ahead. But the economy has shown remarkable resilience in the face of a succession of substantial blows. Critical to our nation’s performance over the past few years has been the flexibility exhibited by our market-driven economy and its ability to generate substantial increases in productivity. Going forward, these same characteristics, in concert with sound economic policies, should help to foster a return to vigorous growth of the US economy to the benefit of all our citizens. In fact, we will need some further acceleration of productivity just to offset the inevitable decline in net labor force, and associated overall economic, growth as the baby boomers retire.
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board of governors of the federal reserve system
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Speech by Ms Susan S Bies, Member of the Board of Governors of the US Federal Reserve System, at Thunderbird, The American Graduate School of International Management, Glendale, Arizona, 11 February 2003.
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Susan S Bies: Financial markets and corporate governance in the United States and other countries Speech by Ms Susan S Bies, Member of the Board of Governors of the US Federal Reserve System, at Thunderbird, The American Graduate School of International Management, Glendale, Arizona, 11 February 2003. * * * I appreciate the opportunity to speak with you today. My remarks will focus on issues relating to corporate governance and the evolution of banking and financial markets. I will also compare international perspectives on these issues using Japan and Germany as examples. The governance problems that have come to light over the past year have thrust the quality of accounting standards, the professionalism of auditors, and governance practices of major companies into the limelight. These issues have triggered a spate of regulatory reforms in the United States. Besides these issues, some broader, longer-term issues that have not been the center of the recent debate affect accounting and corporate governance and I want to talk about these as well. Looking beyond the isolated cases of outright fraud, I believe a fundamental problem is this: As organizations have grown in size and scope, innovative financing techniques have made it more difficult for outside investors to understand a particular firm’s risk profile and the performance of its various lines of business. Traditional accounting standards have not kept pace with the risk-management tools employed by sophisticated corporations. Thus, the disclosure of firms’ risk-management positions and strategies is crucial to improve corporate transparency for market participants. The second issue I want to explore is how financing patterns in different countries emphasize different stakeholders in the corporate governance process. For instance, in Germany and Japan, corporations rely heavily on bank loans for external financing, whereas in the United States most funds are raised through public capital markets. Therefore, it is not surprising that the corporate governance issues in Japan and Germany revolve around the role of banks as delegated monitors. In contrast, corporate governance issues in the United States relate primarily to the conflict between shareholders and corporate executives, a conflict that may be affected by the increasing importance of institutional investors, such as mutual funds and pension funds, as major holders of public equity. In all three countries, adequate disclosure and accounting are fundamental to efficient governance; and because of the recent wave of financial innovation, a combination of increased transparency and market discipline applied by creditors such as banks, counterparties, and investors - including the institutional investors in the United States that hold a large share of corporate equity - is required. Financial Innovation and Risk Management The last decades of the twentieth century were, without doubt, a period of dramatic change in financial engineering, financial innovation, and risk-management practices. Over this period, firms acquired effective new tools to manage financial risk, one of which was securitization. Many assets on a firm’s balance sheet, such as receivables, can now be securitized - that is, grouped into pools and sold to outside investors. Securitization helps a firm manage the risk of a concentrated exposure by transferring some of that exposure outside the firm. By pooling a diverse set of assets and issuing marketable securities, firms obtain liquidity and reduce funding costs. Of course, moving assets off the balance sheet and into special-purpose entities, with the attendant creation of servicing rights and high-risk residual interests retained by firms, generates its own risks. Several types of securitization have grown rapidly over the past decade. One of the fastest growing has been asset-backed commercial paper, which soared from only $16 billion outstanding at the end of 1989 to about $700 billion as of year-end 2002. Commercial mortgage securitizations have also proliferated noticeably since the early 1990s. The dollar amount of outstanding securities backed by commercial and multifamily mortgages has risen from $36 billion at the end of 1989 to just over $400 billion as of this past September. In addition, commercial banks and finance companies have moved business loans off their books through the development of collateralized debt obligations. Securitized business loans amounted to $110 billion in the third quarter of 2002, up from a relatively miniscule $2 billion in 1989. Derivatives are another important tool that firms use to manage risk exposures. In the ordinary course of business, firms are exposed to credit risk and the risk of price fluctuations in currency, commodity, energy, and interest rate markets. For example, when an airline sells tickets months before a flight, the airline becomes exposed to fluctuations in the price of jet fuel. A higher price of jet fuel translates directly into lower profits and, perhaps, a greater risk of bankruptcy. Firms can now use derivatives options, futures, forwards, and so on - to mitigate their exposure to some of these risks. The risk can be transferred to a counterparty that is more willing to bear it. In my example, the airline could buy a forward contract or a call option on jet fuel to hedge its risk and thereby increase its financial stability. A relatively new type of derivative - credit derivatives - has gotten considerable attention lately because of its very rapid growth. Credit derivatives allow a firm to purchase protection against the risk of loss from the default of a given entity. By doing so, financial and nonfinancial firms alike can limit or reduce their exposures to given borrowers or counterparties. In addition, credit derivatives allow financial firms to achieve a more diversified credit portfolio by acquiring credit exposure to borrowers with which they do not have a lending relationship. For example, European insurance companies reportedly have used credit derivatives to acquire exposure to European corporations that, because they rely primarily on bank lending, have little publicly traded debt outstanding. The use of derivatives, like securitizations, has been growing rapidly in recent years. The most recent statistics from the Bank for International Settlements indicated that the notional amount of over-thecounter derivatives outstanding totaled $128 trillion in June 2002, up from $81 trillion just three years earlier. For exchange-traded derivatives, notional amounts outstanding rose from $14 trillion to $24 trillion over the same period. Credit derivatives are small by comparison, with a notional value of just under $700 billion as of the end of June 2001. However, this number reflects an increase of more than 500% from three years earlier. Complex Organizations Are Opaque As indicated by my brief discussion of securitization and derivatives, financial innovations have facilitated the separation and reallocation of risks to parties more willing and able to bear them. In the twenty-first century, businesses will use almost limitless configurations of products and services and sophisticated financial structures. A byproduct of these developments will be that outsiders will have ever more difficulty understanding the risk positions of many large, complex organizations; and traditional financial reporting - which provides a snapshot at a particular moment - will be even less meaningful than it is today. The intended or unintended consequences of the opaqueness that comes with complexity raise serious issues for financial reporting and corporate governance. Effective governance requires investors and creditors to hold firms accountable for their decisions. But its prerequisite is having the information necessary to understand the risks that the firm is bearing and those that it has transferred to others. With sufficient, timely, accurate, and relevant information, market participants can evaluate a firm’s risk profile and adjust the availability and pricing of funds to promote a better allocation of financial resources. Lenders and investors have an obvious interest in accurately assessing a firm’s riskmanagement performance, the underlying trends in its earnings and cash flow, and its incomeproducing potential. In this regard, transparency is essential to providing market participants with the information they need to effect market discipline. Sound, well-managed companies will benefit if enhanced disclosure enables them to obtain funds at risk premiums that more accurately reflect their lower risk profiles. Without such disclosure, otherwise well-managed firms will be penalized if market participants cannot perceive their fundamental financial strength and sound risk-management practices. I have been heartened to see that renewed market discipline appears to be forcing companies to compete for investors’ support by improving the transparency of corporate reporting. Improving Accounting and Disclosure for Complex Firms Most firms and market participants favor sound accounting standards and meaningful disclosure, but some companies have not been completely transparent in their application of accounting and disclosure standards to specific transactions. In these situations, financial reports have neither reflected nor been consistent with the way the business has actually been run or the risks to which the business has actually been exposed. In some of these cases, the company’s external auditors appear to have forgotten the lessons they learned in Auditing 101. Auditors have focused on form over substance when looking at risk-transfer activities, and they have failed to maintain the necessary independence from the client. But the issues run deeper than just a breakdown of basic auditing standards. As a result of the recently recognized failures of accounting, auditing, and disclosure, the market was unable to appropriately discipline the risk-taking activities of these firms on a timely basis because outsiders lacked the information from financial statements or other disclosures to do so. As critical information became available, the market reflected its concerns about underlying business practices and accounting through the declining values of equity and debt. The Sarbanes-Oxley Act, which became law in July of last year, contains a number of provisions to improve accounting and disclosure. Chief executive and financial officers are now required to certify that their financial reports fairly represent the financial condition of the company, not just that the reports comply with generally accepted accounting principles. Sarbanes-Oxley directed the Securities and Exchange Commission (SEC) to issue new rules on the disclosure of off-balance-sheet transactions. It also required that audit committees be composed exclusively of independent directors, and it empowered the audit committees to hire, fire, and determine the compensation of outside auditors, eliminating the incentive for auditors to rubber-stamp the books to please the chief executive officer. To bolster the independence of external auditors, Sarbanes-Oxley prohibited them from providing certain internal audit and other consulting services to their clients. Finally, the act created a new Public Company Accounting Oversight Board, independent of the accounting industry, to regulate audits of public companies. The New York Stock Exchange and NASDAQ boards issued their own proposals which are currently under consideration at the SEC. Besides adopting the Sarbanes-Oxley rules for strengthening the roles of audit committees, these proposals add new rules relating to executive compensation and board independence. The new rules essentially require that shareholders approve all stock-option plans, that independent directors approve CEO compensation, that there be a majority of independent directors on the board, and that the board of directors meet in “executive” sessions without company management. The list of reforms is indeed impressive and encouraging. However, I feel strongly that another important and necessary reform is absent from the regulatory agenda. In particular, we need to insist on higher professional standards for corporate financial officers and outside auditors that emphasize consistent compliance with the fundamental principles underlying accounting standards. Accounting policies used by companies should clearly and faithfully represent the economic substance of business transactions. Accounting standards in the United States have become very detailed over the years. Several reasons are given for this detail: the evolution to morecomplicated financial transactions, the risk of litigation, and an approach to accounting to “game” the rules for the benefit of the reporting entity. The Financial Accounting Standards Board (FASB) has recently indicated that it is committed to work with the International Accounting Standards Board to make US and international standards more consistent. As part of this discussion, we hear of the benefits of the international framework that places more reliance on the principles informing the accounting standard rather than on lengthy rule writing, as in the United States. Principles-based accounting standards, however, cannot succeed without strong professional ethics, since they rely on the business judgment of preparers and auditors. Until the American Institute of Certified Public Accountants takes a stronger role to enforce its code of conduct, or until the new Public Company Accounting Oversight Board becomes an effective regulatory body, principles-based accounting cannot successfully restore consistency in financial reporting that our capital markets require. The scandals of the past year were due to fraud and breakdowns in auditing not to inadequate accounting standards. Besides applying sound accounting treatments, company managers must ensure that public disclosures clearly identify all significant risk exposures - whether on or off the balance sheet - and their effect on the firm’s financial condition and performance, cash flow, and earnings potential. With regard to securitizations, derivatives, and other innovative risk-transfer instruments, traditional accounting disclosures of a company’s balance sheet at any one time may be insufficient to convey the full impact of a company’s financial prospects. Equally important are disclosures about how risks are being managed and the underlying basis for values and other estimates that are included in financial reports. Unlike typical accounting reports, information generated by risk management tends to be oriented less to a particular time and more to a description of the risks. To take an example from the world of banking, where the discipline of risk management is relatively well developed, an accounting report might say that the fair value of a loan portfolio is $300 million and has dropped $10 million from the previous report. However, the bank’s internal risk report would show much more extensive information, such as the interest rate and credit quality of the assets and the range of values the portfolio would take under alternative future scenarios. The user of a risk-management report could determine whether changes in value were due to declining credit quality, rising interest rates, or sales or payoffs of loans. Corporate risk officers have developed other types of reports that provide information on the extent to which the total return in a particular line of business compensates for the line’s comprehensive risk. On an enterprise basis, a reader of such a report can determine whether the growing lines of business have risk exposures that tend to offset those in other business lines - thereby resulting in lower volatility for the earnings of the corporation as a whole. Complex organizations should continue to improve their risk-management and reporting functions. When they are comfortable with the reliability and consistency of the information in these reports, they should begin disclosing this information to the market, perhaps in summary form, paying due attention to the need for keeping proprietary business data confidential. Not only would such disclosure provide more qualitative and quantitative information about the firm’s current risk exposure to the market, it would help the market assess the quality of the risk oversight and risk appetite of the organization. A sound risk-management system in a complex organization should continually monitor all relevant risks - including credit, market, liquidity, operational, and reputational risks. Reputational risk, which recent events have shown can make or break a company, becomes especially hard to manage when off-balance-sheet activities conducted in a separate legal entity can affect the parent firm’s reputation. For all these risks, disclosures consistent with the information used internally by risk managers could be very beneficial to market participants. Companies should ensure that not only do they meet the letter of the standards that exist but also that their financial reports and other disclosures focus on what is really essential to help investors and other market participants understand their businesses. I particularly want to emphasize that disclosure need not be in a standard accounting framework nor exactly the same for all organizations. Rather, we should all be insisting that each entity disclose the information its stakeholders need to evaluate the entity’s risk profile. Companies should be less concerned about the vehicle of disclosure and more concerned with the substance of the information made available to the public. And we should keep in mind that disclosure without context may not be meaningful. These improvements in transparency are a necessary response to the recent corporate scandals and will help strengthen corporate governance in years to come. Financing Patterns and Corporate Governance My remarks thus far have centered on the situation in the United States, but corporate governance is clearly an international issue. The specific governance issues in each country will be influenced by patterns of finance as well as by institutional differences. In my remaining remarks, I will discuss some of the key corporate governance issues in Germany, Japan and the United States. Bank-Based Financial Systems The German and Japanese financial systems are well known for being predominantly bank-based systems. In Germany and Japan, bank loans are the primary source of finance, while in the United States, corporations rely heavily on public capital markets. In both Germany and Japan, total bank assets are around 100% of GDP, whereas in the United States, total bank assets are only around 60% of GDP. Given their importance as providers of finance, banks in Germany and Japan not surprisingly play a significant role in the governance of nonfinancial firms. Some observers have argued that the superior information that banks obtain through their lending relationships may give them more influence in governing borrowers. If this argument is correct, then such influence is likely heightened because bank-firm relationships in Germany and Japan tend to be long-term, stable relationships. In Germany, it is likely also heightened because German banks are universal banks - that is, they perform investing banking as well as commercial banking functions - and thus may control firms’ access to capital markets. The role of banks in corporate governance can also be affected by equity ownership. Japanese banks hold about 20% of the country’s total corporate equity. Up-to-date figures on German bank equity holdings are difficult to obtain, nevertheless, some reports suggest that German banks hold around 10% of the country’s corporate equity. These figures contrast with those of the United States, where banks hold less than 2% of corporate equities. Banks in both Germany and Japan likely have control rights that exceed their ownership stakes. In Germany, banks may act as custodians for customers who own equities, and banks are commonly given the proxy voting rights of these shares. The influence of proxy voting is increased by restrictions in many German corporate charters that cap the voting rights of shareholders, regardless of the amount of voting shares they may own. Typical caps are 5% or 10% of total voting shares. Most of these restrictions were adopted in the 1970s, when investors from oil-producing countries were looking for places to invest their petro-dollars and began buying shares in German companies. Although these restrictions limit the power of any large blockholder, including banks, the restrictions rarely apply to the proxy votes that banks may cast on behalf of dispersed shareholders. In Japan, large banks and other firms in unrelated lines of business make cross-shareholding agreements to form stable shareholding blocks. It is customary for members of such blocks to follow banks’ leads in governance decisions, effectively giving banks control rights that can exceed their ownership stake, much in the same way that proxy voting does for German banks. Banks in Germany and Japan frequently exert control through direct involvement in the management of their borrowers. For instance, in Germany banks sometimes have a representative on a borrower’s supervisory board. In Japan, banks may place staff on a borrower’s board of directors, and former bank employees often serve as both managers and board members of borrowing firms. There has been a lively debate in the academic literature as to whether the strong role that banks play in corporate governance in Germany and Japan is good or bad for the firms to which they lend. One of the arguments in favor of a strong role for banks is that it mitigates problems stemming from informational asymmetries. Banks have extensive information about borrowers through their lending relationship, and this information may be much better than the information available to other outside stakeholders. When the bank is also a shareholder or acts on behalf of shareholders, this information can reduce the informational asymmetries between firm owners and managers. For example, if a firm seeks external funds, a bank with close ties to the firm can know with greater certainty whether this need is a sign of temporary illiquidity of bad firm management. This knowledge, in turn, can increase the ability of a firm to raise external funds when it has liquidity needs. Banks can also act as delegated monitors of borrowers on behalf of other outside stakeholders to help ensure that firm managers apply sufficient effort and do not misuse firm resources. A common argument against a strong role for banks in corporate governance is that, because of their lending activities, they do not act in the interests of shareholders, even when they have an equity stake in a firm. For example, consider the incentives of a bank when one of its large borrowers is having financial difficulty. From the perspective of the bank, the best way to ensure that its loans are repaid might be a merger between the weak borrower and a healthy rival. If the bank has significant control rights over the healthy firm, it might try to use these rights to press for such a merger, as has happened in Germany on at least several occasions. Yet other owners of the healthy firm - owners who have no claims on the weak firm - might find such an action suboptimal, because it would require the healthy firm to assume all the debts of its weaker rival. Conflicting interests of banks and other shareholders might also be manifested through banks encouraging firms to take on more debt, to pay higher interest rates on their debt, or to undertake less-risky projects than would be optimal from the point of view of shareholders. Whatever the manifestation, the result would be the same - lower profits for the firm. Although the empirical evidence for Japan has been somewhat mixed, on balance it suggests that membership in stable shareholding agreements is associated with lower profitability and higher interest rates on loans. Studies of German firms show less of a consensus - some studies suggest that firms with closer ties to banks are less profitable, whereas other studies suggest the opposite. Other observers have raised a more fundamental question about the role banks play in governing nonfinancial firms in Germany and Japan. They point out that banks are subject to the same moral hazard issues that firms face - without sufficient monitoring, managers may not apply sufficient effort or may waste firm resources. They ask: “Who monitors the monitor?” In other words, how can bank shareholders be sure that bank managers use bank resources efficiently and apply appropriate effort to their tasks, including the governance of borrowers? This problem can be especially vexing in the case of banks, which, as naturally opaque institutions, are difficult for outsiders to monitor. Moreover, when bank deposits are insured, a whole class of bank stakeholders - depositors - has little incentive to monitor the bank. In most countries, bank supervisory authorities monitor banks on behalf of bank creditors. However, the low profitability of banks in both Germany and Japan and the prolonged weak condition of Japanese banks suggest that bank supervision is not a panacea for the monitoring problem and that the other stakeholders have an important role to play. This is one reason that market discipline, even in a bank-based system, is an important element of sound corporate governance, and it highlights the importance of adequate disclosure. Market Based Financial System In a market-based financial system, like that in the United States, market discipline and adequate disclosure are perhaps even more important, as the burden of monitoring corporate insiders rests mainly in the hands of shareholders. Besides the changes in transparency to which I alluded earlier, the increasing portion of public equity held by institutional investors on behalf of households is another development that may affect the ability of shareholders to mitigate corporate governance conflicts. According to the most recent flow of funds accounts published by the Federal Reserve, the combined share of household equity managed by mutual funds, pension funds, and life insurance companies grew from only 3% in 1952 to more than 50% at the end of 2001. Mutual funds held 16% of household equity at the end of 2001, and public and private pension funds held about 10 and 20%, respectively. Life insurance companies held about 7 of household equity at that time, mainly through separate accounts that were, in effect, mutual funds with insurance wrappers. These changes are indeed dramatic, but it is not obvious whether we should be comforted or concerned that an increasing share of household equity is in the hands of institutional investors. A primary issue is whether institutional investors are more “active shareholders” than individual investors. That is, are institutional investors more likely than individual investors to actively monitor and influence both management actions and corporate governance mechanisms at the firms in which they invest? Shareholder activism may provide market discipline directly by preventing management from pursuing its own interests at the expense of shareholders. Shareholder activism may also pave the way for other forms of market discipline - such as corporate takeovers, share price changes, and funding cost changes - by eliminating management-takeover protections and by inducing greater transparency. Unfortunately, whether institutional investors have more or less incentive to be activist shareholders than individual investors is not clear. On the one hand, because institutional investors make large investments in companies, they will have more bargaining power with company management than individual investors have, and they will derive more benefits from mitigating corporate malfeasance than individual investors will. Among institutional investors, pension funds and insurance companies are thought to benefit the most from shareholder activism because they tend to have relatively long-term investment horizons. On the other hand, managers of index mutual funds have little interest in shareholder activism since they merely adjust their holdings when the mix of the index changes and want only to follow the index, not influence it. In addition, mutual funds and pension funds may have conflicts of interest that encourage passivity. Activism by a mutual fund complex or a pension fund manager could strain its relationships with corporate clients. For example, a fund manager bidding for the management of a firm’s 401(K) plan may be reluctant to vote against the Board of Directors’ proxy recommendations. In practice, institutional investors appear to have been relatively passive shareholders, in the sense that they have tended to initiate relatively few reform proposals. Before the past twenty years, most reform proposals were submitted by a handful of individuals and religious groups. Since the mid-1980s, some institutional investors - mainly large public pension funds and a few union funds - have stepped up to the plate and offered their own proposals, but corporate pension funds, mutual funds, and insurance companies have remained on the sidelines. Appearances can be misleading, however. Some institutional investors are active behind the scenes, keeping close contact with the management of the firms in their portfolios directly rather than through reform proposals. Moreover, passive institutional investors may still benefit shareholders as a whole by facilitating the building of shareholder coalitions that are initiated by others or by posing a possible threat to managers who might fail to act in the interest of shareholders. Ultimately, the question of whether institutional investors mitigate corporate governance problems is an empirical one. Academic work in this area has not convincingly linked institutional holdings to firm performance, but some studies have shown that institutional shareholder activism does appear to be motivated by efforts to increase shareholder value, and other studies have confirmed that institutional activism is associated with a greater incidence of corporate governance events, such as shareholder lawsuits and corporate takeovers. Based on these findings, it would be premature to conclude that the rising share of household equity held by institutional investors is clearly good in terms of sound corporate governance. That said, it does seem reasonable to believe that institutional shareholder activism has benefits and that these benefits may help pave the way for market discipline in a broader sense. I am hopeful that changes in the regulatory environment will promote greater attention to corporate governance. The SEC proposed a rule this past December that would require mutual funds to disclose their entire portfolio holdings every quarter rather than every six months, and only a few weeks ago the SEC finalized a rule calling for compulsory disclosure of mutual fund proxy voting records. As we go forward in the United States, even if transparency through corporate financial reports improves, shareholder activism will continue to be important for mitigating conflicts between management and shareholders. However, we must recognize that shareholder activism is not a substitute for disclosure. Neither activism nor the more common discipline device of selling the firm’s debt and equity can work well without accurate and complete disclosure. And in bank-based systems, the experience of Japan and Germany suggests that, while banks may have some advantages over shareholders in mitigating governance problems, transparency and market discipline are still fundamental to sound corporate governance.
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board of governors of the federal reserve system
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Speech by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, at the University of Georgia, Athens, Georgia, 12 February 2003.
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Roger W Ferguson, Jr: Rules and flexibility in monetary policy Speech by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, at the University of Georgia, Athens, Georgia, 12 February 2003. * * * Thank you for honoring me with this opportunity to deliver a Charter lecture. As you know, these lectures are designed to commemorate the high ideals highlighted in the charter that established the University of Georgia in 1785. In broad terms, the charter defines some of the fundamental objectives for this university, including working to foster an informed public and thereby promoting an effectively functioning democracy. In addition, the charter describes the key instrument by which the university is to pursue these objectives - namely providing higher education to the public. The charter is also notable for what it does not describe. It does not, for example, lay out a rigid curriculum that all students must complete. The founders no doubt recognized that the university would need a degree of flexibility in designing its programs to suit the needs of a changing student body and changing times. As it happens, academics as well as practicing central bankers around the world have devoted a great deal of thought over the past ten to twenty years to defining the goals and objectives that should be included in central bank charters and also to describing how central banks should go about achieving these goals. In many ways, this discussion has led to a fair degree of consensus around a model similar to that embodied in the University of Georgia charter; that is, central bank charters should clearly state key objectives and describe in general terms the tools that central banks can use to pursue those objectives. However, central bankers, like educators, require some flexibility in applying their tools in order to respond appropriately to changing circumstances over time. The emergence of sustained inflationary pressures in the 1960s and 1970s and central banks' long and difficult struggle to combat these pressures helped forge this consensus. Inflation began to drift higher during the Vietnam War and flared into double digits following the sharp increases in oil prices in the middle and late 1970s. Although snapping the inflationary spiral was painful for our nation - the recession of the early 1980s was the deepest since the Great Depression - the subsequent prosperity in terms of income growth and economic stability has been unprecedented. The experience deepened the conviction of many economists and central bankers that economic policies that push an economy to operate beyond its long-run potential to produce inevitably lead to rising rates of inflation. Moreover, the strong economic performance of the U.S. economy following the taming of inflation has supported the view that price stability fosters economic efficiency and higher productivity. Indeed, price stability is now a formal objective included in the charters of nearly all central banks. A firm long-run focus on price stability does not mean that the central bank cannot have other economic goals, although central bankers disagree on this somewhat, at least in emphasis and priority. Many nations or economic regions, including the United Kingdom and the euro area, have adopted price stability as their primary objective. But in our case, we often summarize the multiple statutory goals of the Federal Reserve in terms of the "dual objectives" of price stability and sustainable economic growth. We see these twin objectives as fully compatible in the long run. Our experience in the United States has been that multiple objectives for policy do not undermine policy performance when the public is convinced that the central bank is committed to price stability over the long run. Indeed, the commitment to long-run price stability can afford the central bank some flexibility in employing its tools to address shorter-run economic issues. Certainly such has been the case for the United States in recent years. Since I joined the Federal Reserve in 1997, the U.S. economy has weathered a remarkable series of economic shocks - both positive and negative - and the Federal Open Market Committee (FOMC) has adjusted the stance of monetary policy over a wide range in response to those shocks. And yet, through it all, long-term inflation expectations have remained very stable and at very low levels. Partly as a result, long-term nominal interest rates, which contain a premium reflecting long-term inflation expectations, are as low as they have been in fifty years. Although central bankers have focused much of their attention on combating and containing inflation pressures over recent decades, the very low levels of inflation and recent sluggish economic growth in the United States have prompted worries in some quarters about the potential for deflation in this country. The case of Japan in recent years serves as a cautionary tale about the dangers of deflation, especially when a central bank has pushed its traditional policy tool - the short-term interest rate - to zero. However, I believe that the risks of a general deflation in the United States are minimal. First, further aggressive monetary and, in all probability, fiscal stimulus would be brought to bear in the unlikely event that deflation were to become a threat. Furthermore, unlike the situation in Japan, the balance sheets of financial firms in this country are fundamentally sound, and so the U.S. financial system seems less prone to debt-deflation dynamics. And perhaps even more important, the U.S. economy has proven enormously resilient and productive in recent years, and the gains in productivity have continued even as the economy has experienced subpar growth. Finally, current rates of inflation depend to a large extent on the inflation rates that people expect in the future, so the stability of inflation expectations over recent years should be a factor working against any buildup of deflationary pressures. Inflation expectations are so stable in part because central bankers have been increasingly clear about both their long-run inflation objectives and their shorter-run tactics in pursuing those objectives. As a case in point, the increase in the transparency of U.S. monetary policy over the past two decades has been quite significant. Twenty years ago the monetary policy decisions of the FOMC were inferred by legions of Fed-watchers who gleaned information from slight variations in how we conducted our open market operations. In the mid-1990s, we began to announce our policy in general terms after each meeting. Now not only do we announce our short-term operating target for the federal funds rate, but we also explain the rationale for our actions, immediately identify the members of the FOMC favoring and dissenting from a policy decision, and announce how we view the risks facing the economy. I am pleased to have been associated with some of the Federal Reserve's more recent initiatives to foster greater transparency and believe that the FOMC should be, and is, willing to consider ideas for greater transparency as they arise. Even with that intent, there are practical limits on how transparent any central bank, including the Federal Reserve, can be. The FOMC is, after all, a committee of individuals with regularly changing membership. As any of you who has ever served on a committee knows, reaching a consensus can be difficult, and explaining a group decision that has resulted from the interplay and balancing of individual views can be challenging to say the least. And the economy is complex, changing, and at best imperfectly understood. As a result, explaining the current economic situation and the way the economy will be affected by our policy actions is not a straightforward task. Still, within those limits we seek to be as clear as possible in our intentions and reasons for our actions. This striving for transparency is a common principle that most central banks have adopted. Reinforcing the trend to transparency, central banks have arguably become more systematic in their responses to the economy over the past several decades. Systematic policy setting is easier to explain and anticipate and, as a consequence, helps to limit economic uncertainty associated with the conduct of monetary policy. A resurgence in interest and research about systematic approaches to monetary policy was sparked by the observation of John Taylor, currently Undersecretary of the Department of the Treasury, that the FOMC's conduct of monetary policy since the late 1980s has been well explained by a simple formula, often called the Taylor rule, that relates the level of the federal funds rate to the observed levels of the inflation and the unemployment rates. John Taylor's keen insight was offered originally as a rough benchmark for policy and not as a binding, prescriptive "rule." And, in fact, the difference between the actual setting of the federal funds rate and the Taylor rule can be large at times, particularly at critical points when the economic outlook has changed suddenly. The part of policy not explained by the rule then reflects the large volume of information about the economy and its prospects that is not captured by current inflation and unemployment rates but that the FOMC does take into account. The FOMC uses all this information in an attempt to anticipate developments; the Taylor rule is backward looking. These differences between actual policy and policies predicted by a backward-looking rule also reflect our imperfect and constantly evolving understanding of the structure of the economy. The success of the Taylor rule in capturing the broad contour of policy actions in recent years has prompted an enormous amount of economic research in search of refinements to or extensions of the original Taylor rule that could provide an even more precise guide for central bankers - in effect, a rule that could serve as an "automatic pilot" for monetary policy. In my view, rules, including the Taylor rule and its many variations, are useful benchmarks, but following an automatic policy prescribed by any pre-established rule would unnecessarily and undesirably limit the flexibility and judgment necessary in setting monetary policy. I have similar misgivings about other formulaic monetary policy proposals - sometimes referred to as strict inflation targeting - that would require the Federal Reserve to announce a numerical inflation target or range and conduct monetary policy at all times so as to keep actual inflation close to that objective. In effect, advocates of strict inflation targeting would have the central bank follow an amended Taylor-type rule in which the setting of interest rates is determined solely by the deviation of actual or projected inflation from a target. I would argue that the conduct of monetary policy and the associated economic performance in the United States in recent years clearly demonstrate that a central bank can and, if directed by the elected officials who create the central bank, should do more than this. As I've noted, the Federal Reserve has successfully established a credible commitment to long-term price stability while operating within a framework that allows flexibility in adjusting the stance of policy in the near-term in response to fluctuations in both economic activity and inflation. Although our understanding of the economy and monetary policy has improved considerably over the past several decades, it is not nearly advanced enough to allow us to pre-specify an optimal policy rule or to adopt a rigid targeting framework that will serve well in all circumstances. And an important part of our understanding of the economy is the lesson that people's behavior may change over time. Furthermore, while requiring the Federal Reserve to target an inflation rate might seem to make our intentions more transparent and credible, the existing twin goals of stable prices and maximum sustainable growth, as I noted, are mutually compatible. Given that inflation is low and stable and that the Federal Reserve has achieved credibility in its commitment to maintain price stability while still acting to buffer employment and output from excessive variability, I see no advantage to taking away our mandate to be concerned about developments other than inflation rates or inflation prospects. What I have just outlined, and rejected, are the strictest forms of rule-based guidance for the Federal Reserve. Strict inflation targeting and other rule-based approaches are ideas put forward by some central bank observers. However, a more nuanced proposal has emerged more recently, known as flexible inflation targeting. Under this regime, a central bank, in this case the Federal Reserve, announces an inflation target and commits to keeping inflation near the target at some horizon while recognizing that inflation may deviate from the target on occasion as other important objectives take on temporary urgency. This approach is in interesting middle ground, but I think advocates of it must recognize some concerns. In particular, I wonder if a central bank announcing the flexible pursuit of a specific numerical target could suffer some loss of credibility. Such an approach might leave the central bank open to the criticism that it has adopted only the language of a more formal inflation target without any of the constraints that normally go with such a regime and, in doing so, is being less transparent, not more. Having an announced inflation target that is pursued flexibly might also lead to greater uncertainty about policy. Deviations of inflation from the target would be highly visible, and the public might not know whether the central bank would choose to return inflation immediately to the target or allow the deviation from target to persist for some time. Allowing inflation to persist by exercising the various escape clauses embedded in many flexible inflation-targeting regimes might also erode central bank credibility. Most important, I believe that the quantified inflation target would come to take greater prominence over other important and consistent objectives implied by the flexible approach, with an inevitable reduction in flexibility and a downplaying of those other objectives. Finally, I believe that proponents of these various rule-based and formulaic approaches put too little weight on the institutional strength of the FOMC. The committee's members, being well-versed in the monetary history of the 1970s and 1980s, recognize the great effort that previous incarnations of the FOMC expended to gain credibility as a central bank committed to price stability, and I expect that future generations of the committee will share that understanding. I do not believe that the current members of the committee will let that position of public trust slip away through inattention, and future members, if they are well selected, should do likewise. To this point, I've noted my concerns about strict rule-based or other formulaic approaches to monetary policy for the United States mostly at an abstract level. But my views have been shaped importantly by the many practical challenges we've faced just in the time that I've been a member of the Board and the FOMC. One of the most notable economic developments in recent years has been the evident step-up in the rate of productivity growth. That development resulted in a considerable divergence of the actual level of inflation from the levels that would have been anticipated based on historical relationships. An automatic, rule-based approach to policy almost surely would have led us in the late 1990s to tighten policy much too aggressively. Instead, the Federal Reserve recognized the changes under way and took account of the step-up in productivity growth in reaching a judgment about the rate of "sustainable economic growth." This judgment permitted more - rapid income growth and considerable progress in reducing unemployment while containing the risk of inflation. Episodes of financial turmoil in recent years have also provided examples of the need for flexibility and discretion in the conduct of monetary policy - and the potential pitfalls of rigid rule-based policy. In the fall of 1998, for example, in the wake of the default by Russia and with financial markets still rattled by the Asian crisis a year earlier, a large hedge fund nearly failed, and several other financial institutions took large losses. Many investors appeared to revise upward their assessments of the riskiness of various counterparties and investments and to become less willing to bear risk. The resulting loss of confidence was described by the Secretary of the Treasury as the worst financial crisis since the Great Depression. Even though the unemployment rate was reaching new lows - which according to standard relationships would lead to higher inflation and which standard monetary policy rules would recommend addressing by tightening policy - the FOMC judged that the severity of the financial crises was likely to imperil future growth and lowered interest rates substantially. By early 1999, financial markets had improved, and the FOMC began to raise rates in view of strong growth in aggregate demand and resulting pressures on our nation's labor and capital resources, which, if left unchecked, could have resulted in greater inflation. As you may remember, concerns were widespread during 1999 that computer systems controlling everything from cash registers to power grids could fail because of Y2K bugs in computer code. Given the pervasiveness of automated systems in the financial sector, concerns about fixing the Y2K bug in that sector were particularly severe. Despite intensive and careful preparations, market participants and others remained concerned that computer failures could result in problems for individual firms and, conceivably, even for the economy. Firms, for example, were extremely reluctant to be exposed to the risk that on January 1, 2000, they would be unable to roll over their debt, and banks similarly were concerned about their own access to funding. In view of these concerns, the Federal Reserve put in place a number of contingency measures to ensure the availability of adequate liquidity to the economy. Moreover, to minimize the risk that monetary policy would inadvertently trigger problems, the monetary tightening process was put on hold at the December 21, 1999, meeting to minimize the uncertainty when everyone was concerned about the century date change. As it turned out, the careful planning and massive investment in updated and more robust information technology paid off - computers functioned smoothly. Again, our approach to monetary policy in the run-up to Y2K would have been very difficult to capture in a simple rule, or in a complicated one for that matter. A few months following Y2K, the stock markets began the steep decline that has reversed much of the remarkable rise witnessed over the latter half of the 1990s. That decline has been one source of the weakness that has undermined the expansion of the economy over the past two years. In recognition of that experience, many have characterized the extraordinary rise in stock prices in the late 1990s as a bubble - a significant and protracted departure in asset prices from fundamentals - and the subsequent decline as a popping of that bubble. Our recent experience has given renewed spark to a vigorous debate about the appropriate response of monetary policy to financial bubbles, with some economists criticizing the Federal Reserve for not having done more to stem the expansion of the bubble. Economists agree that bubbles can impair the functioning of the economy by promoting a misallocation of resources when they are inflating and by provoking severe dislocations when they pop. But because we are talking about economists, you can be sure their opinions differ substantially after that. One branch of economists holds the view that monetary policy should not be influenced by any perceived financial market bubbles. An extreme version of this view is that bubbles probably do not exist - that rational market processes always price assets at their fundamental value. A more moderate version is that even if bubbles do exist, they cannot reliably be identified, and even if bubbles can be identified, we do not know how they respond to monetary policy. The extreme view at the other end of the spectrum holds that central banks should pop bubbles as soon as they can. According to this view, by raising interest rates when a bubble begins, the central bank can avoid the volatility that occurs when a bubble fully inflates and then pops. Central bankers need to be practical, not extreme, and consequently my view falls somewhere in between. On the one hand, I am skeptical that central bankers or anyone else can accurately identify bubbles as they are inflating, and I know of no central banker who understands with great certainty how bubbles respond to monetary policy. On the other hand, the FOMC does attempt to take into account the effect of asset values on the economy when setting interest rates and does consider the likely reaction of asset prices to our policy decisions. Another type of financial instability that can influence monetary policy in a way that is very difficult to embed in a rule occurs when important intermediaries - banks, securities dealers, hedge funds - fail or when markets seize up in a financial crisis. This can happen when a financial bubble pops but also after a large swing in interest rates, commodity prices, or other prices or even, as I will discuss in a moment, a terrorist attack that causes financial market participants to pull back from risk-taking. The Federal Reserve was organized, in part, to combat such financial instability, and economists broadly agree that a central bank should respond to this sort of financial crisis. Generally, in severe financial crises, central banks inject liquidity into the financial system to meet temporarily higher demands and may even inject enough liquidity to lower short-term interest rates if a crisis seems likely to damp economic activity. The goal is to provide liquidity for the market as a whole, not assistance to specific institutions. Some may argue that either type of financial instability - that associated with the formation and popping of bubbles and that associated with the breakdown of markets or the failure of intermediaries can be incorporated into a policy rule by simply making the rule more forward-looking. The central bank responds to the financial difficulties precisely because they threaten to imperil future economic growth. I would certainly agree that forward-looking rules - rules that take into account likely future developments - are likely to be better bases for monetary policy than backward-looking rules. But I remain convinced that the appropriate response to complex, rapidly changing financial developments cannot be simply quantified even when mapped through forecasts of economic activity, and hence it requires flexibility and judgment on the part of the policymakers. Events in 2001 could not have more clearly demonstrated the need for flexibility in monetary policymaking and the inevitable shortcomings of rigid monetary policy rules. When terrorists destroyed the World Trade Center, they disrupted our financial system on an unprecedented scale. Nonetheless, by that afternoon or the next day, most financial institutions had moved to backup sites, using contingency arrangements that had in many cases been strengthened for the century date change; within several days the financial system had recovered most of its functionality. Still, the Federal Reserve needed to respond to the initial dislocations as well as the more enduring economic fallout. In the days following the attacks, we provided a massive injection of liquidity, initially in the form of direct lending through the discount window and subsequently through open market operations. Shortly thereafter, in view of signs that the attacks had caused a severe negative shock to confidence, the Federal Reserve began to ease monetary policy to cushion the likely resulting pullback in spending by households and businesses, again departing from the prescriptions of monetary policy rules based solely upon available backward-looking data for the recent values of variables such as inflation and unemployment. In sum, over the past twenty-five years some important consensuses have been achieved on the best way to conduct monetary policy. Central banks have adopted price stability as a key long-term objective, and they have become more transparent and systematic in their operations. However, opinion on how to conduct policy divides in at least two critical areas - how rigidly monetary policy should be determined by rules and the way monetary policy should respond to financial instability. In my view, these are closely related: Because responding to financial crises requires flexibility, policy cannot be tied too tightly to a rule. As long as policymakers are clear about their aversion to price instability and act in accordance with that aversion, they can respond flexibly to economic and financial developments without losing credibility as fighters for price stability. Therefore, rules and targets may not be an improvement over flexible implementation of policy with multiple objectives. This statement, of course, assumes that the central bank has and maintains its credibility in the pursuit of price stability. As I noted at the beginning of my remarks, the need for clear fundamental objectives and for flexibility in the pursuit of those objectives was recognized in the charter of this university more than 200 years ago. I believe that the central banking community can be equally clear in recognizing the importance of flexibility in the conduct of monetary policy in the context of clear fundamental objectives.
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board of governors of the federal reserve system
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Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the 41st Annual Winter Institute, St. Cloud State University, St. Cloud, Minnesota, 21 February 2003.
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Ben S Bernanke: Balance sheets and the recovery Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the 41st Annual Winter Institute, St. Cloud State University, St. Cloud, Minnesota, 21 February 2003. The references for the speech can be found on the Board of Governors of the Federal Reserve System’s website. * * * Economic growth and prosperity are created primarily by what economists call "real" factors - the productivity of the workforce, the quantity and quality of the capital stock, the availability of land and natural resources, the state of technical knowledge, and the creativity and skills of entrepreneurs and managers. But extensive practical experience as well as much formal research has highlighted the crucial supporting role that financial factors play in the economy. An entrepreneur with a great new idea for building a better mousetrap or curing the common cold needs access to financial capital provided, for example, by a bank or a venture capitalist - to transform that idea into a profitable commercial enterprise. To expand and modernize their plants and increase their staffs, most firms must turn to bond markets, stock markets, or banks to obtain the necessary financial resources. And without a well-functioning mortgage market, most families would not be able to buy homes, undercutting one of our most vital industries. In short, healthy financial conditions help a country to realize its full economic potential. For this reason, one of the first priorities of developing nations is often to establish a modern, well-functioning financial system. Just as a strong financial system promotes growth, adverse financial conditions - for example, a weak banking system grappling with nonperforming loans and insufficient capital, or firms and households whose creditworthiness has eroded because of high leverage, poor income prospects, and assets of declining value - may prevent an economy from realizing its potential. A striking contemporary case is that of Japan, where the financial problems of banks and corporations have contributed substantially to a decade of subpar growth. Likewise, the severity of the Great Depression of the 1930s was greatly increased by the near-collapse of banking and financial systems in a number of major countries, including the United States. Changes in financial conditions may also play a prominent role in the contraction and recovery phases of business cycles, although the specific aspects of the financial system most affected vary from cycle to cycle. For example, recovery from the 1990-91 recession was delayed by the "financial headwinds" arising from regional shortages of bank capital (Bernanke and Lown, 1991). From a financial perspective, the most striking developments of the most recent recession have been sharp declines in equity values (particularly in the high-tech sector) and a series of large, high-profile corporate bankruptcies. Other financial developments have been the subject of comment, however, including the rise in various indicators of financial stress among both consumer and corporate borrowers. Like many others, we at the Federal Reserve are trying to peer into the future and divine the shape of the U.S. economic recovery in 2003 and beyond. In doing so, we have necessarily had to ask: Will financial conditions - as reflected in, for example, the balance sheets and income statements of households, firms, and financial intermediaries - support a strong recovery? Or will financial problems in one or more sectors restrain spending and economic growth? These are the questions I will address today. To anticipate, I will conclude that - although areas of financial weakness are certainly present in the economy, as in every recession - the financial problems that currently exist do not seem sufficient to prevent an increasingly robust economic recovery during this year and next. In particular, households and the banking system seem to be in good financial condition for this stage of the business cycle. The story for firms is more mixed, with some companies and sectors under significant financial pressure. However, as I will discuss, many firms have taken advantage of low interest rates to restructure their balance sheets and most seem financially capable of undertaking new capital investment and of ramping up hiring. Bernanke, Gertler, and Gilchrist (2000) provide a formal quantitative model in which endogenous variation in balance sheet quality - the so-called financial accelerator - enhances the amplitude of business cycles. I will talk briefly about each of these vital sectors: households, firms, and banks. Before continuing, however, I should remind you that the views I express today are mine alone and do not necessarily represent the opinions of my colleagues at the Federal Reserve System or on the Federal Open Market Committee. The financial health of households Let's start our financial checkup of the economy with the critical household, or consumer, sector. Consumer spending accounts for more than two-thirds of gross domestic product (GDP), and residential investment - the construction of new homes - makes up another 4 percent or so of GDP. In 2002, with firms extremely reluctant to make new capital investments or build inventories, strong consumer spending was instrumental in supporting the early stages of the recovery. However, concerns have been raised about the ability of households to continue "shouldering the load," so to speak. Are consumers overburdened, financially speaking? Or do they have the capacity to continue to keep spending at a reasonable pace? According to virtually all studies of household expenditure, two principal factors affect the consumer's ability and willingness to spend. The first factor is real (that is, inflation-adjusted) after-tax income, also called real disposable income, and the second is real wealth. Taken together, disposable income (both current and expected) and wealth summarize the household's lifetime command over resources and thus are major determinants of willingness to spend. A principal reason for the consumer's resilience during the past two years has been continued healthy growth in real disposable income. Real disposable income typically declines at some point during a recession, and indeed the National Bureau of Economic Research's business cycle dating committee treats a period of decline in real income as a primary indicator that a recession has begun. In this latest downturn, however, unlike most recessions, real income never did stop growing; instead it rose by 1.8 percent in 2001 and by a surprisingly strong 4.5 percent in 2002. These increases in real income were made possible to a significant extent by tax cuts and increased transfer payments, although increases in real wages played a role as well. Expectations for future increases in real disposable income also appear to be relatively optimistic, perhaps reflecting the recent strong performance of labor productivity. For example, the most recent Blue Chip consensus forecast is for real disposable income to grow 3.1 percent in 2003 and 3.5 percent in 2004 and to average growth of 3.2 percent per year over the 2004-13 period. For comparison, the average growth in real disposable income between 1993 and 2000 was 3.4 percent. In short, there is a reasonable chance that, in terms of real income growth, the next decade should be as good for households as the nineties were. Although income and income prospects are positive factors for household spending, the behavior of wealth - that is, household assets minus household liabilities - has been more of a mixed bag. Between 1980 and 1994, the ratio of household wealth to household disposable income remained roughly stable, hovering between about 4.3 and 5.0. Then, beginning in 1994, the ratio of household wealth to income surged, peaking at more than 6.0 in 2000. In the past three years or so, however, the ratio of wealth to income has fallen back to about the 1994 level, at just under 5.0. As you might guess, almost all of this large swing is attributable to the recent boom and bust in the stock market. The aggregate value of U.S. equities, which approximately equaled household disposable income at the end of 1994, reached 2.5 times disposable income at the beginning of 2000, but then it fell back to 1.3 times disposable income by the end of 2002. Most of us have heard the wry joke that our 401(k)s are now 201(k)s! Although in dollar terms, stockholdings remain concentrated in the upper income brackets, the pain of falling stock prices during the past three years has been widely shared: More than half of all U.S. households now own at least some equities, either directly or indirectly through such vehicles as mutual funds, pension plans, variable annuities, and personal trusts (Aizcorbe, Kennickell, and Moore, 2003). For some households at least, losses in stock portfolios have been mitigated by significant increases in the value of residential real estate. These rises in house prices have led some to worry about the possibility of a "bubble" in housing prices and the associated risks of further losses in household wealth, should this putative bubble pop. Let me digress for a moment to address this issue. Although bubbles in any asset are notoriously hard to spot in advance (if they were obvious to the naked eye, they would not arise in the first place), in my judgment there is today little evidence of serious or systematic overvaluation in the U.S. residential housing market. In particular, for the nation as a whole, the rise in house prices appears to have closely tracked economic fundamentals - including rising household incomes, high rates of household formation, and historically low mortgage interest rates. Also, the U.S. housing market is not a single market but many markets that are highly dispersed geographically across dozens of disparate standard metropolitan statistical areas, or SMSAs. Experience suggests that house prices across SMSAs are rather imperfectly correlated and that price reversals, when they occur, are typically localized. Moreover, the ratio of the value of mortgage loans outstanding to home values in the aggregate has been roughly constant over the past few years, and most homeowners have substantial equity in their homes; thus even if moderate declines in house prices were to occur, they would not impose financial hardship on the great majority of households. Returning to the main thread of the discussion, I now address two related questions: First, how has the overall decline in wealth associated with the fall in stock prices affected consumer spending thus far, and second, how is it likely to affect spending in the next year or so? Statistical analyses by economists have found that a one-dollar change in wealth leads to a permanent change in consumption spending, in the same direction, of about three to five cents - the so-called "wealth effect." The full effect of a major shift in wealth on consumption spending appears to take place over a period of one to three years. Fed staff estimates are that wealth effects held back the growth in consumption spending by about 1-1/2 percentage points last year, relative to what it would have been otherwise. Assuming no further major declines in the ratio of wealth to income, this drag should diminish a bit, to about 1 percent this year and ½ percent next year. In short, the largest part of the negative wealth effect created by the fall in stock prices is probably behind us. One might wish to dig deeper, of course. For example, disaggregating wealth into asset and liability components is sometimes useful. Breaking out household liabilities reveals that aggregate household debt and the debt service burden - that is, interest on debt measured relative to disposable income rose to fairly high levels in recent years. For example, the ratio of debt service to disposable income peaked at 14.4 percent in the fourth quarter of 2001, although it fell somewhat in 2002 as disposable income rose and interest rates declined. A few other indicators of financial pressures have also risen. For example, personal bankruptcies rose 5 percent between 2001 and 2002 to hit a new high, and have continued to be elevated. Do these indicators imply that the consumer is financially overextended? Broadly, I think the answer is "no." In this regard, two items are worth stressing: first, the composition of the recent surge in consumer debt and, second, the role of the recent growth of the subprime credit market. Regarding the composition of debt, a key fact is that most of the recent expansion in consumer debt has been in the form of mortgage debt. Indeed, in 2002 new mortgage debt accounted for close to 90 percent of the overall growth in household debt. This recent growth in mortgage debt continues a marked trend. Between 1992 and 2002, mortgage debt of households rose from 59 percent of aggregate disposable income to 74 percent of disposable income. Why has mortgage debt risen by so much in the past decade? One very positive factor is the secular increase in U.S. homeownership rates. Because of rising incomes, increased rates of family formation, and the expansion of so-called subprime mortgage lending, more people have chosen to buy homes rather than to rent, increasing the value of mortgages outstanding. A second factor is favorable tax treatment: The 1986 tax reform act, which retained the tax-deductible status of mortgage interest but eliminated it for other types of loans, spurred a substitution of mortgage debt for consumer credit (for example, through the popularization of home equity lines of credit). Finally, most recently, mortgage debt has been powerfully boosted by the low mortgage interest rates available in the past couple of years. These low rates have stimulated record amounts of new home construction, which has not only permitted a growing number of Americans the opportunity for home ownership but has played a vital role in maintaining aggregate demand throughout the recession and recovery - not only in the construction industry but in ancillary industries such as home furnishings. As you may know, low mortgage rates have not only stimulated home construction but have also induced an enormous wave of refinancing of existing mortgages. According to a recent article in the Federal Reserve Bulletin (Canner, Dynan, and Passmore, 2002), 10 percent of U.S. households surveyed in the first half of 2002 reported having refinanced a home mortgage since the beginning of 2001. Refinancing has allowed homeowners both to take advantage of lower rates to reduce their monthly payments and, in many cases, to "extract" some of the built-up equity in their homes. According to the Fed study, the average amount of home equity extracted in cash-out transactions in According to the Bureau of the Census, the share of U.S. households that owned homes rose from 64.0 percent in 1990 to 67.9 percent in 2002, even as the population grew substantially. 2001 and early 2002 was $27,000. Refinancing activity surged further in the second half of 2002: According to one set of Federal Reserve staff estimates, mortgage refinancings totaled $400 billion in the third quarter of 2002 and more than $550 billion in the fourth quarter of 2002, after averaging $325 billion (quarterly rate) over the preceding six quarters. From a macroeconomic point of view the refinancing phenomenon has very likely been a supportive factor. The precise effect is difficult to identify, since we cannot know for sure how much of the spending financed by equity cash-outs might have taken place anyway. Fairly generous assumptions about the propensity of households to devote equity cash-outs to new spending suggest that refinancings may have boosted annualized real consumption growth between ¼ and ½ percentage point in the second half of 2002, the period of maximum impact. A fairly substantial gap still remains between the current level of mortgage interest rates and the average level of interest on the outstanding stock of mortgages, suggesting that refinancings should continue at a brisk pace in the early part of this year. As refinancings slow later this year, however, they will create a slight drag on consumption growth relative to 2002. An important aspect of the surge in mortgage refinancings is that, on the whole, they have probably improved rather than worsened the average financial condition of the household sector. Notably, a substantial portion of equity extraction, probably about 25 percent, has been used to pay down more expensive, nondeductible consumer credit (such as credit card debt or auto loans), with additional funds used to make purchases (such as cars or tuition) that would otherwise have been financed by more expensive and less tax-favored credit. In short, the consumer has taken advantage of an unusual opportunity to do some balance sheet restructuring. This restructuring has not come at the cost of a dangerous increase in leverage. As already noted, loan-to-value ratios for home mortgages have barely changed in recent years. Moreover, analysis by members of the Federal Reserve staff suggests that the great bulk of cashed-out equity has been taken out by older, long-tenure homeowners who have gone into the transaction with high levels of home equity (often 100 percent equity) and have retained substantial equity after the transaction. In summary, a deeper analysis shows that much of the apparent recent increase in the household sector's debt burden reflects a combination of increased home ownership, partial liquidation of the home equity of long-tenure households, and balance-sheet restructuring by households toward a more tax-efficient and collateralized form of debt, that is, mortgage debt. For many families this restructuring has resulted in lower leverage and payments, rather than the reverse. I conclude, therefore, that the rise in consumer debt for the most part does not presage financial problems in the household sector. What then about the rise in bankruptcy rates and similar indicators? Bankruptcy rates are hard to forecast, as they vary over time with changes in law and financial practice; moreover, they themselves do not tend to forecast broad economic conditions very well. One partial explanation for their recent increase, as I intimated earlier, may be the expansion earlier in the decade of the so-called subprime lending market, in which lenders sought to make loans to households whose credit histories excluded them from the mainstream market. Although some legitimate concerns have been raised about lending abuses in this market, overall the expansion of the subprime market is a positive development, opening up as it does new opportunities for borrowers previously excluded from credit markets. Not unexpectedly, however, lenders, borrowers, and regulators have faced a significant learning curve as this market has developed, and perhaps we should not be surprised that some of the loans made in this market in a period of strong economic growth have become distressed in a period of recession and rising unemployment. Moreover, default rates tend to increase with loan age, so that even absent a macroeconomic downturn it would not be entirely unexpected to see a rise in defaults as the subprime loans made in the nineties begin to age. We hope that, as the market evolves and becomes more sophisticated, its sensitivity to cyclical fluctuations will decline, which - among other things should reduce the cost of credit to subprime borrowers. Broadly speaking, the bottom line is that the consumer seems in pretty good shape for this stage of the cycle. As I indicated, I expect that household spending will continue into 2003 and 2004 at a pace consistent with a strengthening recovery. Probably the main risk to this forecast is not the state of household balance sheets but the state of the labor market, as a significant increase in unemployment might lead consumers to retrench. At this point, however, the labor market, while not nearly as robust as we would wish, appears at least to be stable. The financial health of firms If consumers have done their part and more for the economic recovery, so far the dog that hasn't barked is the business sector. True, firms have distinguished themselves in at least one way: The increases in productivity we have seen in the nonfarm business sector over the past two years have been truly remarkable, particularly in light of the fact that productivity growth is typically weak during cyclical declines. Clearly, managers have dedicated themselves to producing more with less and to raising profits by cutting costs. In another, critical sense, however, the business sector has not yet played its normal role in the recovery. Atypically for the post-World War II period, the current recession began as a slowdown in the business sector, particularly in capital investment, rather than as a retrenchment in household spending. Now, two years after the recession began, firms continue to be highly reluctant to expand operations - either by investing in new capital equipment or by adding to their workforces. What's going on? Let's start by discussing the fundamentals underlying firms' investment and hiring, and then ask whether financial conditions can support the fundamentals. As I speak, the enormous uncertainty regarding the situation in Iraq and other foreign hot spots still continues to cast a heavy pall on firms' planning for the future. That uncertainty will have to be significantly reduced, I think, before we can get a real sense of the strength of the underlying economic forces driving the nascent recovery. However, a number of factors suggest that investment and hiring should pick up in the months ahead. For some time now, the business sector has been meeting a growing final demand without adding capital or employees. Presumably, businesses cannot indefinitely squeeze increasing productivity out of fixed resources and eventually will need to invest and add workers to meet the demand for their output. Moreover, much of the investment done during the 1990s boom was in relatively short-lived equipment, which may soon need replacement. Inventories are also currently lean and will likely need replenishment if final demand grows as forecast. Other fundamental factors support the idea that investment will gradually increase this year. The cost of capital remains low for most firms, reflecting the attractive long-term interest rates for borrowers with good prospects and the tax benefits to investing in equipment created by the partial expensing provision. Cash flows are improving. Ongoing technological changes imply that adding the newest generation of equipment should make possible still greater gains in productivity. Indeed, aggregate investment is currently well below what standard econometric models would predict, an effect that I attribute primarily to an unusually high level of uncertainty about geopolitical events and, to a lesser extent, about the likely near-term evolution of the economy. If that interpretation is correct, then, as uncertainty diminishes, investment should increase. One argument against this relatively upbeat assessment is the view that a "capital overhang" remains from the high investment rates of the late 1990s. I will leave a fuller discussion of the putative overhang problem to another time, saying here only that I believe that whatever significant overhang remains is localized in a few industries - possible examples being telecommunications, commercial aircraft, and commercial structures - and is probably not a major negative factor for investment in the broader economy at this juncture. Accepting provisionally that (pending some reduction in uncertainty) economic fundamentals support a near-term expansion of capital investment and hiring, we now ask: Do firms have the financial capacity to undertake substantial expansion? From a financial perspective, the nonfinancial corporate sector presents a mixed picture, one distinctly weaker than that of the household sector. We have already mentioned the poor performance of the stock market. Corporate profitability has recently shown some signs of recovery; however, at about 8 percent of GDP last quarter, nonfinancial corporate profits are still quite low relative to output, considerably below their 1997 peak of about 13 percent of GDP. The general weakness in the economy has, of course, played a role in holding down profits, but, ironically, the stock market's decline itself has also been a factor. By some estimates, because of asset-price declines, the defined-benefit pension plans of U.S. firms swung from being about $250 billion overfunded to being $200 billion to $250 billion underfunded between 2000 and 2002, necessitating Measured on a National Income and Product Accounts (NIPA) basis. The NIPA series provides the most comprehensive measure of profits for U.S. corporations. It is also defined to be consistent with GDP as a measure of output. large contributions to these plans that must be charged against operating profits. As these losses on pension fund assets are by convention amortized over time, firms' pension contributions will depress reported profits at least for the next couple of years (and, incidentally, raise reported compensation to workers). I think one should note, however, that from a purely economic point of view, losses associated with pension fund commitments should be treated as bygones and thus in principle should not affect the willingness of firms to undertake new capital investments, except to the extent that they affect firms' ability to finance those investments. Besides weak profits and the large decline in stock prices, the other obvious negative for the corporate sector is the evident deterioration in aggregate credit quality. The average spreads between yields on risky corporate bonds, such as BBB-rated bonds or high-yield corporate debt, and the yields on safe debt of comparable maturities are currently at elevated levels, equal to or above those seen in the 1990-91 recession. Many companies have had their debt downgraded by ratings agencies, and corporate bond defaults during 2002 amounted to 3.2 percent of the value of bonds outstanding, a rate above the 1991 peak in default rates. Although these statistics are certainly worrisome, a closer examination reveals several mitigating factors. First, though average spreads of risky corporate debt remain high on an absolute basis, they have recently improved substantially. Spreads on BBB-rated corporate debt have come down nearly one-third since their October 2002 peak, and high-yield spreads are down about one-fifth. Risk as measured by credit default swaps has also come down substantially over the same period. At least some of the recent marked improvement in perceived default risk and market liquidity must arise from increasing confidence among investors that we have seen the last of the major accounting scandals that rocked the markets during the summer. If more time passes without new revelations of corporate wrongdoing and if the generally high level of risk aversion in markets continues to moderate (perhaps with decreasing geopolitical risks), we should see further declines in corporate yield spreads over this year. A second mitigating factor is that much of the measured deterioration in aggregate credit quality is actually concentrated in a few seriously distressed sectors, such as telecommunications, airlines, and energy trading firms, with a few high-profile cases making significant contributions. In particular, yield spreads in the telecom, cable, and media industries reached dizzying heights in mid-2002, though recently these spreads have fallen quite markedly. Remarkably, for the entire year 2002, telecom firms accounted for 55 percent of corporate bond defaults, by value. A similar story, though not quite so extreme, applies to energy and utility firms. When these most troubled sectors are excluded, the recent behavior of financial indicators for the corporate sector looks far less unusual. Though less evident than the headline statistics about earnings and stock prices, there is also a positive financial story to tell about corporate America over the past couple of years. Specifically, as in the case of households, the recent low-interest-rate environment has allowed firm managers to restructure their balance sheets in ways that have made them financially better prepared to expand their businesses when they judge that the time is right. First, by borrowing at lower rates and refinancing old loans, firms have been able to significantly reduce their current interest charges. The ratio of interest expenses to outstanding debt for nonfinancial firms indicates that the average interest rate has fallen about 1-1/4 percentage points from its recent high at year-end 2000, to under 6 percent on average. With lower interest rates and higher profits, the average ratio of firms' interest expense to cash flow improved considerably in 2002, to about 18 percent (compared with a peak of 27 percent in 1991). Second, firms have also restructured by substituting long-term debt for short-term obligations, resulting in a sharp decline in the average ratio of current debt to assets. Average liquidity also improved markedly in 2002, reflecting declines in short-term liabilities, higher cash flows, and reduced payouts to shareholders. Finally, on net, firms took on little new debt last year. The bottom line from this restructuring activity is healthier balance sheets for many firms. So, are firms financially able to fund new investment and new hiring, if and when they decide that expansion is justified by the fundamentals? I think that, for the most part, the answer is "yes." Most firms have ample cash and liquid assets to fund investment internally, and they have access to the capital markets as needed to fund investment externally. Though risk premiums remain elevated and lenders are selective, both the corporate bond markets and bank lending windows are "open" to Additionally, many firms will be required to change accounting assumptions about expected rates of return in their pension plans, which may raise future contributions further. reasonably sound borrowers. Indeed, over the past year gross issuance - even of speculative-grade bonds - continued at a moderate pace. The possible exceptions to the presumption that funds are available are the weakest firms in the most troubled sectors. These firms are generally also the ones with the poorest earnings prospects and the most severe problems of excess capacity, and hence they are likely the firms with the least promising opportunities for investment. The financial strength of the banking sector Finally, a brief word about banks. The availability of funds to households and firms depends, of course, on the financial stability of lenders as well as that of borrowers. Historically, there have been numerous occasions in which financial problems in the banking system have slowed economic growth, such as in the already-mentioned case of Japan. How has the U.S. commercial banking sector held up in the latest recession? Despite some high-profile lawsuits and regulatory settlements arising from the accounting and stock analyst scandals of last summer, the answer in this case is "quite well." Following the setbacks of the early 1990s, over the past decade U.S. commercial banks have maintained consistently high profits and returns on assets through their efforts to contain costs, to increase their sources of non-interest income (such as fee income), and to maintain high standards of credit quality. Loan-loss performance has improved steadily, not only because of better credit evaluation techniques but also because banks have learned how to manage credit risks better, by making much greater use of secondary loan markets, derivative instruments such as credit default swaps, and other tools. To a remarkable degree, the profitability and liquidity of the 1990s has been maintained through the past two years of economic weakness. Some of the factors supporting profitability in the banking sector since 2000 include large inflows of cheap core deposits (as households have retreated from riskier investments), booming business in mortgage originations and refinancings, strong demand for credit cards, and capital gains on securities holdings. Capital adequacy in the banking sector remains good; it has been boosted both by increased retained earnings and by banks' shifts into assets with relatively low risk weights, such as government securities and residential mortgages. Loan-loss experience in the past two years has worsened slightly; credit quality has been a particular concern in the corporate sector, with a number of high-profile bankruptcies affecting a number of large banks. In contrast, however, delinquency and charge-off rates on commercial real estate loans declined in 2002 from already low levels, despite negative trends in market rents and vacancy rates. The solid performance of commercial real estate loans contrasts sharply with the difficulties experienced in the late 1980s and early 1990s and may reflect, in part, tighter lending standards by banks, which were reported in the Federal Reserve's Senior Loan Officer Survey as early as 1998. Similarly, delinquency rates on residential mortgages held by banks declined in 2002, and charge-off rates on these loans remained near zero. Delinquency rates on credit card loans were flat in 2002, but remain fairly elevated, partly because of the expansion of subprime lending discussed earlier. Overall, the ratio of banks' bad-loan reserves to delinquent loans remains high, reflecting strong earnings that have allowed banks to step up their rate of provisioning for future defaults. Moreover, banks' ample capital provides a further important cushion against possible losses. Flush with deposits and with high levels of capital, most banks seem willing and able to lend, a situation much different from the period following the 1990-91 recession. The Fed's Senior Loan Officer Survey has found very little tendency toward tightening of loan standards for consumers, either in regard to residential mortgages or other types of consumer loans; and, as I have already discussed, the demand for mortgage loans and home equity loans has been exceptionally strong. Business lending, by contrast, has been weak. In part, reduced business lending may reflect some tightening of lending standards, particularly by larger banks and for riskier borrowers. Probably the more important Bassett and Carlson (2002) discuss bank performance in 2001. That tightening has been most prevalent at the largest banks is suggested by analysis of the Senior Loan Officer Survey. In notable contrast to some of the results of this survey, respondents to the National Federation of Independent Businesses survey of small business - who deal primarily with smaller, regional banks - have not reported consistent tightening of loan terms for business. factor depressing commercial and industrial lending, however, is the weak demand for business credit. As I have stressed, firms have displayed unusual reluctance to invest or to hire additional workers, and many of those who do wish to expand operations have been able to do so out of internal funds rather than go to banks or capital markets. Other firms have taken advantage of low long-term interest rates to substitute long-term financing for bank loans and other short-term liabilities. Reduced merger and acquisition activity has also reduced business demand for bank loans. As for the rest of this year and next year, the banking system seems well positioned to continue to support household spending and to accommodate increased credit demands by financially sound business borrowers. Conclusion My objective today was to assess whether there exist financial constraints that might impede the developing recovery in the U.S. economy. My sense is that the household and banking sectors are in good financial shape for this stage in the business cycle; and that, though financial problems exist, they should not in themselves restrain the building economic recovery. The corporate sector presents a more mixed picture. Equity prices have fallen significantly in the past three years, profits have made only a hesitant recovery, and aggregate indicators of financial stress remain at elevated levels. Still, closer examination of the corporate sector yields some grounds for optimism. Two points in particular deserve re-stating: First, many of the financial problems of the corporate sector are concentrated in just a few industries; excluding these industries, corporate financial conditions are not especially weak for this stage of the cycle. Second, and less widely recognized, many firms have used the past two years to significantly restructure their balance sheets, reduce their interest burdens, and increase liquidity. At such time that they feel they are ready to begin hiring and investing again, these firms should be financially capable of doing so. Thank you for your attention.
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board of governors of the federal reserve system
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Testimony of Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, Washington, D.C., 26 February 2003.
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Alan Greenspan: Deposit insurance Testimony of Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, Washington, D.C., 26 February 2003. * * * Chairman Shelby, Senator Sarbanes, and members of the Committee, it is a pleasure to appear once again before this Committee to present the views of the Board of Governors of the Federal Reserve System on deposit insurance. Rather than refer to any specific bill, I will express the broad views of the Federal Reserve Board on the issues associated with modifications of deposit insurance. Those views have not changed since our testimony before this Committee on April 23, 2002. At the outset, I note that the 2001 report of the Federal Deposit Insurance Corporation (FDIC) on deposit insurance highlighted the significant issues and developed an integrated framework for addressing them. Although as before the Board opposes any increase in coverage, we continue to support the framework constructed by the FDIC report for addressing other reform issues. Benefits and costs of deposit insurance Deposit insurance was adopted in this country as part of the legislative effort to limit the impact of the Great Depression on the public. Against the backdrop of a record number of bank failures, the Congress designed deposit insurance mainly to protect the modest savings of unsophisticated depositors with limited financial assets. With references being made to "the rent money," the initial 1934 limit on deposit insurance was $2,500; the Congress promptly doubled the limit to $5,000 but then kept it at that level for the next sixteen years. I should note that the $5,000 of insurance provided in 1934, an amount consistent with the original intent of the Congress, is equal to slightly less than $60,000 today, based on the personal consumption expenditures deflator in the gross domestic product accounts. Despite its initial quite limited intent, the Congress has raised the maximum amount of coverage five times since 1950, to its current level of $100,000. The last increase, in 1980, more than doubled the limit and was clearly designed to let depositories, particularly thrift institutions, offer an insured deposit free of the then-prevailing interest rate ceilings on such instruments, which applied only to deposits below $100,000. Insured deposits of exactly $100,000 thus became fully insured instruments in 1980 but were not subject to an interest rate ceiling. The efforts of thrift institutions to use $100,000 CDs to stem their liquidity outflows resulting from public withdrawals of smaller, below-market-rate insured deposits led first to an earnings squeeze and an associated loss of capital and then to a high-risk investment strategy that led to failure after failure. Depositors acquiring the new larger-denomination insured deposits were aware of the plight of the thrift institutions but unconcerned about the risk because the principal amounts of their $100,000 deposits were fully insured by the federal government. In this way, the 1980 increase in deposit insurance to $100,000 exacerbated the fundamental problem facing thrift institutions - a concentration on long-term assets in an environment of high and rising interest rates. Indeed, it significantly increased the taxpayer cost of the bailout of the bankrupt thrift institution deposit insurance fund. Despite this problematic episode, deposit insurance has clearly played a key - at times even critical role in achieving the stability in banking and financial markets that has characterized the nearly seventy years since its adoption. Deposit insurance, combined with other components of our banking safety net (the Federal Reserve's discount window and its payment system guarantees), has meant that periods of financial stress no longer entail widespread depositor runs on banks and thrift institutions. Quite the opposite: Asset holders now seek out deposits - both insured and uninsured - as safe havens when they have strong doubts about other financial assets. Looking beyond the contribution of deposit insurance to overall financial stability, we should not minimize the importance of the security it has brought to millions of households and small businesses with relatively modest financial assets. Deposit insurance has given them a safe and secure place to hold their transaction and other balances. The benefits of deposit insurance, as significant as they are, have not come without a cost. The very process that has ended deposit runs has made insured depositors largely indifferent to the risks taken by their depository institutions, just as it did with depositors in the 1980s with regard to insolvent, risky thrift institutions. The result has been a weakening of the market discipline that insured depositors would otherwise have imposed on institutions. Relieved of that discipline, depositories naturally feel less cautious about taking on more risk than they would otherwise assume. No other type of private financial institution is able to attract funds from the public without regard to the risks it takes with its creditors' resources. This incentive to take excessive risks at the expense of the insurer, and potentially the taxpayer, is the so-called moral hazard problem of deposit insurance. Thus, two offsetting implications of deposit insurance must be kept in mind. On the one hand, it is clear that deposit insurance has contributed to the prevention of bank runs that could have destabilized the financial structure in the short run. On the other, even the current levels of deposit insurance may have already increased risk-taking at insured depository institutions to such an extent that future systemic risks have arguably risen. Indeed, the reduced market discipline and increased moral hazard at depositories have intensified the need for government supervision to protect the interests of taxpayers and, in essence, substitute for the reduced market discipline. Deposit insurance and other components of the safety net also enable banks and thrift institutions to attract more resources, at lower costs, than would otherwise be the case. In short, insured institutions receive a subsidy in the form of a government guarantee that allows them both to attract deposits at lower interest rates than would be necessary without deposit insurance and to take more risk without the fear of losing their deposit funding. Put another way, deposit insurance misallocates resources by breaking the link between risks and rewards for a select set of market competitors. In sum, from the very beginning, deposit insurance has involved a tradeoff. Deposit insurance contributes to overall short-term financial stability and the protection of small depositors. But at the same time, because it also subsidizes deposit growth and induces greater risk-taking, deposit insurance misallocates resources and creates larger long-term financial imbalances that increase the need for government supervision to protect the taxpayers' interests. Deposit insurance reforms must balance these tradeoffs. Moreover, any reforms should be aimed primarily at protecting the interest of the economy overall and not just the profits or market shares of particular businesses. The Federal Reserve Board believes that deposit insurance reforms should be designed to preserve the benefits of heightened financial stability and the protection of small depositors without a further increase in moral hazard or reduction in market discipline. In addition, we urge that the implementing details be kept as straightforward as possible to minimize the risk of unintended consequences that comes with complexity. Issues for reform The FDIC has made five broad recommendations. 1. Merge BIF and SAIF The Board supports the FDIC's proposal to merge the Bank Insurance Fund (BIF) with the Savings Association Insurance Fund (SAIF). Because the charters and operations of banks and thrift institutions have become so similar, it makes no sense to continue the separate funds. Separate funds reflect the past but neither the present nor the future. Merging the funds would diversify their risks, reduce administrative expense, and widen the fund base of an increasingly concentrated banking system. Most important, because banks and thrift institutions receive the same level of federally guaranteed insurance coverage, the premiums faced by each set of institutions should be identical as well. Under current arrangements, the premiums faced by equally risky institutions could differ significantly if one of the funds falls below the designated reserve ratio of 1.25 percent of insured deposits and the other fund does not. Should that occur, depository institutions would be induced to switch charters to obtain insurance from the fund with the lower premium, a result that could distort our depository structure. The federal government should not sell a single service, like deposit insurance, at different prices. 2. Reduce statutory restrictions on premiums Current law requires the FDIC to impose higher premiums on riskier banks and thrift institutions but prevents it from imposing any premium on well-capitalized and highly rated institutions when the corresponding fund's reserves exceed 1.25 percent of insured deposits. The Board endorses the FDIC recommendations that would eliminate the statutory restrictions on risk-based pricing and allow a premium to be imposed on every insured depository institution, no matter how well capitalized and well rated it may be or how high the fund's reserves. The current statutory requirement that free deposit insurance be provided to well-capitalized and highly rated institutions when the ratio of FDIC reserves to insured deposits exceeds a predetermined ratio maximizes the subsidy provided to these institutions and is inconsistent with efforts to avoid inducing moral hazard. Put differently, the current rule requires the government to give away its valuable guarantee to many institutions when fund reserves meet some ceiling level. This free guarantee is of value to institutions even when they themselves are in sound financial condition and when macroeconomic times are good. At the end of the third quarter of last year, 91 percent of banks and thrift institutions were paying no premium. That group included many institutions that have never paid a premium for their, in some cases substantial, coverage, and it also included fast-growing entities whose past premiums were extraordinarily small relative to their current coverage. We believe that these anomalies were never intended by the framers of the Deposit Insurance Fund Act of 1996 and should be addressed by the Congress. The Congress did intend that the FDIC impose risk-based premiums, but the 1996 act limits the ability of the FDIC to impose risk-based premiums on well-capitalized and highly rated banks and thrift institutions. And these two variables - capital strength and overall examiner rating - do not capture all the risk that institutions could create for the insurer. The Board believes that the FDIC should be free to establish risk categories on the basis of any economic variables shown to be related to an institution's risk of failure, and to impose premiums commensurate with that risk. Although a robust risk-based premium system would be technically difficult to design, a closer link between insurance premiums and the risk of individual institutions would reduce moral hazard and the distortions in resource allocation that accompany deposit insurance. We note, however, that although significant benefits from a risk-based premium system are likely to require a substantial range of premiums, the FDIC concluded in its report that premiums for the riskiest banks would probably need to be capped in order to avoid inducing failure at these weaker institutions. We believe that capping premiums may end up costing the insurance fund more in the long run should these weak institutions fail anyway, with the delay increasing the ultimate cost of resolution. The Board has concluded, therefore, that if a cap on premiums is required, it should be set quite high so that riskbased premiums can be as effective as possible in deterring excessive risk-taking. In that way, we could begin to simulate the deposit insurance pricing that the market would apply and reduce the associated subsidy in deposit insurance. Nonetheless, we should not delude ourselves into believing that even a wider range in the risk-based premium structure would eliminate the need for a government back-up to the deposit insurance fund, that is, eliminate the government subsidy in deposit insurance. To eliminate the subsidy in deposit insurance - to make deposit insurance a real insurance system - the FDIC average insurance premium would have to be set high enough to cover fully the very small probabilities of very large losses, such as those incurred during the Great Depression, and thus the perceived costs of systemic risk. In contrast to life or automobile casualty insurance, each individual insured loss in banking is not independent of other losses. Banking is subject to systemic risk and is thus subject to a far larger extreme loss in the tail of the probability distributions from which real insurance premiums would have to be calculated. Indeed, pricing deposit insurance risks to fully fund potential losses - pricing to eliminate subsidies - could well require premiums that would discourage most depository institutions from offering broad coverage to their customers. Since the Congress has determined that there should be broad coverage, the subsidy in deposit insurance cannot be fully eliminated, although we can and should eliminate as much of the subsidy as we can. I note that the difficulties of raising risk-based premiums explain why there is no real private-insurer substitute for deposit insurance from the government. No private insurer would ever be able to match the actual FDIC premium and cover its risks. A private insurer confronted with the possibility, remote as it may be, of losses that could bankrupt it would need to set especially high premiums to protect itself, premiums that few, if any, depository institutions would find attractive. And if premiums were fully priced by the government or the private sector, the depository institutions would likely lower their offering rates, thereby reducing the amount of insured deposits demanded, and consequently the amount outstanding would decline. 3. Relaxing the reserve ratio regime to allow gradual adjustments in premiums Current law establishes a designated reserve ratio for BIF and SAIF of 1.25 percent. If that ratio is exceeded, the statute requires that premiums be discontinued for well-capitalized and highly rated institutions. If the ratio declines below 1.25 percent, the FDIC must develop a set of premiums to restore the reserve ratio to 1.25 percent; if the fund ratio is not likely to be restored to its statutorily designated level within twelve months, the law requires that a premium of at least 23 basis points be imposed on all insured entities. These requirements are clearly procyclical: They lower or eliminate fees in good times, when bank credit is readily available and deposit insurance fund reserves should be built up, and abruptly increase fees sharply in times of weakness, when bank credit availability is under pressure and deposit fund resources are drawn down to cover the resolution of failed institutions. The FDIC recommends that surcharges or rebates be used to bring the fund back to the target reserve ratio gradually. The FDIC also recommends the possibility of a target range for the designated reserve ratio, over which the premiums may remain constant, rather than a fixed target reserve ratio and abruptly changing premiums. We support such increased flexibility and smoothing of changes in premiums. Indeed, we recommend that the FDIC's suggested target reserve range be widened to reduce the need to change premiums abruptly. Any floor or ceiling, regardless of its level, could require that premiums be increased at exactly the time when banks and thrifts could be under stress and, similarly, that premiums be reduced at the time that depositories are in the best position to fund an increase in reserves. Building a larger fund in good times and permitting it to decline when necessary are prerequisites to less variability in the premium. In addition to supporting a widening of the range for the designated reserve ratio, the Board recommends that the FDIC be given the latitude to temporarily relax floor or ceiling ratios on the basis of current and anticipated banking conditions and expected needs for resources to resolve failing institutions. In short, to enhance macroeconomic stability, we prefer a reduction in the specificity of the rules under which the FDIC operates and, within the broad guidelines set out by the Congress, an increase in the flexibility with which the board of the FDIC can operate. 4. Modify the rebates system Since its early days, the FDIC has rebated "excess" premiums whenever it considered its reserves to be adequate. This procedure was replaced in the 1996 law by the requirement that no premium be imposed on well-capitalized and highly rated institutions when the relevant fund reached its designated reserve ratio. The FDIC's 2001 proposals would re-impose a minimum premium on all banks and thrift institutions and a more risk-sensitive premium structure. These provisions would be coupled with rebates for the stronger entities when the fund approaches the upper end of a target range and surcharges when the fund trends below the lower end of a target range. The FDIC also recommends that the rebates not be uniform for the stronger entities. Rather, the FDIC argues that rebates should be smaller for those banks that have paid premiums for only short periods or that have in the past paid premiums that are not commensurate with their present size and consequent FDIC exposure. The devil, of course, is in the details. But varying the rebates in this way makes considerable sense, and the Board endorses it. More than 900 banks - some now quite large have never paid a premium, and without this modification they would continue to pay virtually nothing, net of rebates, as long as their strong capital and high supervisory ratings were maintained. Such an approach is both competitively inequitable and contributes to moral hazard. It should be addressed. 5. Indexing ceilings on the coverage of insured deposits The FDIC recommends that the current $100,000 ceiling on insured deposits be indexed to inflation. The Board does not support this recommendation and believes that the current ceiling should be maintained. In the Board's judgment, increasing the coverage, even by indexing, is unlikely to add measurably to the stability of the banking system. Macroeconomic policy and other elements of the safety net - combined with the current, still-significant level of deposit insurance - continue to be important bulwarks against bank runs. Thus, the problem that increased coverage is designed to solve must be related either to the individual depositor, the party originally intended to be protected, or to the individual bank or thrift institution. Clearly, both groups would prefer higher coverage if it cost them nothing. But the Congress needs to be clear about the nature of a specific problem for which increased coverage would be the solution. Depositors. Our most recent surveys of consumer finances suggest that most depositors have balances well below the current insurance limit of $100,000, and those that do have larger balances have apparently been adept at achieving the level of deposit insurance coverage they desire by opening multiple insured accounts. Such spreading of assets is perfectly consistent with the counsel always given to investors to diversify their assets - whether stocks, bonds, or mutual funds - across different issuers. The cost of diversifying for insured deposits is surely no greater than doing so for other assets. A bank would clearly prefer that the depositor maintain all of his or her funds at that bank and would prefer to reduce the need for depositor diversification by being able to offer higher deposit insurance coverage. Nonetheless, depositors appear to have no great difficulty - should they want insured deposits - in finding multiple sources of fully insured accounts. In addition, one of the most remarkable characteristics of household holdings of financial assets has been the increase in the diversity of portfolio choices since World War II. And, since the early 1970s the share of household financial assets in bank and thrift deposits has generally declined steadily as households have taken advantage of innovative, attractive financial instruments with market rates of return. The trend seems to bear no relation to past increases in insurance ceilings. Indeed, the most dramatic substitution out of deposits has been the shift from both insured and uninsured deposits into equities and into mutual funds that hold equities, bonds, and money market assets. It is difficult to believe that a change in ceilings during the 1990s would have made any measurable difference in that shift. Rather, the data indicate that the weakness in stock prices in recent years has been marked by increased flows into bank and thrift deposits even without changed insurance coverage levels. Depository Institutions. Does the problem to be solved by increased deposit insurance coverage concern the individual depository institution? If so, the problem would seem disproportionately related to small banks because insured deposits are a much larger proportion of total funding at small banks than at large banks. But smaller banks appear to be doing well. Since the mid-1990s, adjusted for the effects of mergers, assets of banks smaller than the largest 1,000 have grown at an average annual rate of 13.8 percent, more than twice the pace of the largest 1,000 banks. Uninsured deposits, again adjusted for the effects of mergers, have grown at average annual rates of 21 percent at the small banks versus 10 percent at the large banks. Clearly, small banks have a demonstrated skill and ability to compete for uninsured deposits. To be sure, uninsured deposits are more expensive than insured deposits, and bank costs would decline and profits rise if their currently uninsured liabilities received a government guarantee. But that is the issue of whether subsidizing bank profits through additional deposit insurance serves a national purpose. I might add that throughout the 1990s and into the present century, return on equity at small banks has been well maintained. Indeed, the attractiveness of banking is evidenced by the fact that more than 1,350 banks were chartered during the past decade, including more than 600 from 1999 through 2002. Some small banks argue that they need enhanced deposit insurance coverage to compete with large banks because depositors prefer to put their uninsured funds in an institution considered too big to fail. As I have noted, however, small banks have more than held their own in the market for uninsured deposits. In addition, the Board rejects the notion that any bank is too big to fail. In the FDIC Improvement Act of 1991 (FDICIA), the Congress made it clear that the systemic-risk exception to the FDIC's least-cost resolution of a failing bank should be invoked only under the most unusual circumstances. Moreover, the resolution rules under the systemic-risk exception do not require that uninsured depositors and other creditors, much less stockholders, be made whole. The market has clearly evidenced the view, consistent with FDICIA, that large institutions are not too big for uninsured creditors to take at least some loss should the institution fail. For example, no U.S. banking organization, no matter how large, is AAA-rated. In addition, research indicates that creditors impose higher risk premiums on the uninsured debt of relatively risky large banking organizations and that this market discipline has increased since the enactment of FDICIA. To be sure, the real purchasing power of deposit insurance ceilings has declined. But there is no evidence of any significant detrimental effect on depositors or depository institutions, with the possible exception of a small reduction in those profits that accrue from deposit guarantee subsidies that lower the cost of insured deposits. The current deposit insurance ceiling appears more than adequate to achieve the positive benefits of deposit insurance that I mentioned earlier, even if its real value were to erode further. Another argument is often raised by smaller banks regarding the need for increased deposit insurance coverage. Some smaller institutions say that they are unable to match the competition from large securities firms and bank holding companies with multiple bank or thrift institution affiliates because those entities offer multiple insured accounts through one organization. I note that since the Committee's last hearings on this issue, the force of small banks' concerns has been reduced by recent market developments in which small banks and thrift institutions can use a clearinghouse network for brokered deposits that allows them to offer full FDIC insurance for large accounts. The Board agrees that such practices by both large and small depositories are a misuse of deposit insurance. Moreover, raising the coverage limit for each account is not a remedy for small banks because it would also increase the aggregate amount of insurance coverage that multidepository organizations would be able to offer. The disparity would remain. Conclusion Several aspects of the deposit insurance system need reform. The Board supports, with some modifications, all of the recommendations the FDIC made in the spring of 2001 except indexing the current $100,000 ceiling to inflation. The thrust of our recommendations would call for a wider permissible range for the size of the fund relative to insured deposits, reduced variation of the insurance premium as the relative size of the fund changes with banking and economic conditions, a positive and more risk-based premium net of rebates for all depository institutions, and the merging of BIF and SAIF. There may come a time when the Board finds that households and businesses with modest resources are having difficulty in placing their funds in safe vehicles or that the level of deposit coverage appears to be endangering financial stability. Should either of those events occur, the Board would call its concerns to the attention of the Congress and support adjustments to the ceiling by indexing or other methods. But today, in our judgment, neither financial stability, nor depositors, nor depositories are being disadvantaged by the current ceiling. Raising the ceiling now would extend the safety net, increase the government subsidy to depository institutions, expand moral hazard, and reduce the incentive for market discipline without providing any clear public benefit. With no clear public benefit to increasing deposit insurance, the Board sees no reason to increase the scope of the safety net. Indeed, the Board believes that as our financial system has become ever more complex and exceptionally responsive to the vagaries of economic change, structural distortions induced by government guarantees have risen. We have no way of ascertaining at exactly what point subsidies provoke systemic risk. Nonetheless, prudence suggests that we be exceptionally deliberate when expanding government financial guarantees.
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board of governors of the federal reserve system
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Testimony of Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Special Committee on Aging, U.S. Senate, Washington, D.C., 27 February 2003.
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Alan Greenspan: Aging global population Testimony of Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Special Committee on Aging, U.S. Senate, Washington, D.C., 27 February 2003. * * * Mr. Chairman and other members of the committee, I am pleased to be here today to discuss the economic effects of the aging of the global population. In so doing, I would like to emphasize that the views I will express are my own and do not necessarily represent those of the Federal Reserve Board. The world's population is growing older as a result of both declining fertility and increasing life expectancy. These trends manifest themselves in at least two important dimensions: a more slowly growing population and labor force, and an increase in the ratio of the elderly to the working-age population. The so-called elderly dependency ratio has been rising in the industrialized world for at least 150 years. The pace of increase slowed greatly with the birth of the baby-boom generation after World War II. But elderly dependency will almost certainly rise more rapidly as that generation reaches retirement age. The acceleration will be particularly dramatic in Japan and Europe. For example, in Japan the population share of the elderly, defined here as those at least 65 years of age, climbed from 12 percent to 17 percent in the past decade, and demographers expect it to reach 30 percent by 2030. The absolute size of Japan's working-age population is already declining and is projected to fall 20 percent over the next three decades. Europe's working-age population is also anticipated to recede, and the share of the elderly in its overall population is expected to rise markedly, though less so than in Japan. The changes projected for the United States are not so severe as those projected for Europe and Japan, but nonetheless present daunting challenges. Over the next thirty years, the growth rate of the working-age population in the United States is anticipated to slow, from about 1 percent per year today to about 1/2 percent per year by 2030. At the same time, the percentage of the population that is over 65 will rise markedly - from less than 13 percent today to perhaps 20 percent by 2030. Though the overall population is expected to continue to age, much of the aging of the labor force has already occurred with the aging of the baby-boom generation. Once the baby boomers begin to retire, the mean age of the U.S. labor force is expected to stabilize. These anticipated changes in the age structure of our population and work force result largely from the decline in fertility that occurred following the birth of the baby-boom generation. After peaking in 1957 at about 3-1/2 births over a woman's lifetime, the fertility rate in the United States fell to less than 2 by the early 1970s, and then rose to about 2.1 by 1990. Since then, the fertility rate has remained close to 2.1, the so-called replacement rate, or the level required to hold the population constant in the absence of immigration or changes in longevity. The decrease in the number of children per family since the baby boom has inevitably led, with a lag, to a projected increase in the ratio of elderly to working-age population. Increases in life expectancy, too, have been substantial. In 1950, a man 65 years of age could expect, on average, to live until age 78, whereas now he can expect to live until over 81. And if current trends continue, by 2025 he can expect to live to 83 and, by 2060, to 85. Women's life expectancy is projected to increase about the same amount, from 81 in 1950 to roughly 85 today, 86 in 2025 and 88 in 2060. Of course, it is difficult to predict the age structure of the population in the more distant future. Although we have a good idea of the size of the working-age population over the next twenty years or so - its members are largely already born - forecasting the number of children and future immigration and population growth is much more conjectural. Just recently, for example, the United Nations revised its forecast of world fertility rates downward from its projection only three years earlier; The fertility rate used here is the total fertility rate. It is measured as the average number of children who would be born to a woman in her lifetime if she were to experience the birth rates by age observed in any given year. according to the new forecast, world population is expected to begin actually declining in the latter part of this century, whereas under the previous forecast, it was expected to continue growing. Even with the substantial uncertainty that surrounds these forecasts, population aging in the developed world is not likely to be a temporary phenomenon, associated solely with the retirement of the baby-boom generation. Rather, under current projections, the retirement of that generation should be viewed as hastening the transition between the current distribution of age and one in which the population is notably older. The populations in most developing countries likewise are expected to have a rising median age, but they will remain significantly younger and grow faster than our population over the foreseeable future. Eventually, declines in fertility rates and increases in longevity may lead to similar issues with aging populations in the developing world but likely only well after the demographic transition in the United States. As you know, the aging of the population in the United States will have significant effects on our fiscal situation. In particular, it makes our social security and Medicare programs unsustainable in the long run, short of a major increase in immigration rates, a dramatic acceleration in productivity growth well beyond historical experience, a significant increase in the age of eligibility for benefits, or the use of general revenues to fund benefits. Indeed, according to the intermediate projection of the social security trustees, the level of social security contributions under current law begins falling short of legislated benefits by approximately 2017. While the prospect of a shortfall in social security is reasonably certain given the changing composition of the population, the range of possible outcomes in Medicare is far wider. Rapidly advancing medical technologies, essentially inelastic demand for medical services for the elderly, and a subsidized third-party payment system have created virtually unconstrained demand. How the financing pressures that accompany increasing retirement are resolved will have profound, but uncertain, effects on the structure of both private and public pension plans. Private pension assets already account for about 12 percent of household financial assets in the United States, a level that will almost certainly increase over the next decade. The total investment income of these funds, in conjunction with retirees' other forms of income, must be sufficient to finance a satisfactory standard of living. The real resources available to fund pension benefits depend on the economy's long-term growth rate, which in its simplest terms is determined by the growth rate of labor employed plus the growth rate of the productivity of that labor. As already noted, by 2030 the growth rate of our working-age population is expected to decline by half. The fraction of the working-age population actually employed will doubtless be affected by improvements in health or changes in the economic returns to working. Labor productivity has historically been affected by changes in the amount of capital available to each worker, the pace of technical progress and, perhaps more subtly, changes in the experience of our workforce. These elements are key to assessing the economic effects of aging. One natural response to population aging will almost surely be for a more fit elderly population to increase their participation in the labor force. Americans not only are living longer, but they are generally living healthier. Rates of disability for the elderly have been declining, reflecting both improvements in health and changes in technology that accommodate the physical impairments that are associated with aging. In addition, work is becoming less physically strenuous but more demanding intellectually, continuing a century-long trend toward a more conceptual and a less physical economic output. For example, in 1900, only one out of every ten workers was in a professional, technical, or managerial occupation. By 1970, that proportion had doubled, and today those types of jobs account for about one-third of our workforce. Despite the improving feasibility of work at older ages, Americans have been retiring at younger and younger ages. Some analysts believe this trend has slowed, although few anticipate a rapid Because social security benefits are tied to productivity growth with a lag, only a rate of productivity growth well above historical experience could completely resolve social security’s long-term financing problem. Constraining these outlays by any mechanism other than prices will involve some form of rationing - an approach that in the past has not been popular in the United States. turnaround. But rising pressures on retirement incomes and a growing scarcity of experienced labor could induce greater labor-force participation. Immigration, if we choose to expand it, could prove an even more potent antidote for slowing growth in the working-age population. As the influx of foreign workers in response to the tight labor markets of the 1990s showed, immigration does respond to labor shortages. An expansion of labor-force participation by immigrants and the healthy elderly offers some offset to an aging population. However, it is heightened growth of output per worker that presents the greatest potential to boost the growth of gross domestic product. A significant rise in the growth of labor productivity will be necessary if the standard of living of retirees is to be maintained and that of workers is to continue advancing. One of the more direct ways to raise growth in output per hour is to increase saving and investment, which augment the capital stock available to workers. Another is to increase the incentives for innovation; efficiency gains, broadly defined, currently account for roughly half the growth in labor productivity. Though augmenting saving and investment should raise future labor productivity and thereby help provide for an aging population, the incremental benefit of additional investment may itself be affected by aging. Without a growing labor force, the amount of new equipment that can be used productively will be more limited, and the return to capital investment could decline as a consequence. What actually happens to the saving rate in the next three decades will depend importantly on the behavior of the baby-boom cohort during their retirement years. Over the post-World War II period, the elderly in the United States, contrary to conventional wisdom, seem to have drawn down their savings only modestly. The reasons are not entirely clear. Often people bequeath a significant proportion of their savings to their children or others rather than spending it during retirement. If the baby-boom generation continues this pattern, then the U.S. household saving rate may not decline significantly, if at all. The faster rates of aging in Europe and Japan may also directly affect investment and, hence, the growth of labor productivity here in the United States. If saving rates in these countries decline, global capital flows to the United States that have contributed significantly in recent years to financing domestic investment are likely to decline. As in the United States, much will depend on the extent to which retirees in these countries draw down their savings. For example, the saving rate in Japan, even with the rapidly aging population, has not declined to the extent that some had predicted. However, if households in Japan were to start consuming more and saving less, Japan's trade surplus would likely shrink as consumption of imported goods rose. Some of the elevated level of their imports would be exports from the United States, and our trade balance would improve, all else being equal. Jobs requiring unskilled labor are likely to continue moving to developing countries, and this transfer may increase foreign direct investment by U.S. firms. Most other developed countries are unlikely to be able to offer higher rates of return because they are already aging faster than the United States. Many developing countries have the potential to offer higher rates of return because of their younger and more rapidly growing populations and currently low stocks of capital, but the realization of this potential is far from guaranteed. Historically, returns to investment in many developing countries have been held down by several inhibiting factors: low levels of education, poor infrastructure, and, perhaps most important of all, capricious legal protections. Clearly, if net capital inflows into the United States decline, so must our current account and trade deficits. Any such declines must be offset by higher domestic saving - including government saving - if domestic investment in plant and equipment and in housing are to be maintained. Future labor productivity, however, is determined by more than just saving, investment, and capital intensity. One of the remarkable features of the economy over the past seven years or so has been the acceleration in the pace of innovative use of capital by workers, rather than increases in the amount of capital per worker. Indeed, as I pointed out earlier, such innovation accounted for about one-half of the rapid increase in labor productivity that we observed in the late 1990s. Therefore, it is important to address the possibility that aging will affect the rate of innovation, either through a rearrangement of existing capital resources or through technological advance. Economists understand very little about how technological progress occurs, and research about the effects of aging populations on technological innovation has been sparse. On the one hand, some commentators have worried that an aging population will lead to a less dynamic economy and a lower rate of technological progress; they cite, for example, the fact that the majority of Nobel prizes in the "hard" sciences were awarded for discoveries made by the winners early in their careers. Such issues may have less import going forward, however, as most of the aging of the workforce has already occurred. On the other hand, a slowed rate of growth or a decline in the working-age population may raise technological growth. Although discovery of new technologies is to some degree a matter of luck, we know that human activities do respond to economic incentives. A relative shortage of workers should increase the incentives for developing labor-saving technologies and may actually spur technological development. Economic historians have argued that one reason that the United States surpassed Great Britain in the early nineteenth century as the leader in technological innovation was the relative scarcity of labor in the United States. Patent records of this period show that innovation did respond to economic incentives and that the scarcity of labor clearly provided incentives to develop new methods of production. * * * The aging of the population means that the government will inevitably need to make a number of changes to its retirement programs. These changes in themselves can have profound economic effects. For example, aside from suppressing economic growth, large increases in payroll taxes can exacerbate the problem of reductions in labor supply, whereas policies to promote longer working life can ameliorate it. Reductions in benefits - through changes to the age for receiving full retirement benefits or through reforms to slow the growth of Medicare spending or through other means - can affect retirement, the labor force, and saving behavior. In addition, policies that link increases in longevity over time to the eligibility age for social security, and perhaps Medicare, may need to be considered. Such linkages would help protect the financial and, hence, the economic viability of these programs. The aging of the population is bound to bring with it many changes to our economy - some foreseeable, many probably not. Though the challenges here seem great, the necessary adjustments will likely be smaller than those required in most other developed countries. But how we adjust will also matter. Early initiatives to address the economic effects of baby-boom retirements could smooth the transition to a new balance between workers and retirees. If we delay, the adjustments could be abrupt and painful. Fortunately, the U.S. economy is uniquely well suited to make those adjustments. Our open labor markets can adapt to the differing needs and abilities of our older population. Our capital markets can allow for the creation and rapid adoption of new labor-saving technologies, and our open society has been receptive to immigrants. All these factors put us in a good position to adjust to the inexorabilities of an aging population.
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board of governors of the federal reserve system
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Testimony by Mr Roger W Ferguson, Jr, Vice Chairman of the Board of Governors of the US Federal Reserve System, before the Subcommittee on Domestic and International Monetary Policy, Trade and Technology, Committee on Financial Services, U.S. House of Representatives, Washington, D.C., 27 February 2003.
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Roger W Ferguson, Jr: Basel II Testimony by Mr Roger W Ferguson, Jr, Vice Chairman of the Board of Governors of the US Federal Reserve System, before the Subcommittee on Domestic and International Monetary Policy, Trade and Technology, Committee on Financial Services, U.S. House of Representatives, Washington, D.C., 27 February 2003. * * * Chairman King, Congresswoman Maloney, members of the Subcommittee on Domestic and International Monetary Policy, Trade and Technology: It is a pleasure to appear before you this morning on behalf of the Board of Governors of the Federal Reserve System to discuss Basel II, the evolving new capital standard for internationally active banks and bank holding companies. At this time, bank supervisors in this country and abroad are evaluating the results of a recent survey to assess the potential quantitative impact of the current proposals on the world's large banks. In addition, the supervisors in the United States are still incorporating feedback from our discussions with bankers, an ongoing process that will continue even after final rules are adopted. From the U.S. perspective, a hallmark of the Basel II process has been the effort to tailor the capital framework to the evolving industry best practices. We intend for these dynamic efforts to continue. That having been said, after almost five years of discussion and revision, Basel II is about ready for the last rounds of comment - which we anticipate this spring and summer. We expect the Basel Committee to approve its package by late this year, the corresponding U.S. rulemaking process to be completed next year, and implementation to begin in late 2006. Banks need some certainty for planning, but this is not inconsistent with further changes between 2004 and 2006, and thereafter, as we learn more and as practices evolve. Why is a new capital standard necessary? The supervisors in this country have determined that Basel I, the current capital regime adopted in 1988, must be replaced for the most complex banks for three major reasons: defects in Basel I as it applies to these large entities, evolution in the art of risk management, and increased heterogeneity and concentration in the banking system. Defects in Basel I Basel I was a major step forward in capital regulation. Indeed, for most banks in this country, Basel I is now - and for the foreseeable future will be - more than adequate as a capital framework. Most banking institutions in this country engage in businesses with risks that counterparties and supervisors can evaluate relatively easily. Moreover, because of their lack of geographical diversification and/or limited alternative funding sources, the market continues to force most banks to carry capital positions considerably in excess of regulatory minimums under Basel I. For these reasons, U.S. supervisors do not believe the benefits would exceed the costs of requiring most banks to shift to Basel II. However, for the small number of large, complex, internationally active banking organizations, Basel I has serious shortcomings, which are becoming more evident with time. Developing a replacement to supply to these banking organizations is imperative. First, Basel I is too simplistic to adequately address the activities of our most complex banking institutions. Basel I categorizes each bank's assets into one of only four categories, each of which represents a certain risk class. Each risk class has its own risk weight that is multiplied by 8 percent to get the minimum capital charge: zero for most sovereign debt, 20 percent of 8 percent for most intra-bank exposures and for agency securities, 50 percent of 8 percent for residential mortgages, and 100 percent of 8 percent for all other exposures. These "all other" credits include essentially all corporate and consumer loans, meaning that the whole spectrum of credit quality over which banks do much of their lending - from Aaa to the most speculative credits - receives the same regulatory capital charge. The lack of differentiation among the degrees of risk means that the resultant capital ratios are too often uninformative and might well provide misleading information for banks with risky or problem credits or, for that matter, with portfolios dominated by very safe loans. Moreover, the limited number of risk classes not only limits the value of the capital requirement but also creates a regulatory loophole that creates incentives for banks to game the system by capital arbitrage. Capital arbitrage, in this case, is the avoidance of certain minimum capital charges through sale or securitization of those assets for which the capital requirement that the market would impose is less than the regulatory capital charge. Clearly, the market believes that the 4 percent capital charge on most residential mortgages (50 percent of 8 percent) and the 8 percent on most credit cards (100 percent of 8 percent) is higher than the real risk, facilitating the securitization and sale of a large volume of such loans to other holders. This behavior is perfectly understandable, even desirable in an economic efficiency sense. But it means that banks that engage in such arbitrage retain the higher-risk assets for which the regulatory capital charge - calibrated to average quality assets - is on average too low. Supervisors, through the examination process, are, to be sure, still able to evaluate the true risk position of the bank, but the capital ratios of the larger banks are becoming less and less meaningful, a trend that will only accelerate. Not only are creditors, counterparties, and investors less able to evaluate the capital strength of individual banks from what are supposed to be risk-based capital ratios, but regulations and statutory requirements tied to capital ratios have less meaning as well. The evolving state of the art At the same time, risk management and appropriate capital determination have evolved significantly beyond the state of the art at the time Basel I was developed. Banks themselves have developed and adopted some of the new techniques to improve their risk management and internal economic capital measures. But clearly banks can go considerably further. Basel II would speed adoption of these new techniques and promote the future evolution of risk management by establishing a framework that is more risk-sensitive. Increased heterogeneity and concentration in banking Finally, market pressures have led to consolidation in banking around the world. Our own banking system has not been immune; it, too, has become increasingly concentrated with a small number of very large banks operating across a wide range of product and geographic markets. Their operations are tremendously complex and sophisticated, and their significantly different strategies add a high degree of heterogeneity to their operations. At the same time, significant weakness in one of these entities, let alone failure, has the potential for severely adverse macroeconomic consequences. It seems clear that the regulatory framework should encourage these banks to adopt the best possible risk measurement and management techniques while allowing for the considerable differences in their business strategies. Basel II presents an opportunity for supervisors to encourage these banks to push their management frontier forward. Of course, change is always difficult, and these new mechanisms are expensive. But a more risk-sensitive regulatory and capital system would provide stronger incentives to adopt best practice internal risk management. Let me be clear. If we do not apply more risk-sensitive capital requirements to these very large institutions, the usefulness of capital adequacy regulation in constraining excessive risk-taking at these entities will continue to erode. Such an erosion would present U.S. bank supervisors with a highly undesirable choice. Either we would have to accept the increased risk of instability in the banking system, or we would be forced to adopt alternative - and more intrusive - approaches to the supervision and regulation of these institutions. Basel II I want to stress that the U.S. supervisory authorities intend to apply only the so-called Advanced Internal Ratings Based (A-IRB) version of Basel II. We will not be adopting the two other variants of Basel II - the Standardized and Foundation Internal Ratings Based Approaches - that have been developed by the Basel Committee. We expect to require about ten large U.S. banks to adopt the A-IRB approach, but we anticipate that a small number of other large entities will choose to adopt it as well after making the necessary investment to support their participation. All other banks in this country will remain on the current Basel I capital standard when the new Accord is implemented. For these thousands of banks, the shortfalls of the current rules, as noted, are not sufficiently large to warrant a mandatory shift to the Basel II regime. However, any of these institutions will have the option to adopt the A-IRB requirement, as we expect some large entities to do at the outset. If they seek to do so, however, they will have to meet the same high standards of internal infrastructure and controls that will be required of the core group. The Federal Reserve Board believes that the A-IRB approach of Basel II will address the material defects of Basel I for these entities. By requiring strong internal standards as an entry criterion, the Basel II approach will ensure that these banks adopt structured, formal, empirically based methods of managing credit risk, which will lead to significantly improved risk-management capabilities at the very largest banks and other adopters. Capital requirements themselves will become more risk sensitive and less prone to artificial distortions. The poor incentive structure of Basel I will be removed for A-IRB banks. Supervisory practices will also become more consistent with evolving risk-management practices. Risk-based capital ratios will become more reliable as an indicator of financial strength. I turn now to another aspect of Basel II: its three pillars. At the outset of the Basel II process, the supervisors on the Basel Committee determined that a robust capital adequacy framework should include three important elements or pillars. Pillar I consists of the minimum capital requirements themselves - that is, the rules by which a bank calculates its capital ratio and by which its supervisor assesses whether it is in compliance with the minimum capital threshold. Pillar II, the supervisory oversight pillar, encompasses the concept that well-managed banks should seek to go beyond simple compliance with minimum standards and perform for themselves a comprehensive assessment of whether they have sufficient capital to support their risks. In addition, supervisors should be in a position to provide constructive feedback to bank management on these internal assessments, or "economic capital", based on their knowledge of industry practices at a range of institutions. Finally, Pillar III seeks to complement these activities with market discipline by requiring banks publicly to disclose key measures related to their risk and capital positions. The concept of these three mutually reinforcing pillars has been key to the Basel II effort. Pillar I: Minimum regulatory capital requirements The minimum capital requirements for credit risk under the A-IRB approach are built around the same concepts that underlie all modern portfolio-based methods for systematically measuring credit risk. The first, and perhaps most important, input to this approach is an estimate of the likelihood or probability that a borrower will default. Second, lenders need a sense of the size of the loss in the event of a default because they are often able to recover something from a defaulted borrower's assets or from collateral or a guarantee. Third, the lender, who often has an undrawn credit line or loan commitment to a borrower, needs to estimate what the amount borrowed is likely to be at the time a default occurs. These key inputs - probability of default (PD), loss given default (LGD), and exposure at default (EAD) - are the building blocks of the A-IRB approach to estimating capital requirements. Many banks are currently working to improve their ability to estimate these quantities, using a wide variety of techniques from expert judgment methodologies to quantitative statistical models. A-IRB permits banks to use any or all of these, requiring only that the procedure for estimating these three key parameters be based on empirical information, that it be rigorous, that it be reproducible by third parties, that the process be subject to strong internal controls, and that the results be shown to measure risk accurately. The supervisor must, in fact, validate the estimation procedures and the controls that support them before a bank can use A-IRB. As part of the validation process, a bank must demonstrate that these risk measures are in fact used in credit-granting decisions, as well as for other management purposes such as reserving and pricing. The intention is for the supervisor and the manager to focus on the same issues. These estimated risk variables are inputs to regulatory formulas that will determine the minimum required capital for a given portfolio of exposures. Just as the methods of determining the inputs can change as the state of the art changes, the formulas that translate the inputs into capital requirements can be modified as well by the regulators. Basel II can improve as knowledge improves. The rules surrounding Pillar I are clearly more complicated than I have just described, and the volume of comment letters and the number of pages that have been and will be published for comment will attest to that. One reason for that complexity is that the large, complex banking organizations, to which the rules are addressed are, in a word, complex. Simple rules just cannot address their issues and the nature of their business. These rules have been adjusted and modified significantly as a result of comments from bankers and other interested parties. Sometimes those comments have led to simpler rules. But, more often, they have led to even more complex rules because each complex bank to which they apply operates somewhat differently from other banks. Thus the rules have been modified to address important and meaningful differences in risk. Simple rules too often become straightjackets; flexibility requires more complex rules. Pillar II: Supervisory oversight Indeed, because even complex rules cannot adequately capture the risks and desirable procedures for each bank, the A-IRB establishes with Pillar II a mechanism for dialogue on risk and capital between bank managers and bank supervisors. I have already noted that supervisors will verify the process for determining credit-risk measurement, for ensuring ongoing control over the process of determining these risk-measure inputs, and for ensuring that the risk inputs are used for more than calculation of regulatory capital. In addition, Pillar II requires that the bank maintain its own internal assessment of its risk relative to its capital - both currently and over the cycle as well as in periods of stress - and that the supervisor review and respond to that assessment. The focus is on ensuring that the bank has strong risk-assessment capabilities and that the supervisor and the bank jointly assess and evaluate that capability. This kind of dialogue cannot be captured by any set of rules. It will focus on a frank discussion of loss potential and of any unusual capital needs associated with unbundled risks not captured in Pillar I. It addresses the individual bank's special risk profile, its special business strategy - which might, for example, imply geographic or borrower concentrations - or its unique cyclical sensitivities. Such discussion, review, and analysis are focused on the individual bank's possible unique need for a capital buffer - an amount in excess of its Pillar I minimum. Such buffers are designed to minimize the risk that losses and capital erosion could trigger undesired responses under prompt corrective action and the associated reactions that could affect financial and real macroeconomic stability. Pillar II, we should be clear, has some drawbacks. It is inherently less transparent than Pillar I because outsiders will not know which portion of a bank's excess capital is deemed "necessary" to address a particular risk specific to the bank and which portion is truly an "extra" cushion. It is also more difficult although not impossible - for supervisors to require an uncooperative bank to hold Pillar II capital than rule-imposed Pillar I capital. Pillar III: Market disclosure Basel II seeks to minimize the public difficulty of interpreting capital ratios by requiring public disclosure of considerable quantitative and qualitative information, including, in effect, the risk inputs I described earlier. Such disclosures also provide incentives for banks - the disclosers - to adopt better risk-management techniques and to link their capital requirements to their risk profiles. All these results will enable the public to make comparisons among banks more easily. Indeed, the ability to compare will be an important constraint on any supervisor, foreign or U.S., who might not diligently apply the rules to its banks; outliers will appear unusual and, with insufficient explanation, be subject to market discipline. Indeed, a key reason for Pillar III is to seek to harness market discipline to bring pressure on banks to adopt safe and sound practices. Public disclosure increases market discipline in two ways. First, by providing more information, it enables the market to impose differential funding costs and availability on banks, related to the risks they take; additional risk requires additional Pillar I capital, but the disclosure of that risk and the size of the capital buffer also affects the minimum price that counterparties require to provide funding. Second, as noted, it facilitates comparisons across banks. Because outliers will be subject to particularly close review by the market and other national regulators, banks and their regulators will have more difficulty evading their minimum capital requirements. Key issues Not surprisingly with such a significant proposal, some are concerned about certain aspects of Basel II. It might be useful to the subcommittee if, in the remainder of my comments, I focus on a number of issues that have been raised. Before I do, however, I want to reiterate to the subcommittee that the process of developing the Basel II proposals has involved a truly unprecedented dialogue with banks on a wide variety of issues. That dialogue is still going on, especially with regard to technical issues involving retail credit, risk-mitigation techniques, securitization, and other matters, including some that should be called to your attention. Operational risk One of the early decisions by the participants in the Basel II process was to focus more clearly on credit risk in the capital determination process. Doing so required that all the other risks that had been combined with credit risk in Basel I be unbundled. Several years ago, the first necessary step in the unbundling of these risks was taken when the market risk of trading activities was separated for its own treatment. The Basel II effort has focused very carefully on the credit risks that banks take and has sought to ensure that the framework appropriately measures the marginal contribution of such risks to a bank's total risk profile. But this focus implies the need to consider the way to address other important banking risks. Some of these risks are sufficiently modest that they can be addressed through the supervisory process - Pillar II. But one risk, operational risk, has been historically so important in the depletion of capital and the failure of banks that it should be subject to specific Pillar I minimum capital requirements. Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events, and it includes legal and compliance-related risks. These risks and their associated losses are often in the news: rogue traders, fraud and forgery, settlement failures, inappropriate sales practices, poor accounting and lapses of control, troubles in acting as custodians and managing assets, and legal settlements involving significant payments for losses alleged to have been caused by banks. All of these costs have been substantial both here and abroad. Indeed, many banks, in their internal economic calculations, already allocate a significant portion of their capital for operational risk - averaging 17 percent in the subset of large banks we sampled. A couple of banks even make the amount public, and increasingly the market is sensitive to the fact that not all excess regulatory capital is held just as a general buffer, that is, that excess regulatory capital is not necessarily excess economic capital. But the public is unable in most cases to differentiate the excess regulatory capital held for specific purposes from that held for general purposes. This inability is a particular problem under Basel I for those entities with modest credit risk and dominant operating risk. Under Basel I, the regulatory capital is driven solely by credit risk, and therefore the requirement tends to be too low for activities that do not entail much credit risk but do expose the bank to operational risk. The A-IRB banks under Basel II that specialize in such activities - for example, processing securities and payments and acting as custodians - will experience increases in their regulatory capital requirements on those activities. Every day these entities transfer very large amounts of federal funds, act as custodians for massive quantities of securities, and dominate payments and securities transfer systems. Disruptions in their operations can cause, and have caused, serious difficulties in world financial markets. U.S. supervisors will propose that those banks that are required, or that choose, to adopt the A-IRB approach to Basel II will also be required to hold capital for operational risk, using a procedure to develop the size of that charge known as the advanced measurement approach (AMA). Because of earlier comments by U.S. bankers, the amount of required operational risk capital will not be subject to a minimum floor nor will the charge be based on revenue. Rather, under the AMA, A-IRB banks themselves will have the primary responsibility for assessing their own operational risk capital requirement. This requirement will be a Pillar I charge and will be disclosed to market participants under Pillar III. The banks that remain under Basel I will not be subject to an operational risk capital charge in the United States. The advanced measurement approach gives banks the flexibility to develop their own methodology for calculating the operational, or "op", risk capital charge. The supervisor, to be sure, will require that the procedure be comprehensive, systematic, and consistent with certain broad guidelines. These guidelines specify such factors as the necessity for independent risk management, board and senior management oversight, audits, the use of historical internal and external loss data, scenario analysis, and so forth. The supervisor must review and validate each bank's process, but again considerable flexibility exists for individual bank application. The op risk capital charge is expected to reflect banks' own environment and control mechanisms and can be reduced by insurance and other risk mitigants. For example, if a bank invests in improved contingency procedures and approaches, we would expect such an investment to be reflected in a reduction in the need for operational risk capital under the AMA. Several U.S. banks that are developing an op risk capital requirement under the advanced measurement approach have told us that they are very comfortable with the results so far. Importantly, they say that the procedures have allowed them to better identify business activities and practices that pose operational risks and that they have taken steps to minimize the risks. That result is critical to supervisors who believe that the AMA methodology will produce a lasting discipline for banks, encouraging them to think carefully about and minimize the risks associated with their business activities. Supervisors expect the advanced measurement approach to provide the incentives to invest in new systems and practices that will reduce the potential for serious losses from operational risk. Operational risk and the AMA are issues that I call to the subcommittee's attention because I am aware of a very few banks that aggressively oppose this aspect of Basel II. Accordingly, I have held a number of discussions with bankers on this subject over the last year, including many direct conversations with the senior bankers who have expressed the most concern about the issue. As I indicated earlier, I believe this sort of dialogue has been essential to the appropriate development of the Basel II framework and is something that we will continue to emphasize. But as a bank supervisor and as a central banker, I have to say that we have not found the arguments of the operational risk skeptics to be convincing. The skeptics argue that the cost of developing and using the advanced measurement approach and the associated capital charges divert resources away from actual investment in risk-reducing systems and better backup systems. As I will discuss more fully, Basel II, without doubt, is costly; but the final judgment for any expenditure must rest on the balance between costs and benefits. We and, as noted, many banks believe that the AMA is critical for the kind of formal analysis that focuses banks' attentions on the operational risks they face. We are also convinced that the explicit Pillar I capital charge creates incentives for them to reduce these risks while ensuring that minimum capital is allocated to absorb the remaining risk. Critics also argue that an explicit Pillar I capital charge would upset the competitive balance with nonbank and foreign bank competitors. Foreign regulators, it is argued, will be less aggressive in their rule enforcement than U.S. regulators. As I earlier suggested, Pillar III - disclosure - will highlight any significant differences across banks, in the expectation that counterparties will penalize inconsistent risk measures. In addition, the Basel Supervisors Committee has set up an implementation group of senior supervisors to coordinate the application of the rules across countries. As for nonbanks, the argument ignores the significant edge banks will continue to have from access to the discount window and the Federal Reserve's payments system. This competitive edge attracts customers and lowers funding costs relative to nonbanks. In addition, most of the banks that have expressed concern about the operational risk capital charge are already carrying large excess regulatory capital positions, supplementing their quite small current regulatory capital. Indeed, we do not believe that these entities would have to raise any new capital to meet the proposed op risk charges, but rather would simply shift excess to required capital. "Excess" regulatory capital may be reduced for some banks under Basel II, but we believe that such reductions because of op risk are perfectly consistent with making capital requirements both more risk sensitive and more transparent, not to mention more accurate. The effort not to raise regulatory capital requirements is underlined by the critics' preference that op risk capital needs be addressed in Pillar II - that is, it should be part of the undisclosed capital buffer developed as part of the supervisory oversight of banks on a case-by-case basis. We again disagree. Excess regulatory capital would appear larger than it should, and the transparency of the proposed procedure would be lost. Inevitably, such an approach would treat banks with similar risks differently. Supervisors would also have less leverage over a bank's capital allocation for op risk and third parties would have more difficulty comparing capital among banks than they would under a Pillar I rule. In short, we have not been convinced by the arguments we have heard, and we still believe that op risk is every bit as real a risk as credit risk and should be treated in the same way - with an explicit Pillar I capital charge. Commercial real estate Some banks - mostly those that would not be subject to the A-IRB capital requirements unless they chose to become so - oppose the higher capital charges that A-IRB banks would generally face on their commercial real estate loans. These banks argue that bank lenders have learned from the losses of the 1980s and early 1990s and now do much better underwriting by insisting on more borrower equity and better appraisal procedures for commercial real estate. These improvements, critics argue, have reduced default rates and losses and, if anything, argue for lower, not higher, capital requirements or at least the same capital charge that is applied to business loans under A-IRB. Setting aside that the system has not been tested by a true real estate cycle since the early1990s, the supervisors agree that commercial real estate underwriting has significantly improved. These improvements have been incorporated into the empirical analysis that our staff has used in developing the Basel II proposals. In the view of the Federal Reserve, however, capital requirements should be based on more than just the chance that an individual loan will default: They should also be based on the tendency of defaults to occur at the same time, in "clumps" - what economists refer to as high asset correlation. Defaults and losses occurring in clumps require higher capital than such losses spread out over time. According to our analysis, this clumping tendency is much stronger for commercial real estate credits than for business loans. Moreover, though improvements in underwriting have made individual loans safer, the asset correlations among such loans in a given portfolio - the "clumping" tendency - has not changed as a result of improved underwriting. The staff of the Federal Reserve has discussed this issue with bankers and has shown them an analysis - based on several data sets and using different methodologies - requesting their evidence of any errors or new data sets that challenge the staff's conclusion. The Federal Reserve is in the process of making this analysis widely available and is again asking for critical evaluation and any contradictory information. We are, in short, willing to listen. If banks can provide evidence that this proposal embodies erroneous assumptions or is otherwise analytically faulty, we will change it. Cost. Implementing A-IRB in this country is going to be expensive for the small number of banks for which it will be required, for those banks choosing it, and for the supervisors. For the banks, the greatest expense is in establishing the mechanisms necessary for a bank to evaluate and control their risk exposures more formally. Nonetheless, such costs are modest relative to the size of recent charge-offs. The A-IRB approach will not eliminate losses: Banks are in the business of taking risk and where there are risks, there will be losses. But we believe that the better risk-management that is required for the A-IRB will reduce losses and provide benefits to bank stakeholders and the economy. The cost-benefit ratio looks right. Furthermore, attributing all the costs associated with adopting modern, formal risk-management systems to Basel II is a logical fallacy. The large banks required to adopt A-IRB - banks that must compete for funding in a global marketplace - would ultimately have to undertake such measures with or without Basel II. Basel II may well speed up the adoption process, but many of the costs attributed to Basel II actually just reflect the costs of doing business in an increasingly complex financial environment. Competitive equity Some regional banks have told us that they are concerned that regional, and perhaps smaller, banks will be competitively disadvantaged by Basel II, even if they are not required to adopt A-IRB. Their concern has two parts. First, some regional banks feel that market pressure and the rating agencies will force them to adopt A-IRB and, as a result, to incur significant costs. Our discussions with rating agencies do not support the regional banks' fears. Indeed, our sense is that the rating agencies feel that adoption of A-IRB by regional banks at this time would not be cost effective. In our opinion, any regional bank interested in adopting the A-IRB approach at its inception should carefully assess the costs and benefits of doing so. That said, we expect the art and science and, indeed, the very language, of risk management to migrate toward that used for A-IRB. Over the years ahead, as the new risk-management techniques become more cost effective for them, regional banks, we suspect, will adopt these techniques and, thereafter, probably adopt the A-IRB at the regulatory level. But adopting them now would be premature, and we believe that regional banks will not be pressured to do so by either the rating agencies or the regulators. The second part of the competitive equity concern is the belief by some regional and community banks that they will be placed at a competitive disadvantage with A-IRB banks because of the larger banks' lower regulatory capital charges on residential mortgages, loans to smaller businesses, and certain retail loans. The direct competitive impact on Basel II and Basel I banks is important. Of course, the rulemaking process in the United States will probe the issue fully. However, a number of factors suggest that the concern about competitive impact is not well founded. In terms of overall capital, A-IRB banks will likely face lower capital charges for some types of lending, but they will also face higher charges on other loan categories, such as commercial real estate finance and higher costs of developing the risk-management infrastructure to be an A-IRB bank. They will also be subject to an explicit capital charge for operational risk and the cyclical buffer in Pillar II that will not be imposed on non-IRB banks. In the individual loan markets for which Basel II lowers A-IRB capital charges, we also have reason to believe that competitive balance will not be disrupted. In the business loan market, for example, the smallest banks do not directly compete with the banks that will be required to adopt A-IRB. Small banks' close ties to local communities afford them substantial information advantages over larger banks. As a result, they tend to focus on relationship lending to small businesses and individuals. A-IRB banks, in contrast, tend to make such retail loans by using automated underwriting tools. Larger regional banks are more likely to compete directly with A-IRB banks, but for two good reasons we believe that Basel II will not affect these banks significantly. First, today not regulatory capital but economic capital - the individual bank's management judgment about internal capital allocations for its own decisionmaking - drives loan pricing and origination decisions. Nothing in Basel II will change for the capital charges implied by economic capital. Moreover, for some years, as I discussed earlier, when there has been a difference between regulatory and economic capital, sophisticated banks have used capital arbitrage techniques to reduce their effective regulatory minimums. Asset securitization deals, in particular, have allowed banks to dramatically reduce the amount of capital they currently hold for residential mortgages and many retail loans. Regulatory capital arbitrage - market reality - thus has already reduced the effective capital charge for the loans for which A-IRB banks will receive lower on-balance capital charges. Basel II increases transparency by bringing regulatory minimums more in line with reality, but it will not change the status quo competitive environment very much, if at all. In short, Basel II will bring A-IRB banks' regulatory capital charges more in line with the capital charges they have, through arbitrage, already obtained. The second reason minimum regulatory capital requirements are unlikely to significantly affect competitive behavior is that most well managed banks carry sizable excess capital buffers. Smaller banks in particular, operating with less leverage than larger banks, hold substantial excess regulatory capital, which reflects their lack of diversification and more limited access to funding. Basel II will not change that fact. Under Basel II, small banks will continue to hold more capital than A-IRB banks, but A-IRB banks' true risk-based capital positions will be measured more accurately. Conclusion The Basel II effort reflects the collective judgment of the supervisors of the world's largest and most complex banking organizations, including those of the United States, that the activities and practices of such firms have been outgrowing our existing supervisory approaches. At the same time, the role of these banks in our financial systems continues to grow. In my judgment, we have no alternative but to adopt, as soon as practical, approaches that are appropriately suited to the task of bank supervision of our larger banks in the twenty-first century. The Basel II framework is the product of extensive multiyear dialogues with the banking industry regarding state-of-the-art risk-management practices in every significant area of banking activity. Accordingly, it provides a roadmap for the improved regulation and supervision of global banking. Basel II will provide strong incentives for banks to continue improving their internal risk-management capabilities as well as the tools for supervisors to focus on emerging problems and issues more rapidly than ever before. I am pleased to appear before you today to report on this effort as it nears completion. Open discussion of complex issues has been at the heart of the Basel II development process from the outset and no doubt will continue to characterize it as Basel II evolves further.
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board of governors of the federal reserve system
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Speech by Ms Susan S Bies, Member of the Board of Governors of the US Federal Reserve System, at a joint presentation to the National Economics Club and the Committee on the Status of Women in the Economics Profession of the American Economic Association, Washington, D.C., 27 February 2003.
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Susan S Bies: Retirement savings, equity ownership, and challenges to investors Speech by Ms Susan S Bies, Member of the Board of Governors of the US Federal Reserve System, at a joint presentation to the National Economics Club and the Committee on the Status of Women in the Economics Profession of the American Economic Association, Washington, D.C., 27 February 2003. * * * Good afternoon. I am delighted to be here to speak about some of the new challenges and opportunities that American families face from changes in retirement savings and equity ownership in the United States. I know that many of your members are economists who work in policy advisory roles in government. As an economist who enjoys getting back to her Ph.D. roots, I want to also address how traditional economic theory about consumer behavior and corporate governance are, at times, in apparent conflict with the practices that we observe. This in turn raises issues about the appropriate economic and policy frameworks for decisionmaking. There has been a dramatic shift in employer-sponsored retirement plans over the past two decades - a shift from plans in which pension managers controlled most investments and retirees received preset benefits to plans in which workers directly control their investment portfolios and keep their investment returns. Many American families have responded by purchasing corporate equity - frequently through investments in mutual funds or other institutional accounts. With increasing control over their pensions, and broader participation in equity markets, Americans have far more options for financial planning than they did twenty years ago. But with the new opportunities come risks and responsibilities. Households with more control of their resources for retirement have a greater need to employ sound financial planning. Moreover, though many might be unaware of it, stock-owning households share responsibility for oversight and governance of the corporations they own. The headlines of the past couple of years have highlighted the importance of these risks and responsibilities. We have all witnessed a precipitous fall in stock prices and some spectacular corporate failures and have read accounts of retirement savings accrued over long careers only to be lost in a matter of weeks. Some of those corporate meltdowns were accompanied by the revelation of shoddy auditing practices and stock analyses tainted by conflicts of interest. And those who should have been ensuring sound corporate governance were often unwilling or unable to protect the interests of shareholders. Recent developments suggest that households may, in coming years, take on even more responsibility for their retirement saving and assume additional responsibilities for corporate governance. The President's recently released budget for 2004 would considerably expand taxpreferred savings accounts for American families. And newly adopted Securities and Exchange Commission rules that give investors unprecedented access to proxy-voting records of mutual funds will enable and encourage investors to take more active roles in corporate governance. With this backdrop, I would like to start by discussing some of the challenges confronting families, employers, and policymakers as workers assume greater control of their retirement planning. Later, I will turn to some issues related to individual investors' roles in corporate governance. Retirement savings The American pension landscape has changed dramatically in the past twenty years. Mostly gone are the days when companies addressed their workers' retirement needs solely by paying fixed pensions from retirement until death. Today's workers are much more likely to manage their own retirement resources by participating in employee-directed savings accounts. This trend has greatly expanded workers' responsibilities for their retirement planning. But it has also raised significant new questions about how effectively employees are handling their new freedoms and responsibilities, and what the appropriate role for employers should be in helping their workers plan for retirement. What lies behind the two-decade trend toward worker-directed savings accounts? Companies like them because they relieve the firm of the burden of managing a pension fund to finance promised benefits. One need only scan a few recent headlines to be reminded of the difficulties that underfunded pension plans can impose on corporate balance sheets. With a savings-account plan, in contrast, companies need only set up the accounts and let their employees manage the investments. And workers also like savings account plans, because they provide more choices and because they are portable - that is, they can travel with the employee from job to job. A particularly popular type of savings plan is the 401(k), which lets workers make pre-tax contributions to retirement accounts through payroll deduction. Twenty-five years ago 401(k) plans did not exist. Today they cover more than 40 million workers, take in $150 billion in annual contributions, and hold assets worth more than $2 trillion. This is a significant development, because along with the greater flexibility of a 401(k) plan comes greater responsibility on the part of individuals to direct their own retirement saving. Workers must decide whether to participate in the plan, how much to contribute every pay period, where to invest contributions, when to rebalance their asset mix, and what to do with balances when changing jobs. Economic theory provides the basis for making these types of choices, but the problems are complex and the average employee may not have developed the skills to formally evaluate the alternatives. And, in fact, recent research has found some troubling patterns: Many workers do not participate in their employers' retirement plans, contribute a small proportion of their wages, and make questionable investment and distribution choices. Let me just take a minute to cite some telling facts about 401(k) plans. Despite the tax advantages of 401(k) contributions, one-quarter of workers eligible for 401(k) plans do not participate at all, even when their employers would match a portion of their contributions. These workers are effectively turning down a pay raise by leaving compensation on the table. And many who do participate save just a little. In a survey last year, one-quarter of firms reported that their rank-and-file 401(k) participants saved an average of less than 4 percent of pay. How will these plans affect retirement security in the long run? Several studies suggest that many workers are not saving adequately for retirement. In 2001, among households with retirement accounts who were approaching retirement age, one-half had balances of less than $55,000, and one-quarter had balances of less than $13,000. Clearly balances of this size will not be adequate to finance many economic emergencies and will barely supplement social security over the two or three decades that often follows retirement. There are other concerns about the way in which employees manage their 401(k) plans. Some seem to give little attention to the way their contributions are invested. For example, some participants divide assets equally across all available investment options, or simply invest contributions according to plan defaults. And, as was made painfully clear last year, many 401(k) participants seem to invest heavily in employer stock. Overall, about one-quarter of aggregate 401(k) balances are in company stock, but for many employees the share is far higher. Why do workers invest so much in company stock? The question is particularly pressing because workers' financial outcomes are already heavily dependent on the fortunes of their employer. Moreover, employers often require that the matching contributions they make on behalf of their employees be invested in company stock. Thus, when employees invest their own contributions in the company stock, they are ratcheting up an already-risky position. Elementary finance theory suggests they shouldn't do it. Deloitte and Touche, 2002 401(k) Annual Benchmarking Survey. Deloitte and Touche, 2002 401(k) Annual Benchmarking Survey. For a review, see Olivia Mitchell, Brett Hammond, and Anna Rappaport, Forecasting Retirement Needs and Retirement Wealth, University of Pennsylvania Press, 2000. Based on the Federal Reserve Board's 2001 Survey of Consumer Finances. Nellie Liang and Scott Weisbenner, "Investor Behavior and Purchase of Company Stock in 401(k) Plans - The Importance of Plan Design," FEDS Working Paper 2002-36 and NBER Working Paper W9131, 2002. See also Shlomo Benartzi and Richard Thaler, "Naïve Diversification Strategies and Retirement Savings Plans," American Economic Review, vol. 91 (2001), pp. 79-98. Nellie Liang and Scott Weisbenner, "Investor Behavior and Purchase of Company Stock in 401(k) Plans - The Importance of Plan Design." See also Shlomo Benartzi, "Excessive Extrapolation and the Allocation of 401(k) Accounts to Company Stock," Journal of Finance, vol. 56 (2001), pp. 1747-64. Yet many workers believe that their employer's stock is less risky than broad market averages. What explains this apparent disconnect? As someone who held a large fraction of my own 401(k) plan in my company's stock for many years, perhaps I can help answer this question. There is a difference between risk and uncertainty. Employees may feel less uncertain about the prospects of the company for which they work relative to other companies about which they know little. This may make them more comfortable about holding their company's stock - even at the cost of a poorly diversified and highly volatile portfolio. To summarize, experience has shown that while 401(k) plans offer workers unprecedented flexibility in managing their pensions, some workers do not seem to be using them effectively - they contribute too little, make questionable investment choices, or fail to participate at all. In response, some employers have expressed increased interest in employer-provided financial education. But employers' attention to plan design turns out to be just as important. Contrary to predictions of traditional finance theory, the way retirement-plan options are framed to workers affects the choices they make. This is where the new discipline of behavioral finance has begun to offer significant contributions. Some of the most innovative and apparently effective ideas about retirement-plan design owe to the insights of behavioral finance. As compelling evidence that framing matters, researchers have found that so-called "opt-out" plans, or plans that automatically enroll workers, have significantly higher participation rates than plans that require workers to sign up. Not surprisingly, employers have responded by making automatic enrollment more prevalent: A recent survey found that nearly a quarter of large plans either have adopted automatic enrollment or are considering adopting it. But automatic enrollment may not be enough, since automatically enrolled employees often give little attention to the default options of the plan. One study found that half of automatic enrollees had not moved from the defaults even three years after enrollment. This could be a problem because default contribution rates, which are typically 3 percent of pay, are often too low to allow workers to take full advantage of employer matches, let alone to build sufficient assets for retirement. In fact, there is some evidence that the low default rates reduce contributions among workers who would likely have saved more in the absence of the default. Finally, the default investment choice in automatic enrollment plans is typically the least risky, such as a money market or stable value fund. While these investments are especially safe, their expected returns may be too low to achieve long-term retirement security. Subsequent research has highlighted how employers might improve their automatic enrollment plans. For example, they might set higher default contribution rates and greater default exposure to a diversified set of higher-yielding assets. Another possibility is to bring new employees on board with low contribution rates - just as is often done currently - but then to nudge contribution rates up as the workers receive pay raises. Some studies have shown that workers are willing to pre-commit to such a plan, which eventually results in significantly higher rates of savings. But along with these new opportunities for employers come difficult new questions. How high should their employees' savings rates go? In an ideal world, all employees would be making well-informed savings decisions and wouldn't need any encouragement from their employers. But, in reality, a plan's design affects the financial well-being of its participants. And though a default savings rate of 3 percent of pay might seem too low, an employer is not necessarily in a good position to know what the appropriate saving rate should be. A high default rate may be inappropriate, particularly if employees respond by dissaving outside their retirement plan. Vanguard Center for Retirement Research. Vanguard Participant Monitor: Expecting Lower Market Returns in the Near Term, December 2001. Brigitte Madrian and Dennis Shea, "The Power of Suggestion: Inertia in 401(k) Participation and Savings Behavior," NBER Working Paper No. W7682, 2000. Deloitte and Touche, 2002 401(k) Annual Benchmarking Survey. James Choi, David Laibson, Brigitte Madrian, and Andrew Metrick, "For Better or for Worse: Default Effects and 401(k) Savings Behavior," NBER Working Paper No. W8651, 2001. Richard Thaler and Shlomo Benartzi, "Save More Tomorrow: Using Behavioral Economics to Increase Employee Saving," unpublished Manuscript, 2001. Many employers will recoil from making these choices, because they do not want to become too paternalistic. But a significant and inescapable implication of this line of recent research is that employers cannot avoid responsibility in this area, because there is no "neutral" plan design whatever design they choose will affect the retirement security of their employees. To summarize, the past two decades have brought remarkable expansion of the financial options available to ordinary workers, including significant new tools for retirement planning. But this experience has also revealed some important lessons for workers, companies, and policymakers. While many - perhaps most - workers effectively use the new tools to prepare for retirement, some do not. Moreover, participants' choices are often affected by the presentation of the options. Thus, companies offering retirement savings accounts such as 401(k) plans face a delicate balancing act. While they desire to shift the maximum degree of decisionmaking to workers, they must acknowledge that basic plan-design choices will affect the long-term retirement security of their employees. Companies that find the right combination of financial education and plan design will be in the best position to help their employees prepare adequately for retirement. Equity ownership As Americans have stepped up their use of employee-directed savings accounts in the past couple of decades, many have also purchased their first shares of corporate equity - often within their 401(k) plans. More than half of U.S. households now own either stock or stock mutual funds. Moreover, equity ownership reaches further into younger generations and the middle class now than it did in the 1980s. From 1989 to 2001, the fraction of Americans younger than 35 who owned stock more than doubled, as did stock ownership among families with below-median income. This striking increase in equity ownership is, in part, an outgrowth of the move toward worker-directed savings plans, as I've already discussed. More than two-thirds of U.S. stockholders now hold some stock in an employer-sponsored retirement plan. In addition, the heightened popularity of owning stocks probably reflects a broadened understanding of the potential benefits of equity investments and perhaps an increased tolerance for financial risk. Also important, especially for investors of relatively modest means, is that mutual funds in particular have substantially reduced the cost of purchasing a diversified portfolio. Despite the ease with which corporate equities can be traded directly nowadays through on-line brokerage accounts, for example - a recent survey found that two-thirds of stockholders first bought their equity shares through mutual funds. Besides its financial risks and potential rewards, stock ownership imparts important corporate governance responsibilities. In fact, economic theories of firm behavior often stress the competing interests of management and ownership. With an ownership share in a business, every stock investor has a role in providing oversight on how that company is run. The egregious corporate scandals in the headlines last year have highlighted the need for responsible oversight by corporate boards and shareholders alike to check the behavior of management. So, as we look for solutions to corporate governance problems, we should not forget that every individual who owns stock has a role - perhaps a small one, but an important one. Yet the growth in households' equity ownership has come with an ironic twist: While more households own shares of corporations, many of the new stockholders are unable to play a role in corporate governance. Why? Because Americans have largely purchased their shares through pension funds, mutual funds, insurance companies, and other financial institutions. These financial intermediaries, which act as the agents for household investors, have generally not made much, if any, effort to make their governance policies transparent and responsive to the preferences of their investors. Aizcorbe, Ana, Arthur Kennickell, and Kevin Moore, "Recent Changes in U.S. Family Finances: Evidence from the 1998 and 2001 Survey of Consumer Finances," Federal Reserve Bulletin, vol. 89 (January 2003), pp. 1-32, and Federal Reserve Board staff calculations from the Survey of Consumer Finances. See also Investment Company Institute and Securities Industry Association (ICI and SIA), Equity Ownership in America, 2002. Aizcorbe, Kennickell, and Moore, "Recent Changes in U.S. Family Finances: Evidence from the 1998 and 2001 Survey of Consumer Finances." ICI and SIA, Equity Ownership in America. ICI and SIA, Equity Ownership in America. So, as Americans have been purchasing most of their stock indirectly through institutional investors, the responsibilities for active monitoring of corporate management and governance mechanisms have been shifting to institutions. There's good news, bad news, and some promising news to report about this trend. The good news is that we may have reason to expect that institutional shareholders would be especially active in working for good corporate governance. An institutional investor holding a large block of stock naturally reaps more of the rewards of good corporate governance than an individual holding a small number of shares, and the big institutional investor undoubtedly has more leverage with management. In addition, as individuals buy their stock through institutions, the task of forming shareholder coalitions to effect good governance ought to become that much easier. The bad news is that, with some notable exceptions, institutional investors historically appear to have been fairly passive shareholders and have tended to shy away from challenging management directly and from initiating reform-oriented proxy proposals. Also some institutional investors may face conflicts of interest in providing active governance if they also compete to sell financial services - like pension-plan administration - to the firms whose shares they hold. To be sure, the evidence on institutional shareholder activism and conflicts of interest is limited, because few institutional investors provide any information about how they vote the shares in their portfolios. So, individual investors interested in corporate governance are unlikely to be able to ascertain anything about how an institutional investor has voted shares on their behalf. Although some institutional investors may have been active in behind-the-scenes attempts to promote good management decisions, few details about these efforts are made available to the public, which ultimately bears the risk of stock ownership. And the promising news? Just last month, the SEC approved new rules that will require investment advisers and mutual funds to disclose their proxy voting policies and specific proxy votes. For most investors in mutual funds, the new rule will provide unprecedented information about how votes are being cast on their behalf. In fact, some have criticized the new disclosure rules for imposing too great a burden on mutual funds and for providing too much information to be useful to most investors. But that criticism misses the point. Disclosure of proxy voting records will likely initiate new efforts to educate individual investors on corporate governance issues. Disclosures about proxy voting are especially important for index funds. Actively managed funds can signal dissatisfaction with corporate officers by selling shares, but index funds, which passively hold a basket of representative companies, cannot. Soon, by monitoring the proxy-votes of index-fund managers, investors will be able to gauge their fund managers' satisfaction with corporate officers. By the time the first proxy-voting reports are required to become public in 2004, I expect that the initial steps toward corporate governance education will already have been taken. Individual investors looking for guidance on the way mutual funds vote their proxies will be able to turn to a slate of organizations that monitor and analyze mutual funds' voting records. I look forward to learning how my mutual funds have voted their proxies and to comparing their voting records with those of other funds. As other investors do the same, the new disclosures will likely have the additional side benefit of directing new attention to corporate governance. Conclusion Some of last year's most striking developments - tumbling stock prices, evaporating retirement accounts, and improper corporate oversight - highlighted the importance of longer-term trends in pension plans and equity ownership. As more workers have managed their own retirement accounts and more become stockholders through pension plans and mutual funds, more have learned about both the rewards and the risks of investing in capital markets. With individuals' increasing exposure to market fluctuations and greater participation in equity markets come both new opportunities and new responsibilities, for both workers and employers. Today I've discussed some of the issues that have come to light as a result of long-term trends in pension plans and equity ownership. And I'd like to leave you on an optimistic note with this observation: The issues I discussed today are only possible because of the remarkable breadth and depth of capital markets in the United States. I am confident that over the long haul, the concerns I noted will simply represent the ordinary climb along the investment-learning curve as a broader segment of American households work to achieve their financial goals.
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board of governors of the federal reserve system
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the annual convention of the Independent Community Bankers of America, Orlando, Florida, (via satellite), 4 March 2003.
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Alan Greenspan: Home mortgage market Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the annual convention of the Independent Community Bankers of America, Orlando, Florida, (via satellite), 4 March 2003. * * * Last year was surely one of the most memorable years ever experienced by the home mortgage market. Owing largely to the lowest mortgage interest rates in more than three decades and rising home prices, close to 10 million of regular home mortgages were refinanced. I use the term regular mortgage to exclude both home equity and construction loans. The outsized dollar volume of these refinancings - by our estimates, $1-3/4 trillion net of cash-outs - was an all-time record and represented almost one-third of the value of all regular home mortgages outstanding at the beginning of last year. Total regular mortgage originations, at $2-1/2 trillion, also proceeded at a record pace. As part of 2002's process of refinancing, households “cashed out” almost $200 billion of accumulated home equity, net of fees, taxes, points, and commissions. That represented almost 3 percent of estimated total home equity at the beginning of the year, up slightly from the 2001 share. In no year prior to 2001, as best we can judge, did cash-outs exceed 1-3/4 percent of total home equity. Of last year's cash-outs, approximately $70 billion was apparently applied to repayment of home-equity loans, and a significant part was employed to reduce higher-cost credit card debt, judging from the slowed pace of growth in installment debt outstanding. Previous Federal Reserve surveys of the disposition of cash-outs indicate that a substantial amount perhaps half - was used to finance home modernization and personal consumption expenditures, outlays that directly affect GDP and jobs, and that likely was the case again last year. Low mortgage rates doubtless motivated much of this spending, but the ready availability of home equity for extraction appears to have also played a substantial and independent role in prompting additional household expenditures. Even as recently as the late 1980s, a family that wanted to use housing wealth to finance consumption would have faced an expensive and time-consuming process. Although substantial home equity wealth has existed for many years, only in the last decade or so has secured borrowing against home equity become a cost-effective source of credit in a wide variety of circumstances. An even greater support to the economy than cash-outs last year was the extraction of home equity associated with a record 6.4 million existing home sales, including condos, at record prices. This pace of ownership turnover of the existing housing stock also reflected the near-record-low mortgage rates. We estimate that mortgage originations for existing home purchase last year topped $600 billion. Subtracting the home sellers' repayments of the remaining debt of their outstanding mortgages, we infer a net increase of approximately $350 billion in debt on the homes that turned over last year. That debt increase exactly matches the extraction of previously built-up equity on those homes plus fees and taxes folded into the loans. Not surprisingly, the change in mortgage debt is highly correlated with the realized capital gains on the turnover of those homes. We do not have a direct measure of how the equity extracted from last year's home turnover was expended. It is likely, however, that home sellers, after setting aside a down payment for the family's next home, expended a considerable part of their home equity extraction on goods and services. In addition to the extraction of equity financed by regular mortgages last year, approximately $130 billion was drawn through a net increase of home equity loans, also a record, and also presumed to be the consequence of low mortgage rates as well as accelerated appreciation of homes. Federal Reserve studies of the disposition of home equity loans suggest a slightly higher rate of repayment of credit card and other consumer nonmortgage debt than our cash-out disposition surveys concluded. All in all, the amount of previously built-up equity extracted from owner-occupied homes last year, net of fees and taxes, totaled $700 billion by our calculations, or more than 10 percent of estimated equity at the beginning of the year. Home equity extraction for the economy as a whole is, of necessity, financed by debt. In fact, the $700 billion of equity extraction is similar to the increase in mortgage debt last year. Despite the exceptionally large extraction of equity, the total remaining equity at the end of 2002 was higher in dollar terms than at the beginning of the year, owing to a 7 percent increase in existing home prices over the four quarters of last year and $300 billion in new home construction, net of mortgage extensions on those homes. Mortgage debt as a percent of the market value of homes accordingly rose somewhat more than 1 percentage point during the year. Mortgage debt service costs as a percent of the disposable income of homeowners last year were little changed from 2001. The estimated 10 percent of homeowners' disposable income allocated to mortgage debt service in the third quarter of last year was well below the highs in 1991, though the ratio of homeowners' mortgage debt to their disposable income rose to a record high. Refinance and home purchase originations, seasonally adjusted, peaked in the fourth quarter of last year. It is difficult to imagine that pace being maintained in the current quarter. Seasonally adjusted applications for refinancings, as reported by the Mortgage Bankers Association, are off their peaks but still impressively high. So are home purchase mortgage applications. This suggests a somewhat less robust market for mortgage originations this quarter. With home price increases now subsiding, and mortgage interest rates no longer declining at last year's impressive pace, some slowdown in the rate of mortgage debt expansion is to be expected. That is likely to be the case for equity extraction from home turnover as well. As I noted earlier, that extraction appears to parallel the realized capital gains on home sales, which mainly reflect the number of existing home sales. Home price change, of course, is also a factor, but it is the average change over the length of occupancy - nearly ten years for the typical homeowner - that matters, not recent price trends. Similarly, refinancing and the cash-outs associated with them accelerated last year as the decline in mortgage interest rates on new loans far exceeded the modest decline in the average rate on all outstanding regular home mortgages. This wider spread between the current mortgage rate and the rate on outstanding loans, as you all know, markedly increased the incentive to refinance. So any stabilizing of rates on new mortgages would narrow the spread as portfolio rates continue to decline as a consequence of continued refinancing at interest rates still below the portfolio average. A narrowed spread would likely reduce cash-outs, lessening the level of equity extractions from this source. We do not have estimates of total home equity loans beyond the end of last year, but lines of credit at commercial banks - approximately a fourth of total home equity loans - rose during the first 7 weeks of 2003, considerably more than the typical seasonal change. In summary, the frenetic pace of home equity extraction last year is likely to appreciably simmer down in 2003, possibly notably lessening support to household purchases of goods and services. *** The very large flows of mortgage funds over the past two years have been described by some analysts as possibly symptomatic of an emerging housing bubble, not unlike the stock market bubble whose bursting wreaked considerable distress in recent years. Existing home prices (as measured by the repeat-sales index) rose by 7 percent during 2002, and by a third during the past four years. Such a pace cannot reasonably be expected to be maintained. And recently, price increases have clearly slowed. It is, of course, possible for home prices to fall as they did in a couple of quarters in 1990. But any analogy to stock market pricing behavior and bubbles is a rather large stretch. First, to sell a home, one almost invariably must move out and in the process confront substantial transaction costs in the form of brokerage fees and taxes. These transaction costs greatly discourage the type of buying and selling frenzy that often characterizes bubbles in financial markets. Second, there is no national housing market in the United States. Local conditions dominate, even though mortgage interest rates are similar throughout the country. Home prices in Portland, Maine, do not arbitrage those in Portland, Oregon. Thus, any bubbles that might emerge would tend to be local, not national, in scope. Third, there is little indication of a supply overhang in newly constructed homes. The level of overall new home construction, including manufactured homes, appears to be well supported by steady household formation and not dependent on high and variable replacement needs or second-home demand. Census Bureau data suggest that one-third to one-half of new household formations in recent years result directly from immigration. In evaluating the possible prevalence of housing price bubbles, it is important to keep in mind that home prices tend to consistently rise relative to the general price level in this country. In fact, over the past half century, the annual pace of home price increases has been approximately 1 percentage point faster on average than the rise in the GDP deflator. This higher home-price inflation rate results from persistently slower productivity growth in new home construction than in the economy overall. This lag in productivity growth drives up new home prices relative to the general price level and, by arbitrage, it drives up the prices of existing homes as well. In addition, local building and land use restrictions continue to constrain the supply of buildable land in many areas, whose price increases also tend to outstrip the rate of inflation. Clearly, after their very substantial run-up in recent years, home prices could recede. A sharp decline, the consequences of a bursting bubble, however, seems most unlikely. Nonetheless, even modestly declining home prices would reduce the level of unrealized capital gains and presumably dampen the pace of home equity extraction. Home mortgage cash-outs and home equity loan expansion would likely decline in the face of declining home prices. However, the five-year old home building and mortgage finance boom is less likely to be defused by declining home prices than by rising mortgage interest rates. Should rates rise, it is entirely possible that new and existing home sales would decline, leading to a lower level of realized capital gains on homes, a further narrowed refinance spread and, as a consequence, less overall home equity extraction. It is worth bearing in mind, however, that any sustained increase in rates presumably would occur only in the context of a more vigorous upturn in the pace of business activity, suggesting that the net effect on housing activity might be relatively limited. *** Most of the aforementioned data are new and derive from a much broader home mortgage data system in the early stages of development by the Federal Reserve Board. As a consequence, all specific numbers I have cited this morning are preliminary and subject to revision. The evident increasing importance of tracking these very large flows of housing-related credits that have become so prominent in the past decade or two has led the Federal Reserve Board into a major statistical program to fill a notable gap in currently available data. The Board has for years estimated outstanding home mortgage debt and published these estimates in our Flow of Funds accounts. We publish quarterly estimates of the stock of one- to four-family home mortgage debt as compiled from the vast majority of institutions that originate or hold home mortgage loans. These quarterly estimates of the levels of mortgage debt, however, do not allow us to monitor important flows such as refinancings, cash outs, and repayments. That shortfall needed to be remedied. The availability of considerable detail on the vast majority of originations required by the Home Mortgage Disclosure Act (HMDA) was a catalyst of this new project. Our latest tabulation of HMDA data, for the year 2001, provided detailed characteristics on almost 13 million mortgages with dates of application and origination. This unique body of data enables us to create weekly, monthly, and quarterly data on applications and originations of regular mortgages. These data are available for home purchase and refinance mortgages as well as for originators' purchase and sale of regular mortgages. Incidentally, the proportion of refinance to home purchase mortgages appears consistently higher in the data reported to us than in the data published elsewhere. Independently, we have constructed a set of quarterly gross mortgage flows consistent with our series on mortgage debt outstanding. These calculations suggest significantly higher estimates of mortgage originations, but otherwise closely parallel the HMDA published originations. We are working on a system to adjust the HMDA internal detail to the wider coverage of originations consistent with our published outstanding mortgage debt on one- to four-family homes. *** Home equity extraction directly finances household purchases of goods and services by liquefying previously illiquid assets. It also indirectly finances such purchases by facilitating outlays financed by Estimates of construction loans are excluded. credit card and other nonmortgage consumer debt. Equity extraction has been a major source of repayment of such debt. Borrowing against home equity has been a staple of household finance for decades, but as I noted earlier, it has been only in the past decade or so that such practices have been encouraged by lenders. We need to far better understand the economics of this major addition to household finance and its impact on the economy. One hopes, new data will form the basis of better insights. There can be little doubt that the availability of a ready source of home equity has reduced the costs and uncertainties associated with income volatility, retirement, unexpected medical bills and a host of other life events that can unexpectedly draw down savings. Home equity extraction may be the household sector's realization of the benefit of a rapidly evolving financial intermediation system.
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board of governors of the federal reserve system
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Speech by Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve System, at the Conference on Finance and Macroeconomics sponsored by the Federal Reserve Bank of San Francisco and Stanford Institute for Economic Policy Research, San Francisco, 28 February 2003.
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Donald L Kohn: The strength in consumer durables and housing: policy stabilization or problem in the making? Speech by Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve System, at the Conference on Finance and Macroeconomics sponsored by the Federal Reserve Bank of San Francisco and Stanford Institute for Economic Policy Research, San Francisco, 28 February 2003. * * * We have spent the day examining the intersection of finance and macroeconomics from a theoretical and longer-run empirical perspective. I thought it might be interesting as after-dinner entertainment to bring the topic to the here and now - to the current economic and monetary policy situation. In particular, a number of commentators have raised the specter that imbalances are being created in the markets for consumer durable goods and houses - unsustainably high prices or activity - that will produce macroeconomic strains when, inevitably, they correct. These concerns obviously echo those expressed by some observers that monetary policy allowed run-ups in equity prices and capital spending in the 1990s that ultimately proved to be destabilizing. In that context, I thought it might be useful to consider the choices and information available to the central bank on this related question now - in real time - without the aid of 20-20 hindsight. I want to emphasize that what follows is focused on the question of imbalances in houses and durables and is not intended to be a comprehensive discussion of the outlook for the U.S. economy, which will depend on a wide array of influences I am not addressing. I should note the views on this question are my own and do not necessarily represent those of my colleagues on the Federal Open Market Committee. Monetary Policy Backdrop The basic story is straightforward: In response to a series of developments that curtailed aggregate demand in the United States, the Federal Reserve has eased policy aggressively, cutting the federal funds rate 5-1/4 percentage points in two years, bringing the real federal funds rate to below zero. The most important contributors to economic weakness have been sharp contractions in investment spending and equity prices as businesses and investors re-evaluated the profitability of capital spending and the productive capacity built up in the late 1990s. The lower interest rates boosted investment in housing and consumer durables, helping to offset the drag of the decline in business investment and the damping effects of the drop in household wealth on consumer spending. These policy actions have kept the economy from softening even further and inflation from dropping by more from already low levels. To a considerable extent, monetary policy easing is working no differently today than in the past: It stimulates interest-sensitive spending. But there are many forces at work in this cycle that have required interest rates working through their effects on household spending to shoulder an unusually heavy burden to support growth. Unlike most other cycles in recent U.S. economic experience, the weakness was initiated by a cutback in investment spending. This contrast is illustrated in chart1 which shows spending relative to GDP for a number of components of investment. While business fixed investment, shown in the upper panel, typically drops more than GDP when the economy weakens, the recent episode is remarkable in a couple of ways. First, the drop in the high-tech share, the red line, is unprecedented. Second, the drop in the share for non-high-tech equipment, the black line, has been unusually steep, exceeded only in the 1979-82 episode, when the contraction in output was far deeper. Another unusual aspect of the current cycle is that equity prices and wealth continued to move lower long after interest rates started falling and kept declining well after the economy seemed to have bottomed out. This pattern appears to have occurred because the re-evaluation of corporate profitability has persisted for some time; because of last summer's revelations of corporate misdeeds; and because the recent increase in perceptions of geopolitical risk. These same concerns have continued to raise risk spreads in credit markets, damping the passthrough of lower policy interest John Roberts of the Board's staff contributed to the preparation of these remarks. rates to the cost of business credit. With uncertainty high and financial markets skittish, firms have remained hesitant to commit their cash and investment has been very slow to turn around. In addition, economic weakness and sharp declines in equity prices have been widespread globally, and, until recently, these developments have helped keep the dollar strong despite the reduction in interest rates. Sluggish growth in the economies of our trading partners and the relatively high dollar have held down net exports, blunting another potential channel for monetary policy easing to bolster spending. In the late 1990s, the rise in the dollar reflected global perceptions of expanding investment opportunities in the United States and the resulting current account deficit provided a safety valve through which strong domestic demand was met in part by higher foreign production. But even though we do not need that safety valve anymore, the current account deficit has continued to increase of late, requiring easier monetary policy to keep domestic demand elevated relative to domestic income. In the lower panel, chart 1 also gives some sense of the extent to which household investment has been carrying the economy. Economic contractions have frequently been led by weakness in the household sector, which often has responded to higher interest rates as the Federal Reserve acts to reverse inflation pressures. This pattern can be seen in the chart, where the spending shares of housing and consumer durables typically drop sharply before and during recessions. In this episode, however, these shares have continued to move slightly higher, despite a pronounced drop in wealth and a weak economy. Thus, household investment has stayed unusually strong throughout the recession and early in the recovery, buoyed, no doubt, by low interest rates. Going Forward: The Benign Scenario As a consequence, it is to be expected that stocks of interest-sensitive investment goods - in the present circumstances, especially cars and houses - are greater than they would otherwise be. And with demand for housing strong, it is perhaps not surprising that house prices are probably higher than they otherwise would be. But judging from the steep upward slope of the yield curve, few see interest rates as holding at current levels indefinitely. When, at some point, interest rates rise to more typical levels, desired stocks of these goods likely would fall, holding other factors equal, restraining this interest-sensitive spending. But it is important to remember that such an increase in interest rates would not occur in a vacuum; it would occur because the economy looked to be growing more vigorously. Most economists expect that a more pronounced step-up in the pace of activity will be brought about by a recovery in business investment from its current subdued levels. In that case, the need for high levels of spending on housing will be reduced. And higher interest rates will be instrumental in bringing about the adjustment in housing expenditures required to keep economic activity from overshooting its potential. In principle, a housing or durables boom induced by monetary policy need not entail a bust that would be painful to the economy. Of course, it is not likely to occur as smoothly as that. Among other things, markets could get it wrong for example, they could anticipate greater strength in underlying demand than is actually occurring. Then, higher interest rates would tend to damp spending unduly. But there is an “automatic stabilizer” aspect to the interaction of financial markets and the economy. As investors realized their error, rates would fall back. And markets would likely get a nudge from the Federal Reserve: We would set rates lower than the markets have built in, and in our various statements we would attempt to make clear our assessment of economic prospects. Interest rates could then stay low for an extended period, the desired stock of housing would remain elevated, and housing investment would remain high as well. But that would be just what is required. Alternatively, business investment could snap back faster than expected. In that case, interest rates would rise more rapidly as the extent of the strength of demand became clear - with, undoubtedly, some help from the Federal Reserve - weakening household investment more sharply as would be required. With production currently well below potential and inflation and inflation expectations low, it is doubtful that the temporary misalignment of rates would result in the development of any perceptible inflation pressures before the Federal Reserve would have time to take countervailing steps. Costs and Risks to the Benign Scenario So far I have painted a rather sanguine picture of the longer-term consequences of a monetary-policy-induced boom in household investment. While this story has the virtues of plausibility and internal consistency, it does involve some features that bear further thought. First, the benign scenario relies on the transfer of productive resources across sectors - in particular, it involves primarily the inflow of resources into the residential construction sector. Presumably, the transfer of these resources entails some costs - retraining and perhaps relocation of workers, a different mix of capital, and so forth. If residential construction were eventually to shrink as interest rates rose, further costs would be incurred as those resources shifted yet again to different uses. Another possibility is that the reality of the housing and consumer durables booms may not work out as neatly as the benign scenario would suggest. Indeed, some have drawn the comparison with the high-tech investment boom that peaked in 2000. As events have unfolded, it appears that firms concluded that the investment they undertook in those years was not justified; the subsequent drop in investment suggests that, in hindsight, firms concluded that they had “overinvested” in high-tech equipment; and that sharp cutback in investment created a recession. Is it possible, these commentators have asked, that the current boom in housing and durables will leave us with similar regrets in a few years? Furthermore, prices of houses have been rising faster than inflation in recent years, reminiscent of the surge in equity prices through 2000. Some analysts argue that loose monetary policy is feeding a bubble in housing prices that will eventually burst. In short, the question is whether the stimulus to household investment, while cushioning the economic cycle in the near-term, is setting the stage for greater instability in the longer run. Taking these concerns in turn: Reallocation costs. There is little doubt that it is costly to build up a commercial enterprise. Workers must be hired, office space rented, equipment purchased, management expertise redirected. All of these actions entail costs. At the same time, as I already noted, if the yield curve is any indication, interest rates will one day go back up, giving rise to the possibility that some of the current expansion of construction firms will eventually need to be unwound. So relying on the housing sector to offset weakness elsewhere in the economy clearly entails costs. But these costs need to be put against the costs of underutilized resources. Facilitating an increase in residential construction puts resources to use that would otherwise lie idle. Implicit in the conventional story is the assumption that the costs of unemployment are significantly greater than the costs of shifting resources across sectors; if so, the presence of adjustment costs should not seriously impede the desire to offset weakness in spending elsewhere with greater spending on household investment. Alternatively, a judgment that the adjustment costs were large, or the shock to demand temporary, might argue in the direction of a more measured policy response. While it is hard to know for sure how important these adjustment costs may be, it is worth noting that, historically, there has been considerable variation in employment and production in the residential construction sector. Seasonal fluctuations in residential construction are quite large, and in business cycles from the early 1970s to the early 1990s, it was not uncommon for housing starts to drop by more than half. So it appears that this sector of the economy has evolved in such a way that it can expand and contract rapidly. Moreover, in the current episode, the falloff in commercial construction has freed many resources that can readily be put to work building houses for now, then shifted back when business spending picks up. Similarly, even with the strong sales of light motor vehicles and other consumer durables last year, capacity utilization in these industries for the most part has remained at moderate levels, which suggests that the additional production induced by the monetary stimulus has occurred without important and costly new investment in production capacity. Another possibility is that the buildup of debt associated with the strength in household investment will feedback adversely on financial conditions, especially as the boom unwinds. Such consequences could occur even in the absence of a “bubble” in housing prices if households were overextended and lenders had not taken adequate precautions against even a measured drop in collateral values. However, the link between debt burdens and consumer spending are tenuous at best, and when measured on a consistent basis, burdens do not look especially large. Moreover, loan-to-value ratios on mortgages have been about flat, leaving ample cushion for moderate housing price declines, should they occur. These observations suggest that widespread credit difficulties with important macroeconomic effects are unlikely when interest rates rise. For this reason, and to keep the subject manageable, I will not deal with the debt associated with acquiring the houses and durables. The exception was for light trucks, when capacity utilization reached 97 percent in the third quarter of 2002. In sum, it does not seem that the costs of shifting resources across sectors should be a concern now. This is especially true when you consider that these resources would quite possibly otherwise be idle. That is not to say that such costs might not loom larger in other circumstances - say when resources are being temporarily shifted between the tradeable goods and nontradeable service sectors - though policymakers and their critics would still also need to be mindful of the costs of keeping more people unemployed. Excesses. Perhaps the more challenging question is whether excesses and imbalances have built up that could create economic instability in the future when they are unwound. It is not hard to see why the issue arises. Chart 2 shows that real house prices have risen rapidly in the last few years. On a constant quality basis, new house prices still have not breached the peak of the late 1970s, but the prices of existing homes have sky-rocketed. Moreover, as can be seen in chart 3, the stock of consumer durables has risen at an elevated rate in the last few years; while the stock of houses has been growing more moderately, that pace has been maintained for some years. The difficulties of real-time identification of imbalances are hard to overstate. One can never be sure until well after the event whether prices or quantities have indeed deviated from sustainable levels, because the sustainable level is never observable but must be estimated, and those estimates are quite sensitive to the assumptions being made. This point is especially true of asset prices: For example, the literature on both equity prices and exchange rates indicates that it is hard to beat a random walk. A similar point can be made about investment and the capital stock - including the stock of houses and durables. As the recent experience with business capital so graphically illustrates, excesses are only clearly evident after the fact - and the size of the over-investment may be disputable even then. All that said, we can identify a number of factors that should affect what I will call the “sustainable” stock of housing and consumer durable goods - the level that would be desired over time at particular levels of interest rates and other key determinants of demand. Among these determinants are wealth, permanent income, and the user cost of owning the good - in effect its “price.” That price, in turn, depends importantly on the rate of interest. The demand for housing as an asset may also reflect some specific institutional changes. In particular, in recent decades, the rise of home equity lines of credit and the lower costs of mortgage refinancing has meant that housing wealth has become increasingly “liquid,” and as a consequence, may have become more attractive. Chart 4 compares the actual levels of the stocks of housing and consumer durables with their desired levels derived from the Board staff's “FRB/US” model of the U.S. economy, using both current interest rates and their historical averages. Somewhat surprisingly, estimates from this conventional approach suggest that, at current interest rates, the existing stocks of houses and consumer durables are appreciably below the sustainable levels. In this model, low interest rates have a powerful effect on the desired stocks of housing and durables. Even when we estimate sustainable levels based on historical average interest rates, we conclude by this method that current housing and durables stocks are about in line with long-run demand. We need to keep in mind that these are only very rough estimates of unobservable variables. But such as they are, they do not suggest that as interest rates rise we will find that we are left with a vast oversupply of houses and durables. What about house prices? Unfortunately, as I already noted, asset prices are even harder to model than investment. Just as equity prices can be thought of as being the present discounted value of future benefits of equity ownership - in principle, dividends and share repurchases - so house prices can be thought of as being the present discounted value of the future benefits of home-ownership, which, in theory, should be the potential market value of the rent from the house. And, just as the rate of return on equity should fall along with interest rates, so should the rental rate of return on houses. With rents changing very slowly over time, we ought to expect that, other things being equal, lower interest rates would raise house prices. In addition, households may be weighing houses against alternative investments other than bonds. In that regard, the collapse of expectations for gains from holding equity have undoubtedly made real estate relatively more attractive, contributing to price increases and higher activity. On the supply side of the market, the scarcity of desirable land relative to population growth naturally puts upward pressures on prices. In addition, productivity in construction has lagged gains in the This conclusion proved relative robust to alternative models using varying definitions of permanent income and wealth. In all models, the elasticity of the demand for housing relative to user cost was 0.5 and that of consumer durables was 0.9. overall productivity of nonfarm businesses. Consequently, it should not be surprising to see the price of housing rise relative to the prices of other goods and services. The combination of demand and supply factors has caused house price gains to outstrip per capita income gains in recent years. The top of chart 5 shows that the ratio of house prices to per capita disposable income has increased substantially since 1998. But owing to the decline in mortgage rates, this has not made housing less affordable. The bottom of chart 5 shows an index of housing “affordability,” which compares the mortgage payment on a typical home to median household income; high levels of the index mean greater affordability. Although house prices outpaced income through much of the late 1990s, housing remained quite affordable by historical standards. It does not appear that the rise in prices has meant that the market is being supported on an increasingly narrow base, given increases in incomes and declines in interest rates. If interest rates were to rise so that real mortgage rates were equal to their long-term average, the affordability index would drop back, but only to a level that would still leave houses more affordable than they were in the second half of the 1980s. Conclusion: Implications and Policy Choices In sum, the rise in housing prices and the increase in household investment in houses and consumer durables do not appear out of line with what might be expected in the current environment of low interest rates and continuing growth in real disposable incomes. Judging from this analysis, and bearing in mind its inherently tentative - if not speculative - character, it seems likely that as the economy strengthens and interest rates rise in response, household investment and prices are likely to soften some relative to recent trends, but not to break precipitously. Houses and cars would not be providing the impetus to economic activity they often have in past recoveries, but they do not appear set to replicate the experience of fiber-optic cable. We are making inferences from very inexact proxies for desired stocks and sustainable prices. No one could definitively rule out the possibility that home construction and prices could drop sharply. Undoubtedly this will occur in some local markets, and it could become widespread. But the odds would seem to favor a more measured response to the inevitable tightening of policy as the recovery in business investment picks up steam, consistent with keeping the economy on a sustainable growth track rather than becoming another source of macroeconomic instability. And weighing those odds is what policy is all about: Making choices in real time, using incomplete knowledge of future asset market behavior, and weighing potential costs and benefits for economic performance over time from alternative policy strategies. By lowering interest rates aggressively, the Federal Reserve undoubtedly has shifted some forms of economic activity from the future to the present. In effect, we are trying to cushion the effects of decisions by the private sector to postpone business capital spending for now. Adjustment costs aside, and these appear to be minor, it is not clear why we would not want to bring construction spending in from the future, when it is likely that other parts of the economy would not be so weak. It makes sense to build the houses and cars now, when the cost of doing so is relatively low, rather than waiting. And building them now has kept more people employed and reduced the risk of deflation. All in all, from my perspective, with the knowledge and analysis available to me, the policy choices we have made seem consistent with fostering our legislated goals of maximum employment, stable prices, and moderate long-run interest rates, not only in the near term, but most likely over the longer run as well.
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the Bank of France International Symposium on Monetary Policy, Economic Cycle, and Financial Dynamics, Paris, France, (via satellite), 7 March 2003.
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Alan Greenspan: Global finance - is it slowing? Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the Bank of France International Symposium on Monetary Policy, Economic Cycle, and Financial Dynamics, Paris, France, (via satellite), 7 March 2003. * * * For at least the past twenty years, the process of financial globalization has been rapidly advancing. The development of new financial products, notably a wide variety of over-the-counter (OTC) derivatives, and the removal of many barriers to international capital mobility have tightened linkages among global financial markets. As a result, capital has flowed more freely across national borders in search of the highest risk-adjusted rates of return. At some point, globalization undoubtedly will reach maturity. Financial innovation will slow as we approach a world in which financial markets are complete in the sense that all financial risks can be efficiently transferred to those most willing to bear them. Equivalently, as institutional and legal impediments to cross-border flows are eliminated, the bias in the allocation of savings toward local investments will be reduced to its minimum, and the opportunity for arbitrage across national markets will disappear. In my lecture today, I will consider whether there are signs that globalization is nearing maturity. In particular, has the pace of financial innovation begun to slow? Do the patterns of capital flows suggest that global financial markets are approaching full integration? And, most important, what do the answers to these questions imply regarding the potential for future contributions of globalization to economic growth and financial stability? Has the Pace of Financial Innovation Begun to Slow? Although the pace of innovation cannot be measured with precision, important new instruments continue to emerge. Credit derivatives arose only in the early to mid-1990s. Still more recent has been the marriage of derivatives and securitization techniques in the form of synthetic collateralized debt obligations (CDOs). These instruments have broadened the range of investors willing to provide credit protection by pooling and unbundling credit risk through the creation of securities that best fit their preferences for risk and return. The combination of derivatives and securitization techniques is being applied to a growing range of underlying assets. Additionally, the way that OTC derivatives are traded and settled clearly could be significantly improved. Despite, or perhaps because of, the rapid pace of product development, the derivatives industry still executes trades predominantly by telephone and confirms them by fax. Systems for the electronic execution and confirmation of trades require a degree of standardization and a large measure of cooperation that are not required for developing new instruments. Still, the derivatives industry has a long history of cooperating to standardize documentation, and it is disappointing that so little progress has been made in adopting efficient and reliable means of executing and confirming trades. We must also consider how broadly the recent innovations have been adopted. Of course, the growth of OTC derivatives over the past twenty years has been spectacular and shows no obvious signs of abating. The latest estimate by the Bank for International Settlements of the worldwide notional amount of OTC derivatives outstanding reached $128 trillion in June 2002, a figure more than 25 percent larger than that recorded a year earlier. Such derivatives have become indispensable riskmanagement tools for many of the largest corporations. Yet a recent study drawing on U.S. Securities and Exchange Commission filings indicated that, as of year-end 1997, only a little more than half of the 1,000 largest U.S. non-financial corporations used OTC or exchange-traded derivatives. More detailed, comprehensive and timely data are available for American banking organizations. Those data show that although the fifty largest U.S. banking organizations all used derivatives as of September See W. Guay and S.P. Kothari, “How Much Do Firms Hedge with Derivatives?” Journal of Financial Economics, forthcoming. 2002, only 5 percent of all U.S. banking firms used any type of derivative. In the case of OTC credit derivatives, which have proved to be particularly effective in risk management, a mere 0.2 percent of U.S. banking organizations have begun to use such tools. Even among the fifty largest, less than half use these instruments. Thus, judging from the data on the use of derivatives, the potential for financial innovation to have a broader impact and thereby to continue contributing to globalization appears considerable. Evidence of Financial Globalization in Capital Flows Implicit in the criterion for complete globalization that opportunities for cross-border arbitrage disappear is that global savings should flow irrespective of location to investment in projects with the highest risk-adjusted rate of return. A half-century ago, Harry Markowitz showed mathematically that an investor can reduce the variance, and hence the riskiness, of his portfolio for a given expected return by diversifying into assets with imperfectly correlated returns. Subsequent research showed that foreign assets are excellent candidates for diversification. Direct barriers to capital flows, such as restrictions on foreign purchases of domestic assets and limitations on the ability of domestic residents to invest abroad, have promoted home bias, although, as I will discuss shortly, many such direct obstacles in recent decades have been mitigated. Indirect barriers, such as high costs of foreign transactions, inadequate information on foreign investments and cultural and linguistic differences between foreign and domestic investors, are also seen as sustaining home bias. And finally, there are exchange rate and country risks. Wild swings in exchange rates can entirely erase earnings on foreign assets, even as those same assets yield a healthy return in local currencies. Concern over who will bear the exchange-rate risk or, alternatively, who will bear the costs of hedging that risk are an additional factor retarding international investment. Along with foreign exchange risk, political risk helps to drive a wedge between foreign and domestic perceptions of the expected risk-adjusted return to an asset. The consequence of such dual expectations is a lower market clearing price for those assets and a lower level of foreign investment than would exist in the absence of such distortions. Aside from any direct or indirect barriers, people seem to prefer to invest in familiar local businesses even though currency and country risks do not exist. The United States has no barriers to interstate investment, and the states share a common currency, culture, language, and legal system, yet studies have shown that individual investors and even professional money managers have a slight preference for investments in their own communities and states. Trust, so crucial an aspect of investing, is most likely to be fostered by the familiarity of local communities. Researchers have consistently found that, in general, investors direct too much of their savings domestically. Owing to risk aversion, they tend, to their own detriment, to over-discount foreign returns. Such suboptimal allocation of capital lowers living standards everywhere. In their seminal paper twenty years ago, Feldstein and Horioka pointed out that, on net, nations’ savings are generally invested domestically. Their research implies that global savings are inefficiently distributed to investment, meaning that savers are bearing too much risk for the returns they achieve and that countries with high-potential investment projects are getting less financing than Risk-neutral investors, if they exist, will price an asset solely on the basis of its expected return. But at best, very few humans are risk neutral. In general, investors require an asset’s price to be discounted below the risk-neutral price as compensation for bearing risk. The amount of compensation required will vary both with the actual riskiness, or variance, of the asset’s returns and with the investor’s degree of risk aversion. If familiarity reduces an investor’s uncertainty over expected returns to an asset, one would expect that that investor would discount unfamiliar assets more heavily than familiar assets. In such a case, differences between foreign and domestic investors’ familiarity with an investment would lead to under-investment by foreigners relative to domestic investors, leaving an irreducible minimum bias toward investing locally. It is thus total risk, not neutral risk, that is arbitraged. H. Markowitz,”Portfolio Selection,” Journal of Finance, vol. 7, no. 1 (1952), pp. 77-91. See H.G. Grubel, “Internationally Diversified Portfolios,” American Economic Review, vol. 58 (1968), pp. 1299-314; or B.H. Solnik, “Why Not Diversify Internationally Rather than Domestically?” Financial Analyst Journal, vol. 30 (1974), pp. 91-135. M. Feldstein and C. Horioka, “Domestic Savings and International Capital Flows,” Economic Journal, vol. 90 (1980), pp. 314-29. they could productively employ. A clear benefit of financial globalization is that, to the extent that it reduces home bias, savings will be better directed to the most promising investments in the world, increasing global economic growth and prosperity. However, so long as risk aversion exists and trust is enhanced by local familiarity, we cannot expect that home bias will fully dissipate. Nevertheless, is globalization at least reducing home bias toward its minimum level? Survey data collected in the United States suggest a large swing toward foreign investment. U.S. residents began to increase the share of foreign assets in their portfolios from less than 9 percent in the late 1970s to about 15 percent by the mid-1990s. Since then, the trend has leveled off. The increased allocation to foreign assets was broad based, encompassing portfolio flows into debt and equity securities as well as foreign direct investment. A substantial part of the swing to holdings of foreign assets by U.S. residents coincided with a significant liberalization of capital accounts in both developed and emerging-market economies. In Western Europe, as goods markets became increasingly integrated, capital accounts followed suit. Starting in the 1980s, controls on foreign exchange and on inbound and outbound capital flows were relaxed. In Japan, the most-restrictive capital controls were relaxed in the early 1980s, but major liberalization came in the mid-1990s with the “Big Bang” financial reform measures. Similarly, many emerging-market economies removed or weakened currency and capital account controls in the 1990s. One cross-country study finds that, from 1983 to 1998, capital account openness improved markedly. With increased experience, U.S. investors doubtless improved their familiarity with foreign investment opportunities, and home bias, accordingly, declined. Data on financial flows into the United States indicate that foreign purchases of U.S. securities and foreign direct investment in the United States began to pick up in the early 1990s, and it has surged in the past four years. A similar pattern is apparent in the accumulated foreign holdings of securities issued by U.S. residents. As late as 1998, foreign residents owned just 6 percent of U.S. equities, but by 2001 that figure had risen to almost 15 percent. Reliable data on capital flows and securities holdings outside the United States are scarce, but what data we can muster tell a similar story. Although international diversification appears to have increased over the past two decades, it remains puzzling that, as I mentioned previously, shares of foreign assets in U.S. residents’ portfolios began to plateau in the mid-1990s at levels still well below full diversification. This outcome might indicate either that substantial indirect barriers to capital flows still exist or that an irreducible home bias among U.S. investors is inhibiting geographic diversification. Formidable indirect institutional barriers to lowering home bias beyond those to which I alluded earlier obviously do remain. Legal restrictions on foreign ownership of domestic assets or limits on the flow of domestic funds abroad can be significant. Informal disclosure practices that favor local investors may lead to information asymmetries - that is, an advantage to domestic residents in acquiring information about prospective investments - that discourage foreign investment in a country. These asymmetries may be exacerbated by differences in corporate governance and local norms of fairness that diverge from foreign standards, undercutting trust. This unfamiliarity fosters risk aversion and elevates home bias. Recent studies suggest that differing disclosure and corporate governance standards preserve home bias. Researchers have shown that, in most countries, holding a controlling interest in a firm yields significant benefits that do not accrue to minority shareholders, and that a substantial portion of home bias in those countries can be attributed to local holdings of closely held firms. Additionally, staff at the Federal Reserve Board and International Monetary Fund have shown that, for firms from emerging-market economies that meet U.S. standards for disclosure and protection of minority shareholder rights, U.S. residents hold the theoretically predicted proportion of company shares in their portfolios. Thus, it appears that an improvement in global reporting and corporate governance standards could significantly reduce global home bias. J. Miniane, “A New Set of Measures on Capital Account Restrictions,” mimeo, Johns Hopkins University, November 2000. See A. Dyck and L. Zingales, “Why are private benefits of control so large in certain countries and what effect does this have on their financial development?” mimeo, University of Chicago, 2001; or T. Nenova, “The value of corporate votes and control benefits: cross-country analysis,” Journal of Financial Economics, forthcoming; and M. Dahlquist et alia, “Corporate governance and the home bias,” Journal of Financial and Quantitative Analysis, forthcoming. H. J. Edison and F. E. Warnock, “U.S. investors’ emerging market equity portfolios: a security-level analysis,” prepared for the IMF Global Linkages Conference, January 2003. So do derivatives markets that help to narrow the wedge between the perceived risk-adjusted returns of foreign and domestic residents on any particular investment. Foreign exchange forward contracts and swaps have helped reduce the overall risk of securities denominated in foreign currencies or to transfer the risks to agents with either a greater appetite for risk or a longer investment horizon over which to smooth losses. Even the imposition of capital controls, foreign exchange restrictions, or devaluations of fixed currencies can now be at least partially hedged through nondeliverable forward contracts that settle in dollars for the change in value of an underlying currency over some pre-determined period. Credit default swaps now allow agents to hedge or exchange even sovereign risk. Argentina’s recent default provided a powerful test of these new derivatives and proved their worth, perhaps even helping to limit contagion. The further development of derivatives markets, particularly in smaller economies where idiosyncratic risk may be more difficult to hedge, will likely facilitate greater cross-border flows and a more productive distribution of global savings. The coincident development of local derivatives markets may facilitate the development of local currency bond markets in small or emerging-market economies by giving foreign and domestic investors more tools with which to hedge their exposure to the country risk. What Are the Real Economic Implications of Financial Globalization? It should be apparent that the process of financial globalization has come a long way but is as yet incomplete. Further development should lead to the enrichment and growth of developing economies as global savings are efficiently directed to capital accumulation in those countries where the marginal product of capital is highest. Another possible result of the process of financial globalization is increasingly large international payment imbalances as countries exporting capital run current account surpluses and those receiving capital run current account deficits. However, such developments should not necessarily be taken as a sign of a systemic problem. They can, in fact, be a sign that the global economy is becoming more efficient at directing capital to assets with the highest risk-adjusted rate of return. Along the way, the economies that liberalize first and to the greatest extent, and credibly commit to respect the property rights of foreigners, may receive the greater portion of free-flowing capital and thus potentially both greater net inflows and larger current account deficits. This process may have contributed to the recent expansion of the U.S. current account deficit. That expansion coincided with a steady appreciation of the U.S. dollar in the late 1990s, suggesting that net demand for U.S. assets was an important factor driving the significant widening of the U.S. current account deficit. As noted earlier, U.S. savers’ appetite for increasing the share of their portfolio devoted to foreign assets began to wane, and at roughly the same time capital account liberalization in other countries freed a large pool of savings to be invested internationally. These newly freed savings flowed disproportionately to the United States, where as a consequence one must assume risk-adjusted returns were perceived to be highest. Apparently, rapid U.S. productivity gains not seen elsewhere raised expectations for the return to capital on U.S. assets. Moreover, the Asian crisis in 1997 combined with the Russian default a year later to reverse global investors’ enthusiasm for investments in developing economies. The crises reminded foreign investors of the indirect barriers that continue to exist, especially in the developing world: a lack of adequate corporate disclosure and governance; underdeveloped, and often capricious, legal structures for contract dissolution and bankruptcy; and ex post government intervention in favor of domestic residents over foreign investors. Capital flows to the emerging-market economies, which had been at record levels throughout the early 1990s, dried up as a result. In contrast, the deep and broad financial markets of the United States and a well-developed legal system with a long history of respect for private property drew record financial flows into the United States. The lesson we should draw, however, is not that continued financial globalization will draw ever greater amounts of capital to the United States or even to the industrial world more generally. There are limits to the accumulation of net claims against an economy that persistent current account deficits imply. The cost of servicing such claims adds to the current account deficit and, under certain circumstances, can be destabilizing. The gross size of global quarterly or annual surpluses and matching deficits should rise as indirect barriers to cross-border investment are eliminated and home bias is reduced. However, portfolio adjustments will presumably continuously ameliorate such imbalances. As international accounting and reporting standards become better, information asymmetries that currently exist between foreign and domestic investors will diminish. Adequate disclosure will, one hopes, accompany the development of institutions that will reduce corruption, and improve corporate governance, respect for private property and the rights of minority shareholders. Together with the growth of deeper and broader markets for derivatives, these developments should lower the risk of cross-border investment, making a wider array of the world’s assets more attractive to international investors. Despite much progress, the process of global financial integration is far from complete. Though most direct barriers to international capital flows have been eliminated, numerous indirect barriers remain in place. While a dazzling array of financial innovations has sprouted in recent decades, the inability of market participants to hedge, trade, or share certain risks, especially those related to cross-border investment, implies that financial markets still need further innovation and deepening. Such barriers to capital flows preserve home bias and impede the efficient distribution of global savings to the most productive investments. We must remember that as financial globalization matures it will have consequences to economies that we cannot ignore. Global capital flows will increase in size and will switch directions more easily. As a result, temporary imbalances will naturally occur from time to time. To counter these, we need to consider various multilateral policy initiatives, from international accounting standards to international capital requirements for banks, from a “New Financial Architecture” to crisis prevention and resolution mechanisms. Also, market participants will need to enhance their ability to manage vast quantities of collateral that are integral to globalized modern finance. Our goals should include not only global financial stability, but also the promotion of free flowing capital directed to its most productive uses throughout the world. That goal will bring about greater financial stability and a more prosperous future for all who choose to participate in the global economy.
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Speech by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the Annual Washington Policy Conference of the National Association of Business Economists, Washington, DC, 25 March 2003.
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Ben S Bernanke: A perspective on inflation targeting Speech by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the Annual Washington Policy Conference of the National Association of Business Economists, Washington, DC, 25 March 2003.The references for the speech can be found on the website of the Board of Governors of the US Federal Reserve System. * * * One of the more interesting developments in central banking in the past dozen years or so has been the increasingly widespread adoption of the monetary policy framework known as inflation targeting. The approach evolved gradually from earlier monetary policy strategies that followed the demise of the Bretton Woods fixed-exchange-rate system--most directly, I believe, from the practices of Germany's Bundesbank and the Swiss National Bank during the latter part of the 1970s and the 1980s. For example, the Bundesbank, though it conducted short-term policy with reference to targets for money supply growth, derived those targets each year by calculating the rate of money growth estimated to be consistent with the bank's long-run desired rate of inflation, normally 2 percent per year. Hence, the Bundesbank indirectly targeted inflation, using money growth as a quantitative indicator to aid in the calibration of its policy. Notably, the evidence suggests that, when conflicts arose between its money growth targets and inflation targets, the Bundesbank generally chose to give greater weight to its inflation targets (Bernanke and Mihov, 1997). The inflation-targeting approach became more explicit with the strategies adopted in the early 1990s by a number of pioneering central banks, among them the Reserve Bank of New Zealand, the Bank of Canada, the Bank of England, Sweden's Riksbank, and the Reserve Bank of Australia. Over the past decade, variants of inflation targeting have proliferated, with newly industrialized and emerging-market economies (Brazil, Chile, Israel, Korea, Mexico, South Africa, the Philippines, and Thailand, among others) being among the most enthusiastic initiates. Most recently, this policy framework has also been adopted by several transition economies, notably the Czech Republic, Hungary, and Poland. Central banks that have switched to inflation targeting have generally been pleased with the results they have obtained. The strongest evidence on that score is that, thus far at least, none of the several dozen adopters of inflation targeting has abandoned the approach. As an academic interested in monetary policy, several years ago I became intrigued by inflation targeting and went on to co-author a book and several other pieces about this approach. As I continue to follow developments in the area, I must say, however, that discussions of inflation targeting in the American media remind me of the way some Americans deal with the metric system--they don't really know what it is, but they think of it as foreign, impenetrable, and possibly slightly subversive. So, in the hope of cutting through some of the fog, today I will offer my own, perhaps somewhat idiosyncratic, view of inflation targeting and its potential benefits, at least in what I consider to be its best-practice form. I will also try to dispel what I feel are a few misconceptions about inflation targeting that have gained some currency. Finally, I will end with a few words, and one modest suggestion, about the implications of the experience with inflation targeting for the practice of monetary policymaking at the Federal Reserve. My main objective today, however, is to clarify, not to The interpretation of the Bundesbank as a proto-inflation targeter is not universally accepted. Certainly, the Bundesbank did not put the same emphasis on communication and transparency that modern inflation-targeting central banks do. Mishkin and Jonas (forthcoming) describe the experiences of the three transition economies with inflation targets. A few countries that used inflation targeting in the transition to European monetary union are a partial exception. The European Central Bank itself has an inflation objective (a ceiling of 2 percent) but does not refer to itself as an inflationtargeting central bank, largely on the grounds that (officially, at least) it also puts some weight on money growth in its policy decisions. As a newly created central bank presiding over a monetary union, the ECB is unique in more fundamental ways as well; hence, the lessons from the ECB experience for the Federal Reserve and other established central banks may be somewhat limited. See in particular Bernanke and Mishkin (1997) and Bernanke, Laubach, Mishkin, and Posen (1999). By focusing on what I call “best practice” inflation targeting, I must necessarily be somewhat subjective; but then my goal today is largely normative, not descriptive. For a more detailed exposition of the case for inflation targeting in the United States, see Goodfriend (forthcoming). advocate. Of course, my comments today reflect my own views and do not necessarily reflect those of my colleagues at the Federal Reserve Board or on the Federal Open Market Committee. Best-Practice Inflation Targeting: One View Although inflation targeting has a number of distinguishing features--the announcement of a quantitative target for inflation being the most obvious--capturing the essence of the approach is not entirely straightforward. The central banks that call themselves inflation targeters, as well as the economies they represent, are a diverse group indeed, and (not surprisingly) institutional and operational features differ. Moreover, many central banks that have not formally adopted the framework of inflation targeting have clearly been influenced by the approach (or, if you prefer, the same ideas and trends have influenced both inflation-targeters and non-inflation-targeters). For example, over the past twenty years, the Federal Reserve, though rejecting the inflation-targeting label, has greatly increased its credibility for maintaining low and stable inflation, has become more proactive in heading off inflationary pressures, and has worked hard to improve the transparency of its policymaking process--all hallmarks of the inflation-targeting approach. In short, to draw a bright line between central banks practicing full-fledged inflation targeting and those firmly outside the inflationtargeting camp is more difficult than one might first guess--a fact, by the way, that substantially complicates economists' attempts to assess empirically the effects of this approach. Nevertheless, for expository purposes, I find it useful to break down the inflation targeting approach into two components: (1) a particular framework for making policy choices, and (2) a strategy for communicating the context and rationale of these policy choices to the broader public. Let's call these two components of inflation targeting the policy framework and the communications strategy, for short. The policy framework of inflation targeting By the policy framework I mean the principles by which the policy committee decides how to set its policy instrument, typically a short-term interest rate. In an earlier speech, I referred to the policy framework that describes what I consider to be best-practice inflation targeting as constrained discretion. Constrained discretion attempts to strike a balance between the inflexibility of strict policy rules and the potential lack of discipline and structure inherent in unfettered policymaker discretion. Under constrained discretion, the central bank is free to do its best to stabilize output and employment in the face of short-run disturbances, with the appropriate caution born of our imperfect knowledge of the economy and of the effects of policy (this is the "discretion" part of constrained discretion). However, a crucial proviso is that, in conducting stabilization policy, the central bank must also maintain a strong commitment to keeping inflation--and, hence, public expectations of inflation--firmly under control (the "constrained" part of constrained discretion). Because monetary policy influences inflation with a lag, keeping inflation under control may require the central bank to anticipate future movements in inflation and move preemptively. Hence constrained discretion is an inherently forward-looking policy approach. Although constrained discretion acknowledges the crucial role that monetary policy plays in stabilizing the real economy, this policy framework does place heavy weight on the proposition that maintenance of low and stable inflation is a key element--perhaps I should say the key element--of successful monetary policy. The rationale for this emphasis goes well beyond the direct benefits of price stability for economic efficiency and growth, important as these are. The maintenance of price stability--and equally important, the development by the central bank of a strong reputation for and commitment to it-also serves to anchor the private sector's expectations of future inflation. Well-anchored inflation expectations (by which I mean that the public continues to expect low and stable inflation even if actual inflation temporarily deviates from its expected level) not only make price stability much easier to achieve in the long term but also increase the central bank's ability to stabilize output and employment in the short run. Short-run stabilization of output and employment is more effective when inflation expectations are well anchored because the central bank need not worry that, for example, a policy easing will lead counterproductively to rising inflation and inflation expectations rather than to stronger real activity. Bernanke (2003). In my earlier speech, I gave the Great Inflation of the 1970s in the United States as an example of what can happen when inflation expectations are not well anchored. Contrary to the belief in a long-run tradeoff between inflation and unemployment held by many economists in the 1960s, unemployment and inflation in the 1970s were both high and unstable. Even today conventional wisdom ascribes this unexpected outcome to the oil price shocks of the 1970s. Though increases in oil prices were certainly adverse factors, poor monetary policies in the second half of the 1960s and in the 1970s both facilitated the rise in oil prices themselves and substantially exacerbated their effects on the economy. Monetary policy contributed to the oil price increases in the first place by creating an inflationary environment in which excess nominal demand existed for a wide range of goods and services. For example, in an important paper, Barsky and Kilian (2001) noted that the prices of many industrial commodities and raw materials rose in the 1970s about the same time as oil prices, reflecting broad-based inflationary pressures. Without these general inflationary pressures, it is unlikely that the oil producers would have been able to make the large increases in oil prices "stick" for any length of time. Besides helping to make the oil price increases possible, the legacy of poor monetary policies also exacerbated the effects of the oil price increases on output and employment. When the oil price shocks hit, beginning in 1973, inflation expectations had already become very unstable, after several years of increased inflationary pressures and a failed program of price controls under President Nixon. Because inflation expectations were no longer anchored, the widely publicized oil price increases were rapidly transmitted into expectations of higher general inflation and, hence, into higher wage demands and other cost pressures. Faced with an unprecedented inflationary surge, the Fed was forced to tighten policy. As it turned out, the Fed's tightening was not enough to contain the inflationary surge but was sufficient to generate a severe recession. The upshot is that the deep 1973-75 recession was caused only in part by increases in oil prices per se. An equally important source of the recession was several years of overexpansionary monetary policy that squandered the Fed's credibility regarding inflation, with the ultimate result that the economic impact of the oil producers' actions was significantly larger than it had to be. Instability in both prices and the real economy continued for the rest of the decade, until the Fed under Chairman Paul Volcker re-established the Fed's credibility with the painful disinflationary episode of 1980-82. This latter episode and its enormous costs should also be chalked up to the failure to keep inflation and inflation expectations low and stable. In contrast to the 1970s, fluctuations in oil prices have had far smaller effects on both inflation and output in the United States and other industrialized countries since the early 1980s. In part this more moderate effect reflects increased energy efficiency and other structural changes, but I believe the dominant reason is that the use of constrained discretion in the making of monetary policy has led to better anchoring of inflation expectations in the great majority of industrial countries. Because inflation expectations are now more firmly tied down, surges and declines in energy prices do not significantly affect core inflation and thus do not force a policy response to inflation to the extent they did three decades ago. Indeed, rather than leading to a tightening of monetary policy, increases in oil prices today are more likely to promote consideration of increased policy ease--a direct and important benefit of the improved control of inflation. The communications strategy of inflation targeting The second major element of best-practice inflation targeting (in my view) is the communications strategy, the central bank's regular procedures for communicating with the political authorities, the financial markets, and the general public. In general, a central bank's communications strategy, closely linked to the idea of transparency, has many aspects and many motivations. Aspects of communication that have been particularly emphasized by inflation-targeting central banks are the public announcement of policy objectives (notably, the objective for inflation), open discussion of the bank's policy framework (including in some cases, but not all, a timeframe for achieving the inflation In some countries, improved transparency has accompanied greater central bank independence, on the argument that more independent central banks must also provide enhanced accountability. objective), and public release of the central bank's forecast or evaluation of the economy (as reported, for example, in the Inflation Reports issued by a number of inflation-targeting central banks). Why have inflation-targeting central banks emphasized communication, particularly the communication of policy objectives, policy framework, and economic forecasts? In the 1960s, many economists were greatly interested in adapting sophisticated mathematical techniques developed by engineers for controlling missiles and rockets to the problem of controlling the economy. At the time, this adaptation of so-called stochastic optimal control methods to economic policymaking seemed natural; for like a ballistic missile, an economy may be viewed as a complicated dynamic system that must be kept on course, despite continuous buffeting by unpredictable forces. Unfortunately, macroeconomic policy turned out not to be rocket science! The problem lay in a crucial difference between a missile and an economy--which is that, unlike the people who make up an economy, the components of a missile do not try to understand and anticipate the forces being applied to them. Hence, although a given propulsive force always has the same, predictable effect on a ballistic missile, a given policy action--say, a 25-basis-point cut in the federal funds rate--can have very different effects on the economy, depending (for example) on what the private sector infers from that action about likely future policy actions, about the information that may have induced the policymaker to act, about the policymaker's objectives in taking the action, and so on. Thus, taking the "right" policy action--in this case, changing the federal funds rate by the right amount at the right time--is a necessary but not sufficient condition for getting the desired economic response. Most inflation-targeting central banks have found that effective communication policies are a useful way, in effect, to make the private sector a partner in the policymaking process. To the extent that it can explain its general approach, clarify its plans and objectives, and provide its assessment of the likely evolution of the economy, the central bank should be able to reduce uncertainty, focus and stabilize private-sector expectations, and--with intelligence, luck, and persistence--develop public support for its approach to policymaking. Of course, as has often been pointed out, actions speak louder than words; and declarations by the central bank will have modest and diminishing value if they are not clear, coherent, and--most important--credible, in the sense of being consistently backed up by action. But agreeing that words must be consistently backed by actions is not the same as saying that words have no value. In the extreme, I suppose a central bank could run a "Marcel Marceau" monetary policy, allowing its actions to convey all its intended meaning. But common sense suggests that the best option is to combine actions with words--to take clear, purposeful, and appropriately timed policy actions that are supported by coherent explanation and helpful guidance about the future. One objection that has been raised to the public announcement of policy objectives, economic forecasts, and (implicit or explicit) policy plans by central banks is that even relatively modest commitments along these lines may limit their flexibility to choose the best policies in the future. Isn't it always better to be more rather than less flexible? Shouldn't the considered judgment of experienced policymakers always trump rules, even relatively flexible ones, for setting policy? I agree that human judgment should always be the ultimate source of policy decisions and that no central bank should--or is even able to--commit irrevocably in advance to actions that may turn out to be highly undesirable. However, the intuition that more flexibility is always better than less flexibility is quite fallacious, a point understood long ago by Homer, who told of how Ulysses had himself tied to the mast so as not to fall victim to the songs of the Sirens. More recently, the notion that more flexibility is always preferable has been pretty well gutted by modern game theory (not to mention modern monetary economics), which has shown in many contexts that the ability to commit in advance often yields better outcomes. For illustration of the potential benefits to policymakers of even modest self-imposed restrictions on flexibility, consider fiscal policy, which shares with monetary policy some of the same issues that arise when a group of shifting membership makes a series of policy decisions that have both short-run and long-run implications. In the short run, fiscal policymakers may have important and legitimate reasons I refer to these features as communication rather than as rules because they simply make public the elements of the policy framework, that is, constrained discretion. Even when the inflation target itself is set outside the central bank or by an outside agency with the cooperation of the central bank, for the most part inflation-targeting central banks themselves rather than outsiders (such as the legislature) are the principal enforcers of their own targets and procedures. “Self-enforced” inflation targets are the only case I will consider here. to depart from budget balance, sometimes even substantially--for example, to appropriate funds to deal with a national emergency or to provide a stimulus package to assist economic recovery. In the long run, however, maintaining public confidence requires that fiscal policy be conducted in such a way that the ratio of national debt to GDP remains stable at a moderate level. Arguably, public confidence, and hence the ability of policymakers to use fiscal instruments aggressively to address short-term concerns, is enhanced by whatever legislative rules, guidelines, or procedures exist that-however gently or firmly--tend to compel the policymakers to bring the budget back toward balance, and the debt-GDP ratio back toward stability, after the crisis has passed. True, spending caps, comprehensive budget resolutions, mandatory long-term deficit projections, and similar provisions, to the extent that they are effective, may reduce at least a bit the flexibility of fiscal policymakers. But if intentionally yielding a bit of flexibility increases public confidence in the long-run sustainability of the government's spending and tax plans, fiscal policymakers may find that adopting these rules actually enhances their ability to act effectively in the short run. As with fiscal policy, public beliefs about how monetary policy will perform in the long run affect the effectiveness of monetary policy in the short run. Suppose, for example, that the central bank wants to stimulate a weak economy by cutting its policy interest rate. The effect on real activity will be strongest if the public is confident in the central bank's unshakable commitment to price stability, as that confidence will moderate any tendency of wages, prices, or long-term interest rates to rise today in anticipation of possible future inflationary pressures generated by the current easing of policy. Now the central bank's reputation and credibility may be entirely sufficient that no additional framework or guidelines are needed. Certainly, in general, the greater the inherited credibility of the central bank, the less restrictive need be the guidelines, targets, or the like that form the central bank's communication strategy. But credibility is not a permanent characteristic of a central bank; it must be continuously earned. Moreover, an explicit policy framework has broader advantages, including among others increased buy-in by politicians and the public, increased accountability, reduced uncertainty, and greater intellectual clarity. Hence, though a central bank with strong credibility may wish to adopt a relatively loose and indicative set of guidelines for communication with the public, even such a bank may benefit from increasing its communication with the public and adding a bit of structure to its approach to making policy. From the public's perspective, the central bank's commitment to a policy framework, including a long-run inflation target, imposes the same kind of discipline and accountability on the central bank that a long-term commitment to fiscal stability places on the fiscal authorities. Misconceptions about inflation targeting I would like to turn now, briefly, to comment on a few key misconceptions about inflation targeting that have gained some currency in the public debate. Misconception #1: Inflation targeting involves mechanical, rule-like policymaking. As Rick Mishkin and I emphasized in our early expository article (Bernanke and Mishkin, 1997), inflation targeting is a policy framework, not a rule. If it is to be coherent and purposeful, all policy is made within some sort of conceptual framework; the question is the degree to which the framework is explicit. Inflation targeting provides one particular coherent framework for thinking about monetary policy choices which, importantly, lets the public in on the conversation. If this framework succeeds in its goals of anchoring inflation expectations, it may also make the policymaker's ultimate task easier. But making monetary policy under inflation targeting requires as much insight and judgment as under any policy framework; indeed, inflation targeting can be particularly demanding in that it requires policymakers to give careful, fact-based, and analytical explanations of their actions to the public. Misconception #2: Inflation targeting focuses exclusively on control of inflation and ignores output and employment objectives. Several authors have made the distinction between so-called "strict" inflation targeting, in which the only objective of the central bank is price stability, and "flexible" inflation targeting, which allows attention to output and employment as well. In the early days of inflation targeting, this distinction may have been a useful one, as a number of inflation-targeting central banks talked the language of strict inflation targeting and one or two came close to actually practicing it. For quite a few years now, however, strict inflation targeting has been without significant practical relevance. In particular, I am not aware of any real-world central bank (the language of its mandate notwithstanding) that does not treat the stabilization of employment and output as an important policy objective. To use the wonderful phrase coined by Mervyn King, the Governor-designate of the inflation-targeting Bank of England, there are no "inflation nutters" heading major central banks. Moreover, virtually all (I am tempted to say "all") recent research on inflation targeting takes for granted that stabilization of output and employment is an important policy objective of the central bank. In short, in both theory and practice, today all inflation targeting is of the flexible variety. A second, more serious, issue is the relative weight, or ranking, of inflation and unemployment (or, more precisely, the output gap) among the central bank's objectives. Countries differ in this regard, both in formal mandate and in actual practice. As an extensive academic literature shows, however, the general approach of inflation targeting is fully consistent with any set of relative social weights on inflation and unemployment; the approach can be applied equally well by "inflation hawks," "growth hawks," and anyone in between. What I find particularly appealing about constrained discretion, which is the heart of the inflation-targeting approach, is the possibility of using it to get better results in terms of both inflation and employment. Personally, I subscribe unreservedly to the Humphrey-Hawkins dual mandate, and I would not be interested in the inflation-targeting approach if I didn't think it was the best available technology for achieving both sets of policy objectives. Misconception #3: Inflation targeting is inconsistent with the central bank's obligation to maintain financial stability. Let me address this point in the context of the United States. The most important single reason for the founding of the Federal Reserve was the desire of the Congress to increase the stability of American financial markets, and the Fed continues to regard ensuring financial stability as a critical responsibility. (By the way, this is a reason to be nervous about the recent trend of separating central banking and financial supervision; I hope we have the sense not to do that here.) I have always taken it to be a bedrock principle that when the stability or very functioning of financial markets is threatened, as during the October 1987 stock market crash or the September 11 terrorist attacks, that the Federal Reserve would take a leadership role in protecting the integrity of the system. I see no conflict between that role and inflation targeting (indeed, inflation targeting seems to require the preservation of financial stability as part of preserving macroeconomic stability), and I have never heard a proponent of inflation targeting argue otherwise. Inflation targeting and the Federal Reserve As I noted earlier, the Federal Reserve, though rejecting any explicit affiliation with inflation targeting, has been influenced by many of the same ideas that have influenced self-described inflation targeters. Increasingly greater transparency and more forward-looking, proactive policy are two examples of convergence in practice between the Fed and inflation-targeting central banks, and I think most would agree that both of these developments have been positive and have led to better outcomes. Most important, however, as I discussed in the earlier speech, under Chairman Volcker and Chairman Greenspan, the Fed has moved gradually toward a policy framework of constrained discretion. In King (1997) appears to be the source of the phrase. Svensson (1999), who I believe coined the phrase “strict inflation targeting”, calls this point “uncontroversial.” Svensson’s paper and his related work also show in detail the consistency of inflation targeting with a dual mandate. A number of inflation-targeting central banks refer to inflation stabilization as the central bank’s “primary long-run objective.” At one level, this statement does not have much content because inflation is the only variable that central banks can control in the long run. Its real import is to say that the central bank is responsible for long-run price stability, a statement that should be unobjectionable in any framework. Meyer (2001) draws a distinction between a hierarchical mandate, which subordinates other objectives to the price stability objective, and a dual mandate, which places price stability and employment objectives on equal footing. Like Meyer, I prefer the dual mandate formulation and find it to be fully consistent with inflation targeting. Formally, the dual mandate can be represented by a central bank loss function that includes both inflation and unemployment (or the output gap) symmetrically. Here is part of a verbal reply that I made to a commenter on a paper about inflation targeting and asset prices that Mark Gertler and I presented at the Fed’s Jackson Hole conference in August 1999, as published in the conference volume: “I want to correct the impression . . . that Mark and I are somehow against lender-of-last-resort activities, which is absolutely wrong. I have studied the Depression quite a bit in my career, and I think there are two distinguishing mistakes that the Federal Reserve made. The first was to allow a serious deflation, which an inflation targeting regime would not have permitted. And the second was to allow the financial system to collapse, and I absolutely agree with, for example, what happened in October 1987 and other interventions . . . One advantage of the inflation targeting approach as opposed, for example, to a currency board, is [that] it gives you considerably more scope for lender-of-last-resort activities.” (Federal Reserve Bank of Kansas City, 1999, p. 145) Bernanke (2003). Gramlich (2000) made a similar observation and cited empirical evidence. particular, through two decades of effort the Fed has restored its credibility for maintaining low and stable inflation, which--as theory suggests--has had the important benefit of increasing the institution's ability to respond to shocks to the real economy. The acid test occurred in 2001, when the FOMC cut interest rates by nearly 500 basis points without any apparent adverse effect on inflation expectations. Given the Fed's strong performance in recent years, would there be any gains in moving further down the road toward inflation targeting? The most heated debates are said to occur on questions that are inherently impossible to prove either way, and I am afraid that this question gives rise to one of those debates, involving as it does counterfactual futures. Personally, though, I believe that U.S. monetary policy would be better in the long run if the Fed chose to make its policy framework somewhat more explicit. First, the Fed is currently in a good and historically rare situation, having built a consensus both inside and outside the Fed for good policies. We would be smart to try to lock in this consensus a bit more by making our current procedures more explicit and less mysterious to the public. Second, making the Fed's inflation goals and its medium-term projections for the economy more explicit would reduce uncertainty and assist planning in financial markets and in the economy more generally. Finally, any additional anchoring of inflation expectations that we can achieve now will only be helpful in the future. To move substantially further in the direction of inflation targeting, should it choose to do so, the Fed would have to take two principal steps: first, to quantify (numerically, and in terms of a specific price index) what the Federal Open Market Committee means by "price stability", and second, to publish regular medium-term projections or forecasts of the economic outlook, analogous to the Inflation Reports published by both inflation-targeting central banks. Particularly now that we are in the general range of price stability, I believe that quantifying what the FOMC means by price stability would provide useful information to the public and lend additional clarity to the policymaking process. Let me add a caveat however. Despite the potential long-run benefits of such a change, FOMC members may be concerned at this juncture that the Congress and the public would misperceive the quantification of price stability as an elevation of the Fed's price stability objective above its employment objective in violation of the dual mandate, even if that were in no way the intention. Although personally I have no doubt that quantification of the price stability objective is fully consistent with the current dual mandate, I also appreciate the delicate issues of communication raised by such a change. Realistically, this step is unlikely to occur without a good bit more public discussion. I hope that my talk today contributes to that discussion. The publication of medium-term forecasts does not raise nearly the same difficult political and communication issues that quantification of price stability may, in my view, and so I propose it here as a more feasible short-term step. The FOMC already releases (and has released since 1979) a range and a "central tendency" of its projections for nominal GDP growth, real GDP growth, PCE inflation, and the civilian unemployment rate twice each year, publishing them as part of the semiannual Monetary Policy Report to the Congress. These projections are actually quite interesting, as they represent the views of Fed policymakers of the future evolution of the economy, conditional on what each policymaker views as the best path for future policy. Two drawbacks of these projections as they now stand are that (1) they are sometimes not released for a number of weeks (the time between the FOMC meeting at which they are assembled and the Chairman's testimony to the Congress), and the January projections cover only the remainder of the current year (the July projections cover the remainder of the current year and all of the subsequent year). I think it would be very useful to detach these projections from the Monetary Policy Report and instead release them shortly after the meetings (in January and July) at which they are compiled. I would also suggest adding a second year of forecast to the January projection, to make it more parallel to the July projection as well as to the forecasts in the staff-prepared Greenbook. By releasing the projections in a more timely manner, and by adding a year to the January projection, the FOMC could provide quite In principle, the Federal Reserve could also publish its estimate of the long-run growth potential of the U.S. economy, for symmetry with its estimate of price stability. Unfortunately, potential output growth tends to be variable and difficult to measure with precision. A deeper asymmetry arises from the fact that, unlike the long-run rate of inflation, the Federal Reserve cannot control, and thus cannot be held responsible for, the long-run economic growth rate. The Monetary Policy Report is required by the Congress under Section 2B of the Federal Reserve Act. The report is required to contain “a discussion of the conduct of monetary policy and economic developments and prospects for the future . . .” The projections may be interpreted as satisfying part of the requirement to provide the Federal Reserve’s view on prospects for the future. useful information to the public. In particular, the FOMC projections would convey the policymakers' sense of the medium-term evolution of the economy, providing insight into both the Fed's diagnosis of economic conditions and its policy objectives. Ideally, the release of these projections also would provide occasions for Governors and regional Bank Presidents, drawing on the expertise of their respective staffs, to convey their individual views on the prospects for the economy and the objectives of monetary policy. Conclusion Inflation targeting, at least in its best-practice form, consists of two parts: a policy framework of constrained discretion and a communication strategy that attempts to focus expectations and explain the policy framework to the public. Together, these two elements promote both price stability and well-anchored inflation expectations; the latter in turn facilitates more effective stabilization of output and employment. Thus, a well-conceived and well-executed strategy of inflation targeting can deliver good results with respect to output and employment as well as inflation. Although communication plays several important roles in inflation targeting, perhaps the most important is focusing and anchoring expectations. Clearly there are limits to what talk can achieve; ultimately, talk must be backed up by action, in the form of successful policies. Likewise, for a successful and credible central bank like the Federal Reserve, the immediate benefits of adopting a more explicit communication strategy may be modest. Nevertheless, making the investment now in greater transparency about the central bank's objectives, plans, and assessments of the economy could pay increasing dividends in the future. An alternative, suggested by Blinder et al. (2001), is to release a summary of the staff-prepared forecasts (the “Greenbook” forecasts). I think that option is worth considering but prefer focusing on the FOMC projections for now. The projections of the FOMC members draw heavily on the expertise of the Board staff, as well as the staff of the regional Banks, but they also reflect the policymakers’ personal views, which I think is important. Reporting policymakers’ projections rather than staff projections is in keeping with the practices of most other central banks.
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board of governors of the federal reserve system
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Speech by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the JumpStart Coalition¿s Annual Meeting, Washington, DC, 3 April 2003.
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Alan Greenspan: Financial education Speech by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the JumpStart Coalition’s Annual Meeting, Washington, DC, 3 April 2003. * * * I am pleased to be here today to share with you my perspective on the importance of financial education. I commend the leadership of the JumpStart Coalition and the activities it has undertaken to support teachers working on the front-line of financial education. Trends in consumer finances As you are aware, today’s financial world is highly complex when compared with that of a generation ago. An understanding of how to maintain a checking and savings account at a local financial institution may have been sufficient twenty-five years ago. Today’s consumers, however, must be able to differentiate between a wide range of products, services, and providers of financial products to successfully manage their personal finances. Certainly, young adults have access to credit at a much earlier age than their parents did. Accordingly, they need a more comprehensive understanding of credit than was afforded to the previous generation--including the impact of compounding interest on debt balances and the implications of mismanaging credit accounts. In addition, as technological advances have contributed significantly to the dramatic changes within the financial services market, consumers more generally must be familiar with the role that computers play in the conduct of every traditional financial transaction, from withdrawing funds to gaining access to credit. While the focus of your efforts is to provide youth with a solid foundation for understanding personal financial management, the benefits of that objective extend to a much broader audience. Data, both empirical and anecdotal, point to trends in consumer financial conditions that have caused concern among some consumer groups. For example, Federal Reserve statistics indicate that household debt outstanding increased more than 9 percent last year--the largest rate of increase since 1989. And while analyses suggest that, overall, this level of debt is being serviced adequately, reports of nonbusiness bankruptcy filings reaching record highs in 2002 reveal that many consumers are experiencing significant financial crises. Regulators, lenders, community leaders, and consumer advocates continue to be concerned about abusive home mortgage lending practices. More recently, the emergence of certain deposit-linked products has also sparked debate among these parties. For example, one product marketed as protection against bounced checks has generated concerns among consumer groups ranging from the appropriateness of assessed fees to the possible unintended effect of reinforcing poor accountmanagement practices on the part of consumers who do not properly monitor their accounts. Trends in the financial services industry Perhaps, some may judge such information as an indication that the combination of market forces and industry trends has had negative effects on consumers. On the contrary, many benefits have accrued to consumers of household and business credit as the result of the remarkable growth and technological developments that have occurred in financial services. Computer and telecommunications technologies have lowered the cost and broadened the scope of financial services. As a consequence, specialized lenders and new financial products tailored to meet very specific market needs have proliferated. At the same time, the development of credit-scoring tools and the securitization of loan pools hold the potential for opening doors to national credit markets for both consumers and businesses. Deregulation has created important structural changes in the financial services industry and has contributed significantly to creating a marketplace that is increasingly competitive and highly innovative as a result of the entry of new players or expansion of existing players. Throughout our banking history, we have seen significant adjustments to existing policies to enable markets to respond to the demand for services. These structural changes have heightened competition, resulting in market efficiencies that continue to help drive down costs and foster the emergence of increasingly diverse and highly specialized organizations. These entities range from banks and brokerage firms that offer their services exclusively through electronically based delivery mechanisms to locally based public-private partnerships that provide counseling and financing arrangements to low- and moderate-income families. Corporations, for example, often allow employees to self-direct their investments in pension and other benefit plans, whereas employers dictated such decisions twenty years ago. The advent of on-line brokerage firms has enabled individual investors to directly conduct stock transactions. The role of financial education However beneficial, constant change, of course, can be unsettling, and one challenge we face is overcoming such anxieties. But just as the rapid adoption of new information technologies has expanded the scope and utility of our financial products, so, too, has it increased our means for addressing some of the challenges these changes pose. For example, just as universities provide remote learning options to allow students to pursue continuing education via the Internet, consumers can use software to create customized budgets to develop long-term savings strategies for retirement or for their children’s college education. In both scenarios, technological advances represent the opportunity for achieving efficiencies and exercising preferences, but only when the end users possess the knowledge necessary to access pertinent information and to capitalize on it. Fostering education that will enable individuals to overcome their reluctance or inability to take full advantage of technological advances and product innovation in the financial sector can increase economic opportunity. As market forces continue to expand the range of providers of financial services, consumers will have more choice and flexibility in how they manage their personal finances. They will also need to learn ways to use new technologies and to make wise financial decisions. In considering means to improve the financial status of families, education can play a critical role by equipping consumers with the knowledge required to choose from among the myriad of financial products and providers. Financial education is especially critical for populations that have traditionally been underserved by our financial system. In particular, financial education may help to prevent vulnerable consumers from becoming entangled in financially devastating credit arrangements. Regulators, consumer advocates, and policymakers all agree that consumer education is essential in the quest to stem the occurrence of abusive, and at times illegal, lending practices. An informed borrower is simply less vulnerable to fraud and abuse. Financial education can empower consumers to be better shoppers, allowing them to obtain goods and services at lower cost. This process effectively increases consumers’ real purchasing power, and provides more opportunity for them to consume, save, or invest. In addition, financial education can help provide individuals with the knowledge necessary to create household budgets, initiate savings plans, manage debt, and make strategic investment decisions for their retirement or for their children’s education. Having these basic financial planning skills can help families to meet their near-term obligations and to maximize their longer-term financial well-being. The importance of basic financial skills underscores the need to begin the learning process as early as possible. Indeed, improving basic financial education at the elementary and secondary school level will provide a foundation of financial literacy that can help prevent younger people from making poor decisions that can take years to overcome. In particular, it has been my experience that competency in mathematics--both in numerical manipulation and in understanding the conceptual foundations-enhances a person’s ability to handle the more ambiguous and qualitative relationships that dominate our day-to-day financial decisionmaking. For example, through an understanding of compounding interest, one can appreciate the cumulative benefit of routine saving. Similarly, learning how to conduct research in a library or on the Internet helps one find information to enhance decision-making. Focusing on improving fundamental mathematical and problem-solving skills can develop knowledgeable consumers who can take full advantage of the sophisticated financial services offered in an ever-changing marketplace. ****** In the long run, better basic education at home and at the elementary and secondary school level will provide the foundation for a lifetime of learning. We must also be alert to the need to improve the skills and earning power of those who appear to be falling behind. Strategies must be developed to overcome the education deficiencies that all too many of our young people have. Just as the marketplace has responded to an increased demand for conceptual job skills by increasing the range of education options available to individuals, efforts to provide consumers with information and training about financial matters throughout their lives must also be expanded. The Federal Reserve has a keen interest in measuring the effectiveness of financial education programs. For example, we hosted a forum on best practices in credit education, which focused on effective educational tools and techniques and identified programmatic challenges and issues. In response to a call for papers, studies evaluating the impact of such training initiatives were presented at our Community Affairs Research Conference held last week. In addition, we have recently engaged in collaborative efforts with the Department of Defense and with several Native American tribal education councils to develop programs to assess their individual financial education efforts. Quantitative study of the quality and long-term success of education and training will be of particular interest to the Federal Reserve System as we develop and distribute a wide variety of financial and economic literacy products. Building bridges between community organizations, our educational institutions, and private businesses will be an essential aspect of our efforts to increase familiarity with new technological and financial tools that are fundamental to improving individual economic well-being. And the success of such efforts will bear significantly on how well prepared our society is to meet the challenges of an increasingly knowledge-based economy. The advent of new technologies and other market innovations will certainly bring new challenges and new possibilities for our businesses, our workers, and our educational system. These changes are affecting both financial and nonfinancial institutions around the world. Although we cannot know the precise directions in which these changes will take us, we can reasonably expect that the pace of technological developments and competitive pressures will increase. As in the past, our economic institutions and our workforce will strive to adjust. We must recognize, however, that adjustment is not automatic, and expanded linkages between business and education should be encouraged at all levels of our education system. In closing, let us remember that all shifts in the structure of the economy naturally create frictions and human stress, at least temporarily. However, if we are able to boost our investment in people, ideas, and processes, as well as in machines, the economy can readily adapt to change and support everrising standards of living for all Americans.
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board of governors of the federal reserve system
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Speech by Mr Roger W Ferguson, Jr, Vice Chairman of the Board of Governors of the US Federal Reserve System, at the Risk Management Association's Conference on Capital Management, Washington, D.C., 9 April 2003.
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Roger W Ferguson, Jr: Basel II - a realist's perspective Speech by Mr Roger W Ferguson, Jr, Vice Chairman of the Board of Governors of the US Federal Reserve System, at the Risk Management Association's Conference on Capital Management, Washington, D.C., 9 April 2003. * * * I am grateful to the Risk Management Association (RMA) for inviting me to speak with you today. In recent years, the RMA has been at the forefront of efforts to strengthen risk management within the banking sector and has done excellent work fostering discussions of emerging best practices. The RMA has also provided valuable input to another effort that is intimately connected with improvements in bank risk management--Basel II. Today, I intend to provide you with my candid perspective on the Basel II effort, its current status, and where it is headed. It is important that each of us with a stake in the outcome of Basel II consider it seriously and realistically; I intend to contribute today to such a discussion. I want to first present some of the premises on which I have based my own involvement in the Basel II effort and then turn to the process that we see unfolding in the United States. I will also address some of the concerns that have been raised regarding whether the U.S. approach to Basel II is overly limited in scope. Starting Points Let me begin with a now-familiar argument: The need for Basel II arises because our current capital framework, Basel I, is deficient for our larger banks, particularly for our largest, most complex banks. The familiarity of this argument does not lessen its force. As you know, the purpose of a risk-based regulatory regime for capital adequacy is to define a minimum cushion for banks to ensure their safety and soundness and to provide a benchmark by which the financial condition of banks can be measured. The risk-based ratios seek to compare available capital to a measure of the risks taken on. We see today that the largest, most complex banks operate their businesses and conduct risk management in a manner that is substantially different from the method by which they calculate regulatory capital. This difference reduces the usefulness and meaningfulness of regulatory capital ratios and places a burden on banks that must reconcile their risk-management and regulatory capital approaches. In addition, we must consider that material weakness, let alone failure, among the larger, more-complex banks in the United States could pose a significant challenge for our economy and could generate substantial costs. Effective supervision and regulation and other policies that promote a strong banking sector are in the best interests of us all. For these reasons, policymakers and others with a similar perspective should care deeply that our risk-based capital rules provide a meaningful and comprehensive measure of the risks to which the largest banks in our society are exposed. The significant gap between current capital ratios and the banks' own measures of risk is widening, and in my view, that justifies the need for modifying the capital regime used by our largest, most complex banks. I believe the U.S. regulatory community is in agreement that Basel I as currently applied in the United States is no longer an appropriate system for these banks. Therefore, we have realized that we need to provide our largest banks with a substantially different system for regulatory capital going forward. Frankly, there appears to be no significant disagreement with this premise. But, of course, the realization that Basel I needs to be overhauled to better address our largest, most complex banks does not itself dictate the form of that restructuring. This is the subject of the second premise, which is that the most promising and, one could argue, only realistic possibility for construction of a Basel II is to use a framework that builds on the modern techniques of corporate finance and risk management and applies them across banks in a broadly similar fashion. There is not much disagreement with the assertion that Basel II should be built on modern techniques of risk management. Clearly, the incorporation of such techniques at some level seems to be a necessary condition if the goal is a risk-based capital framework that produces a meaningful, comprehensive measure of risk relative to capital. However, not all would agree with the approaches that the Basel Committee has chosen in particular areas or, perhaps more fundamentally, with the nature of the balance between flexibility and comparability that is incorporated into Basel II. For the moment, let me focus on the latter point, the balance between flexibility and comparability. Some would argue that Basel II should permit banks the flexibility to measure risks precisely as they do internally or that it should allow banks to assess their own minimum capital requirement, subject to various tests and penalties for mis-estimation. While one can perfectly well understand the motivation behind these sentiments, most do not view them as realistic. In a moment, I will talk about the need for us to take seriously the competitive equity issues associated with Basel II. But those competitive equity issues are also relevant here because, given the current and prospective state of technology in banking, a regime that would give the largest banks the flexibility to set their own capital requirements could not satisfy the need for competitive equity. Similarly, a balanced assessment of the state of credit risk modeling and internal ratings approaches leads me to think that a full models regime could not in the near future produce measures of risk sufficiently comparable for a regulatory capital standard. The tradeoff that is at the heart of Basel II is the tradeoff between flexibility and comparability. Allowing banks to calculate regulatory capital in any manner that they see fit would certainly maximize the flexibility of such calculations, but the results would not be comparable across banks and thus the value of the capital standard would be compromised. On the other hand, to focus too rigidly on comparability would require an approach that made no use whatsoever of internal measures of risk or allowed no differences of technique across banks. Such an approach would not be sufficiently flexible and would prevent us from measuring risk as sensitively as necessary. It would inevitably not be much different than the Basel I standard we have today. The current Basel II proposals are a balancing act. That is their strength and their vulnerability. In seeking to produce a balance between the virtues of flexibility and comparability, the proposals introduce more complexity than some would prefer to see. Yet, although we could debate at length the optimal proportions of flexibility and comparability in the different areas of the proposals, there is not a realistic alternative to the need to strike some balance between these two extremes. The proposed framework builds on modern corporate finance and risk-management techniques; it gives banks some flexibility to develop their own internal assessments of risk but also constrains their assessments in various ways to ensure a greater degree of comparability. We have not so far been presented with any realistic alternative to this proposed framework that would not in conceptual terms look a great deal like Basel II. Having elaborated on these two premises--that Basel I is no longer adequate for our largest banks and that the structural concept of Basel II is the only realistic alternative to Basel I--let me now turn to a discussion of the path forward. Process Going Forward The Basel Committee is planning to release by early May a third version of its proposals for comment. This third consultative paper--CP3 for short--will contain some modifications resulting from the committee's recent quantitative impact survey, but it will be broadly similar to the proposals that banks in this country and around the world tested in that survey last fall. The U.S. federal banking agencies are working hard to develop an advance notice of proposed rulemaking, or ANPR, that will explain concretely their vision of how Basel II would be implemented in the United States. The ANPR will be tailored to the U.S. context in a way that particular banks will be able to see whether the proposal applies to them and what it will mean for them if it does. The ANPR will also seek to pose questions in several areas in which the U.S. agencies need specific feedback. We hope to issue the ANPR by the end of June. The next stage in the process will be the feedback that we receive from you and other interested parties, both on the CP3 and especially on the ANPR in the United States. The federal banking agencies will consider these comments very carefully. I should be very clear about this. Some believe that with the issuance of CP3, the shape of Basel II is essentially set in stone. This is wrong. If the CP3 or ANPR comments show that elements of the proposal need to be modified, the U.S. agencies will seek such modifications. These views do not conflict at all with those that I elaborated a few minutes ago. As I indicated, there is a well-understood need for a Basel II and any realistic version of it will need to balance flexibility and comparability in the use of modern risk-management techniques. But the members of the Basel Committee need to remain open to the possibility of specific improvements to the proposals. Let me describe some of the conceptual issues that have been raised regarding the proposals and provide some perspective on them. First and foremost has been the issue of complexity. Concern over this issue appears to have several aspects. The first is a concern over the sheer volume of the proposals. This aspect of the complexity concern is, I think, somewhat misguided because it has typically equated the Basel proposals with the sum total of those background papers that have been released in an effort to explain more transparently not only what the proposals are but why they look the way they do. Nevertheless, there is no doubt that the Basel II proposals themselves are several times longer than Basel I. One reason for this is that Basel II contains several different versions--it is no longer a one-size-fits-all approach. But in the United States, we are not proposing to implement every flavor of Basel II. The ANPR should therefore present a reasonably streamlined package for U.S. banks to consider. Needless to say, it will also be imperative that the U.S. agencies explain the proposals as clearly as possible in the ANPR itself. Another aspect of the complexity concern surrounding Basel II is its use of modern risk-management techniques. These techniques inevitably involve complex statistical, and thus mathematical, assessments of risk. To reject such techniques solely because they involve mathematical complexity would be inconsistent with the broader direction that banking and its best-practice risk management have been taking over the past decade. One could not reasonably hope to develop a meaningful or comprehensive assessment of risk at a large, complex bank today without making use of such methods; and, I might add, this view seems to be supported by most of the documents issued on the matter by the RMA. But some of the concern over complexity is driven by the fact that Basel II makes a number of distinctions between exposures and transactions in an effort to improve the risk sensitivity of the resulting capital ratios. Reasonable people might disagree about these particular tradeoffs between complexity and risk-sensitivity that have been chosen by the Basel Committee. Comments and feedback on these tradeoffs will be particularly important. But such comments will be most effective if they address both sides of the question--not only point out areas in which the proposal may be overly complex but also show how the objective of risk sensitivity could be met in less complex ways or state why it may not be necessary to achieve either flexibility or greater risk sensitivity in this particular instance. Competitive equity is a second fundamental area that I hope the comment process will address. The question of competitive equity has domestic aspects, international aspects, and bank-nonbank aspects. Let me start with this last aspect, namely whether the Basel II proposals will impose restraints on banks that are not being imposed on their nonbank competitors. It is important that we receive information on the competitive impact of the Basel II proposals relative to nonbank competitors, particularly if it appears that the marketplace allows nonbanks to operate with less capital--or conversely with more leverage--than similarly situated banks would be required to hold. Clearly, we should not hinder the competitive position of any U.S. banking organization relative to nonbanks and will work to avoid such an outcome. However, bank supervisors also have an obligation to develop the regulations that they feel are appropriate to banks even if similar regulations will not be applied to nonbank competitors. All of you are thoroughly familiar with the elements of the federal safety net--including deposit insurance and access to the discount window and the payment system-that differentiate banks from nonbanks in the United States. The safety net, which is provided at taxpayer expense, obligates supervisors to develop approaches that they believe are prudent for the banks that benefit from that safety net. A second aspect of the competitive equity issue involves domestic competition among banks--what would be the competitive effect of altering the regulatory capital rules for the largest and most complex banks while keeping the existing framework for most other banks? My perception is that pricing, and thus competition, between large and smaller banks today is relatively little influenced by regulatory capital constraints because banks are operating far above regulatory minimum levels, or because economic capital and not regulatory capital is the binding constraint, or because banks are capable of easily selling or securitizing the exposure, as is the case with the majority of residential mortgage loans. Moreover, the ultimate check on the possibility of competitive distortion is that any bank that makes the investment in risk management technology necessary to meet the Basel II standards will be able to adopt the advanced IRB approach. I hope that it goes without saying that in proposing to implement Basel II as we have outlined, we are not seeking or expecting to induce material shifts in the competitive banking landscape in the United States. Nevertheless, if some institutions believe that these proposals will have such an effect, we want them to use the ANPR comment process to enable us to understand and evaluate the rationale for those views and whether modifications to the Basel II proposals, or the way we intend to implement them, are appropriate in response. Another important aspect of the competitive equity issue is competition among the subset of banks covered by the Basel II approaches, particularly the more advanced approaches. As a result of relying on inputs generated by systems at individual banks, there will inherently be variations across these banks in how such systems treat the same transactions and exposures. A certain amount of such variation is clearly a necessary byproduct of the need to provide the flexibility to make use of internally generated data. But there is also a strong policy interest in ensuring comparability across banks, as I have already discussed. This policy interest is one reason why it is desirable to establish minimum qualifying criteria for the use of approaches that rely on internally generated data, whether they might be the Advanced IRB approach for credit risk or the Advanced Measurement Approach (AMA) for operational risk. On the other hand, we do not want these qualifying criteria to so constrict the development of internal methodologies that we end up stifling their creative evolution. As I noted, the balance between flexibility and comparability is clearly a central issue in the design of a framework such as Basel II. In considering the issues of competitive equity among banks operating on Basel II, the manner in which U.S. supervisors will evaluate compliance with the minimum qualifying criteria will not place banks in the United States at a disadvantage. We have a track record of listening to banks and applying regulations and supervisory guidance in a manner that is sensible and focuses on priorities. In the coming months, U.S. supervisors will be releasing draft supervisory guidance describing the approach that we envision taking toward the assessment of internal ratings systems for key parts of the loan portfolio. We will of course be greatly interested in industry feedback on this draft guidance. By including specific qualifying criteria in the Basel II proposals, we help ensure that banks operating in other jurisdictions will develop their internal ratings systems in a broadly similar fashion and thereby advance the achievement of a level international playing field. This seems particularly important if some countries have regimes that rely more on rules and less on on-site supervision. That is, to achieve a level playing field with such rules-oriented regimes, we need to include in the rules for Basel II the elements that we in the United States would be looking for anyway as part of our supervisory oversight process. In the comment process, it will be particularly helpful if banks and others can be explicit in focusing on where concerns about competitive equity across banks are sufficient to warrant a change in the minimum qualifying criteria or in other aspects of the proposals. Basel II as an International Standard While on the subject of international competitive equity, let me now digress a bit to discuss some of the concerns that have been raised regarding whether the envisioned U.S. approach to Basel II truly reflects a commitment to an international capital standard. This concern arose after the announcement that the U.S. agencies proposed to formally implement only the most advanced versions of the Basel II proposals and that these will only be mandatory for approximately ten internationally active banks. We anticipate that another ten or so large banks will voluntarily choose to adopt Basel II because of its greater risk sensitivity. Needless to say, the goal of developing compatible systems of bank capital regulation in different jurisdictions has great merit. The global nature of many banking organizations requires them to consider the rules and regulations of a wide variety of jurisdictions, and so these organizations have a strong interest in common approaches. More importantly, the United States fully supports the role of the Basel Committee in developing capital standards that are appropriate for countries around the world to apply to their banking systems. But as the Basel II process has signaled, one framework can no longer address the needs of all types of banking organizations. To meet this challenge, the Basel II proposals contained in CP3 will include three approaches to the measurement of credit risk as well as three approaches to the measurement of operational risk. So why is the United States not proposing to implement the full range of these options and apply them to all U.S. banks? In addressing this question, I will first explain why we propose to implement the advanced methods and how we see this working. Then I will address why, for reasons perhaps unique to the United States, we do not believe introducing the other options is necessary here. In the United States, we concluded that the greatest potential benefit of Basel II was found in the most advanced versions--the Advanced IRB for credit risk and the AMA for operational risk. We concluded that if we as supervisors were going to make the effort required for Basel II, we would like to focus that effort on the most advanced versions. Obviously, concentrating attention on the most advanced approaches could help reduce the complexity of Basel II as it is implemented in the United States. Clearly, not all banks in the United States can or should use these approaches for the purpose of calculating their capital requirement. So the question naturally arises: Which banks should meet the new requirement? The size, complexity, and international activity of one particular set of U.S. banks makes it imperative that they move to the Basel II advanced approaches as quickly as possible. It is also clear that there will be a significant number of voluntary adopters of Basel II in the United States. Indeed, I believe that the majority of internationally active U.S. banks will be operating under Basel II soon after the initial implementation date, whether or not they are part of the mandatory set. If, as we expect, about twenty U.S. banks adopt the Basel II approaches at the outset, they will account for approximately two-thirds of all U.S. banking assets. In addition, those U.S. banks account for about 99 percent of all foreign assets held by the top fifty domestic U.S. banking organizations, with the ten mandatory banks themselves accounting for about 95 percent. This approach to Basel II implementation is a commonsense, step-by-step approach that makes appropriate distinctions between banks on the basis of their size and the scope of their international activities. It will not compromise the international level playing field. But on the other hand, it will allow U.S. supervisors to retain stronger control over the process by which they approve banks for use of the new advanced standards, and will reduce the incentives for banks to "rush" the necessary implementation efforts. Another aspect of the concerns that have been raised about the focus on advanced approaches relates to the desire for the "mutual recognition" of approaches used in different jurisdictions, so that the differences between home- and host-country capital regimes should be kept to a low level. These home/host issues have already been the focus of discussions within the Basel Committee's Accord Implementation Group, and the discussions will no doubt continue throughout the Basel II implementation period. The United States shares the interests of other countries in trying to ensure that domestic subsidiaries of foreign parents--either U.S. subsidiaries operating abroad or foreign ones operating in the United States--are not required to develop onerous additional procedures to comply with domestic rules. Of course, in the United States and in many other countries, domestic subsidiaries of foreign banks cannot be treated substantially differently from domestic banks. U.S. and foreign supervisors working together can develop approaches, some of them transitional, that will avoid undue burdens on either U.S. bank subsidiaries of foreign bank parents that are using alternative versions of Basel II in their home countries, in particular other flavors of the operational risk or IRB proposals, or on foreign subsidiaries of U.S. banks. In this regard, we believe it will be necessary for U.S. supervisors to allow, in some cases, for the use of transitional measures where banks--either U.S. or foreign--will not have reliable data for some interval. The second part of the question is why U.S. supervisors are not proposing to implement other options in the Basel II package such as the standardized approach to credit risk. This does not mean that U.S. supervisors believe these approaches are flawed or inferior to the Basel I approach. Indeed, they contain innovations that should lead to meaningful improvements in other countries where they will be implemented. For the United States, however, a key factor is that our capital regulations not only embody the Basel I standard but also include various "prompt corrective action" features such as the leverage ratio and the use of well-capitalized thresholds for both the risk-based and the leverage standards. In applying a leverage ratio and a well-capitalized standard, the United States is probably unique. Moreover, virtually all of the U.S. banking system currently meets the well-capitalized standard. This is presumably because of the fact that both market and supervisory attention increases as a U.S. bank falls below the well-capitalized thresholds, which is the essence of prompt corrective action. We are therefore confident that even for those banks not adopting the advanced approaches of Basel II, we will have a capital regime that achieves a standard of prudence as great as Basel II. In light of these specific U.S. circumstances, the cost-benefit tradeoff associated with implementing the other Basel II options here differs from the tradeoff in other countries. Given the costs involved in adopting new approaches, and given that with our current regime the benefits are lower for our smaller banks, it seems best at this time to retain the current regulatory capital framework for most U.S. banks other than the large, complex internationally-active set I described. In addition, for many of the same reasons, we believed that it would be inevitable that even if we proposed to implement the Basel II standardized approach, that we would need to retain the current standards for some set of banks. Thus, implementation of the Basel II standardized approach would not involve the replacement of an existing option but would create an entirely new, third approach in the United States. The U.S. supervisors were of the view that this could result in cherry-picking and, thus, that the added complexity would not be worth the additional benefits. More to the point, given the high capital position these banks continue to retain as well as their virtual lack of direct competition with banks in other countries that will be adopting Basel II, it does not seem reasonable to impose the cost of changing systems on most of these banks. Conclusions Now I would like to return to the main thread of my remarks and to provide some concluding thoughts on the way forward. I have already stressed the importance of the Basel II ANPR and the associated comment process in the United States. Complexity and competitive equity are two important themes for this comment process. Undoubtedly other issues will also be the subject of significant feedback. The issue of operational risk is by now surely familiar to most of you, so I will not belabor these points here. The calibration of the overall framework as well as of particular subsections of the framework will also inevitably attract a great deal of comment and attention. Such attention can likely improve the Basel II proposals. My remarks today have tried to lay out what I see as the central policy choices and issues confronting U.S. supervisors as we evaluate the comments we receive on the ANPR. I have tried to be open and candid about the tradeoffs that I believe are involved, some of which are clearly inherent in the nature of the Basel II effort itself. We will surely not be able to please everybody in our attempt to strike the right balance between flexibility and comparability or between complexity and risk sensitivity. Of course, as supervisors we are not expecting that the banking industry is going to stand up and applaud what remains, after all, a "regulatory requirement." As a sage adviser opined to me recently, if we ever get to the point where all of the banks are too enthusiastic about Basel II, then clearly something must have gone awry from a prudential point of view. But your feedback and comments on the Basel II ANPR will significantly shape the views of U.S. supervisors on how we go forward with these proposals. In closing, I would like to return to the points I made at the outset. Our most fundamental choice as policymakers is whether we are going to replace the Basel I framework for our largest, most complex banks with a framework that relies significantly on internally generated inputs in an effort to achieve significantly greater risk sensitivity. Against the backdrop of the dynamic changes occurring in banking and risk management, we have little if any choice but to find something that improves substantially on Basel I for the largest and most-complex banks. Yet the choices involved in developing a viable and realistic alternative to Basel I are manifold, and each one of them gives rise to arguments and counterarguments. We are not going to make the perfect policy choice initially in every one of these detailed instances. In many cases, moreover, the best choice may evolve over time. If we are going to move to a capital standard built substantially around internally generated assessments of risk, we need to focus on the practical realities of that decision and leave behind some of the wishful thinking about what each of us believes a perfect capital framework would look like. An initiative as important as Basel II is bound to change significantly over time. Basel II contains the promise of a capital framework that will evolve with improvements and advancements in risk-management techniques. As new methods and techniques become more common and well tested, the Basel II framework can and should embrace such advances. The sooner we can gain practical hands-on experience with such a framework, the sooner we can begin to realize its full potential. The Basel II proposals represent a truly significant step in the evolution of bank regulation. They are important and deserve your most thoughtful consideration as the U.S. bank supervisors evaluate exactly how to proceed with them. I hope that my remarks today will be helpful to you in considering your responses. Thank you for your attention.
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board of governors of the federal reserve system
| 2,003 | 4 |
Speech by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve System, at the 2003 Banking Institute, Center for Banking and Finance, University of North Carolina, Charlotte, 10 April 2003.
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Mark W Olson: Basel II - its implications for second-tier and community-size banks Speech by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve System, at the 2003 Banking Institute, Center for Banking and Finance, University of North Carolina, Charlotte, 10 April 2003. * * * As important as the Gramm-Leach-Bliley Act has been to American banking--codifying the new realities of the marketplace--I would argue that the 1988 Basel Capital Accord brought about an even more dramatic change in banking rules of the game. In the late 1980s, as the Congress struggled unsuccessfully to reach agreement on a plan for managing interstate banking, the banking regulators of the Group of Ten (G-10) countries were able to develop a common set of rules for bank capital. What is referred to now as Basel I established a competitive balance among the banking systems of the major industrialized countries. It made the international competitive climate considerably more fair, and it greatly improved bank safety and soundness worldwide. Let me elaborate briefly on the advances embodied in Basel I before I discuss the limitations that have become more evident in the years since it was implemented. In the mid-1980s, it was a major step forward to acknowledge, for example, that residential mortgage lending carried substantially less credit risk than did automobile lending and that certain state and municipal bond issues carried less of a credit risk than home mortgage loans. As a result, when Basel I allowed for loans and investments to be grouped into four "buckets" with risk weightings of 0 percent, 20 percent, 50 percent, and 100 percent, respectively, banks were allowed for the first time to allocate and maintain capital in a manner somewhat consistent with the risk profile of the asset side of their balance sheets. Also, overwhelmingly, banks of all sizes in the United States now had risk capital ratios significantly in excess of their leverage capital ratios. Though the risk buckets were limited and did not fully reflect the range of risk sensitivities in the 100 percent bucket, their implementation represented a significant improvement. The banking industry has changed in many ways, however, since Basel I was implemented in 1988. Two specific areas of change--the expanded use of securitization and derivatives in secondary markets and vastly improved risk-management systems--have significant implications for Basel I. The use of secondary markets and the sophistication of risk-management systems correlate significantly with bank size. While second tier banks and community size banks have also increased their access to secondary markets and have made great strides in managing their risk exposures, the changes implemented by these banks have not threatened the relevance of Basel I. However, the same cannot be said about the nation's largest international banks. The largest institutions use the secondary markets for securitizing loans of all types and for a variety of other liquidity and investment needs. The largest institutions also use enhanced technology resources and risk-management tools to more carefully and specifically measure risks of all types. For banks that operate on a global scale in virtually all financial markets, Basel I has become outdated. The current capital regime has not kept pace with either the complex nature of the operations of the largest banks or the substantial changes in both the concepts and technology of risk management. The current capital rules at these banks have been further undermined by arbitrage between regulatory and market measures of risk mainly through the use of derivatives and securitizations in the secondary markets. Given these developments, the G-10 bank supervisors have been designing a much more risk-sensitive regulatory framework that takes into account the evolution of the art of risk management. The latest version of the proposal (Basel II) will be published by the Basel supervisors committee in a few weeks and an advance notice of proposed rulemaking by the U.S. supervisors is due by midsummer at the latest. An effective date of 2007 is now contemplated. The details of Basel II were described by my colleague, Roger Ferguson, Vice Chairman of the Federal Reserve Board, in a presentation to a congressional committee in February. I have some copies with me today and can make others available. Today, I thought it might be useful to provide a U.S. supervisors' view of how Basel II should be applied in this country and to address some of the concerns we have heard about the scope of application. Given the needs of countries with a far different banking and regulatory structure than ours, Basel II contains three alternative approaches, which are described in the Vice Chairman's testimony. Supervisors in this country have for some time contemplated that only the most risk-sensitive approaches, the Advanced Internal Ratings Based (A-IRB) option for credit risk and the Advanced Measurement approach (AMA) for operational risk, would be applied in the United States. These advanced approaches would be required for only our largest and most complex, internationally active banking organizations--about ten U. S. banks. However, any other bank that meets the qualifying internal infrastructure standards for risk measurement and management could choose to apply these versions of Basel II. We anticipate another ten or so large banks may opt to do so voluntarily because of the greater risk sensitivity it affords. These banks may also make this choice for prestige or competitive reasons, as counterparties look for indications of technical risk measurement skills at the large banking entities with which they deal. U.S. authorities have agreed to implement only the most advanced Basel II options and to limit the number of required participants. First and foremost, the decision reflects a balancing of costs and benefits. Any change is expensive, and the advanced approaches are very costly to implement. The overwhelming majority of banks in this country are well capitalized and well managed under the current modified Basel I, and smaller banks are forced by markets to hold capital considerably above the well-capitalized level, so the cost-benefit ratio of requiring more of our banks to adopt some version of Basel II is tilted, for most banks, very strongly against the desirability of change. When we then add to the equation the fact that it is primarily the megabanks whose operations seem inconsistent with the current capital regime, the decision to limit the scope of application appeared even more clear-cut. Moreover, with our concern about shortfalls of the current regime focused on the complex, large, internationally active banks--and the desirability, on grounds of safety and soundness and macroeconomic stability, to see the best practice risk-management techniques applied to these entities--the decision to deploy only the most sophisticated version of Basel II also seemed obvious to us. You may also recall that an important objective of both Basel I and Basel II is to create cross-border competitive equality, reducing in our minds the necessity of requiring Basel rules to be applied to smaller banks that do not compete in international markets. Although U.S. regulators have for some time signaled that Basel II would apply only to the largest banks, questions have been raised about the implication for those banks that are not A-IRB candidates. Let me share with you our evaluation of what the implications may be for banks that will not be required to adopt Basel II and that opt to remain under Basel I. No bright line marks the separation between the groups of institutions that we refer to as large, complex, internationally active banks (those that would be required to follow the advanced Basel II), other large, complex banks (some of which we think are likely to be opt-in banks), large regional banks, and community banks. Some of the banks in the large regional group--let's say those between the 25th and 100th largest--have voiced the concern that even though they are well capitalized and well managed, they will be forced by market pressures, and especially by the rating agencies, to bear the high costs of moving to Basel II. The risk-management practices embedded in Basel II did not, of course, originate with the Basel committee or with any of the G-10 bank regulators. Rather, to a significant extent, they represent the best practices of risk-management approaches developed in the marketplace. These practices are now being used by some banks in the tier just below the largest organizations. Improved risk-management technology, supplemented by the adoption of Basel II advanced approaches at the largest banks, will accelerate the advance in risk-management sophistication that counterparties will increasingly expect to see at their banks. This market-driven change would have occurred without Basel II--in fact, it is already in progress--but Basel II will surely speed things up. In the near term, however, the cost-benefit ratio I referred to must be considered, and we believe that the benefits for most regional banks do not yet exceed the costs. It is our understanding that this is also the view of the rating agencies. The cost-benefit calculus may well change in the future, but, in the years immediately ahead, I do not believe that regional banks will be required by the market to adopt the more advanced approaches. We are also aware of concerns that the current competitive balance between Basel I banks and Basel II banks might be upset in certain loan markets. The specific worry of the Basel I banks is that the advanced approaches will yield lower capital charges for residential mortgage, retail, and small business loans. These arguments, it seems to me, require some careful thought. My own experience as a banker is that loan pricing and profitability--and that must be what the issue is about--are influenced little by regulatory capital levels. Rather, rate setting on credits is determined by a complex web of factors, including local market competition from banks and other lenders, the cost of funds, the specifics of the bank-customer relationship, and internal capital allocation practices. For many types of retail loans, but particularly residential real estate loans, secondary market pricing has the strongest influence on rate setting. When capital is considered, it is the internal allocation decisions--what the Basel proposal refers to as economic capital--that is relevant, particularly because, as I noted earlier, U.S. banks operate so far above regulatory minimums and can easily change their own regulatory requirements by loan sales and securitizations. On the subject of Basel II, let me, in conclusion, make a few summary observations. First, if you accept the fact that Basel I had a significant effect on international competitiveness and economic stability, then it stands to reason that an update is necessary to make that accord reflect changes in markets and risk-management techniques. Second, the U.S. banking industry represents banks of varying size and complexity; it would be as inappropriate to require our smallest banks to adopt techniques designed for megabanks as it would to limit the largest banks on the basis of the capacity and capability of the smallest. Third, certain basic fundamentals regarding capital measurement and capital adequacy will not change. The provisions of the Federal Deposit Insurance Corporation Improvement Act (FDICIA) requiring prompt corrective action still mandate regulatory responses based on levels of capital adequacy. Finally, just as Basel I has been modified on numerous occasions to accommodate new financial instruments or a new recognition of risk weighting, we anticipate that the current and prospective Basel rules will accommodate future changes in risk measurement and risk taking.
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board of governors of the federal reserve system
| 2,003 | 4 |
Testimony of Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Committee on Financial Services, US House of Representatives, 30 April 2003.
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Alan Greenspan: Follow-up to the semiannual monetary policy report to the Congress Testimony of Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Committee on Financial Services, US House of Representatives, 30 April 2003. * * * Mr. Chairman and members of the committee, I am pleased to have this opportunity to update you on developments in the US economy since mid-February, when I presented the Federal Reserve's semiannual monetary policy report. At that time, I noted that the economic expansion over the preceding year had been modest. Spending by households had contributed importantly to the gains in economic activity. The nation's strong underlying productivity performance was providing ongoing support for household income. That rise in income, combined with low interest rates, reduced taxes, and the availability of substantial home equity, had spurred solid gains in consumer spending and a robust advance in residential construction. In contrast, although the contraction in capital spending appeared to have slowed, we had yet to see any convincing signs that a sustained pickup in business spending was emerging. Moreover, heightened geopolitical tensions were adding to the already considerable uncertainties that had clouded the business outlook over the preceding three years. The general climate of caution in the business sector was manifest in a number of ways, including restrained hiring, a reluctance to invest in new capacity, and aggressive actions to maintain low levels of inventories. In late February and early March, the risks and uncertainties surrounding the economic outlook intensified as the range of possibilities for the timing, duration, and economic consequences of the pending war in Iraq appeared to widen. In financial markets, a greater sense of caution among investors seemed to bolster the demand for Treasury and other fixed-income securities at the expense of equities; the price of crude oil moved up, as did the prices of gasoline and home heating oil; and consumer confidence sagged further. After picking up in January, payroll employment and manufacturing production turned down again in February and March. When the onset of the war became imminent, financial markets rallied, and the price of crude oil dropped back. Market participants seemed buoyed simply by the elimination of uncertainty about the timing of the start, and hence the end of hostilities, although a still-significant amount of unease inevitably remained about the way the war might progress and how severely it might disrupt oil production and economic activity. In such an environment, we had little ability to distinguish temporary changes from more persistent shifts in underlying economic trends. For that reason, the Federal Open Market Committee, at its March 18 meeting, refrained from making a determination about the balance of risks with respect to its long-run goals of price stability and sustainable economic growth. At the same time, we stepped up our surveillance of economic developments. As part of that surveillance, we receive virtually continuous information from commodity and financial markets. The price of crude oil is now well below its peak of early March, as the potential for serious supply disruptions in world oil markets has diminished. Broad equity indexes remain well above their lows of mid-March and have been boosted most recently by incoming information on first-quarter earnings that market participants appear to view as generally positive. In contrast, six weeks after the beginning of the war, we have only limited readings on broader economic conditions, and that information has been mixed. Households appear to have become somewhat less apprehensive about the economic outlook in recent weeks, though reports from businesses have not exhibited a similar improvement in tone. Consistent with this, the persistent high level of new claims for unemployment insurance suggests that firms may still be finding it possible to meet their customers' tepid increases in demand with a leaner workforce. Going forward, some further unwinding of the economic tensions that have been associated with the situation in Iraq seems likely. As that occurs, the fundamental trends shaping the economic outlook should emerge more clearly. As I indicated when I met with you earlier this year, I continue to believe the economy is positioned to expand at a noticeably better pace than it has during the past year, though the timing and the extent of that improvement remains uncertain. Fundamentally, the long-run growth potential of the economy remains solid. And the enhanced flexibility inherent in that trend imparts resilience against shocks of the kinds that we have experienced in the past few years. Unfortunately, the future path of the economy is likely to come into sharper focus only gradually. In the interim, we need to remain mindful of the possibility that lingering business caution could be an impediment to improved economic performance. As you may know, the consensus of economic forecasters is that a material rebound in economic activity will develop in the second half of this year, and certainly a number of elements should be working in that direction. The recent improvements in financial markets that I noted earlier, if maintained, would seem to suggest a turnaround in capital spending. In this regard, the ongoing decline in risk spreads in corporate bond markets so far this year is an encouraging development. To be sure, spreads remain high by historical standards, but the constraint imposed by last fall's huge run-up in risk premiums now appears to have been put largely behind us. In addition, businesses should see some relief from the pressure on profit margins that had developed in recent months as energy prices rose sharply, and improvement on this front could be a positive development for capital spending. A modestly encouraging sign is provided by the backlog of orders for nondefense capital goods excluding aircraft, which has been moving up in recent months. Households, too, are likely to welcome lower energy bills and a continuation of favorable conditions in mortgage and credit markets. As you know, core prices by many measures have increased very slowly over the last six months. With price inflation already at a low level, substantial further disinflation would be an unwelcome development, especially to the extent it put pressure on profit margins and impeded the revival of business spending. The balance of influences on inflation and economic activity will be among the subjects of discussion by the Federal Open Market Committee when it meets in six days.
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board of governors of the federal reserve system
| 2,003 | 4 |
Speech by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, at the Risk Management Workshop for Regulators, The World Bank, Washington, D.C., 28 April 2003.
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Roger W Ferguson, Jr: Basel II - a case study in risk management Speech by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, at the Risk Management Workshop for Regulators, The World Bank, Washington, D.C., 28 April 2003. * * * I am pleased to join you this morning as you begin your conference on risk management in banking. As many of you may know, I have been spending time on the initiative to increase the risk sensitivity of the Basel capital accord - the subject of your first panel discussion. In the last analysis, our Basel II efforts are geared to improving risk management - measuring risk more accurately; communicating those measurements to management, to supervisors, and to the public; and, of course, relating risk both to capital requirements and to the supervisory focus. This morning I will not discuss the details of the Basel proposals. Tomorrow, the Basel Supervisor's Committee will publish its third consultative document describing the proposal in its near-final form, and I urge you to review it and provide your comments and suggestions to the Committee. It is not too late to shape the details. This morning, however, in keeping with the theme of the conference, I will spend my time talking about the objectives of the proposed Basel II, particularly as they relate to risk management. Risk in Banking Any discussion of risk management in banking must start with the understanding that banks exist for the purpose of taking risk, and the objective of supervision is certainly not to eliminate, and perhaps not even to lower, risk-taking. Rather, the objective of supervision is to assist in the management of risk. We cannot lose sight of the fact that banks' willingness and ability to take risk, in turn, has allowed them to contribute significantly to economic growth by funding households and businesses. Nonetheless, this economic function, especially when conducted with a relatively small capital base and using mainly funds that have been borrowed short-term, has historically led to periodic rounds of bank failures and changes in credit availability that have exacerbated macroeconomic cyclical patterns and inflicted losses on households and businesses alike. Such a history has often led to proposals to change dramatically the business of banking; it clearly has been a major reason for central banks and for the regulation and supervision of banking. These developments, however, did not change the risktaking function of banking nor the need for risk management. Banks, from the very beginning, have, to be sure, managed risk - even before there were supervisors or regulators to insist that they do so. Banks managed risk because they were in the business of banking and did not want to fail and lose what, at least initially, was their own capital. Even in modern banking, with professional management largely divorced from the owners, the desire of management to have the institution survive is still a major impetus to risk management. But, until quite recently, systematically and formally managing many of the key risks taken by banks, in particular their credit risk, was difficult. The techniques for quantifying and measuring risk, and the technology and instruments to manage and distribute it, simply did not exist. Individual credit-risk decisions tended to be made by lending and credit officers who used their judgment to decide who was given credit and who was not. A characteristic of lending officers is that they are paid to make loans, and in competitive lending markets they want to make sure they maintain, if not increase, market share. This is to say not that lending officers are uninterested in risk management but rather that their focus is on finding a way to make the loan. In a world of judgment, the risk manager had considerable difficulty in persuading lending officers, indeed management, about excessive risk when quantitative procedures and systems did not exist. Differences in judgments are difficult to resolve. I want to emphasize that historically bank credit availability has demonstrated a clear cyclical pattern that is both consistent with the credit-making decision process I have just described and that, in turn, has exacerbated real economic cycles. During economic recoveries, bank credit officers would become more optimistic and willing to lend, an attitude that only strengthened during booms; in such times the voice of risk managers, even supervisors, calling for caution was likely to carry less weight. During recessions, with losses clear and write-offs rising, caution would come to the forefront, attitudes toward lending would become much more restrictive, reinforced by the arguments of risk managers and supervisors who could point to the losses. One can, I think, begin to notice a change in recent years in this typical pro-cyclical behavior in bank credit availability. It first became apparent in the minimal credit losses at the large US banks during the Asian debt crisis and Russian debt default in the late 1990s. It was also noticeable when these same entities began to tighten lending standards during the later years of the last expansion, in contrast to typical patterns where tightening occurred near or after the peak. It is also apparent in the continued strength in the portfolios of these entities during the recession. To be sure, part of the explanation is new techniques for shifting and sharing risks through various new instruments. But at bottom, I would argue that we are beginning to see the payoff from more formal and rigorous quantitative riskmanagement techniques for credit decisionmaking, techniques that have also been central to the development of new instruments for hedging, mitigating, and managing credit risk. Encouraging Risk-Management Techniques The proposed Basel II attempts to do two things: to apply the concepts of these new risk-management techniques in banking to the supervision of banks and to encourage the widening and deepening of the application of these concepts to the largest and most complex internationally active banking organizations. It is true that the ideas embodied in Basel II began inside banks themselves; but not all banks are using all the concepts, and the advance across banks has been uneven. Increasingly investors and counterparties are asking whether they are being used, and Basel II adds to such pressure. Running through all three pillars of the Basel II proposal is encouragement for banking organizations to invest in and improve their risk-management capabilities. The advanced approaches to credit risk will require large banks to analyze their credit exposures in a formal and systematic way, assigning both default and loss probabilities to such exposures. Basel II is rooted in modern finance and seeks to develop in the larger banking organizations a comprehensive, systematic approach to assessing the various risks to which they are exposed. It inevitably raises both the supervisors' and the market's expectations for banks' risk-management systems. It clearly will increase the resources and management attention devoted to the details of risk management, focusing attention on the kinds of risks being taken and the potential losses that may accompany them. It is exactly that kind of attention, that kind of support for the risk managers, that will minimize the procyclical swings that have historically marked the bank credit cycle: unintended risk-taking from an overly optimistic view followed by intervals of limited credit availability for even low-risk borrowers as pessimistic views came to the fore. Unintended risks are neither priced correctly nor adequately reserved or capitalized. Reductions in credit availability limit economic growth. As the scale and scope of banking has increased and as banking systems have become more concentrated, the effects of mistakes from excessive risk-taking and reductions in credit availability on national and world financial markets and economies has simply become too large to tolerate. The alternatives to strengthening risk management are limited and not very attractive: prohibitions on activities or very intrusive supervision and regulation. Bank managers and stakeholders, as well as those who believe in the market process, have an important stake in making Basel II work because the alternatives to it are so unappetizing. Pro-cyclicality Some observers grant the desirability of better risk management but have voiced concern that a set of rules for risk-sensitive capital requirements still will be excessively pro-cyclical. They argue that as banks re-evaluate the probabilities of default and loss over a business cycle, regulatory capital requirements will fall in booms, as risks are perceived to be low, and increase in recessions, when pessimism replaces optimism, aggravating the underlying real economic cyclical pattern. Better risk management, these critics seem to be saying, will make the world less stable. Let me stipulate that a regulatory structure based on formal risk-management techniques will imply, to some degree, a cyclical pattern of minimum regulatory capital requirements, exactly like the internal pattern of economic capital needs at a bank using modern risk-management techniques on its own. The question is: Is that a bad or good thing? To begin to address that question we first have to recognize that risk itself is not constant over time but, in fact, varies cyclically and in other ways. Regardless of how we construct our capital requirements, at times the same portfolio of loans will face more or less risk over the relevant planning period than at other times. We have a choice: We can decide to ignore that reality or recognize it. The current capital regime chooses the former option by default - risk categories are insufficient to recognize changing risk; less information about reality is conveyed by the capital requirements, facilitating both the banks' and the supervisor's failure to respond to the underlying changes. The proposed Basel II, in contrast, conveys to managers, to supervisors, and importantly, to the public how risk changes as capital requirements respond to changes in the real underlying risk. A sufficiently risk sensitive capital regime will impart timely information regarding risk. That, in turn, will allow adjustments in lending policies sufficiently early to limit excessive swings in lending behavior. Risk sensitivity in capital requirements can damp swings in credit availability, reducing both credit sprees and credit crunches. From a supervisory perspective, it seems clear that we prefer - or at least, ought to prefer - the regulatory capital ratios that convey more information. Supervisors, banks, and the public should want to understand when bank portfolios are facing higher risks or when an updated estimate of risk relative to capital reveals a warning sign that requires attention. No such early warning system is provided by a system of capital requirements that does not signal that a bank has a problem until the problem is sufficiently severe to have already eroded the underlying capital. That is, a capital system with little risk sensitivity creates the potential for problems to escape undetected for longer periods of time. Such delays increase the likelihood that the underlying problems will not be addressed soon enough and will likely grow larger over time. To be sure, it may well be desirable to avoid an excessively conservative calibration of the risk sensitivity of a regulatory capital regime to minimize the potential for over-response in the capital ratio, relative to some regulatory threshold, when risk evaluations change. Overreaction can be as much of a problem as underreaction. The Basel Committee has attempted to avoid such difficulties by selecting, whenever possible, parameters that recognize factors that reduce risk exposures and by adjusting capital charges accordingly. If the Committee has the calibration about right overall, then supervisors, banks, and markets should be able to handle effectively more information embodied in the form of more risk-sensitive capital ratios. Of course, as I noted, the upcoming comment period on the third consultative document will afford an opportunity to express additional views on the issue. An often-heard complaint is that markets and banks will overreact to changing capital ratios, the bank will be overpenalized, or the bank will overrespond in its lending policies. However, the evidence is sufficient to take a more positive view of markets and their ability to evolve in the presence of new and better information. Perhaps more important, these concerns tend to ignore the behavioral effects that more-risk-sensitive regulatory capital ratios will induce. Earlier I noted the cyclical pattern that historically has characterized bank credit availability, a pattern exacerbated by the lack of formal and systematic credit-risk management. A regime of more formal attention to risk exposures, as under Basel II, offers the hope of a more stable pattern of credit availability. Quantitative risk management should reduce the buildup of excessive unintended credit risks that have been assumed in expansions, which in turn will minimize the losses and associated tighter lending standards during recessions. Such lending behavior, in turn, might well reduce the cyclical pattern in minimum capital requirements that would otherwise occur without the better risk-management techniques required under the proposed Basel II. The response to more formal risk management thus creates the reasonable prospect of reducing concerns about the pro-cyclicality of capital ratios under Basel II. In the past, problems have arisen when banks have been too complacent in their judgments of risks during good times, too slow to react when the situation turns, and too risk-adverse once their losses have turned out larger than anticipated. A process that encourages banks to think more carefully and more pro-actively about all of these possibilities offers the hope of a significant improvement in the way that they manage themselves over the course of the business cycle. Along these lines, Basel II emphasizes the importance of stress testing credit-risk measurements. Stress testing as a means for considering how risk assessments and capital requirements can change as the economic environment weakens is a necessary part of the broader shift toward a more proactive approach to risk management. Bank managers should consider the results of their stress testing when determining how much capital they need to hold above the regulatory minimum requirement, which is after all only a portion of the total capital held. Indeed, to facilitate flexibility and to enhance their competitive positions with counterparties, banks will continue, even after the Basel II proposal becomes effective, to carry a buffer stock of capital - an amount above their regulatory minimum. However, under the proposal, the supervisor will incorporate stress testing as a factor in the assessment of how much buffer capital should be held. As part of the second pillar of Basel II, supervisors will discuss the results of the stress test with bank management to ensure that the banks take seriously their need to consider the dynamic management of their capital over the economic cycle. Operational Risks My comments have focused on risk management and the cyclicality of a risk-sensitive capital regime. But thus far I have emphasized the major risk that most banks face - credit risk. At times, however, other risks have proven to be quite costly - sometimes fatal - to banks. In my view, therefore, a discussion of risk management is incomplete without a consideration of operational risk. From a bank's and a supervisor's viewpoint, no matter how real and serious operational risk may be, it is, with the current state of the art, not easy to measure. Thus, the Basel Committee's proposal to apply an explicit capital requirement under pillar I to operational risk has been controversial. Against that background, reviewing the Committee's thinking that led to the proposed treatment of operational risk might be useful. Under the current, Basel I capital regime, capital requirements on credit exposures are set high enough to cover implicitly operational risk, an approach that has helped to undermine Basel I by adding to the wedge between regulatory and market evaluations of lower-risk exposures. If operational risk were subject not to an explicit pillar I capital charge under Basel II but rather to supervisory review under pillar II, capital requirements for credit risk in pillar I would have to be either (1) kept unchanged or (2) treated as they are under Basel I with a safety margin built on top of the credit-risk requirement to cover operational-risk exposures. The conservative calibration of the latter approach, as I earlier noted, would mean that capital requirements, by exceeding the "real" underlying credit risk, would make required capital ratios overly sensitive to cyclical reclassifications of credit-risk exposures. It would also erroneously assume that operational risk and credit risk move in tandem. Including only credit risk within the ambit of explicitly required capital, calibrated as it now is to empirical measures, would lower required capital levels more than is probably warranted because operational risk is a real risk that causes real losses. Even if there were a way to adjust required capital for the absence of an explicit charge for operational risk, the pillar II approach, let us be frank, opens up too real a possibility that operational risk will be relegated to an inferior status, with a slowing down of the current impetus to measure and manage it. Indeed, I think it is fair to say that the proposed pillar I treatment of operational risk has been a major driver behind the substantial management attention and scarce firm resources that have been devoted to operational risk management in the past few years. A robust pillar II approach would require significant and sustained supervisory pressure to ensure that banks continue to invest in improving their operational-risk assessments. Even then, comparability across banks would be difficult to achieve, undermining our efforts to attain a level playing field. And the capital held under pillar II would, to the public, look like any other buffer capital - nonrequired under pillar I - eliminating a high degree of transparency. Moreover, one must be aware that a number of firms are successfully spending time and resources to improve their operational-risk measurement and management approaches. Many are doing so not solely because of Basel II proposals but rather because they believe that their financial interest lies in better measuring and managing this risk. These firms believe that the objective of a reasonable, flexible, comparable approach to operational risk is achievable, and what is more, they believe they already have reduced such risks by applying formal techniques to their measurement and management. Quantifying operational risk is admittedly not simple. But the inability to make precise estimates does not mean that an explicit capital requirement for this real risk is impossible. Indeed, the Basel Committee developed the Advanced Measurement Approaches (AMA) to provide a flexible way to measure operational risk for pillar I purposes. The AMA allows banks to utilize their own internal models, subject to supervisory approval, to determine the capital to be held for operational risk. Banks are expected to use their own internal loss data, external loss data, scenario analysis, and qualitative indicators of operational risk when developing these models. Thus, though the AMA is flexible, it also provides a structure for making a quantitative assessment of the capital needed for operational risk. The AMA provides a road map, with the understanding that no specific approach has been universally adopted within the industry or endorsed by supervisors. It is a practical guide, intended to offer a constructive way to proceed toward assessing an operational-risk capital charge that is reasonable and meaningful. Though the AMA will require banks to use analytic tools to quantify their operational risks, it also allows for the exercise of considerable management judgment. And, as I want to underline, the purpose of developing improved measurement techniques is to use them as a means to the end of better overall operational-risk management. The AMA thus provides banks with the flexibility to parse out the operational risk capital charge in a manner that is reasonable and comprehensive. To be sure, there remains the question of how certain components of an AMA, such as external data and scenario analysis, are expected to be used in arriving at an appropriate level of operational risk capital. It may be necessary to provide banks with a more concrete sense of what supervisors are looking for in this regard, and regulators in the United States are currently working to do so. A frequent objection to the AMA from banks is that without this clear guidance, the scale of the expected AMA charge will be set largely at the discretion of the supervisor and it could turn out to be excessive. This will not be the case, and banks interpreting the AMA in this way have an erroneous perception of how aggressive supervisors will be in this regard. In addition, supervisors have been engaged, through the supervisory process, in gaining understanding of the emerging internal operational risk methodologies that institutions have pursued. Our findings to date are consistent with the expectation that the AMA typically results in a lower capital level than would be the case under the blunter measurement tools. With their new bottom-up, datadriven methodologies, banks are finding that the level of overall economic capital allocated to operational risk is not dramatically different from their old top-down methodologies, although the allocation across business lines often changes significantly. We believe that these methodologies and the resulting capital allocations for operational risk may be indicative of what we are likely to see once the new rules come into effect. Supervisors must be willing to say that the size of the capital charge for operational risk under AMA to some extent will depend on the development of industry practice and the experience and associated consensus that will evolve over time. In the interim, supervisors will need to engage banks in discussions about the likely size of their operational risk capital requirements. Summary In closing, I will review the major points of my presentation. The proposed revision of the international capital accord is, at bottom, about improving risk management in banking, extending and building upon what most large banks have already begun to develop and what the market increasingly demands of large, complex banking organizations. It is a regulatory framework that seeks to develop a comprehensive and systematic approach to risk taking in banking. Some have argued, however, that changing perceptions of risk will make Basel II risk-sensitive capital requirements pro-cyclical, exacerbating the real economic cycle. It is true that the required capital ratio will likely have a cycle; but such a pattern will reflect genuine risk developments, and the more accurate measurement should be helpful to bank managers, supervisors, and the public. Moreover, the behavioral response to more-sensitive capital requirements is likely to reduce the cyclical pattern in bank credit availability. In any event, the buffer capital held will absorb the cyclical movement in required capital. Operational risk is not easy to measure, but it is a real risk that cannot be ignored. Its proposed treatment in pillar I would likely result in more serious, and less uneven, attention. Those banks that have conscientiously tried to measure and manage operational risk have been successful, and Basel II offers flexible techniques for trying different approaches. However, supervisors may well need to provide more guidance that will allow banks to estimate the size of the capital charge for this risk.
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board of governors of the federal reserve system
| 2,003 | 4 |
Speech by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, before the Forecasters Club, New York, 24 April 2003.
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Ben S Bernanke: Will business investment bounce back? Speech by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, before the Forecasters Club, New York, 24 April 2003. The references for the speech can be found on the website of the Board of Governors of the US Federal Reserve System. * * * The recession that began in the United States in March 2001 is distinctive in being one of the few business-led - as opposed to household-led - recessions of the post-World War II period. Typically, US recessions have featured downturns in household spending, with housing and consumer durables being the most severely affected, and with business spending on capital goods playing a secondary and generally reactive role. In the recent episode, by contrast, business fixed investment began to weaken well before the official peak of the business cycle, contracting in real terms from the fourth quarter of 2000 through the third quarter of last year. In an arithmetic sense at least, this decline in investment accounted for a very substantial part of the general economic slowdown of the past few years. Meanwhile, completing the role reversal, households maintained their spending remarkably well, particularly on new homes and automobiles. Although the US economy has managed modest real growth through 2002 and into 2003, most economists agree that a strong and well-balanced recovery will require a greater contribution from the business sector, in the form of increased capital investment and hiring. Today my focus will be on the prospects for capital investment. I will review some of the factors that contributed to the investment boom and bust of the past few years, and then I will turn to the difficult issue of whether we can expect a sufficient rebound in business investment to keep the economy on a recovery path in 2003 and 2004. Along the way I will touch on a few related issues, such as the debate about whether the economy currently faces a "capital overhang" that is inhibiting new investment. Before proceeding, I should note that my comments today reflect my own opinions and not necessarily those of my colleagues on the Board of Governors of the Federal Reserve or the Federal Open Market Committee. How the Federal Reserve Board Staff Forecasts Business Investment Spending As background for my discussion of the recent and likely future behavior of business investment - and in recognition that my audience consists of the distinguished membership of the Forecasters Club - let me begin with a few words on how the Federal Reserve Board staff forecasts business spending on new capital goods. For relatively short horizons, say this quarter and next, the forecasting of business fixed investment (like most other macroeconomic variables) is largely an exercise in applied data analysis. As an organizing principle, the Board staff tries to mimic the methodology used by the Bureau of Economic Analysis in creating the National Income and Product Accounts series for real business fixed investment. For example, following the procedures of the BEA, the staff uses detailed data on manufacturers' shipments of nondefense capital goods, published by the Bureau of the Census and other government agencies, to develop monthly estimates of nominal spending on most major types of equipment. Similarly, monthly data on construction put in place are used to estimate nominal investment in commercial buildings and other types of structures. The staff converts these nominal spending figures into real terms using producer price indexes or other appropriate deflators. In addition to this translation of monthly data published in regular government reports, the Board staff follows BEA procedure in estimating investment in aircraft and motor vehicles from information supplied by the manufacturers directly. Of course, not all the data necessary to replicate the BEA's calculation of business investment for the current quarter are typically available, and virtually none is available for subsequent quarters. I would like to thank, also without implicating, Jason Cummins and Stacey Tevlin for excellent assistance in preparing this talk. Estimating investment spending therefore requires projections over the next few months of the various components of shipments, construction put in place, and other relevant data. The staff makes these projections with the help of various statistical techniques, taking into account the predictive power of related quantitative indicators, such as new orders. In constructing its short-term forecasts, the staff has also found it useful to supplement the available, largely preliminary data on shipments and orders of capital goods with a variety of qualitative information. Examples include material from the Fed's Beige Book, which includes reports about current conditions in the twelve Federal Reserve Districts; the Institute for Supply Management's national surveys of purchasing managers and related regional surveys; various other surveys conducted by both nonprofit groups and private firms; industry reports; and reports and anecdotes from business contacts. Finally, near-term investment projections are assessed for reasonableness relative to the picture presented by broader macroeconomic indicators, such as measures of production, inventories, and hiring. Detailed data analyses of this type are useful in predicting business investment for the current and following quarter. But monetary policymaking requires projections for longer horizons, up to six to eight quarters ahead. To obtain forecasts of investment for those longer horizons, the staff relies on formal econometric models combined with additional statistical and qualitative information. The staff employs a suite of forecasting equations for investment, varying in details of specification. This eclecticism reflects the failure of any single specification to emerge as the clearly "best" model of investment. Indeed, these equations are perpetually works in progress, as forecasting errors are analyzed and performance is compared to alternatives. However, the models which are most heavily used all belong to the same general family, the so-called neoclassical model of investment, most closely associated with Professor Dale Jorgenson of Harvard University (Jorgenson, 1963; Hall and Jorgenson, 1967). According to the neoclassical model, which is based on an analysis of the marginal costs and benefits to a firm of acquiring additional capital goods, investment spending by firms depends primarily on two factors: first, the projected growth in business output, as determined by final demand, and, second, the cost of acquiring and using capital goods, the so-called user cost of capital. Higher projected output growth naturally leads firms to expand their capacity to produce by investing in new capital goods. This relationship between the rate of growth of demand and the level of investment spending, dubbed the accelerator effect, is a venerable and empirically well-supported relationship in economics. The fact that investment spending itself is part of final demand, however, leads to a certain circularity in the analysis: If firms decide to invest aggressively, then final demand will be high, justifying the rapid pace of investment; but likewise, weak investment demand can be partly self-justifying (Kiyotaki, 1988). This possibility of self-justifying optimism or pessimism inevitably creates a role for expectations and attitudes in the analysis, a point to which I will return. The second factor that determines investment spending in the staff model, the user cost of capital, is more precisely defined as the after-tax, per-period cost of using a capital good - it may be thought of as the per-period rental cost of capital. The user cost of capital depends in turn on such factors as the prices of new capital goods, the real interest rate at which firms must borrow to finance their investment spending, the rate at which capital depreciates, and the degree to which the tax code subsidizes or penalizes investment. Not surprisingly, increases in the user cost of capital have been found to reduce business investment, although the size of the effect is less well identified statistically and more controversial among economists than the effect of output growth mentioned previously. A practical question is whether business investment should be forecast as an aggregate quantity or broken down in some way and forecast component by component. The Board staff have found a significant benefit, in terms of reduced forecasting error both in and out of sample, in modeling investment by asset class - for example, in forecasting investment in computers separately from investment in other types of equipment, or investment in office buildings separately from investment in drilling rigs. I will give a concrete example of the advantages of disaggregated forecasting in a moment. The Board staff's econometric models of investment have performed well over the years. However, business investment can be highly volatile from quarter to quarter, a fact that makes forecasting misses - sometimes quite large ones - simply inevitable. A major reason that investment can sometimes be hard to predict is the inherently forward-looking and subjective nature of investment decisions. When firm managers are highly optimistic about the potential of a new technology, a new product, or a new market, for example, they are likely to invest aggressively, almost independently of the level of interest rates and similar "fundamentals." But likewise, if beliefs become more pessimistic, investment can fall significantly, even when financing is easy. Keynes referred to the sometimes rapid changes in mood of business leaders as "animal spirits." Reasonable people can disagree about the importance of this phenomenon in general, but we seem to have seen more of it lately than usual. Recognizing the subjective nature of the investment decision, the staff makes substantial efforts to gather information about management expectations, as reflected for example in analyst earnings projections, surveys, industry reports, interviews, and the like. Particularly at turning points, this type of information may provide important additional insights into the likely course of investment spending. I close this brief survey of forecasting at the Board by emphasizing that the staff forecast is just that the staff's. Monetary policy decisions are made by twelve of the nineteen members of the Federal Open Market Committee: the seven members of the Board of Governors, the President of the Federal Reserve Bank of New York, and four of the remaining eleven Reserve Bank presidents, among whom the vote rotates annually. I suspect that, at any given meeting of the FOMC, virtually every member of the Committee disagrees with some aspect of the staff's forecast - quite possibly in mutually inconsistent ways. Nevertheless, we take the staff forecast as an informative and highly useful starting point for a productive discussion of the prospects for the economy and the way that policy should respond. The Investment Boom of the Nineties With this background, I now review the recent behavior of investment, concentrating on business fixed investment, or investment in nonresidential structures as well as equipment and software. (For now I omit residential investment - that is, investment in housing - and investment in inventory stocks.) The weakness of business fixed investment during the past three years contrasts sharply with the investment boom that was one of the most striking features of the US economy in the 1990s, particularly during the second half of the decade. Growth in real investment averaged close to 10 percent per year between 1995 and early 2000. For comparison, during the strong 1983-87 recovery, real investment grew less than 6 percent per year. The rapid pace of business investment in the nineties was central to the unusually high rates of economic growth, low rates of unemployment, and rapid productivity growth that we observed during that period. Broadly speaking, the factors that the neoclassical model suggests would be needed to underpin an investment boom were indeed present during the late nineties. Final demand and hence output grew strongly, and the user cost of capital was falling. However, as Tevlin and Whelan (2003) have shown in a recent paper, explaining the magnitude of the nineties boom requires modeling the component parts of investment separately, as the Board staff does in practice. In particular, a disproportionate part of the investment boom of the nineties can be attributed to investment in computers, software, and communications equipment, so that an important step toward explaining the overall boom in investment is explaining the surge in these high-tech categories. In their paper, Tevlin and Whelan identified two factors that gave a strong impetus particularly to investment in computers during this period. First, the costs of computing power fell sharply in the late 1990s, arguably reflecting a pickup in the pace of technological advance as well as an intensification of competition among the major chip makers. As a result, the user cost of capital for computers and related equipment declined even more rapidly than earlier in the decade. Together with strong overall business conditions, these low and falling costs of computing power induced many firms to make major investments in information technologies. Second, generally speaking, computers exhibit high rates of economic depreciation; for example, new applications requiring greater speed or more memory sometimes make existing computers effectively obsolete within a few years. High rates of economic depreciation imply rapid replacement cycles, and hence high rates of gross investment in computers. Tevlin and Whelan showed that these two factors - low and falling prices of computing power and high economic depreciation rates - can explain much of the high rates of gross investment in computers during the nineties; and that these high rates of investment in computers in turn help to explain a substantial part of the overall investment boom. Although econometric models can do a reasonable job of explaining the investment boom of the late nineties, standard models do not fully capture other factors that boosted investment spending during that period, especially in the high-tech sector. For example, the Telecommunications Act of 1996 was intended to increase competition in the telecom sector. Many firms apparently believed that the dominant market share would go to companies with the biggest networks and the most "cutting-edge" technologies; consequently, investment boomed in the telecom sector. Similarly, deregulation of the electric power grid may have spurred increased investment in power systems. Outside the legislative arena, rapidly increasing access to the Internet raised the possibility of a huge new on-line demand for products and services, which spurred a wave of new dot-com startup companies hoping to be the first to meet that anticipated demand. Established firms, from booksellers to clothing retailers, responded with their own on-line marketing outlets, which further boosted the demand for servers, software, and other components. In addition, concerns about the potential effects of the Y2K date change led many firms to accelerate their replacement cycles and order new software and computing equipment. In short, during the latter part of the nineties, strong economic fundamentals conjoined with what, in retrospect in least, seems to have been a less well grounded increase in general optimism about the long-term potential of new technologies. (I say "seems" in all seriousness. We are not in the long run yet.) In any event, given this optimism and the attendant rise in earnings forecasts and the stock market, together with good fundamentals in terms of high demand, falling equipment prices, and moderate financing costs, the late-nineties boom in investment is perhaps not so difficult to understand. The Investment Bust of 2000-02 In the second half of 2000, business fixed investment began to decline markedly; between the third quarter of 2000 and the third quarter of last year, the level of real investment outlays declined 12 percent. The drop in investment in computer and communications equipment was particularly sharp. As I noted earlier, this decline in investment led the business cycle, an unusual pattern for the post-World War II period. Standard investment models can explain a portion of the sudden weakening of investment spending in mid-2000. For example, the user cost of equipment and software is estimated to have increased in 1999, the first such increase since 1994. Among the factors contributing to the rising user cost was a much less rapid decline in the relative price of computing power, perhaps reflecting a slowdown in the pace of technological advance, and a policy tightening by the Fed (in part, an unwinding of the easing that took place during the Russian debt crisis). Some weakening also occurred in the demand for business output, including most notably a mild deceleration of personal consumption expenditures early in 2000. The strength of the dollar hurt demand as well, particularly in the manufacturing sector. One should also keep in mind that, besides the modest weakening in fundamentals, investment booms are naturally followed by some slowdown as firms reach their desired level of capital. However, even taking all these factors into account, the fact is that standard investment models missed much of the drop in investment that began in 2000. The importance of disaggregation was illustrated once again, as most of the miss was accounted for by overprediction of investment in high-tech equipment and software. Clearly, factors other than those in the standard model must have been at work in that sector. The most promising place to look for explanations is in the expectations and attitudes of the managers entrusted with making investment decisions. As we can see, in retrospect at least, the year 2000 was one of re-evaluation, particularly for high-tech investment. Though the evidence is strong that high-tech investments have greatly enhanced productivity in the economy, by 2000 many managers had apparently become concerned that the long-term profit potential of their investments in computers and communications equipment was smaller than they had expected. In some cases the difficulties were technological, sometimes (as in the case of on-line retailing) the expected level of consumer demand did not materialize, sometimes the business plans were faulty, sometimes economic or regulatory conditions were not as had been expected, and sometimes the productivity enhancements were less than anticipated. This shift in expectations can be seen clearly in the downward revisions to analysts' long-term earnings expectations (which mirrored declines in equity prices) beginning in the second half of 2000. Analysts' forecasts of long-term earnings growth for the Standard & Poor's 500 companies index declined from about 15 percent per year at their peak in 2000 to less than 12 percent recently (still a historically high level, however). Indeed for this period, augmenting the Tevlin-Whelan model of investment with analysts' long-term expectations substantially improves the fit - although it by no means eliminates all or even most of the puzzle in investment spending during this period. Using panel data, Cummins et al. (2002) show that analysts' earnings expectations provide useful information in investment equations. As management expectations changed, so did the economic environment and firms' investment behavior. Replacement cycles for high-tech equipment apparently slowed, as firms became more skeptical of the business case for next-generation computers and software - particularly since they had just upgraded their information technology in preparation for the Y2K date change. Moreover no "killer apps" that required further system upgrades seemed to be on the horizon. The failures of scores of dot-coms and telecom startups reduced competitive pressure and the perceived urgency of maintaining technological leadership. Both financial markets and the general economy were becoming decidedly less hospitable to firms oriented toward new technologies. In short, a major shift in management expectations about the profit potential of new investments, particularly high-tech investments, is key to explaining the investment bust of 2000-02. A Capital Overhang? The factors just discussed, including the re-evaluation of the long-term profitability of high-tech investments, go a long way toward explaining the decline in investment spending that began in the latter part of 2000. However, some observers have suggested that the problem is deeper and has longer-term consequences than I have suggested so far. Specifically, they have argued that investment during the late 1990s was so great that actual capital stocks rose substantially above longrun desired levels, creating a "capital overhang." Barring a major increase in the desired level of capital, a true capital overhang would imply little or no investment in that particular type of capital for possibly quite a long time, until excess capital has been depreciated away. Is there a capital overhang in the US economy? I believe that this description was a reasonable one for certain sectors during the early stages of the downturn. Telecommunications companies no doubt invested too much in long-haul fiber networks, as firms competed to establish the largest and most complete networks. (I note, however, that economies of scale in laying fiber together with a low inground rate of physical depreciation imply that once a trench is dug, more fiber should be laid than will be needed for quite a while.) Too many startup Internet companies bought too many servers and routers, and the failure of large numbers of high-tech companies contributed to a glut in office space, which is particularly evident in technology centers like San Francisco and Seattle. Undoubtedly the current supply of commercial aircraft is excessive, though arguably much of this sector's overcapacity results from September 11 and structural problems specific to the airline industry rather than from a period of extensive overbuilding. However, the more pressing question is, how many of these putative sectoral overhangs remain relevant today? For high-technology equipment, in my view, overhang effects are probably by this time not of great quantitative importance. In communications, for example, though little additional long-haul fiber is needed at this point, there is probably scope for investment in the sophisticated equipment that transmits signals over the fiber, in the "last mile" of fiber network to customers' doorsteps, and in new wireless technologies and their applications. In the quantitatively important computers and software sector, a key factor is the relatively high rate of economic depreciation to which I alluded earlier. Computer equipment purchased before the millennium date change is now four to five years old and may now or soon be in need of replacement. Indeed, investment in high-tech equipment grew at more than 8 percent in real terms in 2002; investments in computers and software led this gain, but even investment in communications contributed a small part. Continued growth in the high-tech equipment sector will be important in any investment recovery. In all likelihood, a continuing overhang exists in nonresidential structures, including some types of industrial structures as well as office buildings. (Prospects for other types of construction, including institutional buildings, utilities, and mining and drilling, appear somewhat better.) Vacancy rates in office buildings remain quite high in most cities, for example, and rents for many types of buildings have been falling. As a result, investment in these types of structures has been declining. Two silver linings to this cloud, though faint and of little comfort to the heavy construction industry, are nevertheless worth pointing out. First, in large part because of improved risk management practices, weakness in the nonresidential real estate sector has not led to increased incidence of nonperforming loans and capital shortages among financial intermediaries, as was the case in some regions in the 1990-91 "capital crunch" episode. Second, relative to real investment in equipment and software, real investment in nonresidential structures has become significantly less important over the past several decades, a development that has reduced the relative importance of fluctuations in this component of investment for changes in real GDP. Investment in commercial aircraft will likely remain highly dependent on the rate at which the airline industry can work out its problems, as well as on potential new risk factors like SARS. Some analysts have pointed to the historically low capacity utilization rates in manufacturing seen in recent years in support of the view that a capital overhang remains an important factor. The importance of these data in projecting economy-wide investment should not be overstated, however. The manufacturing sector accounts for only about 20 percent of aggregate investment, and trend growth in manufacturing investment, moreover, is well below that of aggregate investment; hence, low capacity utilization in manufacturing is not inconsistent with reasonably robust rates of aggregate investment. Indeed, I doubt that a true capital overhang exists or has existed in non-high-tech manufacturing, in the sense of a period of over-investment and misallocation of capital. Low capacity utilization rates in those sectors primarily reflect not an earlier period of over-investment but rather weak current demand for manufacturing output, the product of a variety of cyclical and secular factors, including a strong dollar and weak conditions abroad. Final demand is already taken into account, for example, in the standard neoclassical model of investment, through projections of business output. Indeed, augmenting a standard investment equation to take account of capacity utilization in addition to aggregate output has essentially no effect on the accuracy of the projections from that model. More generally, historically the value of capacity utilization as a predictor of investment has been modest at best. Prospects for 2003 and 2004 So, to return finally to the question posed by the title of this talk: Will business investment bounce back this year and next? My review of investment-forecasting methodology suggests several complementary ways to go about answering that question. First, one should consider the "fundamental" determinants of investment, the macroeconomic factors that determine the user cost of capital and the demand for business output. Second, one can take a more disaggregated approach and look at various sectors and types of capital to assess their potential for growth. Finally, a complete analysis requires some evidence on the views of managers and analysts about the expected profitability of new investment. Putting these pieces together, though no late-nineties type of boom seems likely, most factors point to a moderate pickup in business investment and economic growth in the second half of 2003 and in 2004. However, even putting aside the possibility of unexpected developments on the geopolitical front or elsewhere, the state of expectations among corporate leaders is an important wild card that must always be considered when forecasting investment. The fundamental factors affecting investment are, as I have indicated, broadly supportive of continuing recovery. The user cost of capital is low and, dominated by continuing reductions in the qualityadjusted prices of high-tech equipment and historically low interest rates, will likely continue to decline. The partial expensing provision passed by the Congress in 2001 provides a significant incentive for firms to purchase equipment and certain types of software before the provision expires in the third quarter of 2004. Under the general heading of financing conditions, favorable factors include the good financial condition of the banking system, improvements in corporate liquidity, and the substantial narrowing of risk spreads in corporate bond markets (though these remain somewhat elevated by historical standards). Potentially favorable, or at least improving, conditions prevail on the output or final demand side of the equation as well. Although many forecasters have marked down their estimates of GDP growth for the full year 2003, most still expect a pickup in the second half of the year and further acceleration in 2004. High productivity, lower oil prices, reduced geopolitical uncertainty, the waning effects of the stock market decline, and stimulative monetary and fiscal policies should all support spending, providing reasonable growth in final demand. However, a negative factor is weak growth abroad. When we disaggregate investment to the sectoral level, what do we find? To begin, I mention the two parts of investment that so far have been omitted from this talk: residential investment and inventory The President's proposed tax package contains additional expensing provisions for some types of equipment investment by small businesses. Bernanke (2003) discusses the relationship between balance sheet conditions and the economic recovery. investment. Residential investment was an important engine of growth in 2002, and most forecasters (as evidenced by the Blue Chip survey, for example) expect that it will continue strong in 2003. Inventory investment, by contrast, is generally expected to contribute little in 2003, in contrast to 2002, when this component made a significant net contribution to GDP growth. The risk here is clearly both downside and upside: On the downside, conceivably housing demand may weaken, but on the upside, firms may increase their inventories more than expected if they grow more optimistic about future sales. With respect to the components of business fixed investment, the chance of a quick rebound in investment in nonresidential structures, particularly office buildings and industrial structures, seems slight. However, given the relatively small contribution of this sector to GDP, even continued (but slower) declines in structures investment would be consistent with an overall recovery in investment and GDP. The more critical sector - because of its size - is investment in equipment and software, particularly high-tech equipment. I have noted some grounds for modest optimism, as the high-tech sector already showed growth in 2002. Moderately improved performance for 2003 in high-tech investment, concentrated in a pickup in the second half of the year, seems feasible and consistent with fundamentals, particularly the continued decline in relative prices and growing replacement demand. Finally, some growth later in the year in non-high-tech equipment, excluding perhaps the relatively small aircraft component, is plausible and consistent with a scenario of strengthening overall investment. In short, a sectoral approach suggests that an investment bounceback of moderate proportions is a reasonable expectation. Finally, what about investor and analyst expectations and attitudes? I noted earlier that adding analyst expectations to standard investment equations helps to explain the 2000-02 investment bust, as analysts (presumably reflecting what managers told them) became suddenly more pessimistic in 2000. It is interesting that the same exercise has little effect on projections of these augmented equations for 2003-04. In particular, long-term analysts' earning projections appear to be bottoming out, and shortterm forecasts are brightening. These trends, if they continue, are consistent with an upturn in investment beginning in the second half of this year. However, when we talk to managers themselves - or talk to the people who talk to the managers - we sometimes get a different story. Clearly, an undercurrent of pessimism has persisted among business leaders for some time now, more so than can be accounted for by what seem to be the generally good fundamentals of the US economy. For policymakers, the most troubling aspect of this pessimism is our inability to ascertain its cause (or causes): Is it geopolitical uncertainty? The aftermath of the accounting scandals of last summer? Concerns about the ultimate profitability of new technologies and products? The depressive side of Keynesian animal spirits? This pessimism does matter, if for no other reason than because it has the potential to become self-fulfilling. For example, high-tech equipment and software will have to play an important part in any investment recovery this year; and as we have seen, this category may be particularly sensitive to management beliefs and expectations. Time will tell how pervasive these downbeat attitudes are and what effects, if any, they will have on investment and the economy. In any case, the clear lesson of recent experience is that forecasting investment requires close attention to the expectations of those responsible for making capital expenditures. Understanding these expectations and their implications is yet another challenge that policymakers must face as we do our best to help the economy toward full recovery.
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board of governors of the federal reserve system
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the 2003 Conference on Bank Structure and Competition, Chicago, Illinois (via satellite), 8 May 2003.
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Alan Greenspan: Corporate governance Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the 2003 Conference on Bank Structure and Competition, Chicago, Illinois (via satellite), 8 May 2003. * * * Corporate governance, the subject of our conference, has evolved over the past century to more effectively promote the allocation of the nation’s savings to its most productive uses. And, generally speaking, the resulting structure of business incentives, reporting, and accountability has served us well. We could not have achieved our current level of national productivity if corporate governance had been deeply flawed. Yet, our most recent experiences with corporate malfeasance suggest that governance has strayed from the way we think it is supposed to work. By law, shareholders own our corporations, and corporate managers ideally should be working on behalf of shareholders to allocate business resources to their optimum use. But as our economy has grown and our business units have become ever larger, de facto shareholder control has diminished: Ownership has become more dispersed, and few shareholders have sufficient stakes to individually influence the choice of boards of directors or chief executive officers. The vast majority of corporate share ownership is for investment, not for operating control of a company. Thus, corporate officers, especially chief executive officers, have increasingly shouldered the responsibility for guiding businesses in what one hopes they perceive to be the best interests of shareholders. Not all CEOs have appropriately discharged their responsibilities and lived up to the trust placed in them, as the events that led to the passage of the Sarbanes-Oxley Act demonstrated. In too many instances, some CEOs, under pressure to meet elevated short-term expectations for earnings, employed accounting devices for the sole purpose of obscuring adverse results. A change in behavior, however, may already be in train. The sharp decline in stock and bond prices after the collapse of Enron and WorldCom has chastened many of those responsible for questionable business practices. Corporate reputation is emerging out of the ashes of the debacle as a significant economic value. I hope that we will return to the earlier practices of firms competing for the reputation of having the most conservative and transparent set of books. *** It is hard to overstate the importance of reputation in a market economy. To be sure, a market economy requires a structure of formal rules--a law of contracts, bankruptcy statutes, a code of shareholder rights--to name but a few. But rules cannot substitute for character. In virtually all transactions, whether with customers or with colleagues, we rely on the word of those with whom we do business. If we could not do so, goods and services could not be exchanged efficiently. Even when followed to the letter, rules guide only a small number of the day-to-day decisions required of corporate management. The rest are governed by whatever personal code of values corporate managers bring to the table. Market transactions are inhibited if counterparties cannot rely on the accuracy of information. The ability to trust the word of a stranger still is an integral part of any sophisticated economy. A reputation for honest dealings within a corporation is critical for effective corporate governance. Even more important is the reputation of the corporation itself as seen through the eyes of outsiders. It is an exceptionally important market value that in principle is capitalized on a balance sheet as goodwill. Reputation and trust were particularly valued assets in freewheeling nineteenth-century America. Throughout much of that century, laissez-faire reigned and caveat emptor was the prevailing prescription for guarding against the wide-open trading practices of those years. A reputation for honest dealings was thus a particularly valued asset. Even those inclined to be less than scrupulous in their private dealings were forced to adhere to a more ethical standard in their market transactions, or they risked being driven out of business. To be sure, the history of business is strewn with Fisks, Goulds, and numerous others treading on, or over, the edge of legality. But they were a distinct minority. If the situation had been otherwise, the United States at the end of the nineteenth century would never have been poised to displace Great Britain as the world’s leading economy. Reputation was especially important to early U.S. bankers. It is not by chance that in the nineteenth century many bankers could effectively issue uncollateralized currency. They worked hard to develop and maintain a reputation that their word was their bond. For these institutions to succeed and prosper, people had to trust their promise of redemption in specie. The notion that “wildcat banking” was rampant before the Civil War is an exaggeration. Certainly, crooks existed in banking as in every business. Some banks that issued currency made redemption inconvenient, if not impossible. But they were fly-by-night operators and rarely endured beyond the first swindle. In fact, most bankers competed vigorously for reputation. Those who had a history of redeeming their bank notes in specie, at par, were able to issue substantial quantities, effectively financing their balance sheets with zero-interest debt. J.P. Morgan marshaled immense power on Wall Street in large part because his reputation for fulfilling his promises was legendary. Today, most banks rely partly on deposit insurance in lieu of reputation to hold below-market-rate deposits. And a broad range of protections provided by the Securities and Exchange Commission, the Commodity Futures Trading Commission, and myriad other federal and state agencies has similarly partially crowded out the value of trust as a competitive asset. *** Trust still plays a crucial role in one of the most rapidly growing segments of our financial system--the over-the-counter (OTC) derivatives market. This market has played an important and successful role in the management of risk at financial institutions, a major element of their corporate governance. I do not say that the success of the OTC derivatives market in creating greater financial flexibility is due solely to the prevalence of private reputation rather than public regulation. Still, the success to date clearly could not have been achieved were it not for counterparties’ substantial freedom from regulatory constraints on the terms of OTC contracts. This freedom allows derivatives counterparties to craft contracts that transfer risks in the most effective way to those most willing and financially capable of absorbing them. Benefits of derivatives Although the benefits and costs of derivatives remain the subject of spirited debate, the performance of the economy and the financial system in recent years suggests that those benefits have materially exceeded the costs. Over the past several years, the U.S. economy has proven remarkably resilient in the face of a series of severe shocks--the collapse of equity values, terrorist attacks, and geopolitical turmoil. To be sure, economic growth has been subpar for some time, but we seem to have experienced a significantly milder downturn than the long history of business cycles and the severity of the shocks to the economy would have led us to expect. Although no single factor can account for this resilience, one striking feature that differentiates this cycle from earlier ones is the continued vitality of most U.S. banks and nonbank financial institutions. In past cycles, economic downturns often produced credit losses that were so severe that the capacity of those institutions to intermediate financial flows was impaired. As a consequence, recessions were prolonged and deepened. This time, the economic downturn has not significantly eroded the capital of most financial intermediaries, and the terms and availability of credit have not tightened to such an extent as to be significant factors in deepening the contraction or impeding the recovery. The use of a growing array of derivatives and the related application of more-sophisticated methods for measuring and managing risk are key factors underpinning the enhanced resilience of our largest financial intermediaries. Derivatives have permitted financial risks to be unbundled in ways that have facilitated both their measurement and their management. Because risks can be unbundled, individual financial instruments now can be analyzed in terms of their common underlying risk factors, and risks can be managed on a portfolio basis. Concentrations of risk are more readily identified, and when such concentrations exceed the risk appetites of intermediaries, derivatives can be employed to transfer the underlying risks to other entities. As a result, not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient. Individual institutions’ portfolios have become better diversified. Furthermore, risk is more widely dispersed, both within the banking system and among other types of intermediaries and institutional investors. Even the largest corporate defaults in history (WorldCom and Enron) and the largest sovereign default in history (Argentina) have not significantly impaired the capital of any major financial intermediary. Likewise, record amounts of home mortgage refinancing and accompanying declines in mortgage asset durations have not imperiled the principal intermediaries in the mortgage markets, in substantial part because these institutions were able to use derivatives to transfer a significant portion of the convexity risk associated with prepayments of fixed-rate mortgages to investors in callable debt and issuers of putable debt. Risks associated with the use of derivatives If derivatives and the techniques for risk measurement and management that they have facilitated have produced all these benefits, why do they remain so controversial? The answer is that the use of these instruments and the associated techniques pose a variety of challenges to risk managers. Inevitably, risk-management failures occur, and in two instances--the highly publicized cases of Barings and Long Term Capital Management--they proved destabilizing. Those that question the net benefits of derivatives see daunting risk-management problems and thus foresee catastrophic outcomes. In particular, they fear that common deficiencies in risk management will result in widespread failures or that the failure of a very large derivatives participant will impose heavy credit losses on its counterparties and yield a chain of failures. Others, like myself, who see the benefits of derivatives exceeding the costs, do not deny that their use poses significant risk-management challenges. But we see ample evidence that the risks are manageable in principle and generally have been managed quite effectively in practice, at least to date. Indeed, credit losses on derivatives have occurred at a rate that is a small fraction, for example, of the loss rate on commercial and industrial loans. Market discipline in the largely unregulated derivatives markets has provided strong incentives for effective risk management and has the potential to be even more effective in the future. To be sure, there undoubtedly will be further risk-management failures. But the largest market participants have such diversified businesses that a risk-management failure involving a single product line is unlikely to be a threat to solvency. Furthermore, risk-management failures are more likely to be idiosyncratic than to reflect common deficiencies in procedure or technique among market participants. In the case of the management of market risk, our bank examiners observe significant differences in approach across the largest U.S. banks, even in the measurement of such a basic concept as value-at-risk. I do not wish to suggest, however, that I am entirely sanguine with respect to the risks associated with derivatives. One development that gives me and others some pause is the decline in the number of major derivatives dealers and its potential implications for market liquidity and for concentration of counterparty credit risks. I also fear that the potential contribution of market discipline to stability in the derivatives markets is not being fully realized because, in our laudable efforts to improve public disclosure, we too often appear to be mistaking more extensive disclosure for greater transparency. This is an issue to which I shall shortly return. Concentration and market liquidity In recent years, consolidation has reduced the number of firms that provide liquidity to the OTC derivatives markets by acting as dealers in the more standardized or “plain vanilla” contracts. To be sure, the resulting concentration sometimes is overstated because of the failure to recognize that the OTC derivatives markets are global markets in which major banks and securities firms from more than half a dozen countries compete. For example, measures of concentration based on data reported by U.S. banks overstate concentration significantly because they ignore the competitive activities of U.S. securities firms and foreign banks. Nonetheless, not all major dealers make markets in all products, and concentration is substantial for certain important types of OTC contracts. Examples include U.S. dollar interest rate options and credit default swaps. In each case, a single dealer seems to account for about one-third of the global market, and a handful of dealers together seem to account for more than two-thirds. When concentration reaches these kinds of levels, market participants need to consider the implications of exit by one or more leading dealers. Such an event could adversely affect the liquidity of types of derivatives that market participants rely upon for managing the risks of their core business functions. Exit could be voluntary. In particular, losses incurred in making markets could lead a dealer to conclude that the returns from market-making are not commensurate with the risks. Alternatively, downgrades of a dealer’s credit rating could force the dealer to exit. Counterparties in the OTC derivatives market are quite concerned about the potential credit risks inherent in such contracts and generally are unwilling to transact with dealers unless their credit rating is A or higher. If a major dealer exited and other dealers were unwilling to fill the void, the liquidity of the market likely would be impaired. Market participants need to consider what their alternatives would be in such circumstances. Are there other liquid markets in which they could manage their risks? In some cases market participants may be able to manage risks reasonably effectively in cash markets or exchangetraded derivatives markets. But in other cases managing risks may become more difficult with the exit of some dealers. If market participants perceive that they are vulnerable to such exit by a liquidity provider, they will tend to redirect some of their risk-management activity to other, more liquid markets or seek out new dealers in the market in which exit is a concern. If enough participants perceive the concentration of dealers as entailing market-liquidity risk, their actions to mitigate the risk should over time reduce that degree of concentration. Concentration and counterparty risk Perhaps the more obvious way in which concentration in OTC derivatives markets creates risks for market participants is through its implications for counterparty credit risks. Concentration of marketmaking has the potential to create concentrations of credit risks between the dealers and the end-users of derivatives as well as between the dealers themselves. This latter concentration of risk results from dealers frequently managing their market risks through derivatives transactions with a limited number of other dealers. As mentioned earlier, critics of derivatives often raise the specter of the failure of one dealer imposing debilitating losses on its counterparties, including other dealers, yielding a chain of defaults. However, derivatives market participants seem keenly aware of the counterparty credit risks associated with derivatives and take various measures to mitigate those risks. The vast majority carefully evaluate the creditworthiness of counterparties before entering into transactions and monitor their credit quality over the life of the transactions. As I indicated earlier, users of derivatives have been reluctant to transact with dealers that are not perceived as solid investment-grade credits. Market participants also establish credit limits for their counterparties and actively monitor their exposures to ensure that they remain within the limits established. Such monitoring, parenthetically, relies heavily on trust in the accuracy of the information forthcoming from the counterparties. Counterparty risk management has been materially assisted by the widespread use of master agreements for derivatives transactions. In the event of a counterparty’s default, such agreements permit the termination of all transactions with the counterparty and the netting of the resulting gains and losses. For many years, market participants have been putting such master agreements in place and working with legislatures to ensure that national laws support the enforceability of netting. Data reported by U.S. banks indicate that, on average, netting now reduces counterparty exposures by almost three-fourths. Even with wider use of netting, however, the outsized growth of derivatives markets has resulted in ever-larger counterparty exposures. Market participants have increasingly responded by entering into collateral agreements to further mitigate counterparty credit risks. Such agreements typically permit counterparties to derivatives transactions to demand collateral if their net credit exposure exceeds a negotiated threshold amount. The threshold often varies with the credit rating of the counterparty: The lower a counterparty’s credit rating, the smaller the threshold. If its credit rating falls below investment grade, a counterparty is often required to overcollateralize its counterparties’ exposures. In effect, it becomes obligated to meet a margin requirement. Collateral agreements are a very effective means of limiting counterparty credit risks. At the same time, they increase market participants’ exposures to other types of risk, especially funding-liquidity risks. Once a counterparty has agreed to collateralize its derivatives contracts, day-to-day declines in the value of those contracts expose it to immediate demands for more collateral. Furthermore, the practice of tying the size of thresholds and margin requirements to credit ratings exposes a counterparty to extraordinary demands for collateral if its rating is downgraded. Collateral demands arising from rating downgrades may be especially costly to meet because a downgrade would reduce the availability of funding and increase its costs at the same time. Incentives for effective risk management As this discussion of the risks associated with derivatives makes clear, effective risk management by market participants is the key to ensuring that the benefits of derivatives continue to exceed their costs. Some may see government regulation of OTC derivatives dealers as essential to ensuring efficacious risk management. This view presumes that government regulation can address the challenges these types of markets engender and that it can do so without lessening the effectiveness of market discipline supplied by counterparties. Market participants usually have strong incentives to monitor and control the risks they assume in choosing to deal with particular counterparties. In essence, prudential regulation is supplied by the market through counterparty evaluation and monitoring rather than by authorities. Such private prudential regulation can be impaired--indeed, even displaced--if some counterparties assume that government regulations obviate private prudence. We regulators are often perceived as constraining excessive risk-taking more effectively than is demonstrably possible in practice. Except where market discipline is undermined by moral hazard, owing, for example, to federal guarantees of private debt, private regulation generally is far better at constraining excessive risk-taking than is government regulation. The very modest credit losses that have appeared in derivatives portfolios at U.S. banks are a testament to the effectiveness of market discipline in this area. Indeed, credit losses on OTC derivatives also have been quite modest at derivatives affiliates of U.S. broker-dealers, which are subject to very limited government regulation. This is further evidence of the powerful effects on behavior that result when market participants recognize that they bear the bottom-line consequences of their risk-taking decisions. A key support for market discipline is the information that market participants have for evaluating the creditworthiness of counterparties. Over the past decade, enormous attention has been given to disclosures market participants make with regard to their risk exposures, particularly those associated with derivatives activities. Both public authorities and private-sector working groups have recommended ways to enhance market discipline through improved public disclosures. The result of these efforts, however, has been mixed. Clearly, we have made great strides in expanding the volume of publicly disclosed information related to risk exposures and derivatives. A more complex question is whether this greater volume of information has led to comparable improvements in the transparency of firms. In the minds of some, public disclosure and transparency are interchangeable. But they are not. Transparency implies that information allows an understanding of a firm’s exposures and risks without distortion. The goal of improved transparency thus represents a higher bar than the goal of improved disclosures. Transparency challenges market participants not only to provide information but also to place that information in a context that makes it meaningful. Transparency challenges market participants to present information in ways that accurately reflect risks. Much disclosure currently falls short of these more demanding goals. Despite the substantial room for progress with regard to transparency, we should not underestimate the barriers to achieving it. Managers no doubt have to struggle with selecting and organizing data in a meaningful way. The difficulties are well illustrated by the annual reports of large institutions that routinely exceed one hundred pages; pressures are enormous to update existing tables and charts as well as to provide even more. In addressing this challenge, however, both managers of firms and makers of public policy would do well to be mindful of the ultimate goal--a clear understanding of a firm’s activities that fosters market discipline. Conclusion In conclusion, the benefits of derivatives, in my judgment, have far exceeded their costs. Derivatives unquestionably do pose risk-management challenges to market participants. But those challenges are manageable and thus far have generally been managed quite well. The best way to ensure that those challenges continue to be met is to preserve and strengthen the effectiveness of market discipline. Market incentives, in particular, reinforce the importance of reputation and trust as sources of market value. Just as market discipline has fostered effective risk management in the derivatives markets, so too it is now being brought to bear on corporate governance generally. Once market discipline firmly reestablishes reputation and trust as corporate values, the incidence of corporate malfeasance should be greatly reduced.
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board of governors of the federal reserve system
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Speech by Ms Susan S Bies, Member of the Board of Governors of the US Federal Reserve System, at the Institute of Internal Auditors Conference, Philadelphia, Pennsylvania, 7 May 2003.
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Susan S Bies: Corporate governance Speech by Ms Susan S Bies, Member of the Board of Governors of the US Federal Reserve System, at the Institute of Internal Auditors Conference, Philadelphia, Pennsylvania, 7 May 2003. * * * Good morning. Thank you for the invitation to speak to the Institute of Internal Auditors (IIA) membership at this timely and important conference. My remarks this morning will focus on issues relating to corporate governance and underscore the critical role of internal auditors in the SarbanesOxley era. Introduction Over the past two years, we have been shocked by the headlines announcing corporate governance or accounting problems at a variety of companies, such as Enron, Worldcom, and HealthSouth. As we read these headlines, the question that comes to mind is, “What were the underlying deficiencies in the internal control processes of these companies that rendered their governance practices ineffective?” As the details about the scandals have been made public, it has become clear that they are examples of breakdowns in internal controls that all of us learned about in Accounting and Auditing 101. Why, then, have we seen so many headlines highlighting corporate governance and accounting problems? The explanation is that these companies lost track of the basics of effective corporate governance--internal controls and a strong ethical compass to guide the organization. While most companies have effective governance processes in place, these events remind all of us of the importance of doing the basics well. Internal control framework After an earlier series of corporate frauds, the National Commission on Fraudulent Financial Reporting, also known as the Treadway Commission, was created in 1985 to make recommendations to reduce the incidence of these frauds. The Committee of Sponsoring Organizations (COSO) of the Treadway Commission issued a report titled Internal Control--Integrated Framework that has become the most referred to standard on internal control. If one re-reads that report, the lesson of returning to focus on the basics becomes clear. The report defines internal control as a process, effected by an entity’s board of directors, management and other personnel, designed to provide reasonable assurance regarding the achievement of…: • Effectiveness and efficiency of operations • Reliability of financial reporting • Compliance with applicable laws and regulations. The COSO framework was the model considered when the Federal Deposit Insurance Corporation Improvement Act was enacted in 1991. FIDICIA 112 requires that management report annually on the quality of internal controls and that the outside auditors attest to that control evaluation. Control assessments COSO requires all managers to, at least once a year, step back from their other duties and evaluate risks and controls. Each manager should consider the current and planned operational changes, identify the risks, determine the appropriate mitigating controls, establish an effective monitoring process, and evaluate the effectiveness of those controls. Managers are then supposed to report their assessment up the chain of command to the chief executive officer, with each new level of management in turn considering the risks and controls under their responsibility. The results of this process are ultimately to be reported to the audit committee of the board of directors. In the case of banks, management publicly reports on its assessment of the effectiveness of controls over financial reporting and the external auditor is required to attest to this self-assessment. Thus, the process helps managers communicate among themselves and with the board about the dynamic issues affecting risk exposures, risk appetites, and risk controls throughout the company. Risk assessments such as the one outlined in COSO presumably could also be useful in assessing the risks and controls from various lines of business when formulating business strategies. But not all corporations and boards consider risk as a part of their annual strategic planning or other evaluation processes. The 2002 survey of 178 corporate directors conducted jointly by you (the IIA) and the National Association of Corporate Directors showed that directors are not focusing on risk management. I was surprised to learn that 45 percent of directors surveyed said their organization did not have a formal enterprise risk management process--or any other formal method of identifying risk. An additional 19 percent said they were not sure whether their company had a formal process for identifying risks. These percentages indicate that there are companies out there that have directors who don’t understand their responsibilities as the representatives of shareholders. The shareholders of those companies should be asking the directors how they govern an organization without a good understanding of the risks the company is facing and without knowledge of a systematic approach to identifying, assessing, monitoring, and mitigating excessive risk-taking. I trust that none of the directors who participated in the survey were on the board of a financial services company. Although directors are not expected to understand every nuance of every line of business or to oversee every transaction, they do have the responsibility for setting the tone regarding their corporations’ risk-taking and establishing an effective monitoring program. They also have the responsibility for overseeing the internal control processes, so that they can reasonably expect that their directives will be followed. They are responsible for hiring individuals who have integrity and can exercise sound judgment and are competent. In light of recent events, I might add that directors have a further responsibility for periodically determining whether their initial assessment of management’s integrity was correct. The COSO framework and FDICIA annual report can be an effective tool for the auditor to communicate risks and control processes to the audit committee. Members of that committee should use the reports to be sure their understanding of business strategy, changing business processes, management reorganizations, and positioning for future growth are done within the context of a sound system of internal controls and governance. The report should identify those areas for which priorities should be established to strengthen the effectiveness of internal controls. Indeed, beyond legal requirements, boards of directors of all firms should periodically assess where management, which has stewardship over shareholder resources, stands on ethical business practices. They should ask, for example, Are we getting by on technicalities, adhering to the letter but not the spirit of the law? Are we compensating ourselves and others on the basis of contribution, or are we taking advantage of our positions? Would our reputation be tainted if word of our actions became public? Internal auditors should ensure that processes are in place for employees to raise ethical and control concerns in an environment that protects them from retribution from affected managers. Internal controls Risk management clearly cannot be effective within a company if we forget about the basics of internal controls. It is worth stating that many of the lessons learned from those headline cases cited violations of the fundamental tenets of internal control, particularly those pertaining to operating risks. Based on the headlines, it seems that boards of directors, management, and auditors desperately need a remedial course in Internal Controls 101. As corporations grow larger and more diverse, internal controls become more, not less, important to the ability of management and the board to monitor activity across the company. The basics of internal controls for directors and management are simple. Directors do not serve full time, so it is important that the auditor establish an annual agenda for boards and audit committees to focus their attention on the high-risk and emerging risk areas while ensuring that there are effective preventive or detective controls over the low-risk areas. The challenge of the auditor is to ensure that the internal audit staff has the expertise and ongoing training to meet the specific and changing risks of the organization. Before a company moves into new and higher risk areas, the boards of directors, management, and the auditors need assurances that they have the tools in place to ensure that the basics of sound governance are being adhered to. Many of the organizations that have seen their reputations tarnished in the past two years have also neglected to consider emerging conflicts of interest when the organization adds new products and lines of business. It is important that if a customer service or control function must be done in an independent, fiduciary, or unbiased manner relative to other activities, appropriate firewalls are in place before the product or activity begins, to ensure that the integrity of the process is not compromised. Boards of directors are responsible for ensuring that their organizations have an effective audit process and that internal controls are adequate for the nature and scope of their businesses. The reporting lines of the internal audit function should be such that the information that directors receive is impartial and not unduly influenced by management. Internal audit is a key element of management’s responsibility to validate the strength of internal controls. Internal controls are the responsibility of line management. Line managers must determine the acceptable level of risk in their line of business and must assure themselves that the combination of earnings, capital, and internal controls is sufficient to compensate for the risk exposures. Supporting functions such as accounting, internal audit, risk management, credit review, compliance, and legal should independently monitor the control processes to ensure that they are effective and that risks are measured appropriately. The results of these independent reviews should be routinely reported to executive management and boards of directors. Directors should be sufficiently engaged in the process to determine whether these reviews are in fact independent of the operating areas and whether the auditors conducting the reviews can speak freely. Directors must demand that management fix problems promptly and provide appropriate evidence to internal audit confirming this. While we have been focused on mid-sized and larger organizations, internal controls are also important to smaller organizations. Many failures of community banks are due to breakdowns in internal controls, thus increasing operational risk. In smaller organizations, the segregation of duties and ability to hire expertise for specialized areas is more difficult. But smaller organizations still must go through the process of assessing risks and controls and ensuring that they are appropriate for the culture and business mix of the organization. A faster growing financial services company in riskier lines of business will need a stronger, more formalized system of internal controls than a wellestablished company engaged broadly in traditional financial services. Internal audit The Federal Reserve is very supportive of independent internal audit functions at financial services companies. Earlier this year, along with the other federal banking agencies, we issued an amended policy statement on the internal audit function that called for each regulated institution to have an internal audit function that is appropriate to its size and the nature and scope of its activities. This amended policy statement addresses several different areas of internal audit in general, including Director and senior management responsibilities. In our view, the board of directors and senior management cannot delegate the responsibility for having an effective system of internal control. Certain portions of the implementation of the control system may be conducted by more junior management, but this does not relieve the board and senior management of responsibility for the design and effectiveness of the system. We also describe the four areas that we believe must be included in the internal audit function. Those areas address the structure, management, scope, and communications of the internal audit function. Structure. The internal audit function must be independent from day-to-day operations. The structure section of the policy statement specifically states, “The manager of internal audit should report directly to the board of directors or its audit committee, which should oversee the internal audit function.” It also states that the board should develop objective performance criteria to evaluate the work of internal audit. The auditor should meet periodically with the chair of the audit committee outside of formal meetings to review audit plans and the results of audits, determine issues of concern to the committee, and create an agenda that engages audit committee members in effective oversight of the internal audit process. Management, staffing, and audit quality. Directors should assign responsibility for the internal audit function to an internal audit manager. The audit manager should be responsible for control risk assessments, audit plans, audit programs, and audit reports. The management section states that institutions should follow professional standards, such as the IIA’s standards. One of the most important roles of the auditor is to identify emerging areas of risk and report management’s progress in implementing mitigating controls and monitors of changing exposures. Scope. We take the position that frequency and extent of internal audit review and testing engaged in during the audit “should be consistent with the nature, complexity, and risk of the institution’s on- and off-balance-sheet activities.” We also state that the audit committee should at least annually review and approve the internal audit manager’s control risk assessment, the scope of the audit plan, including how much the manager relies on the work of an outsourcing vendor, and adherence to the audit plan. At the end of each audit plan year, a critical assessment of the validity of the initial assumptions should be made and appropriate re-allocations of resources scheduled for the new plan. Communications. We advise the board and senior management to foster communication with the internal auditors so that they are aware of pertinent issues and the board is aware of all significant matters. Just as the auditor should have regular communications with the audit committee, the auditor should have senior-enough stature within the organization to be aware of significant initiatives and be able to influence management as needed to adopt appropriate control processes. The policy statement advises banking organizations that the auditor independence rules of the Securities and Exchange Commission apply to institutions covered by FDICIA 112. As a result, internal audit outsourcing to the external auditor is prohibited for such institutions. Nonpublic, non-FDICIA 112 institutions are encouraged to adhere to this prohibition. Sarbanes-Oxley Act Now let’s turn to Sarbanes-Oxley. At its core, the Sarbanes-Oxley Act is a call to get back to the basics that we have been discussing. Since you have other speakers on the program who are planning to provide you with an update on the status of rulemakings currently under way, I won’t cover the act’s provisions in any detail. However, as I’m sure you know, the IIA research foundation published a Sarbanes-Oxley status report just last month. The summary was entitled Assessment Guide for U.S. Legislative, Regulatory, and Listing Exchanges: Requirements Affecting Internal Auditing. As I recall, the guide compares the key requirements of the • Sarbanes-Oxley Act of 2002, • Proposed and final Securities and Exchange Commission rules and interpretations related to the Act, and • Regulations proposed by the listing exchanges and associations. Although the guide identifies 58 separate provisions that affect internal auditing, I think it is also important to stress the fundamental underlying sentiment of the act. Simply stated, the current status quo for corporate governance is unacceptable and must change. This message is applicable to both public and private companies alike and affects everyone within a company. • The message for boards of directors is: Uphold your responsibility for ensuring the effectiveness of the company’s overall governance process. • The message for audit committees is: Uphold your responsibility for ensuring that the company’s internal and external audit processes are rigorous and effective. • The message for CEOs, CFOs, and senior management is: Uphold your responsibility to maintain effective financial reporting and disclosure controls and adhere to high ethical standards. This requires meaningful certifications, codes of ethics, and conduct for insiders that, if violated, will result in fines and criminal penalties, including imprisonment. • The message for external auditors is: Focus your efforts solely on auditing financial statements and leave the add-on services to other consultants. • The message for internal auditors is: You are uniquely positioned within the company to ensure that its corporate governance, financial reporting and disclosure controls, and riskmanagement practices are functioning effectively. Although internal auditors are not specifically mentioned in the Sarbanes-Oxley Act, they have within their purview of internal control the responsibility to examine and evaluate all of an entity’s systems, processes, operations, functions, and activities. If you are feeling a little sensitive or uneasy right now as an internal auditor, that’s good. Because the question you should be asking yourself is whether you are up to this challenge presented by Sarbanes-Oxley. What are the challenges for internal auditors in the Sarbanes-Oxley era? First, internal auditors must step up to the plate and help corporate risk officers and managers reinvigorate the risk assessment and control process over financial reporting and now, under Sarbanes-Oxley, other public disclosures. Before becoming a Federal Reserve Governor, I was at various times the auditor and the CFO of a bank. As a result of this experience, I’m very familiar with the types of internal control risk assessments that are required by FDICIA 112. For the past decade, I’ve worked with both internal and external auditors to ensure that the risk management and reporting functions at banks produce reliable and accurate information. Recently, the Fed has been looking at the management reports on internal controls for several banks that have had significant breaks in internal controls. From these banks, we have identified several whose FDICIA 112 processes were not effective. A closer look at these situations indicates that management had essentially put this process on autopilot. Further, the external auditor had not done an effective review of the basis of management’s report. Before you say, “That could not happen at my company,” let me remind you how we started our discussion today. In each of the cases involving banks, the internal auditor seemed to be content with the loss of vigor in the process and the external auditor was apparently satisfied to simply collect a fee. This type of situation is totally unacceptable. Further, as the organization evolves over time by offering new products, changing processes, outsourcing services, complying with new regulations, or growing through mergers, the controls need to be modified to reflect the changes in risks. In some cases, the controls failed with respect to newer risk exposures that were not identified, or growth put strains on existing control processes that were not suitable for a larger organization. Section 302 of Sarbanes-Oxley requires senior management to assess and report on the effectiveness of disclosure controls and procedures as well as on internal controls for financial reporting. This broader certification addresses controls and procedures related to public disclosure, including financial information, such as Management’s Discussion and Analysis, that is reported outside of the financial statements. To address these new disclosure control certifications, companies are undertaking steps to • Set up disclosure committees composed of the CFOs, the corporate risk officers, in-house counsels, chief internal auditors, and other members of senior management, • Identify the controls and procedures necessary for gathering information and preparing periodic reports, • Determine whether the controls and procedures capture the appropriate information for disclosures and enable the necessary information to be recorded, processed, summarized, and reported on a timely basis, and • Establish an audit program that includes quarterly evaluations of the assessment, control activities, information and communication, and monitoring elements of the disclosure control framework. We have not had enough experience to assess the effectiveness of these new certifications. However, for any framework to be successful, the CEOs and CFOs need to establish strong controls for maintaining and enforcing procedures for collecting, processing, and disclosing information in their securities filings. Now here’s the challenge for you. First, as the company’s internal auditor, you should be proactive in ensuring that your company’s risk assessment and control process over financial reporting and disclosures are vigorous. In this regard • If you are an internal auditor of a financial services company that is subject to FDICIA 112, you should seize this opportunity to take a fresh, objective look at the risk assessment and control process in your company’s internal control framework. • If you are an internal auditor of a publicly traded financial services company, you now have the same responsibility, since section 404 of Sarbanes-Oxley is modeled after FDICIA 112. However, don’t assume that what was acceptable in the past is good enough for the future. Remember, there is a tendency for an organization to go on autopilot if the internal auditor is not vigilant. As for the certifications required by section 302 of Sarbanes-Oxley, you should be part of the disclosure committee. You should also establish a robust audit program for the company’s disclosure controls framework. • If you are an internal auditor of a nonpublic financial services company, you should view this as an opportunity to convince the board and management to adopt a rigorous self-assessment process for controls covered by sections 302 and 404 of Sarbanes-Oxley as a best practice. Second, internal auditors must be willing to sacrifice everything to maintain their independence within the organization. You are not going to be effective unless you report directly to the audit committee. Your company’s entire quality assurance and monitoring program will be tainted if you are not accountable to the audit committee. Most audit committees already know this and are looking for ways to strengthen this area. If the audit committee asks you for recommendations on how to improve independence, your typical response should be that the test for any recommended change is whether it makes management more accountable for the ongoing effectiveness of internal controls and makes the internal audit function more effective in monitoring and process validation. If the audit committee is not ready to accommodate you on this point, you should raise the issue to the full board of directors and the outside auditor. If needed changes do not occur, then your professional standards should compel you to look for a new employer. In this regard, there are several ways that you as the internal auditor can demonstrate independence (not just in appearance) from management and your loyalty to the audit committee: • If you are an internal auditor of a financial services company that is subject to FDICIA 112, you should already have a good working relationship with the audit committee. But if that relationship has grown cold over the years, it is time to break the ice. Explain to the committee how this level of independence reduces the chances of the company’s becoming the next headline. • If you are an internal auditor of a publicly traded financial services company, Sarbanes-Oxley will make management very sensitive to your request for greater independence, given the threat of fines and possible imprisonment. • If you are an internal auditor of a nonpublic financial services company, you should view this as an opportunity to convince the board to establish an audit committee with authority similar to that established for audit committees under Sarbanes-Oxley as a best practice. Further, for all financial institutions, your primary federal banking regulator supports a strong, independent internal audit process at your company. Examinations of the internal audit process, organization structure, and audit committee agenda can provide outside support to the importance of a strong, independent internal audit function. Third, internal auditors must abandon the idea of becoming the roaming general management consultant within the company. Many of the proposed revisions to the IIA’s professional standards focus on adding value by meeting the needs of management and the board. The focus needs to be on making sure the board has no surprises. Internal auditors add value by being effective, independent assessors of the quality of the internal control framework and processes. Auditors lose their independence when they perform management consulting roles for which they later will have to render an opinion. You are one of the few corporate officers that has both the ability and the responsibility to look across all of the management silos within the corporation and make sure that the system of internal controls has no gaps and that the control framework is continually reviewed to keep up with corporate strategic initiatives, reorganizations, and process changes. When an auditor becomes part of management, the independent view is lost. Further, you are the independent eyes and ears of the audit committee around the organization. As you work throughout the organization, you know which managers and which projects are likely to entail greater weaknesses in controls. By helping senior management address these risks before losses occur, you can help protect the reputation of managers and the bank and increase your credibility. Prompt reporting to the audit committee and timely resolution of audit findings will build your credibility with the committee, provided that you follow through on their behalf to ensure that managers are taking control and governance issues seriously. Conclusion My objective in talking to you today was to exhort you to take a stand and make a difference for the better in the corporate governance of your company. The Institute of Internal Auditors is the recognized world leader for the internal auditing profession. You should use the resources of this organization to support your efforts to make the internal audit division an even more effective force to improve the quality of internal controls in your organization. And you should take a leadership role in shaping the dialogue on corporate governance. Although I recognize that some of you are internal auditors of companies that are not subject to Sarbanes-Oxley, I believe the act is a wake-up call more generally for the internal auditing profession.
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board of governors of the federal reserve system
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Testimony by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Joint Economic Committee, US Congress, Washington, 21 May 2003.
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Alan Greenspan: The economic outlook Testimony by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Joint Economic Committee, US Congress, Washington, 21 May 2003. * * * Mr. Chairman, I appreciate the opportunity to testify before the Joint Economic Committee. As you will recall, when I appeared here last November, I emphasized the extraordinary resilience manifested by the United States economy in recent years - the cumulative result of increased flexibility over the past quarter century. Since the middle of 2000, our economy has withstood serious blows: a significant decline in equity prices, a substantial fall in capital spending, the terrorist attacks of September 11, confidence-debilitating revelations of corporate malfeasance, and wars in Afghanistan and Iraq. Any combination of these shocks would arguably have induced a severe economic contraction two or three decades ago. Yet remarkably, over the past three years, activity has expanded, on balance - an outcome offering clear evidence of a flexible, more resilient, economic system. Once again this year, our economy has struggled to surmount new obstacles. As the tensions with Iraq increased early in 2003, uncertainties surrounding a possible war contributed to a softening in economic activity. Oil prices moved up close to $40 a barrel in February, stock prices tested their lows of last fall, and consumer and business confidence ebbed. Although in January there were some signs of a post-holiday pickup in retail sales other than motor vehicles, spending was little changed, on balance, over the following three months as a gasoline price surge drained consumer purchasing power and severe winter weather kept many shoppers at home. Businesses, too, were reluctant to initiate new projects in such a highly uncertain environment. Hiring slumped, capital spending plans were put on hold, and inventories were held to very lean levels. Collectively, households and businesses hesitated to make decisions, pending news about the timing, success, and cost of military action - factors that could significantly alter the outcomes of those decisions. The start of the war and its early successes, especially the safeguarding of the Iraqi oilfields, were greeted positively by financial and commodities markets. Stock prices rallied, risk spreads narrowed, oil prices dropped sharply, and the dour mood that had gripped consumers started to lift, precursors that historically have led to improved economic activity. The quick conclusion of the conflict subsequently added to financial gains. We do not yet have sufficient information on economic activity following the end of hostilities to make a firm judgment about the current underlying strength of the real economy. Incoming data on labor markets and production have been disappointing. Payrolls fell further in April, and industrial production declined as well. Because of the normal lags in scheduling production and in making employment decisions, these movements likely reflect business decisions that, for the most part, were made prior to the start of the war, and many more weeks of data will be needed to confidently discern the underlying trends in these areas. One reassuring development that has been sustained through this extended period of economic weakness has been the performance of productivity. To the surprise of most analysts, labor productivity has continued to post solid gains. Businesses are apparently continuing to discover unexploited areas of cost reduction that had accumulated during the boom years of 1995 to 2000 when the projected huge returns from market expansion dulled incentives for seemingly mundane cost savings. The ability of business managers to reduce costs, especially labor costs, through investment or restructuring is, of course, one reason that labor markets have been so weak. Looking ahead, the consensus expectation for a pickup in economic activity is not unreasonable, though the timing and extent of that improvement continue to be uncertain. The stance of monetary policy remains accommodative, and conditions in financial markets appear supportive of an increased pace of activity. Interest rates remain low, and funds seem to be readily available to creditworthy borrowers. These factors, along with the ability of households to tap equity accrued in residential properties, should continue to bolster consumer spending and the purchase of new homes. The recent declines in energy prices are another positive factor in the economic outlook. The price of West Texas intermediate crude oil dropped back to below $26 per barrel by the end of April, but as indications of a delay in the restoration of Iraqi oil exports became evident and geopolitical risks crept back in, prices have risen to near $30 a barrel - a worrisome trend if continued. Nonetheless, the price of crude oil is still about $10 per barrel below its peak in February. This decline has already shown through to the price of gasoline in May. Some modest further declines in gas prices are likely in coming weeks, as marketers’ profit margins continue to back off from their elevated levels of March and April to more normal levels. In contrast, prices for natural gas have increased sharply in response to very tight supplies. Working gas in storage is presently at extremely low levels, and the normal seasonal rebuilding of these inventories seems to be behind the typical schedule. The colder-than-average winter played a role in producing today’s tight supply situation as did the inability of heightened gas well drilling to significantly augment net marketed production. Canada, our major source of gas imports, has little room to expand shipments to the United States. Our limited capacity to import liquified natural gas effectively restricts our access to the world’s abundant supplies of natural gas. The current tight domestic natural gas market reflects the increases in demand over the past two decades. That demand has been spurred by myriad new uses for natural gas in industry and by the increased use of natural gas as a clean-burning source of electric power. On balance, recent movements in energy prices seem likely to be a favorable influence on the overall economy. In the short run, lower energy bills should give a boost to the real incomes of households and to business profits. To be sure, world energy markets obviously remain susceptible to politically driven supply disruptions, as has been evident recently from the events in Venezuela and Nigeria. But, even taking account of these risks, futures markets project crude oil prices to fall over the longer run, consistent with the notion that current prices are above the long-term supply price of oil. As has been the case for some time, the central question about the outlook remains whether business firms will quicken the pace of investment now that some, but by no means all, of the geopolitical uncertainties have been resolved. A modestly encouraging sign is the backlog of orders for nondefense capital goods excluding aircraft, which has been moving up in recent months. Moreover, recent earnings reports suggest that the profitability of many businesses is on the mend. That said, firms still appear hesitant to spend and hire, and we need to remain mindful of the possibility that lingering business caution could be an impediment to improved economic performance. One new uncertainty in the global economic outlook has been the outbreak of severe acute respiratory syndrome (SARS) in Southeast Asia and elsewhere. This epidemic has hit the economies of Hong Kong and China particularly hard, as tourism and business travel have been severely curtailed and as measures to contain the spread of the virus have held down retail sales. To date, the effects of SARS on the U.S. economy have been minimal. Airlines have obviously suffered another serious blow, and some U.S. multinational corporations are reporting reduced foreign sales. But the effects on other industries have been small. Initially, there had been some concern that SARS would disrupt the just-in-time inventory systems of U.S. manufacturers. Many of those systems rely on components from Asia, and any disruption in the flow of these goods has the potential to affect production in the United States. So far, however, U.S. manufacturing output has not been noticeably affected. In recent months, inflation has dropped to very low levels. As I noted earlier, energy prices already are reacting to the decline in crude oil prices, and core consumer price inflation has been minimal. Inflation is now sufficiently low that it no longer appears to be much of a factor in the economic calculations of households and businesses. Indeed, we have reached a point at which, in the judgment of the Federal Open Market Committee, the probability of an unwelcome substantial fall in inflation over the next few quarters, though minor, exceeds that of a pickup in inflation. Mr. Chairman, the economic information received in recent weeks has not, in my judgment, materially altered the outlook. Nonetheless, the economy continues to be buffeted by strong cross currents. Recent readings on production and employment have been on the weak side, but the economic fundamentals - including the improved conditions in financial markets and the continued growth in productivity - augur well for the future.
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board of governors of the federal reserve system
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Commencement address by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, at the Olin School of Business, Washington University in St. Louis, St. Louis, Missouri, 16 May 2003.
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Roger W Ferguson, Jr: Expectations Commencement address by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, at the Olin School of Business, Washington University in St. Louis, St. Louis, Missouri, 16 May 2003. * * * Dean Greenbaum, distinguished trustees and faculty, and honored guests, I am pleased to be at the Olin School today to congratulate this accomplished group of graduates. I hope today represents but one among many successful milestones to come. And my advice to the graduates is that they look back, not just forward, and thank the family and friends who supported them in school and helped to make today's achievement possible. I intend to do more than just wish the graduates success this afternoon. In fact, I will take a few minutes on this happy occasion for a discussion of economic conditions and policy. I will first explain what the Federal Reserve will be doing to ensure the best possible performance of the economic system that you are about to enter. Then, I will discuss some steps that you can take to navigate better in that wider world. Before I proceed, I should note that the views I will be expressing are my own and do not necessarily represent the views of other members of the Federal Open Market Committee or the Federal Reserve Board. What to Expect from the Central Bank Let me first explain what you, and others graduating during this season, can expect from the central bank. To my mind, the most important potential contribution of monetary policymakers is to anchor inflation expectations so that private-sector decisions can be made as efficiently as possible. We can do this because, as with any central bank, our control over the size of our balance sheet determines the value of our country's money and the general price level in the long run. We must do it because our enabling legislation directs the Federal Reserve to seek monetary conditions fostering “maximum employment, stable prices, and moderate long-term interest rates.” The economics profession has learned, in part from the bitter experience of the 1970s, that those three objectives collapse into one in the long run. That is, only in an environment of stable prices will households and firms be able to direct their complete attention to producing, investing, and saving so that employment will be at its maximum over the long run. And at the same time, when investors are not concerned about a generally rising level of prices for goods and services, inflation premiums will be compressed and long-term interest rates will be moderate. However, an environment of price stability is not one in which measured price indexes do not change. In fact, price indexes of consumer goods and services suffer from a variety of statistical biases that imply that the indexes overstate actual inflation. That is why, following Federal Reserve tradition, I speak of an environment of price stability, or a situation in which concerns about variations in the general price level do not materially influence the decisions of households and firms. In my view, we are in such an environment. The four-quarter growth in the core personal consumption deflator is currently running at a 1-1/2 percent rate, the slowest sustained pace in thirty years and 8 percentage points below its peak recorded in 1980. Think of it: Inflation has declined over the years - that is, we have experienced disinflation - to the point that increases in prices are now at a rate not seen on a sustained basis in the lifetimes of most of today's graduates. This disinflation represents an impressive victory for the disciplined monetary policy of the Federal Reserve under the guidance first of Paul Volcker and then Alan Greenspan. But having won the war, we at the Federal Reserve also have to win the peace. We will do that by always remembering that our mandate to foster price stability imposes a symmetric responsibility. Because resources are misused whenever the economy operates outside the zone of price stability, measured inflation can be too low at times as well as too high. In the quarters ahead and as noted at the conclusion of our policy meeting earlier this month, the Federal Reserve has to guard against further declines from the already low prevailing level of inflation. And we shall be on guard against such a development. Nonetheless, the possibility that the process of disinflation will cumulate to the point that price levels actually decline for a sustained stretch of time that is, we enter into deflation - remains quite remote. Quite simply, the United States has too many good things going for it to make a forecast of deflation credible, including the stimulus imparted by prior monetary policy easings, the marked decline in oil prices associated with decisive victory in the war against Iraq, the progress many households and firms have made in repairing their balance sheets, and the fact that inflation expectations remain well anchored. In discussing the fundamentals supporting economic expansion, I particularly want to single out the impressive growth of labor productivity. These increases in output per hour worked have been made possible by the harnessing of advances in technology in every aspect of business life. The lessons learned at institutions such as the Olin School are being applied everywhere to trim inventories, shorten supply chains, and enhance firms' responsiveness to their customers' needs. Faster productivity growth implies that workers can look forward to more rapidly rising real wages over time. Because the economic pie will be getting larger, those wage gains will not come at the expense of profits. But we must also remember the unpleasant arithmetic attached to those gains in productivity of late. Thus far in the economic recovery and expansion, firms have been able to meet increased demand for their products without adding workers. I would not be credible before this audience if I did not recognize that some may have had trouble finding employment and a few may still be uncertain of their next job opportunity. Indeed, over the past year, about one-half million private payroll jobs in the nonfarm sector have been lost. Because aggregate supply can increase rapidly, aggregate demand also has to grow faster than its recent pace to ensure that economic slack does not build up. Indeed, given the existing level of slack in labor and product markets, the economy should be able to enjoy above-trend growth for some time without putting undue pressure on resources. Recognizing that the economy is experiencing price stability, I also accept that the central bank should work to create conditions conducive to closing the gap between output and the ability of our economy to produce, thereby fostering utilization of resources, including labor. With the sound fundamentals that are now in place, I believe that such an outcome will be achieved. That said, an economic system such as ours that relies on the separate decisions of millions of people working to further their self-interest will be sensitive to expectations and sentiment. As a result, economic outcomes can change quickly and are thus difficult to predict. The difficulties of prediction pose a challenge to monetary policymakers: We prefer to act in advance of, rather than in reaction to, economic developments so as to minimize disruptions to economic activity. We cope with the challenge of prediction as best we can by devoting substantial resources to economic forecasting, by monitoring developments in financial markets, by speaking regularly with an extensive network of business contacts, and by being flexible with our policy actions. But the reality is that the private sector cannot look to the central bank to eliminate all risk. Real decisions have uncertain outcomes, and sometimes the result is adverse. But businesses and households must be prepared to take the reasonable risks associated with modern economies. And I am certain that businesses will return to a more normal pace of investment, although I am less certain of the timing. What to Expect of Yourselves Let me now offer a few thoughts about the world you are entering and the key professional challenges you face. Frankly, you will join the business world at a time when many have lost confidence in the integrity and ethics of our institutional leadership. Questions have been raised in the corporate and nonprofit sectors about the quality and reliability of information that is made available and about the personal ethics of those who had responsibility for managing the business risks that all organizations face. A disregard for ethics, vague accountability, and weak systems of internal control have resulted in unexpected levels of risk in credit or market exposures, in legal liability, and in tarnished reputations and careers. But the damage is not necessarily limited to those situations in which wrongdoing was discovered. The threat is more fundamental: Capital cannot be allocated efficiently if market participants do not have reliable information with which to make reasoned judgments. Many investors, businesspeople, policymakers and regulators understand this and have successfully promoted a needed emphasis on independence, oversight, and accountability. Corporate governance is now properly understood to be the keystone in risk management. Reputation is a critical competitive necessity, as you know, because reputation certainly weighed heavily in your educational selection process. Reputation risk should not be underestimated; I believe, for example, that Enron ceased to be a viable business because the value of its name was severely reduced well before any liability had been found in any court of law. How can the organizations you will soon join manage legal risks and protect their reputations? It is here that I believe a well-crafted ethics policy and the means to monitor compliance can serve as a foundation. A solid program in support of ethical behavior, along with sound corporate governance, can act as an early warning system that raises concerns to senior managers and directors before they ripen into legal liability. A rigorous compliance program can also identify behavior that, while within the law, could tarnish the company's reputation with very tangible consequences on equity value. It would please me thoroughly to say that with your entry into the profession of management the need for these kinds of programs will be reduced. And your educational experience has no doubt included some thoughtful and perhaps heartfelt discussions of business ethics. But one of the constants of human commerce is that a certain proportion of those involved will succumb to the urge to subordinate ethics to the desire for personal gain, however fleeting. I believe that most of you will live up to the highest ethical standards. Some of you will be able to profoundly influence your communities and businesses for the good. I will celebrate that kind of outcome, but my more modest hope is that as a group you will enter the business world as energetic advocates for the careful management of reputation risk and that throughout your careers you will use the lessons of our current experience. My final thought on managing the challenges ahead is one that will be familiar to you. As a person who was privileged, as you are, to attend some of the world's finest educational institutions, and as someone who currently serves in an institution that is heavily dependent on analysis, I know that knowledge matters. Knowing a business plan or an issue or an analytical technique is an absolute requirement. Recognizing that knowledge is fleeting is the beginning of deeper understanding. Thus, my hope for you is a continuing commitment to working through difficult problems, a professional life characterized by the highest commitment to ethical behavior, a lifelong love of learning, and a few moments - days like today - for celebration of your success. Congratulations and good luck. We are rooting for you.
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board of governors of the federal reserve system
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Speech by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve System, before the Chambers of Commerce of Bloomington, Eden Prairie and Edina Bloomington, Minnesota, 22 May 2003.
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Mark W Olson: Assessing prospects for economic growth in the United States Speech by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve System, before the Chambers of Commerce of Bloomington, Eden Prairie and Edina Bloomington, Minnesota, 22 May 2003. * * * Thank you for the invitation to be with you today. I would like to focus my remarks largely on what I think will, over time, lead the U.S. economy back to a path of solid economic expansion. In particular, I want to explain to you why I believe that, although the economy still faces substantial risks and although the timing and the extent of a pickup in activity remain uncertain, the stage has been set for an improvement in the economic climate. To lay the groundwork for that discussion and to put the current situation into perspective, I will briefly step back and touch on some recent economic history. I should note that my comments today reflect my own opinions and not necessarily those of my colleagues on the Board of Governors of the Federal Reserve or the Federal Open Market Committee. As you know, the latter half of the 1990s was a time of remarkable economic performance. Businesses added workers and expanded output at a rapid clip. The unemployment rate fell from over 7-1/2 percent in the middle of 1992 to just under 4 percent by the end of 2000. In Minnesota, the unemployment rate fell from 5.2 percent to 3.4 percent over the same period. The stock market soared, and - remarkably enough - core inflation moderated. Much of this performance was fueled by an investment boom that also contributed importantly to rapid growth in labor productivity. To be sure, some of the acceleration in productivity over that period was cyclical in nature; but more critical for our longer-run economic performance is that at least a portion of the pickup now appears sustainable. By late 2000, the boom had come to an end. The stock market began to retreat in early 2000, and by the end of the year, analysts were revising down their expectations for future earnings. Many businesses were cutting back sharply on capital investment - particularly in high-tech equipment - as demand and profits weakened and many companies, such as those in the telecommunications industry, found that they had overspent on equipment during the boom. The downturn in the economy, which began in 2000, had two distinct characteristics. First, and thankfully, it turned out to be one of the shallowest in our economic history. Second, it was one of the few business-led recessions in the United States since the end of the Second World War. Most recessions since then have been brought on by sharp cutbacks in spending by households, with housing and consumer durables among the most sensitive sectors. The recent experience was clearly different. Consumer spending and residential investment were both relatively well maintained throughout 2001, even as firms cut employment and stock market losses eroded household wealth. Despite only modest increases in nominal wages and salaries, households' real disposable income was supported by tax cuts and lower inflation. In addition, low interest rates helped promote spending. As you know, consumers took advantage of falling mortgage rates to buy new homes, to refinance their existing mortgage debt, and to tap into their increasing home equity to pay off more expensive debt or to finance spending on other things. As a result, the contraction in real GDP during the first three quarters of 2001 turned out to be quite shallow despite the disruptive economic fallout from the horrific events of September 11. By early last summer, economic recovery appeared to be under way. Real GDP increased at an annual rate of roughly 3-1/2 percent over the first three quarters of the year. Businesses seemed to have brought their inventories into better alignment with sales, and employment began to rise again, though the gains were too small to make a dent in the unemployment rate. A particularly encouraging development, given the nature of the downturn, was that the contraction in business investment appeared to be slowing while household spending, still supported by low interest rates and gains in real disposable income, continued to trend up. Although the government statistics were looking a bit better, signs appeared over the summer that the economy's resilience would be tested by several new shocks. As a banker who experienced several previous economic downturns, I know that whatever weaknesses exist in our economy become problematic at the low point of the economic cycle. At such times, we typically see loan losses and evidence of weak business models. What emerged in early 2002 was not what I had expected. The Enron and WorldCom scandals raised serious concerns about the adequacy of the corporate governance system and tended to cloud the outlook for business expansion. Abroad, mounting tensions with Iraq were beginning to take their toll on consumer and business confidence. The stock market moved down again, conditions eroded in corporate debt markets, and risk spreads widened. As we moved into the fall, industrial production faltered, and business investment posted only modest and uneven gains. By the final quarter of 2002, real GDP growth had slowed to a pace of 1-1/2 percent, and heightened caution in the business sector showed through to renewed layoffs and a sharp cutback in inventory investment. That brief review brings us to this year, which began with a few bright spots: Concerns about corporate governance were apparently receding, employment and industrial production moved up solidly in January, and the unemployment rate edged down a bit. Unfortunately, these improvements were short-lived. In late February and early March, as the confrontation with Iraq heated up, uncertainty was pervasive. No one knew if or when the war would start, or end. The possibilities that chemical or biological weapons might be used, that the war might spread, or that terrorists might again attack on U.S. soil seemed to be quite real. There was a risk that Iraq's oil fields might be damaged. The ranges of possible outcomes and of their economic consequences were extremely wide. The uncertainty hit consumer confidence hard. The University of Michigan's survey of consumer attitudes reported that, by the middle of March, confidence had fallen to its lowest level since the early 1990s and was below what we would have expected given the state of the economy. The oil, equity, and financial markets all showed signs of strain. Oil prices rose to nearly $40 per barrel in early March, though civil strife in Venezuela undoubtedly played a role in the increase. Broad stock market indexes moved down about 10 percent in the two months leading up to the war, and the equity risk premium widened. Measures of implied volatility in stocks edged up. All in all, the economy's performance in the first quarter of 2003 ended up little better than it was in the fourth quarter of 2002. Real GDP again rose at an annual rate of about 1-1/2 percent as both households and businesses reined in spending. Our overall economic performance would have been even weaker had housing markets not remained vibrant. Fortunately, the range of plausible outcomes narrowed significantly even before the official conclusion of hostilities with Iraq. As the onset of the war became imminent, financial markets rallied. Oil prices fell sharply during the week that ended with coalition missile attacks on Baghdad. Two months have passed since the war began, and we do not yet have a clear understanding of how strongly the economy is emerging from this most recent shock. The most positive signs are responses from energy and equity markets. The price of crude oil has returned to levels that prevailed at the end of last year, and both households and businesses should welcome the lower energy bills. Equity values, with additional support from generally favorable earnings reports, are up substantially. Spreads have narrowed significantly, continuing the downward trend that began last fall. Other positive signs include further reductions in mortgage interest rates and the rebound in consumer confidence. All told, these indicators point to a noticeable reduction in the economic tensions that built up earlier this year. Though markets can respond instantly to positive news, business investment decisions adjust more slowly, and that distinction is evident in current production and employment data. Businesses cut another 80,000 jobs in April, the jobless rate moved up to 6 percent, and new claims for unemployment insurance in recent weeks remain at levels associated with little net change in jobs. (In Minnesota, the jobless rate moved up to 4.4 percent in March, and about 28,000 workers filed claims for unemployment compensation in April.) Industrial production fell 1/2 percent in both March and April, and capacity utilization is under 75 percent. Retail sales have been, on balance, lackluster in recent months. Turning briefly to inflation, last week's report on the consumer price index showed, as expected, that consumer energy prices had begun to retreat noticeably last month, reversing about one-third of the run-up over the first three months of the year. In April, prices of core goods and services - that is, consumer prices excluding food and energy - were unchanged for a second month. As a result, the core CPI was up just 1-1/2 percent from last April. On balance, these indicators suggest that the economy will probably remain soft in the near future and that inflation will remain low. Nonetheless, I continue to believe that the pieces are in place for future robust growth. Looking back over the past three years, I am struck by how much the U.S. economy has had to contend with. For much of the period since mid-2001, large negative wealth effects from the falling stock market, the shakeout in the high-tech sector, and the slowdown in economic activity abroad have combined to restrain economic activity. Outside shocks, such as September 11, corporate scandals, and the war with Iraq, provided additional drag to renewed expansion. The economy, however, proved to be remarkably resilient. Looking forward, one must ask, what will lead to economic growth? The best way to start answering that question is to look at the fundamental forces shaping economic activity. In that regard, a first consideration is that financial conditions should prove conducive to stronger economic growth over the next year or so. Monetary policy is very accommodative. The nominal federal funds rate is currently 1-1/4 percent, a level that, using standard measures of core consumer price inflation, implies a real funds rate that is at or below zero, as compared with the real rate's long-run average of about 2-3/4 percent. With corporate risk spreads having narrowed considerably, borrowing terms are now quite favorable. Business financing needs have been very limited recently, and demand for credit has been weak. But the financial sector is well capitalized and under little stress, and lenders should be well positioned to fund a pickup in business demand for credit. In addition, as I noted earlier, equity prices have moved up again. Fiscal policy, like monetary policy, has been providing fundamental stimulus to economic growth over the past two years, through both tax cuts and higher outlays for defense. The tax proposals currently under consideration by the Congress could add to that stimulus, either by accelerating some of the tax cuts enacted previously or by excluding some portion of dividends from taxable income. A third factor underpinning longer-run prospects for growth is the sustained strong uptrend in labor productivity. Labor productivity rose 2 percent in 2001, a remarkable showing for a recession year, and it was up an additional 4 percent in 2002. Productivity appears to have a strong underlying trend, which could support overall income growth even if the weakness in the labor market continues for a while longer. In assessing how these factors will play out over time, I find it useful to consider separately how they translate into a pickup in demand among households and among businesses. From the perspective of households, the combination of lower energy prices and tax cuts should help bolster real disposable income in the near term. In addition, the drag on household spending from the earlier declines in stock market wealth should gradually diminish, especially if the stock market holds on to its recent gains. Low interest rates should allow consumers to continue to finance their purchases relatively cheaply, whether through home equity loans or through more standard instruments. The outlook for the business sector is perhaps a more critical consideration. Here, too, the fundamentals look favorable. In the near term, lower oil prices should reduce the costs of production for many businesses and free funds for other uses. Also, with interest rates low, the incentives for capital expenditure in the tax code in place until late 2004, and prices for high-tech goods still falling, the cost of capital should remain low. Over the longer run, the continuing rapid pace of technological innovation implies that there are many potential investments that offer attractive returns. In the uncertain business environment that has prevailed for some time, many businesses have probably been making do with their existing equipment, stretching out their normal replacement cycles, especially for rapidly depreciating high-tech equipment. Overall, though shifts in business attitudes are difficult to measure, I believe that markets reward businesses that outperform their competitors and that, as demand picks up, companies will respond to opportunities to incorporate technological advances in production, communication, and organization. Because of the uncertainties that have been restraining investment, predicting exactly when firms will act is difficult; but I do believe that they will act. As you can see, I remain generally optimistic about the longer-run prospects for the U.S. economy. However, I want to mention some significant questions about the outlook. Perhaps the most significant is whether the slump in capital spending will be more prolonged than expected. Such a slump could occur if firms remain so uncertain about the outlook for a pickup in sales that they continue to shelve plans for upgrading or expanding their businesses. Given the very low levels of capacity utilization both in our factories and in service-providing industries such as telecom and air transportation and the high vacancy rates in many office buildings, this risk is not trivial. For example, here in the Twin Cities metro area, one-fifth of available office space sat empty at the end of last year. Another question that is frequently asked is whether financial stress in the household sector might restrain growth. Specifically, some argue that the high level of consumer debt might mean that households will be unable to increase spending substantially for some time to come. To be sure, the debt service burden is quite high by historical standards, and personal bankruptcies moved up in 2001 and 2002. However, households have been converting their more expensive, non-tax-deductible debt into mortgage debt, which has helped keep the debt service burden fairly stable during the past few years. What is more, banks are not experiencing broad weakness in their consumer loan portfolios as most of the increase in delinquencies has been in a narrow spectrum of households. On the whole, looking at the available evidence, I tend to give less weight to the questions concerning the financial situation of households than I do to the risks of continued uncertainty in the business sector. A third question bearing on the outlook for the U.S. economy regards prospects for a pickup in activity among our major trading partners. Concerns about the strength of the global economy remain, and the emergence of SARS poses a threat to the economic prospects of several emerging-market economies in Asia. To date, however, we have no evidence that the new disease has affected U.S. economic activity. Nonetheless, continued slow growth abroad could have a damping effect on our recovery here. To summarize, the recent news from oil and financial markets and about consumer confidence clearly suggests that the reduction in risks associated with the situation in Iraq has had a number of favorable effects. At the same time, the available indicators of production and employment suggest that the pace of economic activity may remain slow for a while longer, likely restrained by lingering uncertainty about the timing of economic recovery. Looking ahead, however, it seems likely that, at some point the combined effects of a fundamentally solid financial sector, sustained consumer spending power, and improving consumer confidence will demonstrate sufficient demand potential to stimulate increased levels of capital investment.
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board of governors of the federal reserve system
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Speech by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, before the Japan Society of Monetary Economics, Tokyo, 31 May 2003.
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Ben S Bernanke: Some thoughts on monetary policy in Japan Speech by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, before the Japan Society of Monetary Economics, Tokyo, 31 May 2003. The references for the speech can be found on the Board of Governors of the Federal Reserve System’s website. * * * I am delighted to address this meeting of the Japan Society of Monetary Economics. I would particularly like to thank Professor Shimizu both for inviting me and for helping to arrange a series of meetings with officials at the Bank of Japan, the Ministry of Finance, and the Financial Services Agency. Those meetings have given me a first-hand look at the difficult challenges that the current economic situation poses for Japan's leaders and for the Japanese people. The economic situation here is indeed enormously complex. It involves not only structural, monetary, and fiscal problems but also underlying political and social forces, which have at times limited the flexibility of policy. The sometimes frustratingly slow pace of change in Japan is all the more reason, however, for this nation's economists to speak out and present clear, persuasive arguments that will help guide the policy debate and urge leaders to effective action. At stake is not only the economic health of your country but also, to a significant degree, the prosperity of the rest of the world. From my side of the ocean, it seems that many people are looking to the United States to take the responsibility for leading the world into economic recovery. Clearly, however, faster growth in Japan and other major industrial countries would support a stronger, more balanced, and more durable recovery than one driven by U.S. growth alone. Although changes in macroeconomic policy in Japan during the past decade have generally been slow and deliberate, there has also been some willingness to experiment, not least by the Bank of Japan (BOJ). For this reason, the recent appointment of a new leadership team at the BOJ has stimulated considerable interest and expectation around the world. Although Governor Fukui and his colleagues have so far not made radical breaks with previous BOJ policies, there is reason to hope that they will be open to fresh ideas and approaches. In that spirit, my remarks today will be focused on opportunities for monetary policy innovation in Japan, including specifically the possibility of more-active monetary-fiscal cooperation to end deflation. In focusing primarily on macroeconomic policies and the deflation problem, however, I do not wish to imply that more microeconomic measures - such as bank restructuring and recapitalization, development of more liquid capital markets, revitalization of the distressed corporate sector, and broader structural reform - are not essential and urgent. Indeed, all these elements are crucial if Japan's economy is to return to a more satisfactory rate of growth. However, I do think that ending deflation and carrying out banking, financial, corporate, and structural reforms can and should be pursued on parallel tracks, with progress being made wherever possible. Indeed, a definitive end to the deflation in consumer prices - by restoring confidence and stimulating spending - would do much to help moderate the unemployment and financial distress that might otherwise arise as the results of aggressive programs of reform and restructuring. I preface the body of my remarks with two important caveats. First, the opinions I give today are strictly my own and should not be attributed to my colleagues on the Board of Governors of the Federal Reserve or on the Federal Open Market Committee; nor do they reflect any official position of the United States government. Second, the remarks that follow were prepared before my visit to Japan and therefore do not reflect the discussions that I held this week with Japanese officials. Obviously, then, no inference should be made about those meetings from the comments to follow. Today I would like to consider three related issues that bear on contemporary monetary policy in Japan. First, I will discuss the option of asking the Bank of Japan to announce a quantitative objective for prices, as well as how such an objective might best be structured. Rather than proposing the more familiar inflation target, I will suggest that the BOJ consider adopting a price-level target, which would imply a period of reflation to offset the effects on prices of the recent period of deflation. Second, I A number of Board staff provided useful comments and assistance for this talk. Special thanks are due to Linda Kole and Dave Small for their help. would like to consider an important institutional issue, which is the relationship between the condition of the Bank of Japan's balance sheet and its ability to undertake more aggressive monetary policies. Although, in principle, balance-sheet considerations should not seriously constrain central bank policies, in practice they do. However, as I will discuss, relatively simple measures that would eliminate this constraint are available. Finally, and most important, I will consider one possible strategy for ending the deflation in Japan: explicit, though temporary, cooperation between the monetary and the fiscal authorities. What objective for Japanese monetary policy? Before setting off on a trip, one should know one's destination. In that spirit, a discussion of Japanese monetary policy should begin with some discussion of the policy objective. I leave until later how the objective can be achieved. The Bank of Japan Law, passed in 1998, sets price stability as a primary objective for the central bank. As with our own Federal Reserve Act, price stability is not, however, precisely defined in the Law. Currently, the BOJ has promised that the zero-interest-rate policy will be maintained until deflation is brought to an end, a policy that might be deemed consistent with the price stability objective. Two objections to this conclusion might be raised, however. First, the BOJ's statement seems to imply that the current level of policy stimulus might start to be withdrawn as soon as measured inflation returns to zero; in particular, no explicit commitment has been made to maintain inflation at zero, much less at some positive rate, in the longer run. But the presence of measurement bias in Japanese price indexes suggest that a measured inflation rate of at least one percent is likely required in order to achieve true price stability in the long run. Moreover, inflation above zero will be needed if real interest rates in Japan are to be negative for a period, as many observers think is necessary for full recovery. In short, it would be helpful if the zero-interest-rate policy were more explicit about what happens after the deflationary period ends. Second, over the past five years, since the onset of the current deflationary episode - and, incidentally, since the passage of the new Bank of Japan Law - the price level has trended down, registering a cumulative decline (depending on the price index) of between 4 and 9 percent. For example, over this period the GDP deflator has dropped nearly 9 percent, the private consumption deflator has fallen 51/2 percent, and wages and salaries are down 4-1/2 percent. One might argue that the legal objective of price stability should require not only a commitment to stabilize prices in the future but also a policy of actively reflating the economy, in order to restore the price level that prevailed prior to the prolonged period of deflation. As you may know, I have advocated explicit inflation targets, or at least a quantitative definition of price stability, for other leading central banks, including the Federal Reserve. A quantitative inflation target or range has been shown in many countries to be a valuable tool for communication. By clarifying the objectives of the central bank, an explicit inflation target can help to focus and anchor inflation expectations, reduce uncertainty in financial markets, and add structure to the policy framework. For Japan, given the recent history of costly deflation, however, an inflation target may not go far enough. A better strategy for Japanese monetary policy might be a publicly announced, gradually rising price-level target. What I have in mind is that the Bank of Japan would announce its intention to restore the price level (as measured by some standard index of prices, such as the consumer price index excluding fresh food) to the value it would have reached if, instead of the deflation of the past five years, a moderate inflation of, say, 1 percent per year had occurred. (I choose 1 percent to allow for the measurement bias issue noted above, and because a slightly positive average rate of inflation reduces the risk of future episodes of sustained deflation.) Note that the proposed price-level target is a moving target, equal in the year 2003 to a value approximately 5 percent above the actual price level in 1998 and rising 1 percent per year thereafter. Because deflation implies falling prices while the target price-level rises, the failure to end deflation in a given year has the effect of increasing what I have called the Of course, the choice of 1998 as the benchmark year is somewhat arbitrary. It seems however a good compromise choice between the more aggressive tack of trying to make up for the extensive unanticipated disinflation that occurred in the half decade prior to 1998 and the strategy of ignoring past deflation altogether and using 2003 as the base year. price-level gap (Bernanke, 2000). The price-level gap is the difference between the actual price level and the price level that would have obtained if deflation had been avoided and the price stability objective achieved in the first place. A successful effort to eliminate the price-level gap would proceed, roughly, in two stages. During the first stage, the inflation rate would exceed the long-term desired inflation rate, as the price-level gap was eliminated and the effects of previous deflation undone. Call this the reflationary phase of policy. Second, once the price-level target was reached, or nearly so, the objective for policy would become a conventional inflation target or a price-level target that increases over time at the average desired rate of inflation. Although restoration of the pre-deflation price level by means of a price-level target might be a reasonable interpretation of the BOJ's price stability objective, I would not want to push the purely legal argument too far. For example, based on a mandate for price stability, I would not ask either the BOJ or the Federal Reserve to restore the price level prevailing in their respective nations in 1950! Rather, I think the BOJ should consider a policy of reflation before re-stabilizing at a low inflation rate primarily because of the economic benefits of such a policy. One benefit of reflation would be to ease some of the intense pressure on debtors and on the financial system more generally. Since the early 1990s, borrowers in Japan have repeatedly found themselves squeezed by disinflation or deflation, which has required them to pay their debts in yen of greater value than they had expected. Borrower distress has affected the functioning of the whole economy, for example by weakening the banking system and depressing investment spending. Of course, declining asset values and the structural problems of Japanese firms have contributed greatly to debtors' problems as well, but reflation would, nevertheless, provide some relief. A period of reflation would also likely provide a boost to profits and help to break the deflationary psychology among the public, which would be positive factors for asset prices as well. Reflation - that is, a period of inflation above the long-run preferred rate in order to restore the earlier price level - proved highly beneficial following the deflations of the 1930s in both Japan and the United States. Finance Minister Korekiyo Takahashi brilliantly rescued Japan from the Great Depression through reflationary policies in the early 1930s, while President Franklin D. Roosevelt's reflationary monetary and banking policies did the same for the United States in 1933 and subsequent years. In both cases, the turnaround was amazingly rapid. In the United States, for example, prices fell at a 10.3 percent rate in 1932 but rose 0.8 percent in 1933 and more briskly thereafter. Moreover, during the year that followed Roosevelt's inauguration in March 1933, the U.S. stock market rallied by 77 percent. Eggertsson and Woodford (2003) have advanced a second argument for a price-level target for Japan in an important recent paper on monetary policy at the zero bound. These authors point out (as have many others) that, when nominal interest rates are at or near zero, the central bank can lower the real rate of interest only by creating expectations of inflation on the part of the public. Eggertsson and Woodford argue that a publicly announced price-level target of the type just described is more conducive to raising near-term inflation expectations than is an inflation target. One way to understand their argument is to imagine that the public expects the leaders of the central bank to take more aggressive actions, the further they are from their announced objective. Now suppose that, in an economy experiencing a stable deflation, the central bank leadership announces a fixed inflation target but then makes no progress toward that target during a given period. Then in the next period, the central bank is in the same position as previously, in terms of its distance from its objective; hence, by hypothesis, the central bank has no incentive to increase its effort to meet the announced target, and the public has no reason to expect it to do so. In this respect the inflation target is too "forgiving" an objective; failure is not penalized, nor is greater effort demanded. In contrast, under a price-level-targeting scheme, continuing deflation combined with an upward-sloping path for the price-level target causes the size of the price-level gap to increase over time. Thus, failure by the central bank to meet its target in a given period leads to expectations of (and public demands for) increased effort in subsequent periods - greater quantities of assets purchased on Some differences between inflation targeting and price-level targeting are interesting but they need not detain us here. See Cecchetti and Kim (2003) for a comparison. In my view, most contemporary inflation-targeting regimes actually practice a combination of inflation targeting and price-level targeting (or price-path targeting), in that overshoots or undershoots of inflation are usually partly, but not entirely, subsequently reversed. Wolman (1998) provides an earlier analysis with a similar conclusion. the open market, for example. So even if the central bank is reluctant to provide a time frame for meeting its objective, the structure of the price-level objective provides a means for the bank to commit to increasing its anti-deflationary efforts when its earlier efforts prove unsuccessful. As Eggertsson and Woodford show, the expectation that an increasing price level gap will give rise to intensified effort by the central bank should lead the public to believe that ultimately inflation will replace deflation, a belief that supports the central bank's own objectives by lowering the current real rate of interest. A concern that one might have about price-level targeting, as opposed to more conventional inflation targeting, is that it requires a short-term inflation rate that is higher than the long-term inflation objective. Is there not some danger of inflation overshooting, so that a deflation problem is replaced with an inflation problem? No doubt this concern has some basis, and ultimately one has to make a judgment. However, on the other side of the scale, I would put the following points: first, the benefits to the real economy of a more rapid restoration of the pre-deflation price level and second, the fact that the publicly announced price-level targets would help the Bank of Japan manage public expectations and to draw the distinction between a one-time price-level correction and the BOJ's longer-run inflation objective. If this distinction can be made, the effect of the reflation program on inflation expectations and long-term nominal interest rates should be smaller than if all reflation is interpreted as a permanent increase in inflation. A barrier to more aggressive policies: the BOJ's balance sheet Discussing the optimal objectives for Japanese monetary policy is all very well, but what of the argument, advanced by some officials, that the Bank of Japan lacks the tools to achieve these objectives? Without denying the many difficulties inherent in making monetary policy in the current environment in Japan, I believe that not all the possible methods for easing monetary policy in Japan have been fully exploited. One possible approach to ending deflation in Japan would be greater cooperation, for a limited time, between the monetary and the fiscal authorities. Specifically, the Bank of Japan should consider increasing still further its purchases of government debt, preferably in explicit conjunction with a program of tax cuts or other fiscal stimulus. Before going into more detail about this possibility, however, I want to discuss a specific institutional factor that currently constrains - somewhat artificially, I would argue - the ability of the Bank of Japan to pursue more aggressive policies, including both so-called non-conventional and more-orthodox policies. This institutional constraint, often cited by BOJ officials, is the condition of the BOJ's balance sheet, and the fear, in particular, that a successful program of reflation might inflict capital losses on the BOJ and thereby weaken its institutional position. Like other central banks, the Bank of Japan has a balance sheet, with assets, liabilities, and capital. Also like other central banks, the BOJ purchases interest-bearing assets with money that it creates and thus typically earns significant profits, or seignorage. Some of these profits are used to cover the expenses of the BOJ itself, subject to review by the Ministry of Finance (MOF). The BOJ also has reserves for possible losses on securities and foreign exchange transactions and is permitted by the Article 53 of the Bank of Japan Law to retain 5 percent of the surplus from the settlement of profits and losses as a reserve fund. The portion of the surplus not retained by the Bank is paid to the national treasury. From the point of view of conventional private-sector accounting - which, as I will discuss, is not necessarily the correct standard in this case - the BOJ's balance sheet has become noticeably riskier in recent years. For example, the BOJ's most recent financial statement showed that of the 68 percent of its assets held in the form of government securities, about two-thirds are long-term Japanese government bonds (JGBs). This represents a very substantial increase over customary levels in the BOJ's holdings of long-term government debt. Because yields on government bonds are currently so low, these holdings expose the BOJ's balance sheet to considerable interest-rate risk (although any losses would be partly offset by unrealized capital gains on earlier acquisitions of bonds). Indeed, ironically, if the Bank of Japan were to succeed in replacing deflation with a low but positive rate of inflation, its reward would likely be substantial capital losses in the value of its government bond holdings arising from the resulting increase in long-term nominal interest rates. With such concerns in mind, BOJ officials have said that a strengthening of the Bank's capital base is needed to allow it to pursue more aggressive monetary policy easing. In fact, the BOJ recently requested that it be allowed to retain 15 percent (rather than 5 percent) of the surplus for the 2002 fiscal year that just ended to increase its capital, and the Ministry of Finance has indicated that it will approve the request. Even with this additional cushion, however, concerns on the part of the BOJ about its balance sheet are likely to remain. The public debate over the BOJ's capital should not distract us from the underlying economics of the situation. In particular, the private shareholders notwithstanding, the Bank of Japan is not a private commercial bank. It cannot go bankrupt in the sense that a private firm can, and the usual reasons that a commercial bank holds capital - to reduce incentives for excessive risk-taking, for example - do not directly apply to the BOJ. Indeed, putting aside psychological and symbolic reasons, important as these may be in some circumstances, there appear to be only two conceivable effects of the BOJ's balance sheet position on its ability to conduct normal operations. First, if the BOJ's income were too low to support its current expenditure budget, the Bank might be forced to ask the MOF for supplemental funds, which the BOJ might fear would put its independence at risk. This consideration by itself should not necessarily make the BOJ less willing to undertake more aggressive monetary policies, however, because purchasing additional assets with non-zero yields, even if these assets are risky or illiquid, normally increases the Bank's current income. Second, an imaginable, though quite unlikely, possibility is that the Bank could suffer sufficient capital losses on its assets to make it unable to conduct open-market sales of securities on a scale large enough to meet its monetary policy objectives. In short, one could make an economic case that the balance sheet of the central bank should be of marginal relevance at best to the determination of monetary policy. Rather than engage in what would probably be a heated and unproductive debate over the issue, however, I would propose instead that the Japanese government just fix the problem, thereby eliminating this concern from the BOJ's list of worries. There are many essentially costless ways to fix it. I am intrigued by a simple proposal that I understand has been suggested by the Japanese Business Federation, the Nippon Keidanren. Under this proposal the Ministry of Finance would convert the fixed interest rates of the Japanese government bonds held by the Bank of Japan into floating interest rates. This "bond conversion" actually, a fixed-floating interest rate swap - would protect the capital position of the Bank of Japan from increases in long-term interest rates and remove much of the balance sheet risk associated with open-market operations in government securities. Moreover, the budgetary implications of this proposal would be essentially zero, since any increase in interest payments to the BOJ by the MOF arising from the bond conversion would be offset by an almost equal increase in the BOJ's payouts to the national treasury. The budgetary neutrality of the proposal is of course a consequence of the fact that, as a matter of arithmetic, any capital gains or losses in the value of government securities held by the BOJ are precisely offset by opposite changes in the net worth of the issuer of those securities, the government treasury. Although the MOF could insulate, without budgetary cost, the BOJ's balance sheet from interest-rate risk on its holdings of government bonds, a similar program offered by the MOF to private-sector holders of bonds, such as commercial banks, would not be costless from the MOF's point of view, if inflation and interest rates were subsequently to rise. However, if the MOF entered into the proposed swap agreement with the BOJ, new purchases of government bonds from the private sector by the Bank of Japan would be costless to the national treasury. Thus, conditional on the swap arrangement being in force, open-market purchases of government bonds by the BOJ would combine an expansionary monetary policy with a reduction of interest-rate risk in the banking system at no budgetary cost. The simple step of immunizing the BOJ's balance sheet thus opens a number of interesting policy options. There does not appear to be any provision in the Bank of Japan Law that addresses whether the Bank can or cannot have negative net worth, or what would happen if it were to report negative net worth. An alternative approach would be for the MOF to offer the fixed-floating swap to the BOJ only for its holdings of government bonds above some specified level. An advantage of this approach is that it would provide more current income to meet BOJ expenditure needs. However, these losses would be offset to some degree if nominal GDP were to grow with inflation, raising tax revenues. As an historical note, the U.S. Treasury initiated a bond conversion program at the time of the Treasury-Federal Reserve Accord in 1951, which allowed some private holders of long-term bonds as well as the Federal Reserve to avoid capital losses implied by the un-pegging of long-term nominal rates at that time. Because some private bondholders were assisted as well as the central bank, the budgetary cost to the government was not zero; most of the costs of protecting private long-term bondholders were absorbed by the Treasury. See, for example, Eichengreen and Garber (1991) for a discussion. I assume here that the BOJ does not sterilize the effects of its purchases of bonds, that is, it allows current account balances to rise by the amount of its purchases. The bond conversion (or interest-rate swap) just described is all that would be needed to protect the BOJ's balance sheet against any side effects from operations in government bonds. Incidentally, the approach could be extended to insulate the BOJ's balance sheet against potentially adverse effects of other types of asset purchases that the government might want to encourage. For example, to facilitate expanded purchases of asset-backed commercial paper, the government might agree, on request of the BOJ, to exchange government debt of the same maturity for the commercial paper. The net effect would be that the fiscal authority would assume the credit risk flowing from the nonstandard monetary policy action, as seems appropriate. What should the Bank of Japan give up in exchange for the Ministry of Finance's removing a significant amount of risk from the BOJ's balance sheet? One option would be for the Bank to use its increased ability to bear risk to undertake new policy actions that would entail accepting other types of risk onto its balance sheet. Today I will argue for a different approach and suggest that the Bank of Japan cooperate temporarily with the government to create an environment of combined monetary and fiscal ease to end deflation and help restart economic growth in Japan. To do this, the BOJ might have to scrap rules that it has set for itself - for example, its informal rule that the quantity of long-term government bonds on its balance sheet must be kept below the outstanding balance of banknotes issued. Monetary and fiscal cooperation There is no unique solution to the problem of continuing declines in Japanese prices; a variety of policies are worth trying, alone or in combination. However, one fairly direct and practical approach is explicit (though temporary) cooperation between the monetary and the fiscal authorities. Let me try to explain why I think this direction is promising and may succeed where monetary and fiscal policies applied separately have not. Demand on the part of both consumers and potential purchasers of new capital equipment in Japan remains quite depressed, and resources are not being fully utilized. Normally, the central bank would respond to such a situation by lowering the short-term nominal interest rate, but that rate is now effectively zero. Other strategies for the central bank acting alone exist, including buying alternative assets to try to lower term or liquidity premiums and attempting to influence expectations of future inflation through announcements or commitments to expand the monetary base. The Bank of Japan has taken some steps in these directions but has generally been reluctant to go as far as it might, in part because of the difficulty in determining the quantitative impact of such actions and in part because of the Bank's view that problems in the banking system have "jammed" the usual channels of monetary policy transmission. Ironically, this obvious reluctance on the part of the BOJ to sail into uncharted waters may have had the effect of muting the psychological impact of the nonstandard actions it has taken. Likewise the Bank of Japan has resisted calls to manage the value of the yen (see, for example, McCallum, 2000, or Svensson, 2001), citing its lack of authority to do so as well as the prospect of retaliation from trading partners. The alternative approach to stimulating aggregate demand is fiscal policy - government spending increases or tax cuts. Here again the perception is that policy has been less than successful, although Posen (1998) - in a criticism reminiscent of those who have complained that the Bank of Japan should just "do more" - has argued that the problem is less that fiscal policy is ineffective than that it has not been used to the extent that one might gather from official plans and announcements. In Posen's view, Japan's debt problem is primarily the result of slow economic growth rather than active fiscal policies. However, besides possibly inconsistent application of fiscal stimulus, another reason for weak fiscal effects in Japan may be the well-publicized size of the government debt. The severity of the government debt problem may be overstated in some respects - 95 percent of the outstanding debt is domestically held, for example, and 59 percent is held by public institutions, so that the Japanese people truly "owe the debt to themselves" - but that the government's annual deficit is now about 8 percent of GDP is nevertheless a serious concern. Moreover, an aging Japanese population will add to the government's budgetary burden in coming decades. In addition to making policymakers more reluctant to use expansionary fiscal policies in the first place, Japan's large national debt may dilute the effect of fiscal policies in those instances when they are used. For example, people may be more inclined to save rather than spend tax cuts when they know that the cuts increase future government interest costs and thus raise future tax payments for themselves or their children. (It is striking that, despite low interest rates, about 20 percent of the Japanese central government budget, or about 16.8 trillion yen this year, is devoted to servicing the national debt.) In economics textbooks, the idea that people will save rather than spend tax cuts because of the implied increase in future tax obligations is known as the principle of Ricardian equivalence. In general, the evidence for Ricardian equivalence in real economies is mixed, but it seems most likely to apply in a situation like that prevailing today in Japan, in which people have been made highly aware of the potential burden of the national debt. The principle of Ricardian equivalence does not apply exactly to increases in government purchases (for example, road building) but it may apply there approximately. If, for example, people think that government spending projects are generally wasteful and add little to national wealth or productivity, then taxpayers may view increased government spending as simply increasing the burden of the government debt that they must bear. If, as a result, they react to increases in government spending by reducing their own expenditure, the net stimulative effect of fiscal actions will be reduced. In short, to strengthen the effects of fiscal policy, it would be helpful to break the link between expansionary fiscal actions today and increases in the taxes that people expect to pay tomorrow. My thesis here is that cooperation between the monetary and fiscal authorities in Japan could help solve the problems that each policymaker faces on its own. Consider for example a tax cut for households and businesses that is explicitly coupled with incremental BOJ purchases of government debt - so that the tax cut is in effect financed by money creation. Moreover, assume that the Bank of Japan has made a commitment, by announcing a price-level target, to reflate the economy, so that much or all of the increase in the money stock is viewed as permanent. Under this plan, the BOJ's balance sheet is protected by the bond conversion program, and the government's concerns about its outstanding stock of debt are mitigated because increases in its debt are purchased by the BOJ rather than sold to the private sector. Moreover, consumers and businesses should be willing to spend rather than save the bulk of their tax cut: They have extra cash on hand, but - because the BOJ purchased government debt in the amount of the tax cut - no current or future debt service burden has been created to imply increased future taxes. Essentially, monetary and fiscal policies together have increased the nominal wealth of the household sector, which will increase nominal spending and hence prices. The health of the banking sector is irrelevant to this means of transmitting the expansionary effect of monetary policy, addressing the concern of BOJ officials about "broken" channels of monetary transmission. This approach also responds to the reservation of BOJ officials that the Bank "lacks the tools" to reach a price-level or inflation target. Isn't it irresponsible to recommend a tax cut, given the poor state of Japanese public finances? To the contrary, from a fiscal perspective, the policy would almost certainly be stabilizing, in the sense of reducing the debt-to-GDP ratio. The BOJ's purchases would leave the nominal quantity of debt in the hands of the public unchanged, while nominal GDP would rise owing to increased nominal spending. Indeed, nothing would help reduce Japan's fiscal woes more than healthy growth in nominal GDP and hence in tax revenues. Potential roles for monetary-fiscal cooperation are not limited to BOJ support of tax cuts. BOJ purchases of government debt could also support spending programs, to facilitate industrial restructuring, for example. The BOJ's purchases would mitigate the effect of the new spending on the burden of debt and future interest payments perceived by households, which should reduce the offset from decreased consumption. More generally, by replacing interest-bearing debt with money, BOJ purchases of government debt lower current deficits and interest burdens and thus the public's expectations of future tax obligations. Of course, one can never get something for nothing; from a public finance perspective, increased monetization of government debt simply amounts to replacing other forms of taxes with an inflation tax. But, in the context of deflation-ridden Japan, generating a little bit of positive inflation (and the associated increase in nominal spending) would help achieve the goals of promoting economic recovery and putting idle resources back to work, which in turn would boost tax revenue and improve the government's fiscal position. Conclusion The Bank of Japan became fully independent only in 1998, and it has guarded its independence carefully, as is appropriate. Economically, however, it is important to recognize that the role of an The BOJ's announcement of a price-level target should be credible: It is feasible, and it is in the interest of the BOJ, the government, and the public. independent central bank is different in inflationary and deflationary environments. In the face of inflation, which is often associated with excessive monetization of government debt, the virtue of an independent central bank is its ability to say "no" to the government. With protracted deflation, however, excessive money creation is unlikely to be the problem, and a more cooperative stance on the part of the central bank may be called for. Under the current circumstances, greater cooperation for a time between the Bank of Japan and the fiscal authorities is in no way inconsistent with the independence of the central bank, any more than cooperation between two independent nations in pursuit of a common objective is inconsistent with the principle of national sovereignty. I have argued today that a quid pro quo, in which the MOF acts to immunize the BOJ's balance sheet from interest-rate risk and the BOJ increases its purchases of government debt, is a good way to attack the ongoing deflation in Japan. I would like to close by reiterating a point I made earlier - that ending deflation in consumer prices is only part of what needs to be done to put Japan back on the path to full recovery. Banking and structural reform are crucial and need to be carried out as soon and as aggressively as possible. Although the importance of reforms cannot be disputed, however, I do not agree with those who have argued that deflation is only a minor part of the overall problem in Japan. Addressing the deflation problem would bring substantial real and psychological benefits to the Japanese economy, and ending deflation would make solving the other problems that Japan faces only that much easier. For the sake of the world's economy as well as Japan's, I hope that progress will soon be made on all of these fronts.
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Speech by Ms Susan S Bies, Member of the Board of Governors of the US Federal Reserve System, before the Conference of State Bank Supervisors, Asheville, 30 May 2003.
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Susan S Bies: Restoring our confidence in bank controls and financial statements Speech by Ms Susan S Bies, Member of the Board of Governors of the US Federal Reserve System, before the Conference of State Bank Supervisors, Asheville, 30 May 2003. * * * This conference is always an important gathering, but not simply because of what we discuss over these few days. It serves as an annual reminder of the remarkable strength of the dual banking system in the United States. The diversity and flexibility of our banking system are unique. Bankers can make charter choices on the basis of their business needs and particular circumstances. Thousands of community banks coexist comfortably - indeed, thrive - alongside a much smaller number of very large regional and global institutions, regardless of charter. Our system provides a rich menu of choices to the marketplace, encouraging financial institutions to innovate and respond dynamically to the changing economic needs of depositors and borrowers. Under the dual banking system states have fostered innovations that likely would not have occurred as rapidly - if at all - had only federal regulation existed. The dual banking system also helps to safeguard against regulatory excesses. In short, this structure has been critical in producing a banking system that is the most innovative, responsive, and flexible in the world. U.S. banks have developed those characteristics to survive in a market economy that is subject to rapid change and periodic stress. Our banking system is thus better able to finance growth and serve customer needs and has demonstrated its ability to rebound from crises that have, from time to time, devastated more rigid systems. This conference also reminds us of the long history of close and successful cooperation among state and federal regulators that allows state-chartered banks to flourish in the marketplace while remaining safe and sound. As you know, the Federal Reserve has consistently been a strong supporter of the dual banking system, and that will continue. We understand, as you do, the importance of a safe and sound banking system to the proper functioning of the economy, and the role of effective supervision in ensuring sound banks. Supervising these state-chartered banks is a very significant responsibility, considering the scope and vitality of these institutions. State-chartered banks continue to represent about half of the commercial banking industry by assets - $3.41 trillion, or 47.6 percent of the industry at year-end 2002. By number of institutions, roughly three-fourths of banks operate under a state charter - 6,311 institutions or 75.2 percent of the industry as of December. Perhaps most significant, over the past three years the vast majority of new bank charters - once again, about three-fourths of them - have been granted by states. We have a long history of working with the states to coordinate our supervisory programs and achieve quality results. We rely on state supervisors as equal partners to ensure consistent, effective, and high-quality supervision. Together with the Federal Deposit Insurance Corporation, we believe we have a strong relationship with the states, bolstered by our common effort to develop the supervisory protocols of the last decade and, more recently, by our work with the states and the FDIC to foster consistent examination processes and procedures. I believe the flexibility and dynamism of our banking system contributes to the financial soundness and performance of U.S. banks. The banking industry continues to be strong and profitable despite a tepid economy and corporate governance issues. After a record year in 2002, insured commercial banks in the United States earned $24.6 billion in the first quarter of 2003 - a quarterly record. Robust growth in core deposits and vibrant activity in mortgage lending have been the key forces behind recent strong earnings, which have been offset in part by weak loan demand from businesses. Aggregate nonaccrual loans and foreclosed assets remain at about 1.2 percent of loans while credit costs have declined, as first-quarter net charge-offs dropped to 0.91 percent of average loans - the lowest level since June 2001. Although all the facts are not yet in, it appears that this credit cycle hasn't tested us nearly as significantly as we have been tested in the past. Community banks have also remained strongly profitable through this period, although over the past two years they experienced far less of a run-up in problem assets and charge-offs than their larger counterparts. The number of problem banks remains at about 120, but actual failures remain quite low, only ten in all of last year. Corporate governance Based on the current condition of the industry, you might ask what's on the supervisory agenda and where should we focus our attention? Although there are a number of supervisory issues that require our attention, there are two specific areas - corporate governance and quality assurance in the audit process - where I believe we should focus some of our supervisory attention. Over the past two years, corporate scandals have focused our attention on the deficiencies in corporate governance at major companies. The reforms of the Sarbanes-Oxley Act of 2002 focused on the need to enhance the governance, accounting, and disclosure practices at public companies, and the resulting dialogue has focused attention on the need to improve governance practices at other companies. The Securities and Exchange Commission has launched significant regulatory reforms and initiatives to address these issues, and the banking agencies have been actively involved in a dialogue with the SEC on matters of mutual interest. The focal point of this dialogue is to implement practical steps to move the corporate governance practices of public and nonpublic companies forward, particularly with regard to the adequacy of internal controls and audits. I want to focus the rest of my remarks on steps that we can take to improve the quality assurance process surrounding internal controls and audits. Internal controls The essence of corporate governance is ensuring that the company is operated, at all times, in a manner that manages risk, achieves the company's stated operating objectives, and protects the best interests of the shareholders. The Internal Control-Integrated Framework of the Committee of Sponsoring Organizations (COSO) of the Treadway Commission is the most-often-mentioned standard on internal control at banking organizations. The COSO framework defines internal control as "a process, effected by an entity's board of directors, management and other personnel, designed to provide reasonable assurance regarding the achievement of: • effectiveness and efficiency of operations; • reliability of financial reporting; • compliance with applicable laws and regulations." Based on this definition, it is clear that boards of directors are responsible for ensuring that their organizations' internal controls are adequate for the nature and scope of their businesses and that line management is responsible for ensuring that internal controls are functioning on a day-to-day basis. Thus, the board of directors and management need to have a quality assurance process in place for internal controls. So, how do we know that the quality assurance process surrounding the internal controls at banking organizations is working? With respect to this quality assurance process, the Federal Reserve conducted reviews of the documentation and support for management's assessment of internal controls and the auditor's related attestations at a few problem institutions that are subject to section 112 of the Federal Deposit Insurance Corporation Improvement Act. What we found was evidence that notable deficiencies had crept into the quality of the work performed by management over time as the businesses grew and new products were added. Management became less vigilant in the internal control area because of increased performance pressures. This behavior is actually counterintuitive when dealing with internal controls. As the business grows and new products are added, that is precisely the time when management needs to ensure that adequate controls are in place to mitigate risks. We are talking to the other banking agencies about these concerns and are considering the need for more detailed guidance for management that will strengthen banks' internal control practices. Internal audit Recent corporate governance events clearly demonstrate the importance of the internal audit function. While Sarbanes-Oxley does not focus on the role of the internal auditor, bank supervisors have long recognized the importance of an effective internal audit function to the control environment. With respect to the quality of internal audit, the audit committee must pave the way for quality assurance. As we indicated in a recently amended interagency policy statement on the internal audit function, the committee should provide for the utmost independence, objectivity, and professionalism of the internal audit process. The audit committee sets the tone, and our role as supervisors is to reinforce it. The goal for internal audit should be to have no internal control surprises. To support this goal, internal audit should have an effective quality assurance process. Risk-focused audit programs should be reviewed regularly to ensure audit resources are focused on the higher-risk areas as the company grows and produces and processes change. As lower-risk areas come up for review, auditors should do enough transaction testing to be confident in their risk rating. Audit committees should receive reports on all breaks in internal controls to determine where the auditing process can be strengthened. Before a company moves into new or higher-risk areas, the board of directors and management should receive assurances from internal audit that the tools are in place to ensure that the basics of sound governance will be adhered to. The audit committee should actively engage the internal auditor to ensure that the bank's risk assessment and control process over financial reporting are vigorous. Many of the organizations that have seen their reputations tarnished in the past two years have simply neglected to consider emerging conflicts of interest when adding new products and lines of business. It is important to make sure that appropriate firewalls are in place before the product or activity begins. As supervisors, we can focus attention on this area and watch for signs of any internal audit deficiencies at our institutions. The audit committee should also require the highest possible level of independence for the internal audit process and eliminate any threats to this independence, such as the tendency for some internal auditors to act as management consultants within the organization. Many of the proposed revisions to the Institute of Internal Auditors' professional standards focus on adding value by meeting the needs of management and the board. Internal auditors add value by being effective independent assessors of the quality of the internal control framework and processes. Auditors lose their independence when they perform management consulting roles for which they later will have to render an opinion. Internal audit is one of the few corporate functions that has both the ability and the responsibility to look across all of the management silos within the corporation and make sure that the system of internal controls has no gaps and that the control framework is continually reviewed to keep up with corporate strategic initiatives, reorganizations, and process changes. When an auditor becomes part of management, the independent view is lost. External audit Let's turn to the topic of quality assurance in the external audit process. As supervisors, we must take steps to encourage a high standard of professionalism among auditors. In some cases, this may mean undertaking an enforcement action against an accountant. The agencies are finalizing the accountant debarment rule, which will be one more tool we can use to correct errant behavior. However, before we do that, we should look at the lessons learned from some recent audit failures. The typical fact pattern in these failures indicates that some auditors are focusing on the form rather than the substance of transactions when making critical audit judgments. Moreover, when looking at assurance services, such as the FDICIA 112 auditor attestations, some auditors have a tendency to gloss over internal control deficiencies or simply ignore significant control deficiencies because they are "immaterial." It is not meaningful for auditors to apply a financial statement concept of materiality to an attestation engagement on internal controls. From a supervisory perspective, we would consider the existence of a series of such immaterial deficiencies to be useful information in assessing the quality of the internal and external audit process. We need to change this mindset in the auditing community. Some of this can be done through dialogue with the American Institute of Certified Public Accountants and the Public Company Accounting Oversight Board, which we are doing. Once auditors start to routinely report known deficiencies in internal controls, we should begin to eliminate the gap between what we expect an audit or attestation engagement to include and actual services provided by auditors. However, if we continue to find significant internal control deficiencies in safety and soundness examinations that the auditor knows about but fails to disclose, because they are judged to be immaterial, then we should discuss the auditor's lack of action with the banking organization's audit committee. Furthermore, in appropriate circumstances, we may need to refer the auditor to the PCAOB or subject the auditor to sanctions under the agencies' debarment regulations if the bank is subject to FDICIA 112. A secondary cause of the audit failures was lax professional standards. Examples in the banking area are the professional standards for attestation engagements. Currently, the standards don't require auditors to perform any independent testing of controls. Under the current standards, auditors can simply rely on the work of internal audit as the basis for issuing an attestation report on management's report on the effectiveness of internal controls. There is virtually no guidance on the criteria auditors should use to issue a qualified opinion. We have long argued that the professional standards in this area need to be more robust. In response to our criticisms and those of others, the AICPA recently proposed revisions to their professional standards to address some of these issues. However, the AICPA no longer has the authority to issue standards or to administer the quality assurance (peer review) function for audit or attestation engagements of public companies. The newly created Pubic Company Accounting Oversight Board has this authority and is just beginning to develop a framework for quality assurance. So, this may take a little time to correct. However, as supervisors, we will continue to work with the AICPA and the PCAOB to ensure that high-quality professional standards are created for public and nonpublic companies and that a robust process for ensuring audit quality is implemented. Conclusion In closing, I would like to simply encourage all of us to be vigilant about sound corporate governance and internal control processes at banking organizations. To accomplish this, we need to insist on effective attestations on internal controls by external auditors and encourage bankers to improve the quality assurance process and independence of the internal audit function. Finally, supervisors from all regulatory agencies need to continually work together to ensure a consistent, high-quality examination process throughout our banking system.
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Speech by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, before the Institute of International Bankers, New York, 10 June 2003.
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Roger W Ferguson, Jr: Basel II - scope of application in the United States Speech by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, before the Institute of International Bankers, New York, 10 June 2003. * * * I am delighted to join you today as you gather for your Annual General Meeting of the Institute of International Bankers. Larry Uhlick suggested that I might provide an overview of key trends and developments in the regulation and supervision of internationally active banks. Basel II, of course, is the key issue today, and given that the U.S. agencies' position on scope of application has clear implications for your banks' operations in this country, choosing Basel II and its scope of application in the United States as my topic was not difficult. As you all know, Basel II refers to the proposed new capital accord developed by the Basel Committee on Banking Supervision. The committee's third consultative paper was issued for public comment about six weeks ago, and the U.S. agencies plan to issue their preliminary proposals for implementation in this country next month in an Advance Notice of Proposed Rulemaking (ANPR). At the same time, the U.S. authorities will release the first of a series of draft supervisory guidelines to assist bankers in understanding what supervisors will be expecting of U.S. banks. The agencies are actively seeking comments on all these documents. It is not too late to shape Basel II's final form or the way it will be implemented in this country, provided that comments are directed at the way to improve methods and procedures for obtaining the same objectives. We are open-minded and are willing to make changes that meet such criteria. Even though the U.S. ANPR has not yet been released, the authorities have already made known their intended scope of application in this country: which banks will be required to apply Basel II, which banks may choose to adopt the new accord, and which banks may choose to remain under Basel I. This decision is of particular interest, I would think, to this audience because it raises the risk that nonU.S. banks will be required to operate in the United States under rules that will differ from those that apply to their parent bank in their home country and affiliated banks in third countries. I hope that, by the time you leave this room, you will see that such potential conflicts are more apparent than real. Scope of Application in the United States The major goal of the Basel Accord of 1988 (Basel I) was to align the capital requirements of institutions that competed across national boundaries. The Group of Ten and other nations that subsequently adopted Basel I applied it to all their banks, but the Accord focused, and its proposed new version continues to focus, on obtaining a level playing field for cross-border banks. Throughout the discussions and negotiations of Basel II, the United States has emphasized that its interest is in ensuring that banks competing in each other's countries be subject to the same capital regime. Of course, we also want at least those banks to benefit from more-risk-sensitive capital requirements that call for more-sophisticated systems for risk measurement and management. We have concluded, therefore, that the U.S. chartered banks (including subsidiaries of foreign banks) that both are large in scale and have significant foreign activities should be required to adopt Basel II. These U.S. banks are significant competitors in foreign markets and must, if we are to honor our commitments to other countries, be subject to the new Accord. The exact parameters that establish this core set of U.S. banks, those that will be required to adopt Basel II, will be released in the ANPR next month. There are about ten such banks, and each one has been notified about the requirement. The U.S. authorities are also proposing to permit any U.S. bank that can meet the infrastructure requirements for the advanced approaches for handling credit and operational risk to choose to follow Basel II capital requirements. Our best guess is that another ten or so banks will choose Basel II capital requirements in this country in the first round. We believe that the decisions of these banks will reflect their perceptions of their self-interest from either their implied new capital charges under Basel II or the message they want to send their counterparties about their risk-management techniques. We expect that, as time passes, additional larger banks, responding to market pressures, will opt for Basel II. Moreover, the current activities of still other banks suggest that current trends will put them in the mandatory core group in coming years. As U.S. supervisors have previously stated, in this country we expect to apply, for regulatory capital purposes, only the advanced internal-ratings-based (A-IRB) approach for credit risk and the advanced measurement approach (AMA) for operational risk. In line with our additional goal of improving riskmanagement techniques, the authorities believe that the largest, most complex, internationally active banking organizations in the United States - those that our screening criteria determine to be core banks - should be subject to the most sophisticated version of Basel II. To be clear, we are not proposing to implement either the standardized or the foundation internal-ratings-based (F-IRB) approaches within the United States. The twenty banks that we are assuming will be under Basel II in this country either by, or shortly after, the initial implementation date would account for about 99 percent of the foreign assets held by the top fifty domestic U.S. banking organizations. We believe that this high percentage clearly signals our intent to meet our obligation to ensure cross-border competitive equality of capital regimes. That the same twenty banks also currently account for approximately two-thirds of the domestic assets of U.S. banking organization indicates their importance to our banking and financial system. These entities must operate under the best risk-management standards with the most risk-sensitive capital treatment. We do not intend to require the thousands of other banking organizations in the United States, including U.S. subsidiaries of foreign banks that do not meet the mandatory criteria, to adopt Basel II. Unless they choose to adopt Basel II, they will remain under our current regulatory capital rules, which are based on Basel I. Those banks remaining under Basel I will not be subject to an explicit regulatory capital charge for operational risk. To be sure, any of these organizations can choose the Basel II requirements whenever they want, provided they meet the infrastructure prerequisites of the A-IRB and the AMA approaches to Basel II. We believe that the cost-benefit nexus will make this option infeasible for most of these banks in the years immediately ahead, but ultimately that decision resides with the banks themselves. Nonetheless, as the cost of risk-management techniques decline with their wider dissemination and as counter-parties and stakeholders seek the comfort that comes with banks' application of more-sophisticated risk-management techniques, the larger regional banks may wish to migrate from rules based on Basel I to those based on Basel II. Even if larger regional banks do not formally choose to operate under Basel II for regulatory purposes, we expect they may wish to make use of the risk-management process that underlies Basel II. Indeed, I should emphasize that the movement toward more-sophisticated risk management, the prerequisite of A-IRB and AMA, is occurring, and would continue to occur, independent of Basel II. This movement is clearly a market trend reflective of evolving technology, growing complexity, and the understanding of modern finance. For thousands of U.S. banks, the migration to a regulatory capital regime based on advanced riskmanagement techniques is unlikely to occur for many years, however. As a supervisor who believes strongly in a safe and sound banking system, I want to share with you why it is totally acceptable that these entities, whose activities are almost completely limited to those within the United States, remain on the less risk sensitive capital rules based on Basil I. First, their balance sheet and operational structure are relatively straightforward and do not require the sophisticated risk-management techniques of modern finance, although most of these institutions have adopted some of them, like credit scoring. Second, most of these banks already hold considerable capital: More than 93 percent of them have risk-weighted capital ratios in excess of 10 percent - fully 2 percentage points over the minimum and a capital buffer of 25 percent. In part, this strong capital position reflects market realities required of entities whose scale makes raising additional capital, especially under duress, very difficult and whose geographic concentrations of credit risk require greater capital support. In part, it reflects the desire of bank management to hold buffer capital - above regulatory minimums - for the flexibility and survivability that additional capital provides for smaller banks. And in part, it reflects statutory provisions in the United States that link permissible activities to capital positions - including minimum At the end of 2002, there were in the United States 4,998 bank and financial holding companies (some with more than one bank subsidiary) and 1,493 independent banks (not in holding companies), for a total of 6,491 banking organizations. These well-capitalized banks account for 96.5 percent of the assets of all the U.S. banks that are not in the top twenty banks that are likely to be under Basel II. leverage ratios of equity to unweighted total assets; thus as capital ratios decline, supervisors are required to take action. These "prompt corrective action" provisions play a significant role in maintaining the strong capital position of U.S. banks, above and beyond the Basel minimums. Third, as this audience well knows, the United States for some time has had an effective Pillar II, or procedure for supervisory review and guidance. That supervisors evaluate and review banks' operations and policies and discuss their views and suggestions with bank managers has been part of our institutional framework. In certain cases, supervisors may encourage institutions to hold additional capital for risks, such as concentrations, that the Basel I rules do not capture directly. For the United States banking authorities, Pillar II of Basel II requires nothing new. Finally, banks in this country have for quite a while disclosed their capital ratios. The banks that are publicly held and those that issue publicly held securities are required to disclose even more data, although admittedly less than the requirement proposed under Pillar III of Basel II. Moreover, even for smaller banking organizations, considerable information is publicly disseminated - for example, through our Call Reports - and is available for counterparties. When the U.S. authorities considered the cost-benefit ratio of requiring thousands of our banks to become subject to Basel II - presumably the standardized version - we saw the benefits as (1) only slightly more risk sensitivity in the calculation of the minimum regulatory capital requirements under the Standardized version that presumably these banks would select, and (2) more disclosure under Pillar III. In exchange, smaller banks (1) would have to bear additional costs, even though they already maintain far more capital than any change in the required regulatory minimum would produce; would not need, nor be required to adopt, any different risk-management techniques under the Standardized approach; (3) would benefit from no new supervisory oversight under Pillar II; and already disclose considerable information. For all these reasons, the U.S. authorities did not believe that requiring most U.S. banks to bear the cost of shifting from Basel I-based rules to Basel II was reasonable. Of course, supervisors of banks using Basel I-based rules in the United States will continue to seek a full understanding of each bank's process for risk measurement and management as part of their usual efforts to fully evaluate a bank's operations. Asking questions about these important management responsibilities is simply a part of appropriate supervisory oversight. I underline that not many jurisdictions outside the United States have smaller banks - those likely to move to the Standardized version if they adopt Basel II - with the capital position, the intimate supervisory review, or the existing disclosure rules of U.S. banks. Thus, the proposal in this country has no implications for the desirability and benefit of applying Basel II to smaller banks in other jurisdictions that might benefit significantly from the Standardized Basel II approach. Indeed, the U.S. experience proves the value of enhanced supervision and greater transparency even for the smallest institution. Implications for the treatment of U.S. banks abroad As many of you know, the Basel Committee has established a separate subgroup to deal specifically with cross-country implementation issues. The Basel Accord Implementation Group (AIG) comprises line supervisors directly involved in the supervision of large, complex banks in member countries. The AIG has already begun to explore and develop solutions for some of the complex issues arising from cross-border implementation. In addition, the members of the AIG have already established a constructive dialogue with a working group representing non-G10 jurisdictions on the practical challenges of implementation. As I noted, we anticipate that U.S. banking organizations that account for 99 percent of the foreign assets and two-thirds of all assets of our domestic banking system will be under the A-IRB and AMA version of Basel II and thus will be fully compliant with the letter, and certainly the spirit, of the new Basel Accord. U.S. institutions operating under Basel II will apply the framework to the consolidated organization, so that the foreign branches and subsidiaries of these U.S. organizations thus will be in full compliance with the home country rules of the new Accord. We anticipate that these institutions, by operating under A-IRB and AMA, will also be in compliance with the regulatory capital rules of any host country in which they operate. Of course, foreign branches and subsidiaries of U.S. organizations will also have to comply with any special rules applied in the host country. In addition, some U.S. organizations engaging in a relatively small amount of cross-border activity may decide to remain on Basel I-based rules in this country. We anticipate that, so long as their capital position remains strong and they present no supervisory issues, these entities will be able to continue their cross-border activities. In effect, we believe that our well-capitalized standards, combined with our strong supervisory framework, will allow U.S. banks to meet any requirements for consolidated capital requirements in foreign countries and that those standards result in capital requirements at least as prudent as Basel II approaches for their home country banks. In this case, too, any foreign subsidiary of a U.S. bank would naturally have to adhere to the host country rules applied to bank subsidiaries there. We acknowledge that some of these details still have to be clarified - exactly the task that the AIG has undertaken. But I would like to emphasize that these issues relating to Basel II are not necessarily new, since we have been dealing with differences in capital rules among countries for many years, but just perhaps more complex. Implications for the treatment of foreign banks in the United States Now we have arrived at the point that you all have been waiting patiently to hear. What does the proposed scope of application of Basel II in the United States mean for the treatment of foreign banks that operate subsidiaries and branches in this country? It has, of course, few implications for branches in the United States because they are not directly subject to U.S. capital requirements. In addition, U.S. supervisors expect that whichever Basel II approach a foreign bank chooses for its consolidated operations will be acceptable for allowing branch and subsidiary operations in the United States or for evaluating the financial holding company well-capitalized criteria that are applied at the consolidated level. For that matter, we anticipate continuing to accept Basel I-based calculations for such purposes if that is the approach that the home country supervisor continues to employ. Any U.S. bank subsidiary of a foreign bank will, of course, have to comply with U.S. rules for banks, just as foreign bank subsidiaries of U.S. banks will have to do in their host countries. The principle that subsidiaries must comply with host country rules has been discussed by the AIG, and this long-held view has been widely accepted. Moreover, national treatment requires that the rules that apply to purely domestic banks will apply equally to subsidiaries of foreign banks operating in a host country. In the U.S. context, this principle means that a U.S. subsidiary of a foreign bank will eventually have to choose whether it wants to be under the A-IRB and AMA approaches of Basel II, requiring it to meet the same infrastructure prerequisites as other U.S. banks, or to remain under the current Basel Ibased rules. Admittedly, this policy path chosen by U.S. supervisors may present some important choices for foreign banks that operate a U.S. bank subsidiary. For foreign banks operating under A-IRB and AMA on a consolidated basis under their home country rules, choosing A-IRB and AMA for their U.S. bank subsidiaries would not present any particular problems. Granted, there could be some differences in areas of national discretion for specific elements of the Accord; but in terms of the overall approach, things should align well. The U.S. authorities understand, however, that some foreign banks, including those with subsidiaries here, are targeting the F-IRB approach as their preferred global starting point for Basel II. There would, of course, be no significant issue for such organizations if their subsidiary banks in the United States chose A-IRB and AMA while their parent remained on F-IRB. In this instance, the U.S. subsidiary would have to meet the U.S. requirements for A-IRB and AMA, but in so doing it would be able to deliver all the necessary inputs for F-IRB at the consolidated level. A more difficult problem arises if the U.S. bank subsidiary remains on Basel I-based rules. The subsidiary would not be generating IRB parameter inputs for its U.S. regulatory capital requirements that could naturally feed into calculations for consolidated capital requirements for F-IRB at the home country level. Clearly U.S. supervisors see that this latter case could be burdensome for foreign banks, and we are prepared, with our colleagues on the AIG, to assist local subsidiaries in developing the inputs they need for the consolidated parent. In general, most of these banks already employ sophisticated risk-measurement techniques in order to compete in the U.S. market. Moreover, their exposures are skewed toward large corporate firms for which information that can be used to estimate the necessary risk inputs is abundant. The most difficult problem occurs for a foreign bank that chooses F-IRB at home and chooses A-IRB here. The bank here will have to determine parameters for loss given default (LGD) and exposure at default (EAD) for regulatory capital requirements on its corporate exposures here and use those parameters in the risk measurement and management of the U.S. bank, whereas the parent bank will have to develop and use only probability of default (PD) estimates for such exposures at home. Gathering the data and generating viable estimates of LGDs and EADs poses some challenges. To be sure, we believe that the availability of external data sources developed in the United States to help in the generation of these variables will be reasonably wide. Still, some effort will be required, and that effort will not be costless. The cost of developing these parameters and using them in their U.S. operations is likely to be the most difficult problem for foreign banks that do not adopt A-IRB at home. The U.S. agencies did not make their decisions about implementing only the most advanced versions of Basel II lightly. We concluded that, in our markets, entities that are large enough to use IRB techniques should do so using the more-sophisticated approach that includes LGDs and EADs in the process of risk measurement and management. We felt it was important to tailor implementation of Basel II to our own individual banking and financial environment, as other authorities will be doing for their own markets, even though it means the reconciliation of the different approaches to implementation across countries will create some complications for banking organizations. The AIG is working hard to minimize those effects, and we have confidence in their ability to develop reasonable and effective solutions. Nonetheless, we appreciate our responsibility to work with U.S. subsidiaries whose foreign bank parent will, at least initially, adopt F-IRB in their home country. For example, we are prepared to explore the possibility of allowing U.S. subsidiaries of foreign banks to use conservative estimates of LGD and EAD for a finite transitional period, when data are not yet available for parts of some portfolios. If adopted, this approach would apply equally to fully domestic U.S. banks adopting A-IRB. For both sets of banks, any transition measures would need to be limited in both scope and duration. We are also willing to consider methodologies that would permit foreign banks to allocate a portion of their overall operational-risk capital charge for the consolidated entity to the U.S. bank subsidiary, possibly including allocations from non-AMA approaches for a limited period of time. Such transitional approaches indicate our willingness to approach the implementation of Basel II pragmatically. The upcoming ANPR will lay out these issues in more detail, from the perspective of the United States, but we will also have to incorporate the parallel work of the AIG. To the extent that you have concerns about cross-border implementation issues now, we urge you to engage in discussions with U.S. supervisors and provide comments on any U.S. documents that address the issue. In what perhaps would follow naturally, we also suggest that you inform your home country supervisors about these same issues so that discussions at the AIG level will be that much more efficient. In short, let us know what problems our scope of application proposal may cause you, and most particularly, please let us know your suggestions for how to address them. As I have indicated, we are starting from the presumption that we intend to implement only the A-IRB and AMA alternatives of Basel II in the United States and are not eager to reverse course in that regard. Nevertheless, we do want to consider elements that would allow us to meet the objectives we consider to be important while limiting any unnecessary burdens on your institutions. A digression Please allow me to comment briefly on the treatment of capital requirements for commercial real estate (CRE) exposures. I understand that this issue is not of primary concern to most foreign banks, but it may have become confusing for many observers of the U.S. position on Basel II. For many, but not all, U.S. supervisors, CRE exposures in general, and CRE exposures to finance certain property types in particular, are believed to involve more risk than, say, commercial and industrial (C&I) loans. This view has been maintained despite the clearly improved underwriting and appraisal methods that followed U.S. banks' experience in the late 1980s and early 1990s and the associated changes in regulations. The continuing perception of higher risks for CRE credits, despite these developments, reflects the judgment and evidence that losses on individual defaulted CRE properties increase when defaults rise. In other words, CRE exposures have a high asset correlation and thus require higher capital charges. For this reason, the U.S. representatives on the Basel Supervisors Committee argued strongly for two CRE capital functions that translated the risk parameters into capital requirements: One would be identical to the C&I function and would be for CRE exposures with low asset correlation, and one would require larger capital for the same risk parameters and would apply to exposures with higher asset correlation. Further, the Committee proposed in CP3 that, with certain exceptions, all Acquisition, Development, and Construction (ADC) loans on CRE properties would be on the high asset correlation function and that nations would have the option of applying in their jurisdiction that higher function to those CRE loans on in-place property that they felt met thresholds for high asset correlation. Importantly, the Committee also agreed that, when countries did so, supervisors would ensure that all IRB banks - domestic and foreign - making similar loans in that jurisdiction would be subject to these definitions. Thus, for those of your institutions that finance office buildings in the United States, for example, this discussion is not purely academic. The evidence available to the Federal Reserve seemed to support the need in the United States for the high asset correlation function for some types of CRE loans for in-place property. These data for banks, unfortunately, were for a limited period, and additional data that recently came to our attention for other lenders for a longer period produced conflicting evidence. Although our supervisory judgment still is that some of these exposures have high asset correlation, the mixed evidence does not support our position to the standard we believe necessary for applying such a distinction in the regulatory framework. Consequently, the ANPR to be released next month will propose that all CRE loans in the United States for in-place properties be on the low asset correlation function, as all C&I loans are. We will propose for comment the CP3 approach to ADC loans, with certain exceptions. However, in reflection of supervisory concerns and judgment, we will propose that estimates of loss given default - a key risk parameter under Basel II - for CRE loans on in-place properties be based on historical loss rates during periods of high default. This approach, we believe, will capture some of the risk that has historically accompanied such exposures. I would like to emphasize that this change in position reflects the evidence that was provided to us to supplement the evidence we gathered ourselves. It shows the willingness of the regulators to remain open-minded about the Basel II proposals, so long as comments are based on analysis and evidence and remain consistent with the objectives of Basel II. Summary I will conclude by just noting a few highlights. The U.S. authorities are proposing that in this country the A-IRB and AMA approaches of Basel II be required of only the large, internationally active banks that meet certain criteria for size and foreign activity and be permitted to any bank that meets the infrastructure prerequisites of the A-IRB and AMA approaches. All other banking organizations would remain under Basel I. The proposal does not offer the Basel Standardized or Foundation IRB approaches as additional alternatives. This proposal, the authorities believe, is consistent with a level playing field internationally in that it requires the banks that compete materially across national boundaries to be under a Basel II capital regime. It would apply the most sophisticated option to the largest U.S. organizations for which better risk measurement and risk management are most critical. It permits U.S. organizations that wish to choose the more-sophisticated approaches to do so. But it avoids additional costs and burdens on most U.S. banking organizations - those that have less pressing needs for improved risk-management techniques and already have high capital positions, are effectively subject to Pillar II supervisory oversight, and disclose considerable information. The U.S. authorities believe that the few U.S. banks that will remain on Basel I but that have small offices or subsidiaries abroad should be permitted by host countries to maintain those operations so long as the organization retains a high capital position and strong U.S. supervisory oversight. Foreign subsidiaries of U.S. banks, of course, would be subject to whatever requirements the host country imposes on all banks operating in its jurisdiction, including Basel II requirements. We will be working with the AIG at Basel to minimize any issues that may arise because of different capital regimes for the consolidated operations of foreign banks and the choices available to their subsidiaries in the United States. U.S. supervisors will cooperate with foreign supervisors to provide any required inputs from U.S. subsidiaries of foreign banks that the home country supervisors need for their consolidated supervision. The banking agencies here are also willing to consider transition methodologies to assist foreign banks that want to use IRB here to adopt A-IRB and AMA approaches. We urge U.S. subsidiaries of foreign banks, in commenting on the U.S. ANPR, to advise both U.S. and home country supervisors of any problems that our proposed scope of applications may cause them and, in particular, of their suggestions for addressing these problems, while recognizing the desire of the U.S. authorities to apply only the advanced portions of Basel II in this country.
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board of governors of the federal reserve system
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Remarks by Ms Susan S Bies, member of the Board of Governors of the US Federal Reserve System, at the American Bankers Association, Annual Regulatory Compliance Conference in Washington DC, 11 June 2003.
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Susan S Bies: Strengthening compliance through effective corporate governance Remarks by Ms Susan S Bies, member of the Board of Governors of the US Federal Reserve System, at the American Bankers Association, Annual Regulatory Compliance Conference in Washington DC, 11 June 2003. * * * Good morning. I thank you for the invitation to speak to this American Bankers Association Regulatory Compliance Conference. Since coming to the Federal Reserve Board, I have spent much of my time dealing with corporate governance, internal control, and risk management issues. Today, I would like to talk with you about the important role that the compliance function plays in banking organizations, and how the current emphasis on improving corporate governance is an opportunity for you to strengthen the compliance function in your organization. Introduction Over the past two years, we all have been shocked by the headlines announcing corporate governance or accounting problems at a variety of companies, such as Enron, Worldcom, and HealthSouth. As we read these headlines, the question that comes to mind is, "What were the underlying deficiencies in the internal control processes of these companies that rendered their governance practices ineffective?" As the details about the scandals have been made public, it has become clear that they exemplify breakdowns in fundamental systems of internal control. Why, then, have we seen so many headlines highlighting corporate governance and accounting problems? Because these companies lost track of the basics of effective corporate governance - internal controls and a strong ethical compass. While most companies have effective governance processes in place, these events remind all of us of the importance of doing the basics well. Internal control framework After an earlier series of corporate frauds, the National Commission on Fraudulent Financial Reporting, also known as the Treadway Commission, was created in 1985 to make recommendations to reduce the incidence of these types of frauds. The Committee of Sponsoring Organizations (COSO) of the Treadway Commission issued a report titled Internal Control - Integrated Framework that has become the most-referenced standard on internal control. If one re-reads that report, the need to return to focusing on the basics becomes clear. The report defines internal control as: a process, effected by an entity's board of directors, management and other personnel, designed to provide reasonable assurance regarding the achievement of... • Effectiveness and efficiency of operations • Reliability of financial reporting • Compliance with applicable laws and regulations. The COSO framework was the model considered when the Federal Deposit Insurance Corporation Improvement Act (FDICIA) was enacted in 1991. Section 112 of FDICIA requires management to report annually on the quality of internal controls and outside auditors to attest to that control evaluation. Control assessments COSO requires all managers to, at least once a year, step back from their other duties and evaluate risks and controls within their span of authority. Each manager should consider current and planned operational changes, identify risks, determine appropriate mitigating controls, establish an effective monitoring process, and evaluate the effectiveness of those controls. Managers then should report their assessment up the chain of command to the chief executive officer, with each new level of management in turn considering the risks and controls under its responsibility. The results of this process are ultimately reported to the audit committee of the board of directors. In the case of banks, management publicly reports on its assessment of the effectiveness of controls over financial reporting and the external auditor is required to attest to this self-assessment. Thus, the process helps managers communicate among themselves and with the board about the dynamic issues affecting risk exposures, risk appetites, and risk controls throughout the company. Risk assessments such as the one outlined in COSO presumably could also be useful in assessing various lines of business when formulating business strategies. But not all corporations and boards consider risk during their annual strategic planning or other evaluation processes. The 2002 survey of corporate directors conducted jointly by the Institute of Internal Auditors and the National Association of Corporate Directors showed that directors are not focusing on risk management. I was surprised to learn that 45 percent of directors surveyed said their organization did not have a formal enterprise riskmanagement process - or any other formal method of identifying risk. An additional 19 percent said they were not sure whether their company had a formal process for identifying risks. These percentages indicate that some companies have directors who don't understand their responsibilities as the representatives of shareholders. The shareholders of those companies should be asking the directors how they govern an organization without a good understanding of the risks the company is facing and without knowledge of a systematic approach to identifying, assessing, monitoring, and mitigating excessive risk-taking. I trust that none of the directors who participated in the survey were on the board of a financial services company. Although directors are not expected to understand every nuance of every line of business or to oversee every transaction, they do have responsibility for setting the tone regarding their corporations' risk-taking and establishing an effective monitoring program. They also have responsibility for overseeing the internal control processes, so that they can reasonably expect that their directives will be followed. They are responsible for hiring individuals who have integrity and can exercise sound judgment and are competent. In light of recent events, I might add that directors have a further responsibility for periodically determining whether their initial assessment of management's integrity was correct. The COSO framework and FDICIA annual report can be an effective tool for the auditor to communicate risks and control processes to the audit committee. Members of that committee should use the reports to be sure business strategy, changing business processes, management reorganizations, and positioning for future growth are conducted within the context of a sound system of internal controls and governance. The report should identify priorities for strengthening the effectiveness of internal controls. Indeed, beyond legal requirements, boards of directors of all firms should periodically assess where management, which has stewardship over shareholder resources, stands on ethical business practices. They should ask, for example: "Are we getting by on technicalities, adhering to the letter but not the spirit of the law? Are we compensating ourselves and others on the basis of contribution, or are we taking advantage of our positions? Would our reputation be tainted if word of our actions became public?" Compliance officers should help ensure that processes are in place for employees to raise ethical and compliance concerns in an environment that protects them from retribution from affected managers. Internal controls over compliance Risk management clearly cannot be effective within a company if we forget about the basics of internal controls. It is worth stating that many of the lessons learned from those headline cases cited violations of the fundamental tenets of internal control, particularly those pertaining to operational risks. Based on the headlines, it seems that boards of directors, management, and auditors need a remedial course in Internal Controls 101. As corporations grow larger and more diverse, internal controls become more, not less, important to the ability of management and the board to monitor activity across the company. The basics of internal controls for directors and managers are simple. Directors do not serve full time, so it is important that they establish an annual agenda to focus their attention on the high-risk and emerging-risk areas while ensuring that there are effective preventive or detective controls over the low-risk areas. Regulatory compliance is one of these risk areas. While boards are organized in various ways, they do have the responsibility to understand the organization of the compliance function and the extent of its effectiveness and to identify the emerging compliance risks. The challenge for compliance officers is to ensure that their staff has the expertise and ongoing training to meet the specific and changing risks of the organization. Before a company moves into new and higher risk areas, the boards of directors, and management need assurances that they have adherence to the basics of sound governance. Many of the organizations that have seen their reputations tarnished in the past two years have also neglected to consider emerging conflicts of interest when the organization adds new products and lines of business. It is important that if a customer service or control function must be done in an independent, fiduciary, or unbiased manner relative to other activities, appropriate firewalls are in place before the product or activity begins. Internal controls and compliance are the responsibility of line management. Line managers must determine the acceptable level of risk in their line of business and must assure themselves that the combination of earnings, capital, and internal controls is sufficient to compensate for the risk exposures. Supporting functions such as accounting, internal audit, risk management, credit review, compliance, and legal should independently monitor the control processes to ensure that they are effective and that risks are measured appropriately. The results of these independent reviews should be routinely reported to executive management and boards of directors. Directors should be sufficiently engaged in the process to determine whether these reviews are in fact independent of the operating areas and whether the officers conducting the reviews can speak freely. Directors must demand that management fix problems promptly and provide appropriate evidence to internal audit confirming this. While we have been focused on midsized and larger organizations, internal controls are also important to smaller organizations. Many failures of community banks are due to breakdowns in internal controls, thus increasing operational risk. In smaller organizations, the segregation of duties and ability to hire expertise for specialized areas, like regulatory compliance, is more difficult. But smaller organizations still must go through the process of assessing risks and controls and ensuring that they are appropriate for the culture and business mix of the organization. A faster-growing financial services company in riskier lines of business will need a stronger, more formalized system of internal controls than a well-established company engaged broadly in traditional financial services. Compliance risk management To be effective, compliance risk management must be coordinated at various levels within the organization. In any control or oversight function, there are common elements of a successful compliance process that each organization should exhibit. While the diversity, size, and business mix of the organization will affect the specific aspects of an effective process, every financial institution should consider these elements. Director and senior management responsibilities. The board of directors and senior management cannot delegate the responsibility for having an effective system of compliance. Certain portions of the implementation of the compliance process may be conducted by more junior management, but this does not relieve the board and senior management of responsibility for the design and effectiveness of the system. The board of directors and senior management must set a tone that encourages regulatory compliance. The board should receive periodic reports on the effectiveness of the compliance program and emerging issues. The board should ensure that strategic and product development efforts include an independent view of potential conflicts and new risk exposures. The board should ensure that identified compliance weaknesses are dealt with in a timely fashion, and that the line employees, as well as compliance and internal audit staffs, are trained to keep up with changes in regulations and best practices in internal controls. Most importantly, the board should ensure that the senior compliance officer has independent access to the appropriate board committee, and the senior compliance officer has the stature with senior management to see that appropriate controls are implemented. While the governance of a bank's risk-management program comes from the top down, a successful program will involve staff at all levels, and in more than one department. In other words, while senior management bears the ultimate responsibility for successfully managing the compliance risks, management alone cannot contain these risks. This means that the teller who has contact with the customer, the auditor who periodically reviews documents for compliance, the marketing staff who prepare ads and develop new products and the attorney who reviews new forms for compliance all play an integral part in running an effective compliance management program. Structure. The compliance function will vary by the size and complexity of the organization. But the compliance officers should be able to have access to all operational areas. One of the benefits of having an independent compliance function is that it can help identify compliance weaknesses that cross management lines of responsibilities and may not be effectively managed. In larger organizations this may require both business-line and enterprise-wide compliance committees to prioritize resources. Further, you, as compliance officers, are the independent eyes and ears of the audit and other board committees. As you work throughout the bank, you know which managers and which projects are likely to entail greater weaknesses in compliance. By helping senior management address these risks before exceptions occur, you can help protect the reputation of managers and the bank and increase your credibility. Appropriate reporting to the senior management compliance committee and the audit committee of the board, and timely resolution of findings, will build your credibility, provided that you follow through on their behalf to ensure that managers are taking compliance and internal control issues seriously. Scope. Compliance should have an annual work plan that lays out priorities, monitoring processes, and testing. New or changed regulations have to be evaluated and relevant internal policies appropriately modified. This can entail training for both the line and compliance staff. The frequency and extent of compliance reviews and testing should be consistent with the nature and complexity of the institution's compliance risks. Areas with higher penalties for non-compliance, that have prior findings of deficiencies or where new products or processes are being introduced should receive more attention. Unacceptable exceptions should be reported promptly to appropriate management and, if appropriate, the board of directors. Compliance officers should monitor corrective action plans, and retest to ensure deficiencies are corrected in a timely manner. As with any risk management function, the management compliance committee and appropriate committee of the board should at least annually review and approve the compliance risk assessment, the scope of the annual plan, and adherence to the compliance plan. While the plan serves as the prioritization of resources, it should be flexible enough to allow appropriate reallocation of resources as unexpected product introductions or compliance testing results require. At the end of each year, the validity of the initial assumptions should be critically assessed and appropriate reallocations of resources scheduled for the new plan year. Compliance audits. The internal audit function should perform independent reviews of the effectiveness of the compliance function. This would include assurance of the quality of information in compliance reports, adequacy of training programs, prompt correction of deficiencies, and implementation of compliance risk management by product managers. The internal auditor can also assess whether sufficient resources are available to meet the changing needs of the organization. Internal audit should be independent of the compliance function. Auditors lose their independence when they perform management consulting roles for which they later will have to render an opinion. Internal audit has both the ability and the responsibility to look across all of the management silos within the corporation and make sure that the system of internal controls has no gaps. Further, the control framework must be continually reviewed to keep up with corporate strategic initiatives, reorganizations, and process changes. When an auditor becomes part of management, the independent view is lost. Sarbanes-Oxley Act Now let's turn to Sarbanes-Oxley. At its core, the Sarbanes-Oxley Act is a call to get back to the basics that we have been discussing. Simply stated, the current status quo for corporate governance is unacceptable and must change. This message is applicable to both public and private companies alike and affects everyone within a company. • The message for boards of directors is: uphold your responsibility for ensuring the effectiveness of the company's overall governance process. • The message for audit committees is: uphold your responsibility for ensuring that the company's internal and external audit processes are rigorous and effective. • The message for chief executive and chief financial officers and senior management is: Uphold your responsibility to maintain effective financial reporting and disclosure controls and adhere to high ethical standards. This requires meaningful certifications, codes of ethics, and conduct for insiders that, if violated, will result in fines and criminal penalties, including imprisonment. • The message for external auditors is: focus your efforts solely on auditing financial statements and leave the add-on services to other consultants. • The message for internal auditors is: you are uniquely positioned within the company to ensure that its corporate governance, financial reporting and disclosure controls, and riskmanagement practices are functioning effectively. Although internal auditors are not specifically mentioned in the Sarbanes-Oxley Act, they have within their purview of internal control the responsibility to examine and evaluate all of an entity's systems, processes, operations, functions, and activities. What are the challenges for compliance officers in the Sarbanes-Oxley era? First, compliance officers must help corporate risk officers and managers reinvigorate the risk assessment, internal controls, and ethical compass of the organization. Recently, the Fed has been looking at the FDICIA 112 management reports on internal controls for several banks that have had significant breaks in internal controls. From these banks, we have identified several whose FDICIA 112 processes were not effective. A closer look at these situations indicates that managements had essentially put this process on autopilot. Further, the external auditors had not done effective reviews of the basis of management reports. Before you say, "That could not happen at my company," let me remind you how we started our discussion today. In each of the cases involving banks, management seemed to be content with the loss of vigor in the process and the external auditor was apparently satisfied to simply collect a fee. This is totally unacceptable. Further, as the organization evolves by offering new products, changing processes, outsourcing services, complying with new regulations, or growing through mergers, the controls need to be modified to reflect the changes in risks. In some cases, the controls failed with respect to newer risk exposures that were not identified, or growth put strains on existing control processes that were not suitable for a larger organization. Don't assume that what was acceptable in the past is good enough for the future. Remember that there is a tendency for an organization to go on autopilot if the compliance officer is not vigilant. You should view this as an opportunity to convince the board and management to adopt a rigorous selfassessment process for compliance controls. Further, use this as an opportunity to improve your own quality assurance process. Are you surprised by exceptions? Do you find your staff coming to different findings for compliance reviews that have similar fact patterns? Are you harder on some managers in your findings, and "trust" others to improve without citing the weaknesses? When you do not have a consistent quality for the work of the compliance function you send mixed messages to employees and officers. Further, you weaken your credibility. And more importantly in the current environment, you are not part of the process to strengthen corporate governance. Now, certainly, we must know which way the ethical compass of the organization is pointing. Are the product designs, marketing practices, and disclosures communicating a solid image of trust and integrity that your organization is targeting? Conclusion My objective today was to exhort you to take a stand and make a difference for the better in the corporate governance of your company. You should help lead the dialogue on corporate governance. Although I recognize that some of you are compliance officers of companies that are not subject to Sarbanes-Oxley, I believe the act is a wake-up call more generally for everyone who is part of designing and testing a system of internal controls. The events of the past two years demonstrate how quickly a corporation's reputation can be tainted by accusations of inappropriate activities or lack of attention to regulations. Success in banking still is heavily dependent on winning and keeping the trust of customers, employees, and communities. When corporate reputations are tainted, it can take a considerable time to rebuild customer and community relationships.
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board of governors of the federal reserve system
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Speech by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, before the Institute of International Bankers, New York, 11 June 2003.
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Roger W Ferguson, Jr: Uncertain times - Economic challenges facing the United States and Japan Speech by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, before the Institute of International Bankers, New York, 11 June 2003. * * * Despite heavy doses of monetary and fiscal stimulus, the Japanese economy remains mired in a mild, yet protracted, deflationary slump. The origins of the slump date to the bursting of the land and equity price bubble in the early 1990s. Economic weakness, in turn, has led to a sustained deflation that has proven unexpectedly difficult to cure. Here in the United States, the economy has also struggled of late, following a sequence of adverse shocks during the past three years. We have had our own asset bubble, of course, and the steep fall in equity prices since the spring of 2000 has almost halved household equity wealth. The horrific events of September 11, 2001, shook financial markets, and the troubling evidence of corporate malfeasance revealed during the Enron and other scandals, combined with heightened geopolitical tensions that preceded the war in Iraq, tested the willingness of market participants to assume risk. These adverse developments were reflected in a precipitous decline in capital expenditures, which has contributed to a few years of subpar growth. These developments also put considerable downward pressure on inflation, to the point that increases in core consumer prices are now at a rate not seen on a sustained basis in almost forty years. In fact, after its most recent meeting, the Federal Open Market Committee noted that the probability of unwelcome further downward pressure on prices over the next few quarters exceeds that of a pickup in inflation. With near-term economic prospects in the United States still somewhat clouded, market commentators have increasingly focused on the possibility that the United States may follow Japan into a deflationary slump. However, I do not believe that the United States is at the brink of significant and sustained deflation. Indeed, I believe that the probability of such an eventuality is quite low. But as the Japanese experience shows, the onset of deflation can be unexpected, and so to leave the topic unexamined would be imprudent. Of course, public interest is another reason to discuss the issue and contribute, one hopes, to the stock of intellectual capital. Accordingly, I think it is useful to discuss some lessons that can be drawn from the Japanese experience and, with that as background, to examine some reasons that a harmful deflation is unlikely to take hold in the United States. Before proceeding, let me note that the comments expressed reflect my views only and are not necessarily those of my colleagues on the Board of Governors or the FOMC. First, I want to explain the theoretical view of the dangers associated with deflation. A harmful deflation, such as the type experienced by Japan since the mid-1990s, is almost always a consequence of depressed aggregate demand. A deflationary slump driven by contracting demand is more dangerous than a typical economic downturn because of its potential adverse effects on financial markets and the limitations it places on conventional monetary policy. Deflation of sufficient magnitude may result in the falling of nominal interest rates to zero - their practical minimum. This floor, commonly called the “zero bound,” exists because lenders will always prefer to hold cash rather than credit instruments bearing a negative nominal interest rate. In a recession in which short-term nominal interest rates have already been pushed to zero, therefore, further downward adjustment in nominal interest rates is difficult, if not impossible. Because the real interest rate equals the nominal interest rate less the expected rate of inflation, the zero bound on nominal interest rates can lead to rapidly increasing real rates if deflation intensifies. Rising real interest rates, in turn, discourage borrowing, and so capital outlays by businesses, purchases of homes by families, and other types of spending decline further. This deterioration in aggregate demand adds to deflationary pressures and pushes real interest rates even higher. Besides raising the real cost of borrowing, deflation can erode the quality of business and household balance sheets. Even if debtors can refinance existing loans at zero (or very low) nominal interest rates, a sustained fall in prices will transform what might otherwise be a manageable level of nominal debt accumulated by businesses and households into a rising and potentially debilitating level of real debt and real debt service costs. The consequent financial distress of debtors can lead to widespread defaults, bankruptcies, and bank failures, with potentially devastating consequences for the entire financial system. The adverse effects of deflation go beyond financial markets. Deflationary pressures can impede the effective clearing of labor markets. Because employers often have difficulty cutting the nominal wages of their employees, real wages may rise as prices decline, and higher unemployment may result. Deflation also raises a barrier to those monetary policy actions conventionally used to stimulate aggregate demand. Faced with a normal economic downturn, a central bank would lower its target for the short-term nominal interest rate - the overnight federal funds rate in the United States or the overnight call money rate in Japan - to stimulate aggregate demand. In a deflationary environment, in which short-term nominal interest rates have already been pushed to zero, the central bank can no longer ease policy in the usual way. That is not to say that a central bank with its traditional policy rate at zero lacks tools to boost aggregate demand and thereby combat deflation. In fact, central banks have a number of other means at their disposal to stimulate spending should nominal interest rates hit the zero bound. A central bank can increase the supply of reserves to the financial system through regular openmarket operations even after short-term nominal interest rates have hit zero. Such actions may demonstrate a resolve by the central bank to keep short-term interest rates at zero for a prolonged period of time, with the intention of raising inflation expectations and lowering real interest rates. Arguably, a more effective approach to combating deflation - and a relatively straightforward extension of current operating procedures - would be for a central bank to stimulate aggregate demand by lowering interest rates further out along the maturity spectrum. A central bank could expand its open market purchases of longer-term government securities, in sizable quantities if necessary, to drive term premiums lower. Of course, because long-term interest rates incorporate term premiums as well as discounted expectations of future short-term interest rates, the success of operations focused on influencing parts of the yield curve would be bolstered by a credible promise to move the short-term policy rate along a trajectory consistent with the targeted longer-term yields. Alternatively, as economists have long recognized, a central bank could influence expectations of future short-term interest rates directly by committing to keeping the policy interest rate at zero for a specified and relatively long period of time or until some intermediate macroeconomic target - such as the termination of declining prices - was achieved. As a practical matter and to underscore its commitment to boosting aggregate demand, a central bank could write options that would, for a prespecified time, make its raising interest rates costly, or it could operate in the forward interest rate market. If such actions were successful, yields on longer-term government securities would decline. Through arbitrage across financial instruments, yields on longer-term private instruments, such as corporate bonds and home mortgages, would likely follow suit. A sufficient downward adjustment of interest rates over the term structure of government and private securities should stimulate spending and thus help end deflation. Importantly, describing what a central bank could do is easy, but these actions are not simple to execute or without downside risks. In particular, such policies would pose a considerable challenge for a central bank regarding communication. For example, if a central bank tried to cap a longer-term yield below the prevailing market rate, it would, to be most effective, need to convince market participants that it was committed to keeping the short-term policy interest rate low for an extended period. If this commitment was not viewed as credible, the central bank’s purchases of securities to lower longerterm yields would likely have to be massive, given that the term premium component of longer-term interest rates appears rather insensitive to the outstanding supply of various securities. Such a situation would give rise to a risk that the targeted security might become disconnected from the rest of the yield curve and private interest rates. The Federal Reserve has experience in using these tools, although admittedly not in a deflationary environment. Therefore, to describe these tools as “unconventional” may not be entirely appropriate. Rather, they are “rarely used.” In particular, between 1942 and 1951, the Federal Reserve successfully maintained an interest-rate ceiling on longer-term Treasury yields at 2-1/2 percent. From 1979 through much of 1982, the FOMC targeted the amount of nonborrowed reserves in the banking system in an effort to reduce inflation. And around the century date change, the Federal Reserve wrote options on repurchase agreements to reassure market participants that adequate liquidity would be available. To be sure, our understanding of the monetary transmission mechanism in the United States when prices are on a distinct downward trend has not been informed by recent experience, and so calibrating the effects of such policy actions may be difficult. Thus, preventing deflation remains preferable to reversing it. However, if an economy slips into deflation, my belief is that a sufficiently determined central bank can spur aggregate demand and end the deflation. Skeptics may point to Japan, where interest rate cuts and other monetary policy measures have been ineffective in jumpstarting the economy. The Bank of Japan lowered short-term interest rates considerably over the 1990s, after the bursting of the asset price bubble and against the backdrop of a stagnant economy. The overnight nominal interest rate fell from slightly more than 8 percent in 1991 to 1/2 percent in 1995, where it stayed until being lowered essentially to zero in 1999. However, the loosening of monetary policy in the early 1990s, though probably appropriate given the expectations of future economic developments generally held at that time, in retrospect proved to be too slow in light of the declines in spending and prices that subsequently occurred Amid persistent price deflation - and face to face with the constraints on monetary policy imposed by the zero lower bound on short-term nominal interest rates - the Bank of Japan introduced what it called a “quantitative easing” framework in March 2001. This framework included switching the operating target for money market operations from the overnight interest rate to the outstanding balance of reserve accounts held by financial institutions at the central bank. In an attempt to change deflationary expectations, the Bank of Japan stated that it would continue to target reserve accounts until the core consumer price index showed a twelve-month inflation rate of zero or above. Over the roughly two years since then, reserve accounts at the Bank of Japan have risen nearly six-fold, from ¥5 trillion in March 2001 to about ¥28 trillion today. In addition, since March 2001 the Bank of Japan has increased the monthly amount of its outright purchases of long-term government bonds from ¥400 billion to ¥1.2 trillion. I assume that these monetary policy actions have provided some support for economic activity. However, the Japanese economy appears not to have returned to a path of sustainable growth for several reasons, some of which may require responses by entities other than the Bank of Japan. First, the Bank of Japan introduced quantitative easing only after prices were already on a sustained downward trajectory; perhaps, even then, efforts were not aggressive enough, given entrenched deflationary expectations. Since early 1995, consumer price inflation has been around or below zero, and by March 2001, prices were declining at nearly 1 percent per year. According to surveys of private economists and further evidenced by very low interest rates on long-term Japanese government bonds, deflation had clearly become embedded in expectations. Second, the stimulus provided by monetary policy in Japan continues to be damped by wellrecognized problems in Japan’s banking sector. Factors such as low profitability and insufficient actions to restore the banking sector’s health have combined to erode banks’ capital base. Because I believe strongly in capital levels that fully reflect differing categories of risk, I think that the recent strengthening of auditing rules for evaluating the use of deferred tax assets as bank capital is a step in the right direction. However, insufficient capital continues to plague the banking sector, and without the cushion of a strong capital base, banks give evidence of remaining extremely risk averse. Commercial bank lending has thus continued to decline, while banks’ holdings of less risky long-term government bonds have soared. Because banks play an even more crucial role in Japan’s financial system than in other industrialized countries, problems in its banking sector are particularly damaging to the transmission of monetary policy and to the economy more generally. Finally, demand for business and consumer credit in Japan is weak according to the results of various surveys. In a deteriorating economic environment, businesses as well as banks appear to have pulled back from risk-taking. As evidenced by very low long-term interest rates, expectations of future economic growth seem bleak. Capital-output ratios are still high, returns on assets are low, corporate profits are poor, and the economic outlook is fraught with uncertainty. It is not surprising then that firms are not borrowing to finance new investment. Rather, observers argue that much bank lending will keep ailing and inefficient firms afloat and further crowd the field against the dynamic, innovative enterprises needed to fuel sustained expansion. Japan appears to have become a society in which economic agents - banks, insurance companies, corporations, and households - have lost their appetite for risk. This risk aversion has hurt Japan’s economic performance, since risk-taking is critical to growth in a market economy. These crucial factors have limited the effectiveness of both conventional and unconventional monetary policy measures in Japan. In the United States, economic and financial fundamentals are much sounder than those prevailing in Japan when the Bank of Japan started to implement unconventional Measured inflation, even after adjustment for the hike in the value-added tax in 1997, showed small positive rates during 1996 and 1997. But changes in the consumer price index are widely considered to be biased upward, suggesting that true inflation probably remained negative. measures. The available evidence suggests that the U.S. real economy is currently stronger, better balanced, more productive and more dynamic than the Japanese economy was at a comparable period. The economy’s ability to weather the adverse shocks of recent years reflects flexible and efficient markets for labor and capital and dramatic gains in information technology, which have markedly improved the ability of businesses to address incipient economic imbalances before they inflict significant damage. To be sure, considerable uncertainty attends the near-term outlook for the U.S. economy, and recent readings on production and employment have been disappointing. However, a balanced assessment would also take into consideration the fact that the reduction in Iraq-related uncertainties and some recent positive news regarding corporate earnings have caused the tenor of financial markets to improve noticeably: Equity prices have risen, risk premiums of corporate debt have fallen, crude oil prices have declined sharply, and consumer confidence has rebounded since the early spring. Whether this improvement in overall financial conditions is a precursor to sustained recovery in the broader economy is unclear. Fortunately, for the longer term, productivity growth in the United States has remained remarkably robust. Rapid growth of output per hour boosts expectations of future advances in wages and profits, leading eventually to higher aggregate demand. Another key difference between the two countries is that the U.S. financial system continues to function smoothly. Domestic commercial banks are very profitable overall and are well capitalized, and bank regulators have shown a willingness to move quickly to address problems. In contrast, Japanese banks remain saddled with a significant volume of nonperforming loans. Accordingly, the process of financial intermediation through banks has been constricted, hampering the Bank of Japan’s attempts to increase liquidity and to stimulate the flow of credit. On a related point, the existence of highly developed and integrated U.S. financial markets means that the proportion of financing flows intermediated by the banking system in the United States is considerably smaller than in Japan’s bank-centered financial system. As a result, the transmission of monetary policy in the United States operates through multiple and complementary channels. Japan’s dependence on the banking system, a system that has largely ceased to function, represents a further constraint on the transmission of monetary policy in that country. Thus, it seems appropriate for Japan to continue its efforts to develop deeper and more liquid capital markets. Demand for business and consumer credit in the United States is stronger than in Japan, and corporate balance sheets are in better shape. The continued rapid pace of technological innovation is likely to create expanding opportunities for profitable investment and thereby strengthen further the demand for credit. Although business spending on fixed capital has yet to stage a convincing comeback, firms eventually will have to increase such outlays, given the relatively high rates of depreciation on certain types of capital. Finally, as mentioned earlier, by the time the Bank of Japan implemented the quantitative easing framework in March 2001, yields on long-term government securities had already reached a very low level. In the United States today, by contrast, the relatively steep Treasury yield curve affords greater scope for reducing longer-term interest rates. In conclusion, the risk of deflation, a decline in the general price level, appears remote in the United States. Although the near-term outlook is uncertain, the fundamentals are sound. Furthermore, I am confident that, in the unlikely event a harmful deflation emerges in the United States and the Federal Reserve needs to turn to a broader range of monetary policies, such tools will be effective in boosting aggregate demand and putting the economy back on track to sustainable growth. We at the Federal Reserve have been able to glean much from the Bank of Japan’s experience with monetary policy at the zero bound. In particular, the Bank of Japan’s implementation of many innovative policy measures has enhanced our understanding of the monetary transmission mechanism in a low-inflation environment, a valuable ingredient in monetary policy decisionmaking today. For that reason, I am pleased to have had this opportunity to address the Japan Society today.
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board of governors of the federal reserve system
| 2,003 | 6 |
Testimony by Mr Roger W Ferguson, Jr, Vice Chairman of the Board of Governors of the US Federal Reserve System, before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, 18 June 2003.
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Roger W Ferguson, Jr: Basel II - discussion of complex issues Testimony by Mr Roger W Ferguson, Jr, Vice Chairman of the Board of Governors of the US Federal Reserve System, before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, 18 June 2003. * * * Chairman Shelby, Senator Sarbanes, members of the Committee, it is a pleasure to appear before you this morning on behalf of the Board of Governors to discuss Basel II, the evolving new capital accord for internationally active banking organizations. After five years of discussion, the proposal is entering its final stage of public comment and review, although there still remain additional steps to the process. Why is a new capital standard necessary? The banking supervisors in this country believe that Basel I, the current capital regime adopted in 1988, must be replaced for the largest, most complex banks for three major reasons: (1) Basel I has serious shortcomings as it applies to these large entities, (2) the art of risk management has evolved at the largest banks, and (3) the banking system has become increasingly concentrated. Shortcomings in Basel I Basel I was a major step forward in capital regulation. Indeed, for most banks in this country Basel I, as we in the United States have augmented it, is now - and for the foreseeable future will be - more than adequate as a capital framework. However, for the small number of large, complex, internationally active banking organizations, Basel I has serious shortcomings which are becoming more evident with time. Developing a replacement to apply to these banking organizations is imperative. Basel I is too simplistic to address the activities of our most complex banking institutions. The framework has only four risk categories, and most loans receive the same regulatory capital charge even though loans made by banks encompass the whole spectrum of credit quality. The limited differentiation among the degrees of risk means that the calculated capital ratios are too often uninformative and might well provide misleading information for banks with risky or problem credits or, for that matter, with portfolios dominated by very safe loans. Moreover, the limited number of risk categories creates incentives for banks to game the system through capital arbitrage. Capital arbitrage is the avoidance of certain minimum capital charges through the sale or securitization of bank assets for which the capital requirement that the market would impose is less than the current regulatory capital charge. For example, credit card loans and residential mortgages are securitized in volume, rather than held on banks' balance sheets, because the market requires less capital, in the form of bank credit enhancements, than Basel I requires in capital charges. This behavior by banks is perfectly understandable, even desirable in terms of economic efficiency. But it means that banks that engage in such arbitrage retain the higher-risk assets for which the regulatory capital charge - calibrated to assets of average quality - is on average too low. To be sure, through the examination process supervisors are still able to evaluate the true risk position of the bank, but the regulatory minimum capital ratios of the larger banks are becoming less and less meaningful, a trend that will only accelerate. Not only are creditors, counterparties, and investors less able to evaluate the capital strength of individual banks from what are supposed to be risk-based capital ratios, but regulations and statutory requirements tied to capital ratios have less meaning as well. Basel I capital ratios neither adequately reflect risk nor measure bank strength at the larger banks. The evolving state of the art Risk measurement and management have improved significantly beyond the state of the art of fifteen years ago, when Basel I was developed. Banks themselves have created some of the new techniques to improve their risk management and internal economic capital measures in order to be more effective competitors and to control and manage their credit losses. But clearly banks can go considerably further. One objective of Basel II is to speed adoption of these new techniques and to promote the further evolution of risk measurement and management by harnessing them to the regulatory process. Increased heterogeneity and concentration in banking Market pressures have led to consolidation in banking around the world. Our own banking system has not been immune; it, too, has become increasingly concentrated with a small number of very large banks operating across a wide range of product and geographic markets. The operations of these large banks are tremendously complex and sophisticated, and they have markedly different product mixes. At the same time, significant weakness in one of these entities has the potential for severely adverse macroeconomic consequences. Although their insured liabilities have been declining over time as a share of their total funding, these organizations, with their scale and role in payment and settlement systems and in derivatives markets, have presented the authorities with an increasing moral hazard. It is imperative that the regulatory framework should encourage these banks to adopt the best possible risk-measurement and management techniques while allowing for the considerable differences in their business strategies. Basel II presents an opportunity for supervisors to encourage these and other large banks to push their management frontier forward. Basel II The proposed substitute for the current capital accord, Basel II, is more complex than its predecessor for very good reasons. First, the assessment of risk in an environment of a growing number of instruments and strategies with subtle differences in risk-reward characteristics is inevitably complicated. Second, the Basel II reform has several objectives: U.S. supervisors are trying to improve risk measurement and management both domestically and internationally; to link to the extent that we can the amount of required capital to the amount of risk taken; to further focus the supervisor-bank dialogue on the measurement and management of risk and the risk-capital nexus; and to make all of this transparent to the counterparties that ultimately fund - and hence share - these risk positions. To achieve all these objectives, the framework for Basel II contains three elements, called Pillars 1, 2, and 3. The most important pillar, Pillar 1, consists of minimum capital requirements - that is, the rules by which a bank calculates its capital ratio and by which its supervisor assesses whether it is in compliance with the minimum capital threshold. As under Basel I, a bank's risk-based capital ratio under Basel II would have a numerator representing the capital available to the bank and a denominator that would be a measure of the risks faced by the bank, referred to as "risk-weighted assets". The definition of regulatory capital in the form of equity, reserves, and subordinated debt and the minimum required ratio, eight percent, are not changing. What would be different is the definition of risk-weighted assets, that is, the methods used to measure the "riskiness" of the loans and investments held by the bank. It is this modified definition of risk-weighted assets, its greater risksensitivity, that is the hallmark of Basel II. The modified definition of risk-weighted assets would also include an explicit, rather than implicit, treatment of "operational risk." Pillar 2 addresses supervisory oversight; it encompasses the concept that well-managed banks should seek to go beyond simple compliance with minimum capital requirements and perform for themselves a comprehensive assessment of whether they have sufficient capital to support their risks. In addition, on the basis of their knowledge of industry practices at a range of institutions, supervisors should provide constructive feedback to bank management on these internal assessments. Finally, Pillar 3 seeks to complement these activities with stronger market discipline by requiring banks publicly to disclose key measures related to their risk and capital positions. The concept of these three mutually reinforcing pillars has been central to the Basel II effort. Scope of application in the United States The U.S. supervisory agencies will propose that most banking organizations in this country remain under the existing Basel I-type capital rules and would continue to have no explicit capital charge for operational risk. Earlier I emphasized that Basel I had outlived its usefulness for the larger banking organizations. How then did we conclude that most of our banks should remain under rules based on the old accord? Banks remaining under current capital rules To begin with, most of our banks have relatively straightforward balance sheets and do not yet need the full panoply of sophisticated risk-management techniques required under the advanced versions of Basel II. In addition, for various reasons, most of our banks now hold considerable capital in excess of regulatory minimums: More than 93 percent have risk-weighted capital ratios in excess of 10 percent an attained ratio that is 25 percent above the current regulatory minimum. No additional capital would likely have to be held if these institutions were required to adopt Basel II. Moreover, U.S. banks have long been subject to comprehensive and thorough supervision that is much less common in most other countries planning to implement Basel II. Indeed, U.S. supervisors will continue to be interested in reviewing and understanding the risk-measurement and management processes of all banks. Our banks also disclose considerable information through regulatory reports and under accounting rules and requirements of the Securities and Exchange Commission; they already provide significant disclosure - consistent with Pillar 3 of Basel II. Thus, when we balanced the costs of imposing a new capital regime on thousands of our banks against the benefits - slightly more risk sensitivity of capital requirements under, say, the standardized version of Basel II for credit risk, and somewhat more disclosure - it did not seem worthwhile to require most of our banks to take that step. Countries with an institutional structure different from ours might clearly find universal application of Basel II to benefit their banking system, but we do not think that imposing Basel II on most of our banks is either necessary or practical. Banks moving to Basel II We have an entirely different view for our largest and most complicated banking organizations, especially those with significant operations abroad. Among the important objectives of both Basel I and the proposed Basel II is to promote competitive consistency of capital requirements for banks that compete directly in global markets. Another important objective has been to encourage the largest banking organizations of the world to continue to incorporate into their operations the most sophisticated techniques for the measurement and management of risk. As I have noted, these entities use financial instruments and procedures that are not adequately captured by the Basel I paradigm. They have already begun to use - or have the capability to adopt - the techniques of modern finance to measure and manage their exposures; and because substantial difficulty at one of the largest banking organizations could have significant effects on global financial markets, all of the largest banks should be using these procedures. In our view, prudential supervisors and central bankers would be remiss if we did not address the evolving complexity of our largest banks and ensure that modern techniques were being used to manage their risks. The U.S. supervisors have concluded that the advanced versions of Basel II - the Advanced Internal Ratings Based (A-IRB) approach for measuring credit risk and the Advanced Measurement Approaches (AMA) for measuring operational risk - are best suited to achieve this last objective. Under the A-IRB approach, a banking organization would have to estimate, for each credit exposure, the probability that the borrower will default, the likely size of the loss that will be incurred in the event of default: and - where the lender has an undrawn line of credit or loan commitment to the borrower an estimate of what the amount borrowed is likely to be at the time a default occurs. These three key inputs - probability of default (PD), loss given default (LGD), and exposure at default (EAD) - are inputs that would be used in formulas provided by supervisors to determine the minimum required capital for a given portfolio of exposure. While the organization would estimate these key inputs, the estimates would have to be rigorously based on empirical information, using procedures and controls validated by its supervisor, and the results would have to accurately measure risk. Those banks that are required, or choose, to adopt the A-IRB approach to measuring credit risk, would also be required to hold capital for operational risk, using a procedure known as the Advanced Management Approach (AMA) to establish the size of that charge. Under the AMA, banks themselves would bear the primary responsibility for developing their own methodology for assessing their own operational risk capital requirement. To be sure, supervisors would require that the procedures used are comprehensive, systematic, and consistent with certain broad outlines, and must review and validate each bank's process. In this way, a bank's "op risk" capital charge would reflect its own environment and controls. Importantly, the size of the charge could be reduced by actions that the bank takes to mitigate operational risk. This provides an important incentive for the bank to take actions to limit their potential losses from operational problems. Determining Basel II banks To promote a more level global playing field, the banking agencies in the United States will be proposing in the forthcoming Advance Notice of Proposed Rulemaking (ANPR) that those U.S. banking organizations with foreign exposure above a specified amount would be in the core set of banks that would be required to adopt the advanced versions of Basel II. To improve risk management at those organizations whose disruption would have the largest effect on the global economy, we would also require the same of banks whose scale exceeds a specified amount. That is, banks meeting either the foreign exposure criterion or the asset size criterion would be required to adopt the advanced versions of Basel II, although most banks meeting one criterion also meet the other. Ten U.S. banks meet the proposed criteria to be core banks and thus would be required, under our proposal, to adopt A-IRB and AMA to measure their credit and operational risks, respectively. As they grow, other banks could very well meet the criteria and thus shift into the core group in the years ahead. We would also permit any bank that meets the infrastructure requirements of A-IRB and AMA the ability to quantify and develop the necessary risk parameters on credit exposures and develop measurement systems for operational risk exposures - to choose Basel II. Banks that choose to use AIRB and AMA would need to consider several factors, including the benefits of Basel II relative to its costs, the nature of their operations, the capital impact, and the message they want to send their counterparties about their risk-management techniques. We anticipate that after conducting such a review, about ten or so large banks now outside the core group would choose to adopt Basel II in the near term. Thus we expect about twenty banks to adopt the advanced version of Basel II before or shortly after the initial implementation date. Over time, other large banks, perhaps responding to market pressure and facing declining costs and wider understanding of the technology, may also choose this capital regime, but we do not think that the cost-benefit assessment would induce smaller banks to do so for a very long time. Our discussions with the rating agencies confirm they do not expect that regional banks would find adoption of Basel II to be cost effective in the initial implementation period. Preliminary surveys of the views of bank equity security analysts indicate that they are more focused on the disclosure aspects of Basel II rather than on the scope of application. To be clear, supervisors have no intention of pressuring any of the banks outside the core group to adopt Basel II. The ten core banks that would be required to adopt Basel II, together with the approximately ten selfselecting banks that we anticipate would adopt it before or shortly after the initial implementation date, today account for 99 percent of the foreign assets and two-thirds of all the assets of domestic U.S. banking organizations, a rate of coverage demonstrating the importance of these entities to the U.S. and global banking and financial markets. These data also underscore our commitment to international competitive equity and the adoption of best-practice policies at the organizations critical to our financial stability while minimizing cost and disruption at our purely domestic, less-complicated organizations. Issues Bankers have identified three key areas of concern: cost, competitive equity, and Pillar 1 treatment of operational risk. Cost Implementing A-IRB and AMA in this country is going to be expensive for the small number of banks for which it will be required, for other banks choosing it, and for the supervisors. For the banks, the greatest expense would be establishing the mechanisms necessary for a bank to evaluate and control its risk exposures more formally. The A-IRB approach would not eliminate losses: Banks are in the business of taking risk, and where there are risks, there will be losses. But we believe that the better risk-management that is required for the A-IRB and AMA would better align risk and return and thereby provide benefits to bank stakeholders and the economy. And, more risk-sensitive capital requirements would assist in ensuring that banks would have sufficient capital to absorb losses when they do occur. The cost-benefit ratio looks right to the supervisors. This ratio is further enhanced because attributing to Basel II all the costs associated with the adoption of modern, formal risk-management systems is a logical fallacy. The large banks that would be required, or that would choose, to adopt A-IRB and AMA must compete for funding in a global marketplace and thus already have adopted many of these processes and would continue to develop them even without Basel II. The new accord may well appropriately speed up the adoption process, but overall, the costs of adopting these processes are being forced on these banks not by Basel II but by the requirements of doing business in an increasingly complex financial environment. In any event, the ANPR will include questions designed to quantify the cost of implementing Basel II. Competitive Equity A second key concern is competitive equity. Some are concerned that the U.S. supervisors would be more stringent in their application of Basel II rules than other countries and would thereby place U.S. banks at a competitive disadvantage. To address this concern, the Basel agreement establishes an Accord Implementation Group (AIG), made up of senior supervisors from each Basel member country, which has already begun to meet. It is the AIG's task to work out common standards and procedures and act as a forum in which conflicts can be addressed. No doubt some differences in application would be unavoidable across banking systems with different institutional and supervisory structures, but all of the supervisors, and certainly the Federal Reserve, would remain alert to this issue and work to minimize it. I also emphasize that, as is the case today, U.S. bank subsidiaries of foreign banks would be operating under U.S. rules, just as foreign bank subsidiaries of U.S. banks would be operating under host-country rules. Another issue relates to the concern among U. S. Basel II banks of the potential competitive edge that might be given to any bank that would have its capital requirements lowered by more than that of another Basel II bank. The essence of Basel II is that it is designed to link the capital requirement to the risk of the exposures of each individual bank. A bank that holds mainly lower-risk assets, such as high-quality residential mortgages, would have no advantage over a rival that held mainly lowerquality, and therefore riskier, commercial loans just because the former had lower required capital charges. The capital requirements should be a function of risk taken, and, under Basel II, if the two banks had very similar loans, they both should have a very similar required capital charge. For this reason, competitive equity among Basel II banks in this country should not be a genuine issue because capital should reflect risk taken. Under the current capital regime, banks with different risk profiles have the same capital requirements, creating now a competitive inequity for the banks that have chosen lower risk profiles. The most frequently voiced concern about possible competitive imbalance reflects the "bifurcated" rules implicit in the U.S. supervisors' proposed scope of application: that is, requiring Basel II through A-IRB and AMA for a small number of large banks while requiring the current capital rules for all other U.S. banks. The stated concern of some observers is that the banks that remained under the current capital rules, with capital charges that are not as risk sensitive, would be at a competitive disadvantage compared to Basel II banks that would get lower capital charges on less-risky assets. The same credit exposure might have a lower regulatory minimum capital charge at a Basel II bank than at a Basel I bank. Of course, Basel II banks would have higher capital charges on higher-risk assets and the cost of adopting a new infrastructure, neither of which Basel I banks would have. And any bank that might feel threatened could adopt Basel II if they would make the investment required to reach the qualifying criteria. But a concern remains about competitive equity in our proposed scope of application, one that could present some difficult trade-offs if the competitive issue is real and significant. On the one hand is the pressing need to reform the capital system for the largest banks and the practical arguments for retaining the present system for most U.S. banks. Against that is the concern that there might be an unintended consequence of disadvantaging those banks that would remain on the current capital regime. We take the latter concern seriously and will be exploring it through the ANPR. But, without prejudging the issue, there are reasons to believe that little if any competitive disadvantage would be brought to those banks remaining under the current capital regime. The basic question is the role of minimum regulatory capital requirements in the determination of the price and availability of credit. Economic analysis suggests that regulatory capital should be considerably less important than the capital allocations that banks make internally within their organization, so-called economic capital. Our understanding of bank pricing is that it starts with economic capital and the explicit recognition of the riskiness of the credit and is then adjusted on the basis of market conditions and local competition from bank and nonbank sources. In some markets, some banks will be relatively passive price takers. In either case, regulatory capital is mostly irrelevant in the pricing decision, and therefore unlikely to cause competitive disparities. Moreover, most banks, and especially the smaller ones, hold capital far in excess of regulatory minimums for various reasons. Thus, changes in their own or their rivals' minimum regulatory capital generally would not have much effect on the level of capital they choose to hold and would therefore not necessarily affect internal capital allocations for pricing purposes. In addition, the banks that most frequently express a fear of being disadvantaged by a bifurcated regulatory regime have for years faced capital arbitrage from larger rivals who were able to reduce their capital charges by securitizing loans for which the regulatory charge was too high relative to the market or economic capital charge. The more risk-sensitive A-IRB in fact would reduce the regulatory capital charge in just those areas where capital requirements are too high under the current regime. In those areas, capital arbitrage has already reduced the regulatory capital charge. The A-IRB would provide, in effect, risk-sensitive capital charges for lower-risk assets that are similar to what the larger banks have for years already obtained through capital arbitrage. In short, competitive realities between banks might not change in many markets in which minimum regulatory capital charges would become more explicitly risk sensitive. Concerns have also been raised about the effect of Basel II capital requirements on the competitive relationships between depository institutions and their nondepository rivals. Of course, the argument that economic capital is the driving force in pricing applies in this case, too. Its role is only reinforced by the fact that the cost of capital and funding is less at insured depositories than at their nondepository rivals because of the safety net. Insured deposits and access to the Federal Reserve discount window (and Federal Home Loan Bank advances) let insured depositories operate with far less capital or collateralization than the market would otherwise require of them and far less than it does require of nondepository rivals. Again, Basel II would not change those market realities. Let me repeat that I do not mean to dismiss competitive equity concerns. Indeed, I hope that the comments on the ANPR bring forth insights and analyses that respond directly to the issues, particularly the observations I have just made. But, I must say, we need to see reasoned analysis and not assertions. Operational risk The third key area of concern is the proposed Pillar 1 treatment of operational risk. Operational risk refers to losses from failures of systems, controls, or people and will, for the first time, be explicitly subject to capital charges under the Basel II proposal. Neither operational risk nor capital to offset it are new concepts. Supervisors have been expecting banks to manage operational risk for some time, and banks have been holding capital against it. Under Basel I both operational and credit risks have been implicitly covered in one measure of risk and one capital charge. But Basel II, by designing a risk-based system for credit and operational risk, separates the two risks and would require capital to be held for each separately. Operational disruptions have caused banks to suffer huge losses and, in some cases, failure here and abroad. At times they have dominated the business news and even the front pages. Appendix 1 to this statement lists the ten largest such events of recent years. In an increasingly technology-driven banking system, operational risks have become an even larger share of total risk; at some banks they are the dominant risk. To avoid addressing them would be imprudent and would leave a considerable gap in our regulatory system. A capital charge to cover operational risk would no more eliminate operational risk than a capital charge for credit risk eliminates credit risk. For both risks, capital is a measure of a bank's ability to absorb losses and survive without endangering the banking and financial system. The AMA for determining capital charges on operational risk is a principles-based approach that would obligate banks to evaluate their own operational risks in a structured but flexible way. Importantly, a bank could reduce its operational-risk charge by adopting procedures, systems, and controls that reduce its risk or by shifting the risk to others through measures such as insurance. This approach parallels that for credit risk, in which capital charges can be reduced by shifting to less-risky exposures or by making use of risk-mitigation techniques such as collateral or guarantees. Some banks for which operational risk is the dominant risk oppose an explicit capital charge on operational risk. Some of these organizations tend to have little credit exposure and hence very small required capital under the current regime, but would have significant required capital charges should operational risk be explicitly treated under Pillar 1 of Basel II. Such banks, and also some whose principal risks are credit-related, would prefer that operational risk be handled case by case through the supervisory review of buffer capital under Pillar 2 of the Basel proposal rather than be subject to an explicit regulatory capital charge under Pillar 1. The Federal Reserve believes that would be a mistake because it would greatly reduce the transparency of risk and capital that is such an important part of Basel II and would make it very difficult to treat risks comparably across banks because Pillar 2 is judgmentally based. Most of the banks to which Basel II would apply in the United States are well along in developing their AMA-based capital charge and believe that the process has already induced them to adopt riskreducing innovations. Presentations at a conference held late last month illustrated the significant advances in operational-risk quantification being made by most internationally active banks. The presentations were made by representatives from most of the major banks in Europe, Asia, and North America, and many presenters enthusiastically supported the use of AMA-type techniques to incorporate operational risk in their formal modeling of economic capital. Many banks also acknowledged the important role played by the Basel process in encouraging them to develop improved operational risk management. Overall capital and an evolving Basel II Before I move on to other issues, I would like to address the concern that the combination of credit and operational risk capital charges for those U.S. banks that are under Basel II would decline too much for prudent supervisory purposes. Speaking for the Federal Reserve Board, let me underline that we could not support a final Basel II that we felt caused capital to decline to unsafe and unsound levels at the largest banks. That is why we anticipate that the U.S. authorities would conduct a Quantitative Impact Study (QIS) in 2004 to supplement the one conducted late last year; I anticipate at least one or two more before final implementation. It is also why CP3 calls for one year of parallel (Basel I and II) capital calculation and a two-year phase-in with capital floors set at 90 and 80 percent, respectively, of the Basel I levels before full Basel II implementation. At any of those stages, if the evidence suggested that capital were declining too much the Federal Reserve Board would insist that Basel II be adjusted or recalibrated, regardless of the difficulties with bankers here and abroad or with supervisors in other countries. This is the stated position of the Board and our supervisors and has not changed during the process. Of course, capital ratios are not the sole consideration. The improved risk measurement and management, and its integration into the supervisory system, under Basel II, are also critical to ensuring the safety and soundness of the banking system. When coupled with the special U.S. features, such as prompt corrective action, minimum leverage ratios, statutory provisions that make capital a prerequisite to exercising additional powers, and market demands for buffer capital, some modest reduction in the minimum regulatory capital for sound, well managed banks could be tolerable. And, I note that banks with lower risk profiles, as a matter of sound public policy, should have lower capital than banks with higher risk profiles. Greater dispersion in required capital ratios, if reflective of underlying risk, is an objective, not a problem to be overcome. I should also underline that Basel II is designed to adapt to changing technology and procedures. I fully expect that in the years ahead banks and supervisors will develop better ways of estimating risk parameters as well as better functions that convert those parameters to capital requirements. When they do, these changes could be substituted directly into the Basel II framework, portfolio by portfolio if necessary. Basel II would not lock risk management into any particular structure; rather Basel II could evolve as best practice evolves and, as it were, be evergreen. Papers from that conference are available at http://www.newyorkfed.org/pihome/news/speeches/2003/con052903.html The Schedule and Transparency I would like to say a few words about the schedule. In a few weeks, the agencies will be publishing their joint ANPR for a ninety-day comment period, and will also issue early drafts of related supervisory guidance so that banks can have a fuller understanding of supervisory expectations and more carefully begin their planning process. The comments on the domestic rulemaking as well as on CP3 will be critical in developing the negotiating position of the U.S. agencies, and highlighting the need for any potential modifications in the proposal. The U.S. agencies are committed to careful and considered review of the comments received. When the comments on CP3 and the ANPR have been received, the agencies will review them and meet to discuss whether changes are required in the Basel II proposal. In November, we are scheduled to meet in Basel to negotiate our remaining differences. I fear this part of the schedule may be too tight because it may not provide U.S. negotiators with sufficient time to digest the comments on the ANPR and develop a national position to present to our negotiating partners. There may well be some slippage from the November target, but this slippage in the schedule is unlikely to be very great. In any event, implementation in this country of the final agreement on Basel II would require a Notice of Proposed Rulemaking (NPR) in 2004 and a review of comments followed by a final rule before the end of 2004. On a parallel track, core banks and potential opt-in banks in the United States will be having preliminary discussions with their relevant supervisors in 2003 and 2004 to develop a work plan and schedule. As I noted, we intend to conduct more Quantitative Impact Studies, starting in 2004, so we can be more certain of the impact of the proposed changes on individual banks and the banking system. As it stands now, core and opt-in banks will be asked by the fall of 2004 to develop an action plan leading up to final implementation. Implementation by the end of 2006 would be desirable, but each bank's plan will be based on a joint assessment by the individual bank and its relevant supervisors of a realistic schedule; for some banks the adoption date may be beyond the end of 2006 because of the complexity of the required changes in systems. It is our preference to have an institution "do it right" rather than "do it quickly". We do not plan to force any bank into a regime for which it is not ready, but supervisors do expect a formal plan and a reasonable implementation date. At any time during that period, we can slow down the schedule or revise the rules if there is a good reason to do so. The development of Basel II has been highly transparent from the beginning and will remain so. All of the consultative papers over the past five years have been supported by a large number of public papers and documents to provide background on the concepts, framework, and options. After each previous consultative paper, extensive public comment has been followed by significant refinement and improvement of the proposal. During the past five years, a number of meetings with bankers have been held in Basel and in other nations, including the United States. Over the past eighteen months, I have chaired a series of meetings with bankers, often jointly with Comptroller Hawke. More than 20 U.S. banks late last year joined 365 others around the world in the third Quantitative Impact Survey (QIS3), which was intended to estimate the effects of Basel II on their operations. The banking agencies last month held three regional meetings with the bankers that would not be required to adopt Basel II but might have an interest in choosing to adopt the A-IRB approach and the AMA. Our purpose was to ensure that these banks understand the proposal and the options it provides them. As I noted, in about one month the banking agencies in this country hope to release an ANPR that will outline and seek comment on specific proposals for the application of Basel II in this country. In the past week or so we have also released two White Papers to help commenters frame their views on commercial real estate and the capital implications of recognizing certain guarantees. These, too, are available at our web site. This dialogue with bankers has had a substantive impact on the Basel II proposal. I have attached to my statement a comparison of some of the major provisions of Basel II as proposed in each of the three consultative documents published by the Basel Committee on Bank Supervision (appendix 2). As you can see, commenters have significantly influenced the shape and detail of the proposal. For example, comments about the earlier proposed crude formulas for addressing operational risk led to a change in the way capital for operational risk may be calculated; banks' may now use their own methods for assessing this form of risk, as long as these methods are sufficiently comprehensive and The documents used in these presentations are available at the Board's http://www.federalreserve.gov/banknreg.htm ("Documents Relating to US Implementation of Basel II"). web site, systematic and meet a set of principles-based qualifying criteria. That is the AMA. The mechanism for establishing capital for credit risk has also evolved significantly since the first consultative paper on the basis of industry comments and suggestions; as a result, a large number of exposure types are now treated separately. Similarly, disclosure rules have been simplified and streamlined in response to industry concerns. At this stage of the proposal, comments that are based on evidence and analysis are most likely to be effective. Perhaps an example of the importance of supporting evidence in causing a change in positions might be useful. As some members of this committee may know, the Federal Reserve had concluded earlier, on the basis of both supervisory judgment and the available evidence, that the risk associated with commercial real estate loans on certain existing or completed property required a capital charge higher than the capital charge on other commercial real estate and on commercial and industrial loans. In recent weeks, however, our analysis of additional data suggested that the evidence was contradictory. With such inconsistent empirical evidence, we concluded that, despite our supervisory judgment on the potential risk of these exposures, we could not support requiring a higher minimum capital charge on commercial real estate loans on any existing or completed property, and we will not do so. In the same vein, we also remain open minded about proposals that simplify the proposal but attain its objective. Both the modifications of the proposals in CP3 and the changes in U.S. supervisory views, as evidenced by the commercial real estate proposal, testify to the willingness of the agencies, even at this late stage of the process, to entertain new ideas and to change previous views when warranted. Summary The existing capital regime must be replaced for the large, internationally active banks whose operations have outgrown the simple paradigm of Basel I and whose scale requires improved riskmanagement and supervisory techniques to minimize the risk of disruptions to world financial markets. Fortunately, the state of the art of risk measurement and risk management has improved dramatically since the first capital accord was adopted, and the new techniques are the basis for the proposed new accord. In my judgment, we have no alternative but to adopt, as soon as practical, these approaches for the supervision of our larger banks. The Basel II framework is the product of extensive multiyear dialogues with the banking industry regarding evolving best practice risk-management techniques in every significant area of banking activity. Accordingly, by aligning supervision and regulation with these techniques, it provides a great step forward in protecting our financial system and that of other nations to the benefit of our citizens. Basel II will provide strong incentives for banks to continue improving their internal risk-management capabilities as well as the tools for supervisors to focus on emerging problems and issues more rapidly than ever before. I am pleased to appear before you today to report on this effort as it nears completion. Open discussion of complex issues has been at the heart of the Basel II development process from the outset and will continue to characterize it as Basel II evolves further. Appendix 1 (14 KB PDF): Large Losses from Operational Risk, 1992-2002 Appendix 2 (40 KB PDF): Evolution of Basel II Proposals
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board of governors of the federal reserve system
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Speech by Mr Roger W Ferguson, Jr, Vice Chairman of the Board of Governors of the US Federal Reserve System, at the Basel Sessions 2003, Institute of International Finance, New York, 17 June 2003.
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Roger W Ferguson, Jr: Basel II - some issues for implementation Speech by Mr Roger W Ferguson, Jr, Vice Chairman of the Board of Governors of the US Federal Reserve System, at the Basel Sessions 2003, Institute of International Finance, New York, 17 June 2003. * * * I appreciate the opportunity provided by the Institute of International Finance to participate in your allday session on Basel II. It has taken a long time to reach this stage in the negotiations for a new capital accord: five years, 3-1/2 quantitative impact surveys, three consultative papers, and numerous outreach meetings with industry representatives. The process is not yet complete. In a continuation of one of the most transparent efforts to vet a regulatory proposal, we are asking for comment, and again we will carefully consider suggestions to improve the proposal on the basis of evidence and analysis submitted. Perhaps some of those suggestions will come from the sessions today. I think you will see from a comparison of the third consultative paper (CP3) with its predecessor that we are listening to what the public and the industry have been saying. Our response to comments has often added complexity to provide options in the context of a worldwide banking system in which countries and individual banks have different procedures and approaches. We have made every effort to avoid cookie-cutter rules for complicated banking structures. Those efforts continue. For example, in the United States, our Advance Notice of Proposed Rulemaking (ANPR) will seek further comment on additional options for securitization and risk mitigation as well as the treatment of various retail exposures, any one of which may require further negotiation at Basel. Complexity is also added because we are attempting to include principles of modern finance and risk-management, all of which involve complex statistical, and thus mathematical, techniques. Of course, it is exactly that direction that banking and its best-practice management have been taking over the last decade. In short, complexity in many cases provides options and in most cases is simply a part of modern finance. The details are not yet cast in concrete. A point I want you to keep in mind is: We will seriously consider suggestions for furthering the objectives of more-risk-sensitive capital requirements and better risk measurement and management in the least costly and most efficient way. At this point, however, comments must be analytical and empirical if they are to be helpful and likely to modify the proposal. The Framework As we involve ourselves in the fine detail of Basel II, it is useful to keep in mind what we are trying to do. We are developing a replacement for the current capital accord, Basel I, an agreement that simply is no longer consistent with the way the world's largest banks conduct their business. From the perspective of banks, supervisors, and, let us not forget, counterparties and stakeholders, capital is a cushion to ensure safety and soundness and to provide a benchmark against which the financial condition of banks can be measured. The large banks of the world have so changed the nature of how they do business that for them Basel I neither provides an appropriate cushion nor an accurate risk benchmark. It must be replaced, particularly in a world whose financial markets are so interrelated that substantial difficulties at any one of the largest banks, let alone a failure, could place all the large banks of the world at risk. Indeed, with due regard for an international level playing field, which I will discuss later, we should consider that the need of all of our countries for economic stability should be paramount in our supervisory and regulatory judgments. It is worth emphasizing that substantial disruptions in our financial systems linked to a large bank failure could raise the risk of a regulatory, if not legislative, response that would likely add restrictions greatly limiting the flexibility and efficiency of our banking system. In addition, perhaps one of the largest risks to the safety of the world banking system is the competitor - either local or cross-border - that erroneously evaluates risk, acts on that evaluation, and induces a competitive response that increases risk exposures broadly. For both reasons, action is imperative. It must be taken both by banks and by their supervisors to improve risk measurement and management; to link to the extent we can the amount of regulatory minimum capital to the amount of risk taken; to attempt to further focus the supervisor-bank dialogue on the measurement and management of risk and the risk-capital nexus; and to make all of this transparent to the counterparties and uninsured depositors that ultimately fund - and hence share - the risk positions. In a rather large nutshell, that is what Basel II seeks to do, while at the same time seeking a level regulatory playing field for banks that compete across borders. Cyclicality Many critics - in and outside of the industry - have raised concerns that the framers of Basel II have unintentionally overlooked a byproduct of the package that will tend to destabilize the world's economies. With all the world's banks on the same regulatory structure, these critics argue, the typical business cycle will be accentuated by Basel II as perfectly reasonable estimates of probabilities of default and of loss given default decline in economic expansions and rise as the economy weakens. The resultant changes in the cost and availability of credit will be pro-cyclical, that is, will exacerbate cyclical patterns in the real economy. But we should recognize some important responses that have emerged from regulators and markets: flatter risk functions have been adopted in the Basel II proposal; banks maintain buffer capital stocks; Basel II requires that, under Pillar 2, supervisors and banks discuss the size of the necessary buffer capital that each bank should carry for cyclical purposes; and the proposed rules require stress-testing of risk parameters. Perhaps a more important point is that, in evaluating the pro-cyclicality argument, we should not forget the cyclicality in bank credit flows that we see in history. If we are to truly evaluate the critics' concerns with post-Basel II pro-cyclicality in bank credit flows, we should be sure that it is compared with the pre-Basel II pattern. Until quite recently, systematically and formally managing many of the key risks taken by banks, in particular their credit risk, was quite difficult. The techniques for quantifying and measuring risk, and the technology and instruments to manage and distribute it, simply did not exist. Individual credit-risk decisions tended to be made by lending and credit officers who used their judgment to decide who was given credit and who was not. A characteristic of lending officers is that they are paid to make loans, and in competitive lending markets they want to make sure they maintain, if not increase, market share. This is not to say that lending officers are uninterested in risk management but rather that their focus is on finding a way to make the loan. In a world of judgment, the risk manager had considerable difficulty in persuading lending officers, indeed management, about excessive risk when quantitative procedures and systems did not exist. Differences in judgment are difficult to resolve. That is probably the reason that bank credit availability has historically demonstrated a clear cyclical pattern that is consistent with the credit-making decision process I have just described and that, in turn, has exacerbated real economic cycles. During economic recoveries, bank credit officers would become more optimistic and willing to lend, an attitude that only strengthened during booms; in such times the voices of risk managers, even supervisors, calling for caution were likely to carry less weight. During recessions, with losses clear and write-offs rising, caution would come to the forefront, and more-restrictive attitudes toward lending would be reinforced by the arguments of risk managers and supervisors who could point to the losses. One can, I think, begin to notice a change in recent years in this typical pro-cyclical behavior in bank credit availability in the United States. The change first became apparent in the minimal credit losses at the large U.S. banks during the Asian debt crisis and Russian debt default in the late 1990s. It was also noticeable when these same entities began to tighten lending standards during the later years of the last expansion, in contrast to typical patterns, in which tightening occurred near or after the peak. The moderation of pro-cyclical behavior is also apparent in the continued strength in the portfolios of these organizations and in the modest spreads on their subordinated debt during the recession. To be sure, part of the explanation is new techniques and instruments for shifting and sharing risks. But at bottom, I would argue, we are beginning to see the payoff from more-formal and rigorous quantitative risk-management techniques for credit decisionmaking, techniques that have also been central to the development of new instruments for hedging, mitigating, and managing credit risk. Basel II builds on and formalizes these developments in bank credit risk management. Such a regime of greater formal attention to risk exposures, as under Basel II, offers the hope of a more stable pattern of credit availability. Quantitative risk management should reduce the buildup of excessive unintended credit risks that have been assumed in expansions and thereby minimize the losses and associated tighter lending standards during recessions. Such lending behavior, in turn, might well reduce the cyclical pattern in minimum capital requirements that would occur without the better riskmanagement techniques required under the proposed Basel II. The response to more-formal risk management thus creates the reasonable prospect of a reduction in concerns about the pro-cyclicality of capital ratios under Basel II. In the past, problems have arisen when banks have been too complacent in their judgments of risks during good times, too slow to react when the situation turns, and too risk-adverse once their losses have turned out larger than anticipated. A process that encourages banks to think more carefully and more pro-actively about all of these possibilities offers the hope of a significant improvement in the way that they manage themselves over the course of the business cycle. Risk will continue to vary over time. Ignoring that fact is in no one's interest. In fact, capital ratios under Basel I by default fail to convey that pattern to managers, stakeholders, and supervisors because the risk categories are insufficient to recognize changing risk. The proposed Basel II, in contrast, would convey to managers, to supervisors, and importantly, to the public how risk changes as capital requirements respond to changes in the real underlying risk. A sufficiently risk-sensitive capital regime would impart timely information regarding risk. That, in turn, would allow adjustments in lending policies sufficiently early to limit excessive swings in lending behavior. Risk sensitivity in capital requirements would damp swings in credit availability and thereby reduce both credit sprees and credit crunches. Supervisors prefer - or at least ought to prefer - the regulatory capital ratios that convey more information. Supervisors, banks, and the public should want to understand when bank portfolios are facing higher risks or when an updated estimate of risk relative to capital reveals a warning sign that requires attention. No such early warning system is provided by a system of capital requirements that does not signal that a bank has a problem until the problem is severe enough to have already eroded the underlying capital. That is, a capital system with little risk sensitivity creates the potential for problems to escape undetected for longer periods. Such delays increase the likelihood that the underlying problems will not be addressed soon enough and will grow larger. Dispersion in capital requirements under Basel II Basel II is designed to deliver capital requirements that are more risk sensitive. As such, one can expect that some banks - those with less risk exposure - will see their required capital decline; those with larger risk exposures should see their required capital rise. On average, we expect capital requirements for the total of credit risk and operational risk to remain about unchanged for the banking system. As I have just discussed, the resultant dispersion of capital requirements seems desirable to supervisors for its portfolio inducements, for its aid in supervisory evaluations, and for its contribution to safe and sound banking. The dispersion of capital requirements has also created an unexpected criticism from some observers: it will distort the competitive landscape, as if somehow lower capital requirements were a random gift and higher capital requirements a random penalty, rather than correctly reflecting underlying risk. To be sure, some, but not all, of the concern in this country has reflected objections from banks that will not be required to apply Basel II - and thus will not see their capital requirements change at all. Some of these entities fear they will face a rival that will get a capital break because the rival is following Basel II and has lower risk exposures recognized by the new accord. The extent to which regulatory capital requirements drive pricing or profitability is an empirical question. My own view is that in a world in which banks hold capital buffers and can securitize and sell assets, and with bank management increasingly allocating resources and making decisions on the basis of internal economic capital measures, the answer must be: not very much, if at all. Rather, I believe that we are increasingly observing that pricing decisions reflect economic capital allocations that are risk based. We have tried hard to set risk-based regulatory capital requirements in Basel II below economic capital measures so that regulatory requirements will not affect the allocation of capital within the bank. If we make a mistake and set the regulatory capital requirements too high relative to market-based economic capital, we can read the effect of our error right away in the securitization of the exposure; securitization is a release valve that relieves the pressure of our mistakes. To be sure, as better risk measurement and management results in more sensitive risk-based pricing, we may well see that exposures with higher capital charges are priced higher than those with lower capital charges. But such observations should not lead us to confuse cause and effect. The regulatory capital charges and price of credit will both be reflecting the same thing - risk; the higher price won't be a reflection of the higher capital charge. U.S. Scope of Application No discussion on Basel II with a room full of global bankers would be complete without a discussion of the intended scope of application of Basel II in this country. In particular, I would suspect that you want to hear about the implications for the integration of your U.S. and worldwide operations. A week ago, I gave a rather full presentation on that issue to the Institute of International Bankers, and I call your attention to that statement, which is available at the Board's web site. But this afternoon let me present the highlights of what I said. First, what do we plan to do? In this country, we intend to offer only the advanced approaches under Basel II: the Advanced version of the Internal Ratings Based approach (A-IRB) for credit risk and the Advanced Measurement Approach (AMA) for operational risk. There will be no Foundation IRB and no Standardized approach for credit risk in the United States for any U.S. chartered bank - domestic or foreign; nor will there be a Basic Indicator or Standardized method for calculating operational risk for any U.S. chartered bank. In this country, only the largest, most internationally active banks will be required to adopt Basel II: A-IRB and AMA. The proposed criteria indicate that about ten such banks will be in this "core" group. In addition, any U.S. bank - including any subsidiary of a foreign bank - that meets the infrastructure requirements of the A-IRB approach may choose Basel II; we expect that, initially, about another ten banks will do so. The twenty or so U.S. banks that we expect to operate in the near future under Basel II - the ten mandatory core banks and the ten banks choosing Basel II account today for 99 percent of U.S. bank foreign assets and two-thirds of total domestic consolidated assets of all U.S. banking organizations. Those banking organizations in this country not in the core group and not choosing to adopt Basel II will remain on the current capital regime (Basel I). They will not be subject to explicit operational risk capital requirements. These banks may also opt in to Basel II (A-IRB and AMA) whenever they wish, provided they meet the infrastructure requirements. Why did we not make the other Basel II options available in the United States? We have made it clear from the outset that the new accord would apply in this country only to those institutions that genuinely competed across national boundaries to ensure, in so far as possible, a level competitive playing field internationally. Only a small number of U.S. institutions meet the test of truly operating across borders. They happen to be very large and, hence, the authorities here concluded that they should be subject to the most sophisticated Basel II versions so that they receive the very real benefits of improved risk measurement and management and a more risk-sensitive regulatory capital requirement and so that they operate under the increased market discipline that comes from improved disclosure and greater transparency. Indeed, very large banks that do not meet the internationally active criterion will also be required to become core banks for these reasons. The banks that will remain under the current capital regime in this country have certain attributes that led the authorities to conclude that, for those banks, realizing the benefits of Basel II would impose costs that exceeded those benefits. Most of these banking organizations have relatively straightforward balance sheets that would benefit less from the Basel II risk-measurement and management requirements. In addition, in this country, our banks are subject to the requirements of prompt corrective action and minimum leverage and to statutory provisions that induce them to hold buffer capital far above the minimum requirements. More than 93 percent of the expected Basel I banks hold capital that is in excess of 10 percent of their risk-weighted assets. Moreover, in this country, requirements of the sort found in Pillar 2 have been in existence for many years and are well ingrained into our supervisory process. The U.S. banking system also has a greater tradition of disclosure, as those of you with U.S. subsidiaries well know. Thus, the cost-benefit analysis suggested that it would not be responsible to require most of our banks - entities that do not operate across national borders - to adopt Basel II, especially because thousands of them would probably choose the standardized version that adds only modest credit-risk sensitivity to risk-based capital requirements. Smaller banks in many other countries, we believe, would benefit http://www.federalreserve.gov/boarddocs/speeches/2003/200306102/default.htm from adherence to Pillars 2 and 3, and we hope they adopt Basel II, but our banks already operate under regimes fairly close to what the simpler versions of Basel II would provide. In light of their capital and supervision, we anticipate that U.S. banks with modest overseas activities operating under Basel I rules would be able to continue their overseas operations without having to adopt Basel II. Their subsidiaries, of course, would be subject to the rules and requirements of the host country. And, U.S. authorities will make available to host-country supervisors whatever information is required. U.S. branches of foreign banks would be basically unaffected by Basel II rules because they are not subject to direct capital requirements. And U.S. supervisors expect to find any variant of Basel II applied in foreign countries to be acceptable for our evaluations of well-capitalized standards at the consolidated parent level. However, U.S. subsidiaries would be subject to our rules for domestic banks and thus would have to choose either the A-IRB and AMA approaches or remain under the current Basel I rules. We do understand that this could present some complications for foreign banks using approaches for their consolidated organizations that are not offered in the United States, such as Foundation IRB for credit risk. When the parent organization's approach does not align with what the U.S. subsidiary must choose (either advanced approaches or current rules), some adjustments will indeed be necessary. U.S. supervisors and their counterparts from Basel member countries are already working, through the Basel Accord Implementation Group (AIG), to resolve cross-border implementation issues and minimize burden created from differences in home and host-country rules. We understand, however, our responsibilities to work with foreign banks to address the remaining conflicts. When foreign banks with U.S. subsidiaries adopt IRB variants at home and Basel I rules in the United States, U.S. supervisors would be prepared to assist them, and their supervisors, in helping the subsidiary bank here provide the requisite inputs for calculation of capital at the global, consolidated level. When the foreign bank adopts at home the IRB variant not available in this country, the Foundation IRB, the issues are more complicated; if the bank wants its U.S. subsidiary to also be on IRB, doing so would require that subsidiary to adopt the Advanced IRB version here. To meet the requirements for risk measurement and management required by the authorities for U.S. markets, that subsidiary would have to invest the resources to estimate loss given default (LGD) and exposure at default (EAD) parameters for their corporate exposures. Such an effort is not without cost, but we are willing to work with such banks to ease their transition. We are, for example, prepared to explore the possibility of allowing U.S. subsidiaries of foreign banks to use conservative estimates of LGD and EAD for a finite transitional period when data are not yet available for parts of some portfolios. This possible option would, if adopted, apply equally to fully domestic U.S. banks adopting A-IRB. We might also be willing to work out transition methodologies to permit foreign banks to allocate their overall operational risk capital charge for their consolidated entity between their parent and U.S. A-IRB bank subsidiary - for a limited time. Such transition approaches are indicative of our willingness to approach the implementation of our scope of application policy in a pragmatic way. The U.S. authorities strongly encourage U.S. banks and foreign banks concerned about cross-border implementation to establish a dialogue with supervisors in their respective home jurisdictions and, for foreign banks in the United States, also with U.S. supervisors; we want these banks to comment on any documents addressing cross-border issues, so that AIG members can tackle these issues together. The authorities here want to hear your observations on how to avoid creating undue burdens on foreign banks while at the same time retaining our ability to shape the risk-measurement and management methods employed by banks in our own markets. Summary Basel I must be replaced for the large, internationally active banks of the world because it no longer produces an adequate indicator of the strength of such banks, and, moreover, that indicator does not vary as risk changes. Basel II is designed to improve risk management and measurement, to link required capital to risk, to focus supervision more closely on these variables, to make such relationships more transparent, and to facilitate a level playing field for banks that compete across national borders. Critics concerned about the pro-cyclicality of Basel I should compare the likely postBasel II pattern with the pattern of earlier years; in doing so, they should consider the extent to which better risk management, a more risk-sensitive capital requirement, and the rise in market discipline that comes from greater transparency will modify bank lending patterns, particularly the unintended acceptance of risk during expansion periods. The U.S. authorities are proposing that in this country the A-IRB and AMA approaches of Basel II be required of the largest, most internationally active banks that meet certain size and foreign-activity criteria and be permitted for any other bank that meets the infrastructure prerequisites of the A-IRB and AMA approaches. All other banking organizations would remain under Basel I. The proposal would not permit any banking organization in this country to operate under the Standardized or Foundation IRB approaches of Basel II. We will be working with the AIG at Basel to minimize any issues that may arise because of different capital regimes for the consolidated operations of foreign banks and the choices available to their subsidiaries in the United States. U.S. supervisors will cooperate with foreign supervisors to provide any required inputs from U.S. subsidiaries of foreign banks that the home-country supervisors need for their consolidated supervision. The U.S. banking agencies are also willing to consider possible transition methodologies to assist foreign banks that want to use IRB here to adopt the A-IRB and AMA approaches. We urge the U.S. bank subsidiaries that are commenting on the U.S. ANPR to advise both U.S. and home-country supervisors of the problems that our proposed scope of application may cause them. In particular, we solicit suggestions that address these potential problems but still recognize the desire of the U.S. authorities to apply only the advanced versions of Basel II in this country.
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board of governors of the federal reserve system
| 2,003 | 6 |
Speech by Ms Susan S Bies, Member of the Board of Governors of the US Federal Reserve System, before the Oregon Bankers Association, Independent Community Banks of Oregon, and Idaho Bankers Association; Sunriver, Oregon, 16 June 2003.
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Susan S Bies: Managing business risks Speech by Ms Susan S Bies, Member of the Board of Governors of the US Federal Reserve System, before the Oregon Bankers Association, Independent Community Banks of Oregon, and Idaho Bankers Association; Sunriver, Oregon, 16 June 2003. * * * Thank you for inviting me to participate in the joint annual convention of the Oregon Bankers Association, the Independent Community Banks of Oregon and the Idaho Bankers Association. One of my responsibilities as a governor on the Federal Reserve Board is to chair the Board's Committee on Supervisory and Regulatory Affairs. In that role I apply my knowledge of banking to the continuing task of adapting the Federal Reserve's supervision process to meet the needs of the evolving financial services industry. Today I want to explore some issues of joint interest to us, as bankers and supervisors, and to think about how we can better manage the risks inherent in banks. First I'll focus on some of issues arising from events at public companies and banks in the past eighteen months that have shown weaknesses in risk management practices. And then I'll talk about how operational risk management is evolving into a discipline that can strengthen the corporate governance process at banks. Bank earnings and performance Banks in the United States have experienced two consecutive years of record earnings, despite the recession and slow recovery, losses due to exposures to bankruptcies arising from corporate fraud, and record low interest rates. In 2002, the return on assets rose 16 basis points, to 1.33 percent, the highest level in three decades. The improvements in earnings and ROA are even more remarkable in that they occurred while banks were strengthening their capital ratios. Thus, banks' performance was driven by increased net interest margins, lower relative costs and comparatively constant loan loss provisions. The ability of bankers to achieve record earnings during a recession and the early part of the recovery reflects the improvement in risk management that occurred in the 1990s. This is especially true in relation to credit and asset/liability risks. Operational risks are a different matter: Banks have had to deal with losses arising from operational issues, as a few well-publicized events have shown. Operational risk "Operational risk" is a relatively new term that has no unique definition. In the mid-1990s the concept began to receive attention at banks and nonfinancial firms as enterprise-risk management began to evolve. For purposes of my talk today, I am going to refer to operational risk as any risk that arises from inadequate or failed internal processes, people, or systems or from external events. Examples of operational risk include employee fraud, customer lawsuits, failed information system conversions, and mis-sent wires. Operational risk has always been part of banking. But the greater variety of products and services that banks provide, the evolution of business processes, and changes in the ethical environment in which we live have all contributed to more observable exposures to this type of risk. An example of this is the growing use of automated loan underwriting systems. When individual loan officers are responsible for making lending decisions within established credit guidelines, unexpected losses tend to be concentrated. That is, if a particular loan officer is a weak underwriter, only the portion of the loan portfolio generated by that individual shows higher delinquencies and charge-offs. Management could address this risk in many ways, including by providing additional training for that loan officer and by increasing loan-review activities. Today, many lending decisions are made by automated systems. If the model used for underwriting has a weakness, a systemic asset-quality problem can arise. That is, higher delinquencies are no longer isolated in a small portion of the portfolio managed by one loan officer. Instead, significant losses can occur simultaneously across the bank's loan portfolio. Avoiding the problems of "model risk" requires more-rigorous oversight of internal controls. The model should be back-tested to verify that the factors it uses deliver the level of losses that was assumed when the loans were made and priced. Avoiding model risk also requires greater data integrity in loan application and underwriting systems, as data errors can also contribute to unintended results. Many banks today use credit-scoring models to help in mortgage and consumer credit originations. Although most of these models have been shown to be effective in the past few years they have been in use, they have not been tested through a serious consumer-led recession. In the last recession, the weaknesses in asset quality were - and have been since - on the commercial loan side rather than the consumer side. During the period, consumer disposable income continued to grow. The test of the models will come when we hit a period of significantly higher unemployment or falling incomes. Then we'll be able to see if the credit models have reliably predicted the credit losses. Reputational risk Another area of risk that has received attention because of recent events is reputational risk. Bankers know that a critical element of success is customer and investor perceptions of the organization's integrity. When customers select an organization to manage their wealth and financial transactions, they have a few essential expectations - that their privacy will be protected, their transactions will be conducted in a timely manner, the advice they are given will be reliable, and their assets will be invested appropriately and consistently with their financial goals and appetite for risk. Events of the past eighteen months have shown that customers and investors react quickly when a reputation is tainted. Many of these events reflect operational risk breakdowns. The case of Arthur Andersen has several lessons for bankers, and I want to focus on the reputational risk aspects. A key component of many banks' strategies is the use of relationship managers. Bankers believe that a single point of contact will help a customer identify the range of the bank's services, will provide a consistent level of service quality, and will increase the cross-selling of services. As a result, customer retention will increase and profitability will improve. Arthur Andersen had a similar relationship-management strategy. The breakdown occurred because engagement partners who served as relationship managers had the final word on signing-off on accounting policy. Because the engagement partner was compensated on the basis of total revenues paid by the client, the partner had a natural conflict between trying to increase his or her compensation and holding firmly to recognized accounting standards. Further, it appears that Andersen did not have an effective quality-assurance process so that executive management would know when a particular partner was compromising accounting standards to meet his or her own compensation goals. Since the reputation of an independent auditing firm rests on its perceived integrity in ensuring that all its clients meet generally accepted accounting standards, the core value of the enterprise was compromised. As bankers offer more products via a relationship-management model, they should heed the lessons of the Arthur Andersen incident: Make sure operational controls are in place to monitor the conflicts that the account officer is facing. Controls are especially necessary in the area of credit oversight. Rarely can enough fee income be generated to offset credit losses. An effective risk-management process can help identify areas of conflict that emerge as new products and management processes are adopted. Risk assessments initiated early in the planning process can give the bank time to get mitigating controls and monitors in place and conduct an internal audit validation of the quality of those controls, before product launch. Thus, risk management functions can be effective tools for bankers to help limit surprises that affect their reputation in the marketplace. Accounting Over the past year and a half, some organizations have had to restate financial results because of inappropriate accounting. Both corporate financial officers and outside auditors failed to effectively evaluate the sophisticated nature of the underlying transactions and arrive at the appropriate accounting policy. At a few banks, the evaluations were ineffective for special-purpose entities and derivatives. You have all read accounts of these incidents, and I will not dwell on them. Rather, I want to illustrate operational risk in relation to a basic accounting concept by discussing another area of weakness that bank regulators determined needed attention - accounting for subprime credit card activity. The accounting concept is not new or esoteric. Rather, the nature of the subprime credit card business, compared with that of the prime card business, is to rely much more on fee income than on interest income for revenue. For subprime accounts, rapid growth of the account base can mask underlying revenue trends. Some financial institutions did not have management information that allowed them to track the percentage of delinquent accounts that were not paying late fees and other charges that had been billed. In such situations, the accounting is very straightforward. Even if you have billed a customer for services, if you do not think you are going to collect the fee, you should not recognize the revenue and should set up a reserve for bad debt. Some financial institutions with a large subprime client base did not have adequate accounting systems to disclose that a significant amount in fees was not being collected. By recording revenue on the basis of billed fees, these institutions were overstating income. New guidance issued jointly by the bank regulators clarifies these accounting standards. Further, at some subprime banks, management information did not reflect the level of charge-offs of fees and advances as accounts aged. By relying on charge-off reports for the portfolio as a whole, portfolio growth was masking the increasing amount of loan losses. This is a good example of how changes in the customer mix and profit drivers of an existing product can lead to unintended loss exposures if management information and accounting do not reflect the economics and risks of the product when it is altered. FDICIA: Internal controls Other areas of operational risk have come to light as a result of the events and debate surrounding the Sarbanes-Oxley Act. I want to talk about a couple of these areas - internal control assessments and the role of outside auditors. Since 1991, the Federal Deposit Insurance Corporation Improvement Act (FDICIA) has required that the chief executive officer (CEO) and the chief financial officer (CFO) of all Securities and Exchange Commission (SEC) registrants report on the quality of internal controls. One of the observations that regulators made this past year was that at some banks that had breaks in internal controls, the process of reporting on internal controls had become a "paper pushing" exercise rather than a robust part of the corporate governance process. The related lesson is that compliance with a similar requirement in Sarbanes-Oxley will require monitoring by bank regulators to make certain the goal of strengthening accountability and governance is achieved. Recently, the Federal Reserve and the other bank regulators made known our expectations about the application of Sarbanes-Oxley to small, non-SEC registrant banks. Although we are not requiring that these banks report on internal controls for either FDICIA or Sarbanes-Oxley purposes, recent losses at banks and notable corporate scandals demonstrate that sound governance and internal control practices are important for all banks. Depending on the size, riskiness, and complexity of any bank's business mix, elements of the internal control framework developed by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) can provide a process to help identify and monitor areas in which controls should be strengthened. I will describe some ways in which aspects of these processes can assist corporate governance at some community banks. FDICIA came after the savings and loan failures and a series of corporate governance scandals in the 1980s. In the late 1980s, the COSO issued guidance on best practice in the area of internal controls, and FDICIA adopted this framework. The management report on internal controls that banks issue should be prepared in a manner similar to the COSO framework. FDICIA requires that once a year, managers step back and look at the risks inherent in the businesses and processes they manage, and then determine what level of risk exposure is appropriate given the profit and strategic goals of the organization. Once the risk limit is set, managers should evaluate the mitigating controls and monitoring processes to see if they are effective in achieving the designated level of risk. Managers should also look at the organization's business plan to see how risk exposures are expected to change and to determine whether new controls, or changes in existing controls, are needed to manage that level of risk. Finally, managers should prepare action plans for building or modifying existing controls to effectively manage risk. As each manager completes their report on internal controls, the report should go up the chain of command to their boss, who then repeats the process for all of their managed areas. When the report gets to the top of the organization, the CEO and CFO issue the final management report on internal controls to bank regulators. Further, the external auditor is to review the report and attest to its validity. At the Fed, we have been looking at the reports produced by banks at which internal control breakdowns led to significant losses. We have found instances in which failures of internal controls that were known to management were not mentioned in the management report. These failures include basic types of internal control breakdowns, such as failure to reconcile accounts in a timely fashion or failure to segregate duties in critical transaction-processing or accounting functions. In some of these cases, the external auditor did not identify the known failure in the attestations. We are working with banks to make sure this basic control process has substance in the future. Management reports on internal controls can also help bank boards of directors and audit committees gain a better understanding of the nature of the risks and the quality of the controls in place. Audit committees should not just hear that the outside auditors have "signed off" on the FDICIA report. Rather, the report itself can be the basis for an effective discussion of internal controls among managers, internal auditors, external auditors, and the audit committee. Audit committee members can use these reports to discuss how risks are changing and what the priorities for strengthening controls should be. Audit committees can also use the reports to bring to their attention recurring concerns control weaknesses that managers continue to fail to address in a timely manner. Having seen weaknesses in the quality of external auditors' review of financial reporting and internal controls, the bank regulators have issued an exposure draft to define a policy under which an auditor can be debarred from serving as an auditor of a bank. Bank regulators have had this authority since FDICIA but have not chosen to use it in the past. Regulators have relied on the quality assurance process of public accounting firms and the peer review process of the American Institute of Certified Public Accountants' (AICPA) to monitor the quality of auditors. But as you all are aware, the events of the past year have clearly shown that these self-regulatory controls have not always been effective. The Sarbanes-Oxley Act established the Public Company Accounting Oversight Board, which will be the regulator charged with monitoring the quality of audit work. Since bank regulators rely heavily on the work of external auditors, we are proposing that bank regulators also lay out the expectations for the quality of audit work and the conditions under which an individual or firm would be debarred from audit work at a bank. We expect to work closely with the Oversight Board, as it gets fully up and running, to improve the quality assurance for audit services. As bankers, you should make certain that you are receiving value for audit services. As you hire your independent accountant, or if you outsource internal auditing, look for an auditor who regularly works for another financial institution or is part of a larger organization that is aware of and concerned about emerging risks and best practice controls. Such a firm will provide resources to ensure that corporate governance and controls are appropriate for your organization and that internal controls evolve to keep pace with changing business practices. Conclusion Banks are becoming more differentiated as they choose to serve different customer mixes, focus on specialized activities, or rely on new delivery channels. Thus, it is important that you make risk management part of your strategic planning process. Corporate governance and audit failures over recent months demonstrate how quickly trust can be lost. Reputation and integrity are vital to building and maintaining good relations with bank customers, employees, investors and communities. Good governance and continued attention to internal controls are responsibilities that boards of directors and management cannot afford to neglect. With the improvements in credit and asset/liability management, failures in operational controls and corporate governance will continue to be a larger source of losses for banks in the future. Thus, all bankers need to formally add the evaluation and mitigation of operational risk to their corporate governance processes.
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board of governors of the federal reserve system
| 2,003 | 6 |
Testimony of Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, on the occasion of the Federal Reserve Board¿s semiannual monetary policy report to the Congress, before the Committee on Financial Services, US House of Representatives, 15 July 2003.
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Alan Greenspan: Semiannual monetary policy report to the US Congress Testimony of Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, on the occasion of the Federal Reserve Board’s semiannual monetary policy report to the Congress, before the Committee on Financial Services, US House of Representatives, 15 July 2003. * * * Mr. Chairman and members of the Committee, I am pleased to present the Federal Reserve’s semiannual Monetary Policy Report to the Congress. When in late April I last reviewed the economic outlook before this Committee, full-scale military operations in Iraq had concluded, and there were signs that some of the impediments to brisker growth in economic activity in the months leading up to the conflict were beginning to lift. Many, though by no means all, of the economic uncertainties stemming from the situation in Iraq had been resolved, and that reduction in uncertainty had left an imprint on a broad range of indicators. Stock prices had risen, risk spreads on corporate bonds had narrowed, oil prices had dropped sharply, and measures of consumer sentiment appeared to be on the mend. But, as I noted in April, hard data indicating that these favorable developments were quickening the pace of spending and production were not yet in evidence, and it was likely that the extent of the underlying vigor of the economy would become apparent only gradually. In the months since, some of the residual war-related uncertainties have abated further and financial conditions have turned decidedly more accommodative, supported, in part, by the Federal Reserve’s commitment to foster sustainable growth and to guard against a substantial further disinflation. Yields across maturities and risk classes have posted marked declines, which together with improved profits boosted stock prices and household wealth. If the past is any guide, these domestic financial developments, apart from the heavy dose of fiscal stimulus now in train, should bolster economic activity over coming quarters. To be sure, industrial production does appear to have stabilized in recent weeks after months of declines. Consumer spending has held up reasonably well, and activity in housing markets continues strong. But incoming data on employment and aggregate output remain mixed. A pervasive sense of caution reflecting, in part, the aftermath of corporate governance scandals appears to have left businesses focused on strengthening their balance sheets and, to date, reluctant to ramp up significantly their hiring and spending. Continued global uncertainties and economic weakness abroad, particularly among some of our major trading partners, also have extended the ongoing softness in the demand for U.S. goods and services. When the Federal Open Market Committee (FOMC) met last month, with the economy not yet showing convincing signs of a sustained pickup in growth, and against the backdrop of our concerns about the implications of a possible substantial decline in inflation, we elected to ease policy another quarter-point. The FOMC stands prepared to maintain a highly accommodative stance of policy for as long as needed to promote satisfactory economic performance. In the judgment of the Committee, policy accommodation aimed at raising the growth of output, boosting the utilization of resources, and warding off unwelcome disinflation can be maintained for a considerable period without ultimately stoking inflationary pressures. * * * The prospects for a resumption of strong economic growth have been enhanced by steps taken in the private sector over the past couple of years to restructure and strengthen balance sheets. These changes, assisted by improved prices in asset markets, have left households and businesses better positioned than they were earlier to boost outlays as their wariness about the economic environment abates. Nowhere has this process of balance sheet adjustment been more evident than in the household sector. On the asset side of the balance sheet, the decline in longer-term interest rates and diminished perceptions of credit risk in recent months have provided a substantial lift to the market value of nearly all major categories of household assets. Most notably, historically low mortgage interest rates have helped to propel a solid advance in the value of the owner-occupied housing stock. And the lowered rate at which investors discount future business earnings has contributed to the substantial appreciation in broad equity price indexes this year, reversing a portion of their previous declines. In addition, reflecting growing confidence, households have been shifting the composition of their portfolios in favor of riskier assets. In recent months, equity mutual funds attracted sizable inflows following the redemptions recorded over much of the last year. Moreover, strong inflows to corporate bond funds, particularly those specializing in speculative-grade securities, have provided further evidence of a renewed appetite for risk-taking among retail investors. On the liability side of the balance sheet, despite the significant increase in debt encouraged by higher asset values, lower interest rates have facilitated a restructuring of existing debt. Households have taken advantage of new lows in mortgage interest rates to refinance debt on more favorable terms, to lengthen debt maturity, and, in many cases, to extract equity from their homes to pay down other higher-cost debt. Debt service burdens, accordingly, have declined. Overall, during the first half of 2003, the net worth of households is estimated to have risen 4-1/2 percent - somewhat faster than the rise in nominal disposable personal income. Only 15 percent of that increase in wealth represented the accumulated personal saving of households. Additions to net worth have largely reflected capital gains both from financial investments and from home price appreciation. Net additions to home equity, despite very large extractions, remained positive in the first half. Significant balance-sheet restructuring in an environment of low interest rates has gone far beyond that experienced in the past. In large measure, this reflects changes in technology and mortgage markets that have dramatically transformed accumulated home equity from a very illiquid asset into one that is now an integral part of households’ ongoing balance-sheet management and spending decisions. This enhanced capacity doubtless added significant support to consumer markets during the past three years as numerous shocks - a stock price fall, 9/11, and the Iraq war - pummeled consumer sentiment. Households have been able to extract home equity by drawing on home equity loan lines, by realizing capital gains through the sale of existing homes, and by extracting cash as part of the refinancing of existing mortgages, so-called cash-outs. Although all three of these vehicles have been employed extensively by homeowners in recent years, home turnover has accounted for most equity extraction. Since originations to purchase existing homes tend to be roughly twice as large as repayments of the remaining balances on outstanding mortgages of home sellers, the very high levels of existing home turnover have resulted in substantial equity extraction, largely realized capital gains. Indeed, of the estimated net increase of $1.1 trillion in home mortgage debt during the past year and a half, approximately half resulted from existing home turnover. The huge wave of refinancings this year and last has been impressive. Owing chiefly to the decline in mortgage rates to their lowest levels in more than three decades, estimated mortgage refinancings net of cash-outs last year rose to a record high of more than $1.6 trillion. With mortgage rates declining further in recent months, the pace of refinancing surged even higher over the first half of this year. Cash-outs also increased, but at a slowed pace. Net of duplicate refinancings, approximately half of the dollar value of outstanding regular mortgages has been refinanced during the past year and a half. Moreover, applications to refinance existing mortgages jumped to record levels last month. Given that refinance applications lead originations by about five weeks and that current mortgage rates remain significantly below those on existing mortgages, refinance originations likely will remain at an elevated level well into the current quarter. We expect both equity extraction and lower debt service to continue to provide support for household spending in the period ahead, though the strength of this support is likely to diminish over time. In recent quarters, low mortgage rates have carried new home sales and construction to elevated levels. Sales of new single-family homes through the first five months of this year are well ahead of last year’s record pace. And declines in financing rates on new auto loans to the lowest levels in many years have spurred purchases of new motor vehicles. * * * In addition to balance sheet improvements, the recently passed tax legislation will provide a considerable lift to disposable incomes of households in the second half of the year, even after accounting for some state and local offsets. At this point, most firms have likely implemented the lower withholding schedules that have been released by the Treasury, and advance rebates of child tax credits are being mailed beginning later this month. The Joint Committee on Taxation estimates that these and other tax changes should increase households’ cash flow in the third quarter by $35 billion. Most mainstream economic models predict that such tax-induced increases in disposable income should produce a prompt and appreciable pickup in consumer spending. Moreover, most models would also project positive follow-on effects on capital spending. The evolution of spending over the next few months may provide an important test of the extent to which this traditional view of expansionary fiscal policy holds in the current environment. Much like households, businesses have taken advantage of low interest rates to shore up their balance sheets. Most notably, firms have issued long-term debt and employed the proceeds to pay down commercial paper, bank loans, and other short-term debt. Although rates on commercial paper and bank loans are well below yields on new long-term bonds, firms have evidently judged that now is an opportune time to lock in long-term funding and avoid the liquidity risks that can be associated with heavy reliance on short-term funding. At the same time, the average coupon on outstanding corporate bonds remains considerably above rates on new debt issues, suggesting that firms are well positioned to cut their debt service burdens still further as outstanding bonds mature or are called. The net effect of these trends to date has been a decline in the ratio of business interest payments to net cash flow, a significant increase in the average maturity of liabilities, and a rise in the ratio of current assets to current liabilities. With business balance sheets having been strengthened and with investors notably more receptive to risk, the overall climate in credit markets has become more hospitable in recent months. Specifically, improvements in forward-looking measures of default risk, a decline in actual defaults, and a moderation in the pace of debt-rating downgrades have prompted a marked narrowing of credit spreads and credit default swap premiums. That change in sentiment has extended even to the speculative-grade bond market, where issuance has revived considerably, even by lower-tier issuers that would have been hard-pressed to tap the capital markets over much of the last few years. Banks, for their part, remain well-capitalized and willing lenders. In the past, such reductions in private yields and in the cost of capital faced by firms have been associated with rising capital spending. But as yet there is little evidence that the more accommodative financial environment has materially improved the willingness of top executives to increase capital investment. Corporate executives and boards of directors are seemingly unclear, in the wake of the recent intense focus on corporate behavior, about how an increase in risk-taking on their part would be viewed by shareholders and regulators. As a result, business leaders have been quite circumspect about embarking on major new investment projects. Moreover, still-ample capacity in some sectors and lingering uncertainty about the strength of prospective final sales have added to the reluctance to expand capital outlays. But should firms begin to perceive that the pickup in demand is durable, they doubtless would be more inclined to increase hiring and production, replenish depleted inventories, and bring new capital on line. These actions in turn would tend to further boost incomes and output. Tentative signs suggest that this favorable dynamic may be beginning to take hold. Industrial production, as I indicated earlier, seems to have stabilized, and various regional and national business surveys point to a recent firming in new orders. Indeed, the backlog of unfilled orders for nondefense capital goods, excluding aircraft, increased, on net, over the first five months of this year. Investment in structures, however, continues to weaken. The outlook for business profits is, of course, a key factor that will help determine whether the stirrings we currently observe in new orders presage a sustained pickup in production and new capital spending. Investors’ outlook for near-term earnings has seemed a little brighter of late. The favorable productivity trend of recent years, if continued, would certainly bode well for future profitability. Output per hour in the nonfarm business sector increased 2-1/2 percent over the year ending in the first quarter. It has been unusual that firms have been able to achieve consistently strong gains in productivity when the overall performance of the economy has been so lackluster. To some extent, companies under pressure to cut costs in an environment of still-tepid sales growth and an uncertain economic outlook might be expected to search aggressively for ways to employ resources more efficiently. That they have succeeded, in general, over a number of quarters suggests that a prior accumulation of inefficiencies was available to be eliminated. One potential source is that from 1995 to 2000 heavy emphasis on new and expanding markets likely diverted corporate management from tight cost controls whose payoffs doubtless seemed small relative to big-picture expansion. However, one consequence of these improvements in efficiency has been an ability of many businesses to pare existing workforces and still meet increases in demand. Indeed, with the growth of real output below that of labor productivity for much of the period since 2000, aggregate hours and employment have fallen, and the unemployment rate rose last month to 6.4 percent of the civilian labor force. * * * Although forward-looking indicators are mostly positive, downside risks to the business outlook are also apparent, including the partial rebound in energy costs and some recent signs that aggregate demand may be flagging among some of our important trading partners. Oil prices, after dropping sharply in March on news that the Iraqi oil fields had been secured, have climbed back above $30 per barrel as market expectations for a quick return of Iraqi production appear to have been overly optimistic given the current security situation. Also worrisome is the rise in natural gas prices. Natural gas accounts for a substantial portion of total unit energy costs of production among nonfinancial, non-energy-producing firms. And as I noted in testimony last week, futures markets anticipate that the current shortage in natural gas will persist well into the future. Although they project a near-term modest decline from highly elevated levels, contracts written for delivery in 2009 in excess of $4.50 per million Btu are still at double the levels that had been contemplated when much of our existing gas-using capital stock was put in place. The timing and extent of the pickup in economic activity in the United States will also depend on global developments. Lethargic growth among many of our important global trading partners is posing some downside risk to the U.S. economic outlook. As has been true for some time, Japan’s economy remains in difficult straits, burdened by a weak banking sector and an ongoing deflation, although recent data have seemed somewhat less negative. Economic activity in many European countries especially Germany - has been soft of late and has been accompanied by a decline in inflation to quite low levels. While Japan and Europe should benefit from global economic recovery, the near-term weakness remains a concern. * * * Inflation developments have been important in shaping the economic outlook and the stance of policy over the first half of the year. With the economy operating below its potential for much of the past two years and productivity growth proceeding apace, measures of core consumer prices have decelerated noticeably. Allowing for known measurement biases, these inflation indexes have been in a neighborhood that corresponds to effective price stability - a long-held goal assigned to the Federal Reserve by the Congress. But we can pause at this achievement only for a moment, mindful that we face new challenges in maintaining price stability, specifically to prevent inflation from falling too low. This is one reason the FOMC has adopted a quite accommodative stance of policy. A very low inflation rate increases the risk that an adverse shock to the economy would be more difficult to counter effectively. Indeed, there is an especially pernicious, albeit remote, scenario in which inflation turns negative against a backdrop of weak aggregate demand, engendering a corrosive deflationary spiral. Until recently, this topic was often regarded as an academic curiosity. Indeed, a decade ago, most economists would have dismissed the possibility that a government issuing a fiat currency would ever produce too little inflation. However, the recent record in Japan has reopened serious discussion of this issue. To be sure, there are credible arguments that the Japanese experience is idiosyncratic. But there are important lessons to be learned, and it is incumbent on a central bank to anticipate any contingency, however remote, if significant economic costs could be associated with that contingency. The Federal Reserve has been studying how to provide policy stimulus should our primary tool of adjusting the target federal funds rate no longer be available. Indeed, the FOMC devoted considerable attention to this subject at its June meeting, examining potentially feasible policy alternatives. However, given the now highly stimulative stance of monetary and fiscal policy and well-anchored inflation expectations, the Committee concluded that economic fundamentals are such that situations requiring special policy actions are most unlikely to arise. Furthermore, with the target funds rate at 1 percent, substantial further conventional easings could be implemented if the FOMC judged such policy actions warranted. Doubtless, some financial firms would experience difficulties in such an environment, but these intermediaries have exhibited considerable flexibility in the past to changing circumstances. More broadly, as I indicated earlier, the FOMC stands ready to maintain a highly accommodative stance of policy for as long as it takes to achieve a return to satisfactory economic performance.
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board of governors of the federal reserve system
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Speech by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, before the Economics Roundtable, University of California, San Diego, La Jolla, 23 July 2003
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Ben S Bernanke: An unwelcome fall in inflation? Speech by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, before the Economics Roundtable, University of California, San Diego, La Jolla, 23 July 2003. The references for the speech can be found on the Board of Governors of the Federal Reserve System’s website. * * * Achieving and maintaining price stability is the bedrock principle of a sound monetary policy. Price stability promotes economic growth and welfare by increasing the efficiency of the market mechanism, facilitating long-term planning, and minimizing distortions created by the interaction of inflation and the tax code, accounting rules, financial contracts, and the like. Price stability also increases economic welfare by promoting stability in output and employment. In particular, the marked decline in the variability of both inflation and output in recent decades, not only in the United States but also in most of the rest of the world, is by no means an accident. A significant portion of this improved performance has resulted from a reorientation of central bank policies toward a greater emphasis on keeping inflation low and stable. These policies have helped to anchor the public’s inflation expectations at a low level, which has not only helped to contain inflation but has also given central banks greater latitude to stabilize the real economy with less concern than in the past about potential inflationary consequences. Since the inflation crisis of the 1970s, the Federal Reserve has consistently pursued the goal of price stability in the United States. And not too long ago, something remarkable happened--the goal was achieved! Core inflation measures (that is, measures of inflation that exclude the prices of the relatively volatile food and energy components) now lie in the general range of 1 to 2 percent per year, which (taking into account factors such as measurement biases in inflation indexes) is probably the de facto equivalent of price stability. Attaining price stability is an important accomplishment, one of which my predecessors on the Federal Open Market Committee (FOMC) can justifiably be proud. But this development has also forced the Federal Reserve--as well as the public--to reorient its thinking about inflation in a fundamental way. After a long period in which the desired direction for inflation was always downward, we are now in a situation in which risks to the inflation rate can be either upward, toward excessive inflation, or downward, toward too-low inflation or deflation. As many of you are aware, the Federal Reserve officially recognized this new situation in its balance-of-risks statement issued at the close of the FOMC meeting this past May 6. That statement was the first to assess the risks to economic activity and inflation separately, recognizing explicitly that upside and downside risks to inflation could exist under varying conditions of the real economy. Previous FOMC statements had characterized the balance of risks one-dimensionally, as being either in the direction of economic weakness or in the direction of excessive inflation. The May 6 statement was more than a procedural innovation; it also broke new ground as the first occasion in which the FOMC expressed the concern that inflation might actually fall too low. Let me repeat the critical portion of the statement for you: “Although the timing and extent of [the] improvement remain uncertain, the Committee perceives that over the next few quarters the upside and downside risks to the attainment of sustainable growth are roughly equal. In contrast, over the same period, the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level. The Committee believes that, taken together, the balance of risks to achieving its goals is weighted toward weakness over the foreseeable future.” Though terse, the FOMC’s statement--and the subsequent statement after the June meeting, which contained similar language--evoked powerful reactions in the media and in the financial markets. Notably, since the May 6 statement, the concept of deflation has commanded wide public attention for the first time in many decades. Moreover, long-term government bond yields have fluctuated sharply, falling to unusually low levels immediately after May 6 but rising more recently as bond market participants have reacted both to Fed pronouncements and to incoming economic data. Today I would like to share my own thoughts on the prospect of an “unwelcome substantial fall in inflation”--in particular, why a substantial fall in inflation going forward would indeed be unwelcome; why some risk of further disinflation, though “minor,” should not be ignored; and what such a fall would imply for the conduct of monetary policy. Obviously, the opinions I will express are strictly my own and are not necessarily those of my colleagues on the Federal Open Market Committee or the Board of Governors of the Federal Reserve System. Why a fall in inflation would be unwelcome After a decades-long war on inflation--dubbed “public enemy number one” in some public opinion polls in the 1970s--imagining that a “substantial fall in inflation” would be unwelcome seems just a bit strange. Why does this risk, minor though it may be, concern the Fed? Let’s first be clear what we are talking about. Some in the media apparently interpreted the May 6 statement as saying that the Federal Reserve anticipated imminent deflation in the United States and informed the public accordingly. In my view, such an interpretation substantially overstates the concerns that the FOMC intended to communicate with its statement. First, we have no reason to think that a drastic change in the inflation rate is imminent. Should further declines occur, a more gradual downward drift over a period of one to two years would be the more likely scenario. Second, nowhere did the statement refer specifically to deflation (that is, to a decline in the general price level); rather, the reference was, again, to a “substantial fall in inflation.” In the present circumstances, a disinflation (a decline in the rate of inflation) and a deflation (a falling price level) are not necessarily the same thing. Inflation could decline somewhat from present levels and still remain positive, although it is true that the lower the inflation rate goes, the greater is the risk of actual deflation at some future time. This distinction between inflation that is positive yet too low and deflation is worth exploring for a moment. Although the Federal Reserve does not have an explicit numerical target range for measured inflation, FOMC behavior and rhetoric have suggested to many observers that the Committee does have an implicit preferred range for inflation. Most relevant here, the bottom of that preferred range clearly seems to be a value greater than zero measured inflation, at least 1 percent per year or so. Both the apparent tendency of measured inflation to overstate the true rate of price increase, as suggested by a range of studies, and the need to provide some buffer against accidental deflation serve as rationales for aiming for positive (as opposed to zero) measured inflation, both in the short run and in the long run. To the extent that one accepts the view that measured inflation should be kept some distance above zero, a very low positive measured rate of inflation (say, 1/2 percent to 1 percent per year) is undesirable and implies a need for highly accommodative monetary policy, just as would be required for outright deflation. The language of the May 6 statement encompasses the risks of both very low inflation and deflation. I suspect that for the foreseeable future, of the two, the risk of very low but positive inflation is considerably the greater. That is, inflation in the range of 1/2 percent per year in the United States in the next couple of years, though relatively unlikely, is considerably more likely than deflation of 1/2 percent per year. Having drawn a distinction between very low inflation and deflation, however, I must also point out that, in terms of their costs to the economy, no sharp discontinuity exists at the point that measured inflation changes from positive to negative values. Very low inflation and deflation pose qualitatively similar economic problems, though the magnitude of the associated costs can be expected to increase sharply as deflationary pressures intensify. What are these costs? In practice, the potential harm of very low inflation or deflation depends importantly on the economic environment in which it occurs. For example, deflation can be particularly harmful when the financial system is already fragile, with household and corporate balance sheets in poor condition and with banks undercapitalized and heavily burdened with nonperforming loans. Under such circumstances, deflation or unexpectedly low inflation, by increasing the real burden of debts, may exacerbate financial distress and cause further deterioration in the functioning of the financial markets. This process of “debt deflation” (a term coined by the early twentieth-century American economist Irving Fisher) was important in the U.S. deflation and depression of the 1930s and may have played an important role in the economic problems of contemporary Japan. Fortunately, I would like to thank members of the Board staff for valuable assistance, particularly Flint Brayton, Deb Lindner, David Reifschneider, and Jeremy Rudd. financial conditions in the United States today are sound, not fragile. Both households and firms have done excellent jobs during the past few years of restructuring and rationalizing their balance sheets. For example, households have taken advantage of low interest rates to refinance their mortgages, in the process both lowering their monthly house payments and using accumulated equity to pay off more expensive forms of consumer debt, such as credit card debt. Likewise, firms have lengthened the maturities of their debts, lowered their interest-to-earnings ratios, and improved their liquidity. Completing the picture, the U.S. banking system is highly profitable and well-capitalized and has managed credit risk over the latest cycle exceptionally well. Thus, in my view, a deflation that was relatively limited in magnitude and duration would be unlikely to have serious adverse effects on the U.S. financial system. A second set of circumstances in which deflation or very low inflation may pose significant problems is potentially more relevant to the current U.S. economy. That situation is one in which aggregate demand is insufficient to sustain strong growth, even when the short-term real interest rate is zero or negative. Deflation (or very low inflation) poses a potential problem when aggregate demand is insufficient because deflation places a lower limit on the real short-term interest rate that can be engineered by monetary policymakers. This limit is a consequence of the well-known zero-lowerbound constraint on nominal interest rates. For example, if prices are falling at a rate of 1 percent per year, the short-term real interest rate cannot be reduced below 1 percent, since doing so would require setting the nominal interest rate below zero, which is impossible. (Likewise, the very low inflation rate of 1/2 percent would prevent setting the real interest rate lower than minus 1/2 percent.) Thus, in a situation of insufficient aggregate demand, deflation or very low inflation might prevent the Fed from achieving full employment, at least by means of the Fed’s traditional policy tool of changing the short2 term nominal interest rate. In the worst-case scenario, one might worry that the interaction of deflation, the short-term nominal interest rate, and aggregate demand could conceivably touch off a destabilizing dynamic. Suppose that initially short-term nominal interest rates were already near zero and prices were falling. If aggregate demand was sufficiently low relative to potential supply, deflation might grow worse, as economic slack led to more aggressive wage- and price-cutting. Because the short-term nominal interest rate cannot be reduced further, worsening deflation would raise the real short-term interest rate, effectively tightening monetary policy. The higher real interest rate might further reduce aggregate demand, exacerbating the deflation and continuing the downward spiral. That, at least, is the theoretical possibility. Fortunately, in practice, even if the Fed’s ability to influence aggregate demand was weakened by the interaction of worsening deflation and the zero-bound constraint on nominal interest rates, other factors could serve to short-circuit any incipient downward spiral. First, even in the presence of deflation, aggregate demand can be raised by fiscal actions. Second, the link between excess capacity in the economy and increased deflation, essential to this story, is not hard and fast. For example, despite a decade of economic weakness in Japan, deflation there has remained relatively stable at less than 1 percent per year; it has not worsened over time, as the “deflationary spiral” scenario would imply. Third, if inflation expectations remain well anchored, the real return expected by borrowers and lenders--equal to the nominal interest rate less expected inflation-need not rise even as inflation declines. Finally, as I have discussed in earlier talks and will allude to again today, the Fed’s tools for managing aggregate demand are not limited to control over the shortterm nominal interest rate, but include other channels as well. In any case, I hope we can agree that a substantial fall in inflation at this stage has the potential to interfere with the ongoing U.S. recovery, and that in conceivable--though remote--circumstances, a serious deflation could do significant economic harm. Thus, avoiding a further substantial fall in inflation should be a priority of monetary policy. To my mind, the central import of the May 6 statement is that the Fed stands ready and able to resist further declines in inflation; and--if inflation does fall further--to ensure that the decline does not impede the recovery in output and employment. Even when the zero bound is not binding, a fall in the rate of inflation raises real interest rates, thereby eroding the effects of any previous monetary easing. A further fall in inflation: what is the likelihood? What, then, is the likelihood of a further, possibly substantial fall in inflation? And, in particular, why worry about further disinflation when financial markets and forecasters seem moderately optimistic about economic recovery in the United States? As a starting point, we should note that underlying inflation has declined noticeably in the past year or so. Let me cite a few numbers, focusing on core inflation measures, which I remind you are defined to exclude the relatively more volatile food and energy prices. According to numbers just released, inflation as measured by the core consumer price index, or CPI, was 1.5 percent in the year ending June 2003, compared with 2.3 percent in the year ending June 2002, a deceleration of 0.8 percentage points over the year. Inflation as measured by the core personal consumption expenditure (PCE) price index, a so-called chain-weight index that has the advantage of allowing for shifting expenditure weights, also fell, though less dramatically, from 1.7 percent in the year ending May 2002 to 1.2 percent in the year ending May 2003 (June data are not yet available), a fall of 0.5 percentage points. These inflation rates, though declining (and they have declined a bit more in the past six months), remain generally above the 1 percent “buffer zone,” and it is always possible that their recent declines will prove to be short-lived. Nevertheless, watchfulness is certainly warranted. Where is inflation likely to go over the foreseeable future? Medium-term inflation forecasting is highly contentious--not least because the underlying theory of the determination of inflation continues to divide macroeconomic schools of thought--and I cannot begin to do justice to the topic in a short talk. The Board staff, for example, uses an eclectic approach that includes a number of components, including data analysis, statistical techniques, a suite of econometric models, and judgment. However, much of the analytic framework used by the staff and other leading forecasters can be summarized by an expectations-augmented Phillips curve, of the type implied by the work of Friedman (1968) and Phelps (1969), further augmented by measures of “supply shocks,” as suggested for example by the work of Robert Gordon (for a recent application, see Gordon, 1998). This model is familiar from many textbook treatments. In addition, most variants of the model include dynamic elements, in order to capture aspects of expectations formation, multi-year contracts, and other factors. According to this class of models, inflation in the intermediate term is affected primarily by four factors: 1. Economic slack. If aggregate demand is below potential output, implying a positive output gap, the rate of increase in labor compensation and other input costs should slow, firms should be less able to pass price increases, and thus inflation should slow. 2. Inflation expectations. All else being equal, higher expected rates of inflation will intensify pressure for increases in wages and other costs and thus raise actual inflation. The objectives and performance of monetary policymakers over the long run are key determinants of these expectations. 3. Supply shocks, such as changes in energy prices, food prices, or import prices. Some supply shocks, such as shocks to import prices other than those of food and energy, affect core inflation directly. Shocks to the prices of energy or food may affect core inflation if they become embodied in inflation expectations or if they boost core prices indirectly by raising the costs of inputs in the production of non-energy, non-food goods and services. Part of the reason that core PCE inflation fell less than CPI inflation is that the PCE index includes so-called nonmarket prices--prices that are imputed by the Bureau of Economic Analysis because reliable market data are not available--and nonmarket prices have been trending upward lately. Indeed, the market-based portion of core PCE inflation for the year ending in May was only 0.7 percent. The success of the Board staff in forecasting inflation is well documented (Romer and Romer, 2000; Sims, 2002). Much of this success comes from intensive data analysis (including computing projections of many components of the important price indexes, using a wide variety of data and anecdotal information) that leads to highly accurate short-term inflation forecasting. Since inflation tends to be inertial, “getting the initial conditions right” is important for medium-term forecasting success (Sims, 2002). Another important element of successful inflation forecasting, at the Board and elsewhere, is the use of a wide range of information in forming the forecast. Cecchetti, Chu, and Steindel (2000) show that single indicators, such as unemployment or the money supply, are unlikely to be reliable forecasters of inflation. Purely statistical forecasting methods based on multiple indicators have been developed by Stock and Watson (1999), among others. The Chicago Fed National Activity Index, an index of eighty-five economic indicators, is based on the Stock-Watson work and has been used to forecast both inflation and economic activity (Fisher, 2000; Evans, Liu, and Pham-Kanter, 2002). 4. Inflation persistence. Many economists have argued that inflation tends to be persistent, or “sticky,” perhaps for institutional reasons related to the process of wage determination, supply contracts, and the like. Hence, current trends in inflation can be expected to persist. Of course, this model, like any model, will have an error term, which represents a portion of the behavior of inflation that we can’t reliably explain or predict. Historically, the error terms of estimated inflation models have tended to be large relative to the overall variability of inflation, implying that inflation is more difficult to forecast than we would like. This difficulty of forecasting inflation has important implications, as we shall see. You may have noted that I did not include money growth in this list of inflation determinants. Ultimately, inflation is a monetary phenomenon, as suggested by Milton Friedman’s famous dictum. However, no contradiction exists, as the expectational Phillips curve is fully consistent with inflation’s being determined by monetary forces in the long run. This point, originally made by Friedman himself, has been demonstrated in many textbooks and so I will not discuss it further here. I only note that, as an empirical matter, instabilities in money demand, financial innovation, and many special factors affecting the monetary aggregates make them relatively poor predictors of inflation at medium-term horizons. For this reason, the role of the money supply remains implicit in this discussion. Within this framework for thinking about price dynamics, the factor most likely to exert downward pressure on the future course of inflation in the United States is the degree of economic slack that is currently prevailing and will likely continue for some time yet. Although (according to the National Bureau of Economic Research) the U.S. economy is technically in a recovery, job losses have remained significant this year, and capacity utilization in the industrial sector (the only sector for which estimates are available) is still low, suggesting that resource utilization for the economy as a whole is well below normal. By conventional analyses, therefore, even if the pace of real activity picks up considerably this year and next, persistent slack might result in continuing disinflation. A highly simplified, though not quantitatively unreasonable, calculation may help. Let us suppose that economic activity does pick up in the second half of this year, by enough to bring real GDP growth in line with its long-run potential growth rate--roughly 3 percent or so, by conventional estimates. Moreover, suppose that activity strengthens further next year so, so that real GDP growth climbs to approximately 4 percent, a full percentage point above potential. What will happen to resource utilization and inflation? Focusing first on the implications for economic slack, we note that this projected path for real GDP gap would imply no change in the output gap through the end of this year, followed by a percentage point reduction in the output gap during 2004. Given the average historical relationship between the change in the output gap and labor market conditions, known as Okun’s Law, the unemployment rate would be expected to remain at about its current level of 6.4 percent through the end of the year and then decline gradually to about 6.0 percent by the end of next year. This projection is fairly close to many private-sector forecasts. Let us turn now to the implications for inflation. From 1994 to 2002, core PCE inflation remained in a stable range while the unemployment rate averaged about 5 percent; so let us suppose, for purposes of this example, that the unemployment rate at which inflation is stable is 5 percent. (If the unemployment rate at which inflation is stable is lower than 5 percent, the disinflation problem I am discussing becomes larger.) A little arithmetic shows that this scenario involves 1.9 point-years of extra unemployment (relative to the full-employment benchmark) between now and the end of 2004. Now make the additional assumption that the sacrifice ratio (the point-years of unemployment required to reduce inflation by 1 point) is 4.0, a high value by historical standards but one in the range of many current estimates. Then the additional disinflation between now and the end of next year should be about 1.9 divided by 4, or about 0.5 percentage points. So given our assumptions about GDP growth, core PCE inflation, say, might fall from 1.2 percent currently to 0.7 percent or so by the end of 2004. Atkeson and Ohanian (2001) criticized the idea that measures of economic slack are useful for forecasting inflation. They showed that, for the sample period 1984-99, three statistical models that included measures of slack were no better on average at predicting inflation than the “naïve” alternative of guessing that inflation next year would be the same as inflation this year. They make a similar finding when comparing the naïve forecast to Board staff inflation forecasts (which incorporate an economic slack concept). However, the Atkeson-Ohanian results, it turns out, are dependent on their choice of sample period, a period that included only one relatively moderate recession. Extending their sample period to include additional recessions (or, for that matter, using alternative measures of inflation) tends to overturn their main results (see, for example, Sims, 2002). The precise figures I have used in this exercise should be taken with more than a few grains of salt. But the bottom line (which would not be much affected if we played around with the numbers) is that, even if the economy recovers smartly for the rest of this year and next, the ongoing slack in the economy may still lead to continuing disinflation. So the FOMC’s May 6 statement, by indicating both balanced risks to economic growth (that is, a reasonable chance of a good recovery) and a downward risk to inflation, had no internal inconsistency. Now, further disinflation of half a percentage point in conjunction with a significant strengthening of the real economy would not pose a significant problem. But of course, the simple scenario I just outlined has risks. If the recovery is significantly weaker than we hope, for example, the greater level and persistence of economic slack could intensify disinflationary pressures at an inopportune time. Another possibility, given the uncertainty inherent in measures of potential output, is that the amount of effective slack currently in the economy is greater than most analysts think--which, if true, would help to explain the recent pace of disinflation. There are good reasons not to discount this possibility. For example, during the late 1990s, economists worked hard to explain the combination of an unusually low unemployment rate and stable inflation--possible evidence of a decline in the economy’s sustainable unemployment rate. Factors that were thought to have contributed to a lower sustainable rate of unemployment included the maturation of the labor force (Shimer, 1998); increased numbers of people on disability insurance (Autor and Duggan, 2002) and increased rates of incarceration (Katz and Krueger, 1999), both of which tended to remove less employable individuals from the labor force; improved matching between workers and jobs, facilitated by increased access to the Internet and the rise of temporary help agencies (Katz and Krueger, 1999); and perhaps other factors as well. Many of these forces continue to operate in today’s economy, conceivably with greater force than in the late 1990s. In addition, measured labor productivity has continued to increase rapidly since early 2001--remarkably so, considering that productivity tends to be strongly procyclical--raising the possibility that we have underestimated the degree to which innovation and better use of existing resources have increased potential output. If so, the true level of slack in the economy is higher than conventional estimates suggest, implying that incipient disinflationary pressures may be more intense. Of the various elements that make up the expectations-augmented Phillips curve, the degree of economic slack is the one currently providing the greatest impetus for further disinflation. By contrast, other elements of this conventional framework offer somewhat more reason to hope that inflation will instead stabilize at current levels or fall only slightly. In particular, as best we can tell, the public’s inflation expectations have not declined very much, particularly at longer horizons. For example, according to the University of Michigan’s Survey Research Center, the median respondent’s expectation of inflation over the next twelve months fell from 2.5 percent in January 2003 to 2.1 percent in June; however, the median expectation for inflation for the next five to ten years was 2.7 percent in both January and June. Inflation compensation at the five-year horizon as measured by indexed government bonds has cycled up and down recently but has averaged about 1.5 percent since early 2001. Interpretation of all these measures of expected inflation is made more difficult by the fact that they are defined for total (as opposed to core) CPI inflation and hence presumably are affected by fluctuations in energy prices. Nevertheless, the evidence thus far does not support the view that there has been a significant break in medium-term inflation expectations. Supply shocks are another element of the modern Phillips curve framework. In this category the most relevant current factor is probably the recent decline in the exchange value of the dollar. For a various reasons, including the limited pass-through of price increases by foreign producers and uncertainties about the future course of the dollar, the dollar’s fall is likely to have only a modest effect on the inflation rate; but any effect it has should work against further disinflation. Overall, the stabilizing effects of well-anchored inflation expectations and the slightly inflationary effect of the dollar depreciation are two reasons to expect whatever disinflation takes place to be reasonably gradual. Some economists argued that the tendency of real wages to lag behind the unexpectedly strong productivity gains of the 1990s also reduced sustainable unemployment during that period (Ball and Moffitt, 2001; see also Braun, 1984). To the extent this argument was valid, presumably this factor is less relevant today, because productivity growth has moderated somewhat and has probably become more fully incorporated into the wage determination process. Preliminary July figures show a drop in the 12-month median inflation expectation to 1.7 percent. However the long-term inflation expectation edged up in July to 2.8 percent. One more element of the model for inflation is important to mention: the error term. At the upcoming August meeting, the Board staff, as it always does, will present the FOMC with its forecasts for inflation. Based on historical experience (using actual staff forecasts for 1985-97), the staff’s forecast for CPI inflation for the full year 2003 (that is, the current year) will prove fairly accurate; the confidence interval for that forecast, as measured by the root mean squared error, will be only 0.3 percentage points. However, if history is a guide, the forecast the staff provides next month for CPI inflation during 2004 will have a confidence interval of about 1.0 percentage points, a fairly wide range. This amount of uncertainty is no reason to be defeatist about trying to forecast inflation but it is a reason to be cautious. We are currently in a range where undershooting our inflation objective by 1 percentage point is more costly than overshooting by 1 percentage point. All else being equal, that fact should put us on our guard against unwanted further declines in inflation. Implications for monetary policy In summary, there appears to be some possibility that the recent trend toward disinflation will continue, primarily because of the potentially large amount of economic slack in the system. Stable expectations of inflation and the recent weakening of the dollar may help to offset that tendency. In any case, we must keep in mind that the uncertainty regarding our forecasts of inflation is significant. What are the implications for monetary policy of these observations? First, as the May 6 statement made clear, for the foreseeable future the risk of further declines in inflation from an already low level outweighs the risk of a resurgence of inflation. Hence, monetary ease appears to be indicated for a considerable period. Of course, an extended period of ease dovetails well with the FOMC’s objective of supporting a strong and self-sustaining recovery in output and employment. The form that this continued ease will take depends on developing conditions. Keeping the federal funds rate target at or near its current level for an extended period may be sufficient. Alternatively, as Chairman Greenspan testified last week, we could certainly cut the rate from where it is now. In my view, though recognizing that such an action imposes costs on savers and some financial institutions, we should be willing to cut the funds rate to zero, should that prove necessary to provide the required support to the economy. Should the funds rate approach zero, the question will arise again about so-called nontraditional monetary policy measures. I first discussed some of these measures in a speech last November (Bernanke, 2002). Thanks in part to a great deal of fine work by the staff, my understanding of these measures and my confidence in their success have been greatly enhanced since I gave that speech. Without going into great detail, I see the first stages of a “nontraditional” campaign as focused on lowering longer-term interest rates. The two principal components of that campaign would be a commitment by the FOMC to keep short-term yields at a very low level for an extended period (I’ll say more about this in a moment) together with a set of concrete measures to give weight to that commitment. Such measures might include, among others, increased purchases of longer-term government bonds by the Fed, an announced program of oversupplying bank reserves, term lending through the discount window at very low rates, and the issuance of options to borrow from the Fed at low rates. I am sure that the FOMC will release more specific information if and when the need for such approaches appears to be closer on the horizon. I motivated today’s talk by reference to the May 6 statement. Let me end the talk by discussing the role of such statements in both traditional and nontraditional monetary policy. A crucial element of the statement was an implicit commitment about future monetary policy; namely, a strong indication that, so long as a substantial fall in inflation remains a risk, monetary policy will maintain an easy stance. Particularly at very low inflation rates, a central bank’s ability to make clear and credible commitments about future policy actions--broadly, how it plans to adjust the short-term interest rate as economic conditions change--is crucial for influencing longer-term interest rates and other asset prices, which are themselves key transmission channels of monetary policy (Eggertsson and Woodford, 2003). The question is, then, how can the Fed sharpen the communication of its policy commitments? For example, how could the Fed be more precise about how long it will maintain monetary ease or about the conditions under which it would change its policy? In my view--and here I am quite obviously speaking for myself--one useful approach would be for the FOMC to provide the public with a quantitative, working definition of price stability. The definition of price stability would be expressed as a range of measured inflation, with the lower boundary of the range a safe distance from zero. What I have in mind here is not a formal inflation target but rather a tool for aiding communication. The main purpose of this quantification of price stability would be to provide some guidance to the public and to financial markets as they try to forecast FOMC behavior. In a situation like the current one, with inflation presumably near the bottom of the acceptable range and trending down, and with considerable slack remaining in the real economy, the Fed could make use of this quantitative guidepost to signal its expectation that rates will be kept low for a protracted period, and indeed that they would be reduced further if disinflation were not contained. If private-sector forecasts also called for disinflation, confirming the downward risk to price stability, then medium-term bond yields should accordingly be low, supporting the Fed’s reflationary efforts. In principle, one could communicate a similar message, though perhaps less precisely, without a quantitative measure of price stability. What is missing from the purely qualitative communication approach, however, is an exit strategy. At some point in the future, if all goes well, inflation will stabilize, and interest rates will begin to rise. The task of communicating the timing of that switch to markets with a minimum of confusion and uncertainty is crucial and difficult. A quantitative measure of price stability provides one objective basis that bond market participants could use to help forecast the change in policy stance. For example, they would know that as disinflation risk recedes and inflation forecasts begin to cluster in the middle to upper portions of the price stability range, the Fed is quite likely to react. And, indeed, the forecasts of bond market participants and the resulting rise in private yields will help to contain inflation, doing some of the Fed’s work for it. In closing, for me the lesson of the May 6 statement was to underscore the vital importance of central bank communication. In a world in which inflation risks are no longer one-sided and short-term nominal interest rates are at historical lows, the success of monetary policy depends more on how well the central bank communicates its plans and objectives than on any other single factor. Ideally, the FOMC would specify the inflation range and price index only after careful staff work to analyze the economy’s operating characteristics under various alternatives. In particular, in keeping with the Fed’s dual mandate, both employment and inflation performance should be analyzed.
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board of governors of the federal reserve system
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Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the Annual Meeting ...
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Susan S Bies: Effective corporate governance and the role of counsel Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the Annual Meeting of the American Bar Association, San Franciso, California, 10 August 2003. * * * Good morning. Thank you for the invitation to speak to the American Bar Association about a subject that has been in the spotlight in the business community the past two years. This morning I would like to make a few remarks about the role that legal counsel and other professionals should play in ensuring effective corporate governance. The problems associated with companies such as Enron, HealthSouth, and WorldCom, to name a few, have caused lawmakers, regulators, managers, and directors to dramatically increase their attention to internal controls, accounting policies, risk management, and corporate governance procedures. At government agencies, a great deal of time and effort has gone into reviewing and clarifying standards of how companies should implement these basic functions. Within industry, corporate leaders have worked to enhance existing controls and procedures to address these areas. Much has been accomplished, but still more needs to be done in today's changing environment. Some of the most high-profile problems reported in the media have caused us to step back and ask, “How did this happen?” We've seen some astonishing corporate governance and internal control breakdowns in companies that exhibited no outward indication of serious problems. In some cases it appears that critical internal controls were treated as very low priorities or simply ignored altogether. In a number of cases, regulatory or law enforcement actions precipitated the very active involvement of rafts of highly capable outside professionals, including auditors, consultants, and attorneys, to investigate and address the identified issues. It is fair to ask why those resources and expertise were absent earlier in the risk-management processes, when more diligent attention to fundamental principles could have helped companies and their shareholders avoid serious reputational and financial harm. I would like to talk about the role the legal community can play in ensuring that the important basic elements of risk management and internal controls are effectively addressed on a proactive basis, rather than after problems arise. First I will describe some problems we have recently seen at financial institutions. Then I will provide a suggested framework for effective internal controls and compliance in the context of good corporate governance. Finally, I will outline some specific enforcement actions we have recently taken that relate to effective legal and reputational risk management. Examples of some current problems at financial institutions As a member of the Federal Reserve Board and the Chair of the Board's Committee on Supervisory and Regulatory Affairs, I've seen several problem situations recently that have been the result of weak internal control environments, poor accounting practices, inadequate corporate governance mechanisms, or less-than-thorough risk-management procedures. Here are some examples of notable recent situations that have come to our attention and in some instances to the attention of the press and the public. These particular fact patterns relate to financial institutions, but the underlying corporate governance issues have wider application. · We have seen instances where inadequate anti-money laundering programs permitted criminals to launder funds through banks. The programs had deficient audit and management oversight, and did not receive an appropriate level of compliance and legal review. · In a couple of cases, failures to segregate duties enabled individuals to commit fraud by entering false information into a bank's books and records or by accessing the general ledger and authorizing fraudulent funds transfers. 1/6 · In one case, grossly inadequate management oversight resulted in the operation of a trading program with numerous phony transactions. This extended over a period of years, causing significant financial losses to the financial institution. · A repeated problem is inadequate management and audit committee oversight of business lines. In one case, this resulted in an institution engaging in transactions with special purpose entities without adequate director knowledge and without effective identification and management of risks. · Despite apparent approval by outside auditors and lawyers, we have seen transactions that elevated form over substance, transgressed accounting rules, created serious reputational and legal risk for the institution and ultimately resulted in serious sanctions. During the subsequent investigations, moreover, facts surfaced that raised serious questions about the independence of the outside professionals engaged to provide crucial advice. · Finally, we have seen banking organizations enter into novel, complex financial transactions, driven almost entirely by business line managers, without adequate review by supporting areas and without full consideration of attendant risks. In the course of our review of these situations, we found that the banking organizations subject to the Board's enforcement actions generally had no hesitation in securing the assistance of experienced and qualified counsel to represent them during the discussions with the Board's supervision and enforcement staff. However, that expertise often was apparently not consulted before the problems became so severe that formal, public corrective action became necessary. This failure raises several questions: Did these financial institutions properly utilize their in-house and outside counsel? Did companies' counsel get involved, did they perform poorly, or did management ignore their advice? Alternatively, are current legal standards and practices inadequate to address the types of problems that are now arising in these very important areas? I don't believe there is a single answer that applies in each case, but as a general matter, we may conclude that in each case the institution failed to give risk management the appropriate attention and resources until it was too late to fix the problems without significant financial or reputational damage. Therefore, a clear priority for companies should be to refocus on the basics of internal controls and risk management, and to review how these basics should be applied from the inception of projects rather than in hindsight. I'd like to mention a few principles of good corporate governance that particularly apply to the effective use of professional expertise, whether in-house or independent. Internal control fundamentals A mainstay of standards on internal controls is the report of the Committee of Sponsoring Organizations (COSO) titled Internal Control--Integrated Framework. The report defines internal control as “a process, effected by an entity's board of directors, management and other personnel, designed to provide reasonable assurance regarding the achievement of…: · effectiveness and efficiency of operations, · reliability of financial reporting, and · compliance with applicable laws and regulations.” The COSO model served as the basis for the internal control assessment and reporting requirements that have applied to depository institutions as part of the Federal Deposit Insurance Corporation Improvement Act since 1991, and that now are broadly applicable to public companies under the Sarbanes-Oxley Act. In July, COSO issued draft guidance on enterprise risk management (ERM), which identifies all of the aspects that should be present in an enterprise risk management framework and describes how they Internal Control--Integrated Framework, available from the American Institute of Certified Public Accountants, Order Department, Harborside Financial Center, 201 Plaza Three, Jersey City, NJ 07311-3881; www.coso.org 2/6 can be implemented. It also identifies the interrelationships between risk and ERM, and the COSO Internal Control framework. The guidance defines enterprise risk management as: …a process, effected by an entity's board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risks to be within its risk appetite, to provide reasonable assurance regarding the achievement of entity objectives. As in-house or outside legal counsel, you are one of the “other personnel” referred to in this definition. As such, you will likely be part of the company's team that will implement ERM. I strongly encourage you to become familiar with your role in this process as outlined in the draft guidance. Since the guidance is currently out for a ninety-day comment period, which ends on October 14, 2003, I also encourage you to provide comment to COSO. The COSO internal control framework provides a comprehensive approach that is versatile enough to apply to organizations of all sizes and complexity. COSO requires all managers to, at least once a year, step back from their other duties and evaluate risks and controls within their scope of authority. Each manager should consider current and planned operational changes, identify risks, determine appropriate mitigating controls, establish an effective monitoring process, and evaluate the effectiveness of those controls. Managers then should report their assessment up the chain of command to the chief executive officer, with each new level of management in turn considering the risks and controls under its responsibility. The results of this process are ultimately reported to the audit committee of the board of directors. In the case of banks with assets greater than $500 million, management publicly reports on its assessment of the effectiveness of controls over financial reporting and the external auditor is required to attest to this self-assessment - a process that soon will be in place for public companies as well. Thus, the process helps managers communicate among themselves and with the board about the dynamic issues affecting risk exposures, risk appetites, and risk controls throughout the company. Risk assessments such as the one outlined in COSO presumably could also be useful in assessing various lines of business when formulating business strategies. But not all corporations and boards consider risk during their annual strategic planning or other evaluation processes. The 2002 survey of corporate directors conducted jointly by the Institute of Internal Auditors and the National Association of Corporate Directors showed that directors were not focusing on risk management. I was surprised to learn that 45 percent of directors surveyed said their organization did not have a formal enterprise risk-management process - or any other formal method of identifying risk. An additional 19 percent said they were not sure whether their company had a formal process for identifying risks. These percentages indicate that some companies have directors who don't understand their responsibilities as the representatives of shareholders. The shareholders of those companies should be asking the directors how they govern an organization without a good understanding of the risks the company is facing and without knowledge of a systematic approach to identifying, assessing, monitoring, and mitigating excessive risk-taking. I trust that none of the directors who participated in the survey were on the board of a financial services company. Although directors are not expected to understand every nuance of every line of business or to oversee every transaction, they do have responsibility for setting the tone regarding their corporations' risk-taking and establishing an effective monitoring program. They also have responsibility for overseeing the internal control processes, so that they can reasonably expect that their directives will be followed. They are responsible for hiring individuals who have integrity and can exercise sound judgment and are competent. In light of recent events, I might add that directors have a further responsibility for periodically determining whether their initial assessment of management's integrity was correct. The COSO framework and the internal controls annual report process can be effective tools for management and the auditor to communicate risks and control processes to the audit committee. Members of that committee should use the reports to be sure business strategy, changing business processes, management reorganizations, and positioning for future growth are conducted within the Copies of the draft may be obtained on the web site at www.erm.coso.org. 3/6 context of a sound system of internal controls and governance. The report should identify priorities for strengthening the effectiveness of internal controls. Indeed, beyond legal requirements, boards of directors of all firms should periodically assess the adherence by management, which has stewardship over shareholder resources, to ethical business practices. They should ask, for example: “Are we getting by on technicalities, adhering to the letter but not the spirit of the law? Are we compensating ourselves and others on the basis of contribution, or are we taking advantage of our positions? Would our reputation be tainted if word of our actions became public?” Legal professionals, whether in-house or outside counsel, can help direct management to focus on these kinds of questions. They can also help ensure that processes are in place for employees to raise ethical and compliance concerns in an environment that protects them from retribution from affected managers. Internal controls over compliance While much of the public attention around Sarbanes-Oxley focuses on the first two areas of the COSO framework - operations and financial reporting, counsel especially should not forget about the third area, “compliance with applicable laws and regulations.” Risk management clearly cannot be effective within a company if we forget about the basics of internal controls. It is worth stating that many of the problems at the heart of those headline cases stemmed from violations of the fundamental tenets of internal control, particularly those pertaining to operational risks. Based on the headlines, it seems that boards of directors, management, auditors, and counsel need a remedial course in Internal Controls 101. As corporations grow larger and more diverse, internal controls become more, not less, important to the ability of management and the board to monitor activity across the company. The basics of internal controls for directors and managers are simple. Directors do not serve full time, so it is important that they establish an annual agenda to focus their attention on the high-risk and emerging-risk areas while ensuring that there are effective preventive or detective controls over the low-risk areas. A board of directors has the responsibility to understand the legal, reputational, and compliance risks facing an organization; legal professionals can assist in identifying those risks, quantifying them, and providing expertise in managing them. Before a company moves into new and higher-risk areas, the boards of directors and management need assurances that the organization's governance practices are sound and effective. Many of the organizations that have seen their reputations tarnished in the past few years have neglected to consider emerging conflicts of interest when the organization adds new products and lines of business. For example, if a customer service or control function must be done in an independent, fiduciary, or unbiased manner relative to other activities, appropriate firewalls must be in place before the product or activity begins. Internal controls and compliance are the responsibility of line managers, who must determine the acceptable level of risk in their line of business and assure themselves that the combination of earnings, capital, and internal controls is sufficient to compensate for the risk exposures. However, supporting functions such as legal, accounting, internal audit, and risk management should independently monitor the control processes to ensure that they are effective and that risks are measured appropriately. The results of these independent reviews should be routinely reported to executive management and boards of directors. Directors should be sufficiently engaged in the process to determine whether these reviews are in fact independent of the operating areas and whether the officers conducting the reviews can speak freely. Where it appears that supporting functions have not been sufficiently involved, directors must demand that management adjust the processes as necessary. If the in-house legal, accounting, or audit staff believes that a supporting function has not been given adequate information or opportunity for consultation, it must bring this deficiency to the attention of the board. Sarbanes-Oxley Act Now let's turn to Sarbanes-Oxley. I am not going to dwell on the specifics of the Act. You most likely already know the details of this important piece of legislation including, in particular, the provisions directly affecting attorneys practicing before the Securities and Exchange Commission. What I'd like to focus on is the purpose of the Act. At its core, the Sarbanes-Oxley Act is a call to return to the basics 4/6 that we have been discussing. Simply stated, the current status quo for corporate governance is unacceptable and must improve. This message is applicable to both public and private companies alike and affects everyone within a company, as well as outside professionals hired by the company. As in-house or independent counsel you should fulfill your duties with the competence, integrity, and independence expected of members of the bar and be sure that any material concerns that you have concerning the company's conduct are raised to appropriate levels within the organization. On a broader level, the role for legal counsel, in-house and outside, also is to ensure that the client understands the messages of Sarbanes-Oxley and that all areas within a company are taking appropriate steps to fulfill their obligations. To accomplish this task, legal professionals must become engaged in the mechanisms of internal controls, ensure that they receive prompt, comprehensive information from management, and have adequate access to the appropriate level of management and the board to be able to offer useful and timely counsel. The role of legal professionals In many recent cases, including the fact patterns I described a little earlier, companies did not take adequate steps to prevent the problem behavior in the first instance, and the companies' accountants, auditors and counsel were not asked to assist, were not able to assist, or were simply not actively engaged in foreseeing, identifying or addressing problems as they developed. As legal representatives to various corporate entities, you are charged with making sure that your clients understand the basic need to put into place strong internal controls, state-of-the art accounting practices, and robust corporate governance systems. You also need to make sure that your clients understand potential corporate and individual liabilities in the event that basic functions are not adequately performed. Professionals such as yourselves can do a number of things to participate in effective corporate governance. When a problem rises to the level of a formal enforcement action, we give institutions a lot of fairly detailed direction on how to improve internal controls and risk management, and professionals generally have a very important role in making these improvements. In some of our recent public actions we have required financial institutions to take steps to ensure that legal and reputational risks are adequately addressed, and these steps all involve or have the potential to involve legal professionals. We have required institutions to establish controls that include the following: · a formal policy that addresses tolerance for legal and reputational risks, including regular reassessments of risk tolerance by appropriate senior management; · procedures for assessing legal and reputational concerns and, where appropriate, escalating them to appropriate levels of senior management; · transaction approval and monitoring procedures that involve all relevant areas, including legal; and that everyone in the process receive complete information about the transaction, including the counterparty's purpose; · appropriate due diligence on control processes at the institution's corporate clients, and procedures for addressing any deficiencies in those processes that could result in increased risk exposure for the institution; · depending on the risk assessment for particular transactions, enhanced review of the overall customer relationship that considers the entire consolidated organization, so that risks are identified and managed on a comprehensive basis and not in silos; and · procedures to ensure that business lines comply fully with company policy for consulting with or obtaining opinions from outside counsel on particular transactions or client relationships. These measures provide a few examples of areas where professionals can and should assist their corporate clients. And it is clear that the timing is essential - almost as important as what to do is when to do it. Institutions cannot allow problems to develop to the point where regulators or law enforcement must identify them. Similarly, legal professionals should be proactive, informed, and engaged, and 5/6 should not confine themselves to a responsive role of addressing problems once they have progressed to a very serious stage. Conclusion In today's environment, regulators, lawmakers and shareholders are looking for providers of legal services to be vigilant on behalf of their clients and to ensure that clients receive the best possible assistance in meeting the standards for corporate governance, compliance, internal controls, and legal and reputational risk management. Your clients will be better served if your work reflects the highest professional standards and you take a proactive approach to help them avoid the financial, reputational and other penalties for failures in corporate governance. 6/6
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board of governors of the federal reserve system
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, 29 August 2003.
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Alan Greenspan: Monetary policy under uncertainty Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, 29 August 2003. * * * Uncertainty is not just an important feature of the monetary policy landscape; it is the defining characteristic of that landscape. As a consequence, the conduct of monetary policy in the United States at its core involves crucial elements of risk management, a process that requires an understanding of the many sources of risk and uncertainty that policymakers face and the quantifying of those risks when possible. It also entails devising, in light of those risks, a strategy for policy directed at maximizing the probabilities of achieving over time our goal of price stability and the maximum sustainable economic growth that we associate with it. Toward that objective, we have drawn on the work of analysts who over the past half century have devoted much effort to improving our understanding of the economy and its monetary transmission mechanism. A critical result has been the identification of a relatively small set of key relationships that, taken together, provide a useful approximation of our economy’s dynamics. Such an approximation underlies the statistical models that we at the Federal Reserve employ to assess the likely influence of our policy decisions. Despite the extensive efforts to capture and quantify these key macroeconomic relationships, our knowledge about many of the important linkages is far from complete and in all likelihood will always remain so. Every model, no matter how detailed or how well designed conceptually and empirically, is a vastly simplified representation of the world that we experience with all its intricacies on a day-to-day basis. Consequently, even with large advances in computational capabilities and greater comprehension of economic linkages, our knowledge base is barely able to keep pace with the everincreasing complexity of our global economy. Given this state of flux, it is apparent that a prominent shortcoming of our structural models is that, for ease in parameter estimation, not only are economic responses presumed fixed through time, but they are generally assumed to be linear. An assumption of linearity may be adequate for estimating average relationships, but few expect that an economy will respond linearly to every aberration. Although some nonlinearities are accounted for in our modeling exercises, we cannot be certain that our simulations provide reasonable approximations of the economy’s behavior in times of large idiosyncratic shocks. Recent history has also reinforced the perception that the relationships underlying the economy’s structure change over time in ways that are difficult to anticipate. This has been most apparent in the changing role of our standard measure of the money stock. Because an interest rate, by definition, is the exchange rate for money against non-monies, money obviously is central to monetary policy. However, in the past two decades, what constitutes money has been obscured by the introduction of technologies that have facilitated the proliferation of financial products and have altered the empirical relationship between economic activity and what we define as money, and in doing so has inhibited the keying of monetary policy to the control of the measured money stock. Another example of ongoing structural change relates to innovations in mortgage finance. This includes the elimination of Regulation Q, the emergence of variable rate loans, the growth of the mortgage-backed securities market, and improvements in the efficiency of the credit application process. These developments appear to have buffered activity in the housing market to some extent from shifts in monetary policy. But some of the same innovations in housing finance have opened new avenues of policy influence on economic behavior. For example, households have been able with Nonetheless, in the tradition of Milton Friedman, it is difficult to disregard the long-run relationship between money and prices. In particular, since 1959 unit money supply, the ratio of M2 to real GDP, has increased at an annual rate of 3.7 percent and GDP prices have risen 3.8 percent per year. (A consistent time-series for M2 is available back to 1959. Among other changes, deposit data at a daily frequency were incorporated in measures of the monetary aggregates as of that date.) increasing ease to extract equity from their homes, and this doubtless has helped support consumer spending in recent years, complementing the traditional effects of monetary policy. *** What then are the implications of this largely irreducible uncertainty for the conduct of monetary policy? A well-known proposition is that, under a very restrictive set of assumptions, uncertainty has no bearing on the actions that policymakers might choose, and so they should proceed as if they know the precise structure of the economy. These assumptions--linearity in the structure of the economy, perfect knowledge of the interest-sensitivity of aggregate spending and other so-called slope parameters, and a very specific attitude of policymakers toward risk--are never met in the real world. Indeed, given our inevitably incomplete knowledge about key structural aspects of our ever-changing economy and the sometimes asymmetric costs or benefits of particular outcomes, a central bank seeking to maximize its probability of achieving its goals is driven, I believe, to a risk-management approach to policy. By this I mean that policymakers need to consider not only the most likely future path for the economy but also the distribution of possible outcomes about that path. They then need to reach a judgment about the probabilities, costs, and benefits of the various possible outcomes under alternative choices for policy. A policy action that is calculated to be optimal based on a simulation of one particular model may not, in fact, be optimal once the full extent of uncertainty in the policymaking environment is taken into account. In general, it is entirely possible that different policies will exhibit different degrees of robustness with respect to the true underlying structure of the economy. For example, policy A might be judged as best advancing the policymakers’ objectives, conditional on a particular model of the economy, but might also be seen as having relatively severe adverse consequences if the true structure of the economy turns out to be other than the one assumed. On the other hand, policy B might be somewhat less effective in advancing the policy objectives under the assumed baseline model but might be relatively benign in the event that the structure of the economy turns out to differ from the baseline. These considerations have inclined Federal Reserve policymakers toward policies that limit the risk of deflation even though the baseline forecasts from most conventional models would not project such an event. *** At times, policy practitioners operating under a risk-management paradigm may be led to undertake actions intended to provide some insurance against the emergence of especially adverse outcomes. For example, following the Russian debt default in the fall of 1998, the Federal Open Market Committee (FOMC) eased policy despite our perception that the economy was expanding at a satisfactory pace and that, even without a policy initiative, was likely to continue to do so. We eased policy because we were concerned about the low-probability risk that the default might severely disrupt domestic and international financial markets, with outsized adverse feedback to the performance of the U.S. economy. The product of a low-probability event and a severe outcome, should it occur, was judged a larger threat than the possible adverse consequences of insurance that might prove unnecessary. The cost-or premium--of the financial-contagion insurance was the associated increase in the risk of higher inflation at some future date. This cost was viewed as relatively low at the time, largely because increased competition, driven by globalization, thwarted employers’ ability to pass through higher labor costs into prices. Given the Russian default, the benefits of the unusual policy action were deemed to outweigh its costs. Such a cost-benefit analysis is an ongoing part of monetary policy decisionmaking, and tips more toward monetary ease when the fallout from a contractionary event such as the Russian default seems increasingly likely and its occurrence seems especially costly. Conversely, in 1979, with inflation threatening to get out of control, the cost to the economy of a major withdrawal of liquidity was judged far less than the potential long-term consequences of leaving accelerating prices unaddressed. William Brainard, “Uncertainty and the Effectiveness of Monetary Policy,” American Economic Review, May 1967, pp. 411-25. See minutes of the FOMC meeting of September 29, 1998. *** In implementing a risk-management approach to policy, we must confront the fact that only a limited number of risks can be quantified with any confidence. And even these risks are generally quantifiable only if we accept the assumption that the future will replicate the past. Other risks are essentially unquantifiable--representing Knightian uncertainty, if you will--because we may not fully appreciate even the full range of possibilities, let alone each possibility’s likelihood. As a result, risk management often involves significant judgment on the part of policymakers, as we evaluate the risks of different events and the probability that our actions will alter those risks. For such judgment, we policymakers, rather than relying solely on the specific linkages expressed in our formal models, have tended to draw from broader, though less mathematically precise, hypotheses of how the world works. For example, inference of how market participants might respond to a monetary policy initiative may need to reference past behavior during a period only roughly comparable to the current situation. Some critics have argued that such an approach to policy is too undisciplined--judgmental, seemingly discretionary, and difficult to explain. The Federal Reserve should, some conclude, attempt to be more formal in its operations by tying its actions solely to the prescriptions of a formal policy rule. That any approach along these lines would lead to an improvement in economic performance, however, is highly doubtful. Our problem is not the complexity of our models but the far greater complexity of a world economy whose underlying linkages appear to be in a continual state of flux. Rules by their nature are simple, and when significant and shifting uncertainties exist in the economic environment, they cannot substitute for risk-management paradigms, which are far better suited to policymaking. Were we to introduce an interest rate rule, how would we judge the meaning of a rule that posits a rate far above or below the current rate? Should policymakers adjust the current rate to that suggested by the rule? Should we conclude that this deviation is normal variance and disregard the signal? Or should we assume that the parameters of the rule are misspecified and adjust them to fit the current rate? Given errors in our underlying data, coupled with normal variance, we might not know the correct course of action for a considerable time. Partly for these reasons, the prescriptions of formal interest rate rules are best viewed only as helpful adjuncts to policy, as indeed many proponents of policy rules have suggested. *** In summary then, monetary policy based on risk management appears to be the most useful regime by which to conduct policy. The increasingly intricate economic and financial linkages in our global economy, in my judgment, compel such a conclusion. Over the next couple of days, we will have the opportunity to consider in greater detail some important changes in our economic and financial systems and their implications for the conduct of monetary policy. As always, I look forward to an engaging discussion.
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Speech by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, before the Bloomberg Panel for the Outlook on the U.S. Economy, New York, 4 September 2003.
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Ben S Bernanke: The economic outlook Speech by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, before the Bloomberg Panel for the Outlook on the U.S. Economy, New York, 4 September 2003. The references for the speech can be found on the Board of Governors of the Federal Reserve System’s website. * * * I am pleased to have this opportunity to participate in the Bloomberg Panel on the Outlook for the U.S. Economy. When I was a boy in South Carolina, my parents always advised me never to discuss religion or politics in public, those being subjects on which everyone has a strong opinion but on which no one can ever be proved wrong. I have always followed their advice on those particular topics, but I am afraid that economic forecasting may be just about as bad on both counts. Everyone has strong views on where the economy is heading, but when the time finally comes to compare your forecast with the data, the world has changed in eleven unpredictable ways that no one can blame you for failing to foresee - that is, if they remember what you forecast in the first place. Unfortunately, as helping to make monetary policy is part of my current job, I cannot avoid forming some opinions about the outlook for the U.S. and world economies. Today I will give you a few of my impressions about what seems likely to unfold in the next year to eighteen months, as well as what I see as the most important risks to that forecast. I will talk first about output growth and unemployment, and then about inflation, and I will conclude by discussing some implications for monetary policy. Both my prepared remarks and the comments I may make in the discussion later should be clearly understood as reflecting only my own views and not those of my colleagues on the Federal Open Market Committee (FOMC) or the Board of Governors of the Federal Reserve System. The forecast through 2004: Growth and unemployment To provide some context for this talk, I consulted the prognostications (in August releases) of some prominent private - sector forecasters and surveys of forecasters, namely Global Insight (formerly DRI-WEFA), the Blue Chip Survey, Macroeconomic Advisers, and the Survey of Professional Forecasters (see table 1). As you will see, I agree with several aspects of these well-regarded forecasts but (perhaps at my peril) disagree with, or at least have reservations about, some others. Beginning with the real side of the economy, we see in table 1 substantial agreement among the private-sector forecasters about the prospects for real GDP growth and the unemployment rate through the end of 2004. All the forecasters expect output growth during the second half of this year to be strong, in the general range of 3.7 to 4.2 percent. Despite the projections of high growth rates, the private forecasters expect the unemployment rate to remain at about the current rate of 6.2 percent through the end of this year. The private-sector forecasters also see strong economic growth continuing, although generally not accelerating, in 2004. Measuring growth as 2004:Q4 over 2003:Q4, Global Insight forecasts 4.1 percent growth for real GDP in 2004, Blue Chip calls for 3.7 percent growth, Macroeconomic Advisers sees 4.0 percent growth, and the Survey of Professional Forecasters looks for 3.8 percent growth. Notably, according to the professionals, even this performance is not expected to decrease the unemployment rate by very much. Only Macroeconomic Advisers sees unemployment in the fourth quarter of 2004 falling as low as 5.4 percent; the rest foresee the unemployment rate remaining at 5.8 or 5.9 percent during the last quarter of next year. These projections for the paths of growth and unemployment are broadly consistent with forecasts made by the members of the FOMC prior to our June 24-25 meeting and released shortly thereafter as part of the Federal Reserve's semiannual Monetary Policy Report to the Congress. The FOMC members' forecasts for real GDP for 2003 were for growth over the entire year; they were not broken down by quarter. However, given information about the first half available at the time the Committee's forecasts were made, the central-tendency FOMC forecast for real GDP growth for the year as a whole almost certainly implies a noticeable pickup in the pace of expansion in the second half of 2003. For 2004, the central-tendency FOMC projection for real GDP growth as of the end of June covered the range of 3-3/4 percent to 4-3/4 percent, a forecast more optimistic than even current private-sector forecasts of growth for next year and suggestive of an acceleration in real activity from the second half of 2003 to 2004. The central tendency of FOMC forecasts for the unemployment rate, as of the end of this past June, called for the rate to fall to between 6 and 6-1/4 percent in the fourth quarter of this year and to decline to between 5-1/2 and 6 percent in the fourth quarter of 2004. Again, these values are broadly consistent with the more recent private-sector forecasts. In particular, the private-sector forecasters and FOMC members evidently agree that strong GDP growth will only gradually erode the accumulated slack in the job market. Simple arithmetic tells us that all the forecasters are expecting much of the projected increase in output to be met by ongoing increases in labor productivity, rather than by substantial new hiring. This point is a crucial one, to which I will return later when discussing inflation projections. I should tip my hand at this point and say that I personally find the real growth and unemployment forecasts just described to be broadly reasonable, though there are important risks. In particular, I have been of the view for quite a while that acceleration of growth to 4 percent or better in 2004 is plausible; and I agree also that the decline in the unemployment rate, though steady, is likely to be slow. Why do I believe that there are grounds for optimism about economic growth, even as more caution is warranted regarding unemployment? The consumer plays a central role as always, and recent news on retail sales (including automobile sales) and housing starts and sales, among other data, suggests that household spending continues to hold up well, as it has throughout the past three years. Tax cuts, signs of stabilization in the job market, and rising stock prices are among the factors that should keep the consumer in the game as the recovery proceeds. What makes the situation today feel particularly encouraging, however, is that we may finally be seeing some signs of a revival in business investment. Because I see the strength and sustainability of that revival as the key to the forecast, I would like to discuss it in a bit more detail. In a speech I gave to the Forecasters' Club last April (Bernanke, 2003a), entitled “Will Business Investment Bounce Back?,” I pointed out that the recession that began in March 2001 is distinctive in being one of the few business-led-as opposed to household-led-recessions of the post-World War II period. In particular, a sharp decline in business investment spending that began in the second half of 2000 was the proximate cause of the recession. By the same token, I argued in my earlier speech making a point that many others have made as well - that a balanced recovery would be impossible without a sustained revival in capital expenditures. My earlier speech surveyed the prospects for various types of investment spending but emphasized the importance for the strength of the investment recovery of CEOs' views on prospective returns to capital expenditure and the future of the economy - their animal spirits, if you will. With a little more than four additional months' worth of data, what can we say today about the recovery of investment spending? As I noted in April, the best prospects for an investment rebound in the corporate sector lie in the equipment and software sector, particularly in high-tech equipment. Over the summer we have seen indications of at least a moderate pickup in this sector. Notably, according to the preliminary GDP estimates, real investment in equipment and software rose at an annual rate of 8 percent in the second quarter. Real expenditures for high-tech equipment advanced 34 percent (at an annual rate) in the second quarter, a significant step up from the first quarter, and real spending on software rose at a 9 percent rate. Perhaps managers have finally decided that they can't put off that IT upgrade any longer. Even spending on communications equipment was strong in the second quarter. Investment in non-high-tech equipment, including both transportation and general machinery, has also improved. In recent months, indicators such as orders data and indexes based on surveys of managers' plans for capital expenditures have strengthened, on balance, suggesting that investment in equipment and software is likely to continue to rise in the near term. By contrast, as I noted in my earlier speech and others have observed, investment in nonresidential structures is not a promising source of growth. The strength in this category in the second quarter was due importantly to an increase in spending in the drilling and mining sector, tied primarily to high natural gas prices. The outlook for buildings, particularly office and industrial buildings, remains weak, as high vacancy rates and low utilization rates persist. However, for better or worse, investment in nonresidential structures has become such a small part of aggregate spending on average that recovery in this sector is not a make-or-break factor for the overall economy. Looking beyond the very near term, I see some grounds for optimism that the revival in business investment will persist, laying the foundation for continuing rapid expansion in 2004. First, the strong growth in demand already in train should provide incentives to corporate managers to expand productive capacity, particularly given the efforts that they have already made to reduce costs and increase the efficiency of production within existing plants. In that regard, I think it is worth pointing out that firms have been meeting demand recently not only by getting greater productivity out of their existing capital and labor resources but also by running down inventory stocks relative to sales. If the past is a guide, we may soon see a quarter or two of inventory building that provides a powerful boost to the growth rate of output. Second, financial conditions remain favorable to business investment. Profits are rising smartly, and corporations have considerably improved their balance sheets. Although corporate bond rates have risen in the past few months, they remain low by historical standards, and spreads have continued to come down. Banks are well capitalized, profitable, and eager to lend to business borrowers. In short, both internal funding and external finance for investment are available. Third, tax provisions passed in 2001 and 2003 lower the effective cost of investing in new equipment. Finally, as best as we can tell, expectations and attitudes in the business community - as reflected in surveys, information from business contacts, analysts' expectations of long-term earnings growth, and the like - have brightened somewhat. When all these factors are taken together, it seems a reasonable bet that the revival in capital expenditures will continue and will strengthen sufficiently to support the optimistic growth forecasts that I discussed earlier. As the prospective investment revival is central to the optimistic growth forecast, however, it is also the locus of the most critical risks to the forecast. For some time now, CEOs have displayed a greater reluctance to invest and hire than standard econometric models predict. Commentators have given this negative residual many names: the workout of post-bubble excesses, geopolitical uncertainty, the reaction to the accounting scandals of 2002, and self-fulfilling pessimism. Personally, I admit that I don't fully understand the sources of this conservative behavior on the part of company management, and for that reason, I cannot be entirely confident that caution will not continue to predominate in the executive suite. A weaker investment trajectory reflecting continued CEO caution would probably not derail the current recovery, but it would certainly put the more-optimistic growth projections for 2004 out of reach and would substantially slow the absorption of unemployed resources. I have not mentioned the trade sector. Net exports have been a drag on U.S. growth; indeed, in the second quarter, net exports deducted (in an arithmetic sense) a hefty 1-1/2 percentage points from U.S. real GDP growth. My sense is that the optimistic growth forecasts for the United States for the next year do not rely on anything more than a modest increase in growth in the rest of the world. Of course, to the extent that unanticipated strength abroad materializes and raises demand for U.S. exports, the outlook here will improve further. Finally, a word on long-term interest rates, which as you know have been rising. At current levels, bond yields do not pose a major risk to continuing strength in housing or the recovery in corporate investment, in my view, though they may well end the boom in mortgage refinancing activity. Since those consumers who had the most to gain from refinancing have mostly already done so, a slowdown in refinancing is unlikely to have a significant effect on household spending. The forecast through 2004: Inflation I turn now from the forecast for real activity to the outlook for inflation. As before, I will both compare the various published projections and talk about some risks to the forecast. Inflation has been quite low, of course, and the private-sector forecasters expect inflation to remain low for the rest of this year and next. As table 1 shows, forecasts for CPI inflation for the second half of 2003 (the average of third- and fourth-quarter inflation forecasts, at an annual rate) by Global Insight, Blue Chip, Macroeconomic Advisers, and the Survey of Professional Forecasters are tightly clustered in a range of approximately 1-1/4 percent to 1-1/2 percent. (I will not comment here on forecasts for inflation as measured by the GDP price index, also shown in table 1, other than to say, as you can see for yourselves, that they are also quite low.) The same four sources report CPI inflation forecasts for 2004, fourth quarter over fourth quarter, of between 1-1/4 and 2 percent. For monetary policy purposes, one is often interested in measures of underlying inflation. One such measure is so-called core CPI inflation, defined as the rate of change of the consumer price index excluding food and energy prices, which tend to be relatively volatile. I was able to find a core CPI inflation forecast only for Macroeconomic Advisers. Macroeconomic Advisers expects core CPI inflation for 2004 to be 1.5 percent, compared with an expectation of 1.3 percent for overall CPI inflation. If Macroeconomic Advisers is representative, then the distinction between core and overall CPI inflation is not of first-order importance for next year's inflation forecast. As best as I can tell, the same should be roughly true for inflation forecasts for the second half of 2003, though not for 2003 as a whole (the third column of the table) because of the sharp increases in energy prices in the first quarter of this year. For comparison with the private-sector forecasts, the FOMC's central-tendency forecast at the end of June was that inflation in 2004 will range between 1 and 1-1/2 percent, as measured by the personal consumption expenditures (PCE) chain-type price index. Because of differences in the construction of this index and the CPI, an upward adjustment of 0.2 to 0.4 percentage point is probably necessary to make PCE inflation comparable to CPI inflation. Hence the FOMC central-tendency forecast for inflation for 2004 is also broadly consistent with the private-sector estimates. One can try to assess the validity of these forecasts in two ways. For the short run, a couple of quarters, looking in some detail at the components of price indexes, to try to isolate trends and special factors, is useful. For the longer run, there is no substitute for thinking hard about the underlying economic factors influencing inflation. Consideration of the details of the price indexes suggests that the rather marked deceleration we recently saw in core inflation measures has come to a halt for now, and indeed, that core inflation may tick up a few tenths during the remainder of 2003. The reasons are largely technical. Probably the most important factor, quantitatively speaking, has to do with the way that the Bureau of Labor Statistics (BLS) calculates owners' equivalent rent (OER), an estimate of the cost of living in one's own home. Data on market rental rates for homes and apartments are important inputs into the calculation of OER. Because rental leases often include landlord-provided utilities, the BLS subtracts estimates of the costs of utilities from market quotes of gross rents to obtain estimates of rents net of utilities. However, to the extent that, in the short run, landlords do not fully pass on changes in utility costs to renters, the BLS adjustment is an over-correction. In particular, in periods when energy prices and hence utility costs are rising, as in the first half of 2003, the BLS procedure may overstate the deceleration in rents net of utilities and hence in owners' equivalent rent. As a result, on this particular count, the slowdown in CPI inflation may have been slightly overstated in the first half of 2003. If so, the stabilization in residential energy costs in the second half of 2003 should unwind this effect and likely add a bit to measured inflation going forward. Another example of a special factor affecting measured inflation arises from the fiscal problems of state and local governments: To cover rising budget deficits, a number of public university systems have announced large tuition price hikes for the upcoming academic year. These tuition hikes will naturally affect the measured cost of living. As one-time events that are more fiscal than monetary in nature, however, I do not consider them particularly important from a monetary policy point of view. A similar effect was seen in the increase in the July CPI number, which was partly attributable to a rise in tobacco excise taxes imposed by a number of states. Other examples arise because of lags in data collection: For example, telephone rates are incorporated into the CPI only with some lag, so that rate increases that occurred earlier this year will not be reflected in the index for a few months yet. I alert you to some of these special cases only to illustrate why the Federal Reserve does not react to monthto-month changes in inflation data, or any other series for that matter. For assessing the inflation forecast for the longer run, in this case the year 2004, one has to turn to the underlying economics. I do not disagree with the general tenor of the private-sector forecasts and the FOMC projections. It seems plausible that the combination of a strengthening recovery, well-anchored inflation expectations, and a monetary authority strongly committed to stabilizing inflation will serve to keep inflation in the projected range. However, in my view, the most likely outcomes are in the lower part of that range, and I believe that the risks remain to the downside. The reason is that ongoing productivity growth, together with stepped-up capital investment, may enable producers to meet expanding demand without substantially increased hiring in the near term, with the result that labor markets remain soft. Indeed, as I have noted, several of the private-sector forecasters project unemployment rates still near 6 percent in the fourth quarter of 2004, despite real growth approaching 4 percent for the second half of 2003 and all of 2004. By a standard textbook calculation (Bernanke, 2003b), this amount of slack should lead to additional disinflation of a few tenths of a percentage point or so by the end of 2004. So by my reckoning, inflation in 2004 might well be a bit lower than in the second half of 2003, not higher as the majority of private-sector forecasters have projected. Of course, if real growth were to disappoint - for example, because the investment rebound in 2004 was less strong than is hoped for and expected - the disinflationary pressures would be all the stronger. Caveats abound, of course. As I have already noted, for various reasons including some special technical factors, core CPI inflation is likely to tick up during the remainder of 2003. It is always possible that employment may rebound more quickly than we now expect. And, as history tells us, inflation forecasts only two to five quarters out have large standard errors, so that a wide range of inflation outcomes are possible for 2004. Nevertheless, for now it seems to me that, with inflation already low, disinflation risk will remain a concern for some time. Implications for monetary policy Let me turn then to the implications for monetary policy. Given these forecasts, how should the Federal Reserve be expected to respond? Since May 6, the Federal Open Market Committee has assessed the risks separately for the two main components of its mandate, economic growth and inflation. According to the statement that followed our August meeting, the FOMC views the risks to sustainable growth as being roughly balanced. However the risks to inflation, according to the statement, are tilted downward, with the probability of an unwelcome fall in inflation outweighing the probability of an increase in inflation. As I see it, the persistence of economic slack even as growth picks up makes it likely that inflation will remain low and in some scenarios may fall still further. As the statement concluded, “the Committee believes that policy accommodation can be maintained for a considerable period.” How long is “a considerable period”? The right answer, I think, is that “a considerable period” is not a fixed stretch of time but depends on the evolution of the economy. In particular, in my view, the Federal Open Market Committee has little reason to undertake significant tightening so long as inflation remains low and promises to remain subdued, as it does today. Let me elaborate. In the past, significantly tighter monetary policy often came shortly after the beginning of a cyclical pickup in economic growth. When Fed policymakers responded that way, they did so as the consequence of living in a regime in which inflation was already above the desired range, and the rapid acceleration of activity threatened to press against capacity and raise inflation still higher. Then the risk to satisfactory economic performance was that inflation would rise too high, and policy was forced to preempt that risk. Today inflation is at the lower end of the range consistent with optimum economic performance, and soft labor markets and excess capacity create a further downward risk to inflation. As a result, I believe that increased economic growth may not elicit the same response from the Fed that it has sometimes elicited in the past. Besides the fact that inflation is currently at the low end of the desirable range, there is a second reason why the Fed may not respond as it has in the past to a pickup in economic growth. As you know, we have seen in the past few years a truly remarkable increase in labor productivity, sufficient to permit growth in output even as employment has fallen. Output growth arising from higher productivity is not typically accompanied by increased inflationary pressures. Indeed, I would argue that, in situations of considerable slack, growth that is generated solely by increased productivity, and that is unaccompanied by substantial employment growth, may possibly require monetary ease, rather than monetary tightening, in the short run. I should emphasize that, though current circumstances should permit the Federal Reserve to accommodate a considerable period of above-trend growth, this does not in my view imply an increased tolerance for inflation. The FOMC has made clear in its new statement, as introduced after the May 6 meeting, that it has an acceptable range for inflation, consistent with its mandate for maintaining price stability. The current policy of ease results from concerns that inflation will fall below that acceptable range. But at some point in the future, disinflationary forces will abate, and the risks to inflation may turn upwards. At that point I expect that the FOMC will act forcefully to ensure that inflation remains low and stable. Let me close by restating and summarizing the three main conclusions of these forecasts for monetary policy. First, a “considerable period of time” is not a fixed period of time but depends on the evolution of the economy. In my view, the Fed has no reason to undertake a significant tightening of policy so long as inflation is low and inflation pressures remain subdued. Second, productivity-led growth that does not raise the underlying rate of resource utilization does not increase inflationary pressures and thus, in my view, should not prompt a policy tightening. Finally, the Fed's current policy of resisting a fall of inflation below its implicit zone for price stability does not, in my opinion, signal a new dovishness with respect to inflation in general. I expect the Fed to be just as tough in resisting unwanted upward movements in inflation as it currently is in resisting undesired declines. References Bernanke, Ben (2003a). “Will Business Investment Bounce Back?” Speech delivered at the Forecasters' Club, New York, New York, April 24, www.federalreserve.gov. Bernanke, Ben (2003b). “An Unwelcome Fall in Inflation?” Speech delivered at the Economics Roundtable, University of California, San Diego, La Jolla, California, July 23, www.federalreserve.gov. Table 1: Comparison of Private-Sector Forecasts 2003:Q3 2003:Q4 2003:Q4/ 2004:Q4/ 2002:Q4 2003:Q4 GDP (percent change) Global Insight (8/11/03) 3.6 3.7 2.8 4.1 Blue Chip (8/10/03) 3.7 3.8 2.8 3.7 Macroeconomic Advisers (8/21/03) 4.2 4.2 3.1 4.0 Survey of Professional Forecasters (8/22/03) 3.5 3.9 2.8 3.8 Global Insight 6.2 6.2 6.2 5.9 Blue Chip 6.2 6.2 6.2 5.8 Macroeconomic Advisers 6.2 6.1 6.1 5.4 Survey of Professional Forecasters 6.2 6.1 6.1 5.8 Global Insight 1.5 1.0 1.7 1.5 Blue Chip 1.5 1.6 1.9 1.9 Macroeconomic Advisers 1.8 1.0 1.8 1.3 Survey of Professional Forecasters 1.5 1.4 1.8 2.0 Global Insight 1.3 1.1 1.4 1.7 Blue Chip 1.3 1.3 1.5 1.6 Macroeconomic Advisers 0.6 0.6 1.1 0.9 Survey of Professional Forecasters 1.4 1.5 1.5 1.8 Unemployment Rate (level) CPI (percent change) GDP Price Index (percent change) 1. 2. Formerly DRI-WEFA Return to table Figures in the annual columns are Q4 levels. Return to table
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Remarks by Mr Edward M Gramlich, Member of the Board of Governors of the US Federal Reserve System, at the Georgia Summit on Economic and Financial Education, Federal Reserve Bank of Atlanta, Atlanta, 4 September 2003.
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Edward M Gramlich: Economic and financial education Remarks by Mr Edward M Gramlich, Member of the Board of Governors of the US Federal Reserve System, at the Georgia Summit on Economic and Financial Education, Federal Reserve Bank of Atlanta, Atlanta, 4 September 2003. * * * Thank you for inviting me to speak at today's conference. For many years, the Federal Reserve has played an active role in furthering economic education among youth. Recently, we expanded our involvement by promoting the importance of personal financial education for all demographic and social groups. In May, we launched a national campaign that included a public service announcement featuring Chairman Greenspan. Our goal is to increase public awareness of the value of effective personal financial management in home ownership, higher education, retirement security, and overall economic well-being. While some may not consider the topic of economic and financial education to lie within the purview of a central bank, it is in fact quite consistent with the Federal Reserve's interests in many areas economic policy, banking supervision, consumer regulation, public information, and community affairs. Hence, we appreciate your efforts in furthering education on these topics and applaud your interest in strengthening the effectiveness of your programs. As you are well aware, a solid understanding of economics and finance is relevant to both individual financial success and to the proper functioning of markets. Consumers who are familiar with basic economic principles, who are able to analyze personal financial scenarios and options, and who have access to pertinent financial information are important components to the success of our free market system. With these tools - knowledge, analytical skills, and access to information - consumers are able to make more effective financial decisions. This furthers market efficiency by creating demand for products that are more responsive to consumer needs. As providers of economic and financial education, you are quite familiar with the difficulties of choosing among the myriad products and services offered by our financial services sector. Financial markets are becoming steadily more sophisticated and expansive. Consumers are required to assume ever greater responsibility for managing their personal finances, such as their employer-sponsored retirement savings accounts. The result is that the need for financial education is also growing, and is indeed experiencing an unprecedented level of attention and funding from a broad base of supporters, ranging from financial institutions to employers to faith-based organizations. With the growth in financial education programs has come an increased interest in measuring the effectiveness of such programs. Performance and outcome measurement should be the way to justify continued support for any program. Further, the data collected for the program evaluation process can identify “best practices” which can be replicated on a broad scale to increase the reach and effectiveness of successful programs. But unlike readily quantifiable outcome measures such as business profits, a bright-line test of success is not always available for financial education programs. There is often no single outcome that conveys success, and the determinants of achievement may depend on factors that vary from one individual to the next. Further, these programs may not realize a return on their investment for months, or even years. Given the importance of evaluating a program's success, leaders of various economic and financial education programs have been exploring ways to measure the effectiveness of their activities. Staff of the Federal Reserve and the Department of Defense are currently collaborating to develop extensive and ongoing survey instruments to measure the value of financial education courses offered to Army personnel. Organizations such as Jump$tart, the National Endowment for Financial Education, and the National Council on Economic Education have employed various testing and survey strategies to quantify the impact of and measure the need for their programs. In considering how to develop measurement criteria for financial education programs, it is logical to begin with primary objectives. The desired outcomes for financial education are · Getting the message out - that is, increasing consumers' awareness of the importance of the issue to their well-being. · Altering consumer behavior to improve short- and long-term prospects. These goals have parallels to other public awareness and educational campaigns, and the parallels can assist in program design and evaluation. I will illustrate by offering some perspectives. With regard to the first outcome - getting the message out - the Ad Council has sponsored studies to determine the impact of public service announcements on its targeted audiences. The findings suggest that certain public service announcements are effective in increasing awareness, reinforcing positive beliefs, intensifying concern, and moving people to action. One study, conducted by the Advertising Research Foundation, focused on the impact of public service announcements for colon cancer awareness that were aired in four major cities over the course of a year. The research found that as a direct result of the public service announcement, awareness of the threat of colon cancer increased by more than 3.5 times after a year, and the number of people discussing colon cancer with their doctor increased by 43 percent. The research also found that the message had a particularly strong impact on men, with awareness among males increasing nearly six times and the number of males taking action increasing by 114 percent. A separate study was conducted by the University of Wisconsin to gauge the impact of the National Crime Prevention Council's anti-crime campaign. This study found that awareness of the trademark McGruff the Crime Dog reached 80 percent among the general public and 88 percent among crime prevention practitioners. In addition, nearly one-third of respondents indicated that they had learned from the public service announcements, and one-fifth reported that they had taken specific actions as a result of what they had learned from the campaign. These research findings suggest that issuerelated information campaigns not only increase awareness of the importance of a given topic, but also motivate positive behavior change. The second objective is to alter consumer behavior. This key goal is unfortunately quite difficult to quantify, but financial education organizations have committed their resources to conduct surveys and administer tests in order to better estimate programmatic impacts. The U.S. Department of Education is one agency that has conducted such assessments. It studied literacy programs involving teachingrelated issues, including the provision of reading skills instruction to parents alongside children, the effectiveness of participatory and traditional approaches to teaching, and strategies for increasing participation and ongoing development of reading skills. While there are many factors that differentiate financial education from adult literacy training, certain research results are suggestive. In particular, studies of methods that engage both parents and children in the educational process do reveal positive outcomes. One study compared the results of participants in Toyota Families for Learning, a family literacy-training program, with the results for participants in two adult-oriented literacy programs. Participants in the family-focused programs gained more than one grade level in their reading skills after one year, much greater than the grade-level increase of students in the two adult-oriented programs. The study attributes the increased level of success to higher retention rates in the family-focused program. It showed that 19 percent more adults remained in the family-focused program for more than twenty weeks. Other research on family literacy programs indicates that benefits also spread to child participants, with young children showing an increased interest in literacy and being better prepared for school than their peers. Some other relevant information on educational programs designed to change consumer behavior may be found in research sponsored by the U.S. Department of Agriculture's (USDA) Food and Nutrition Service. The agency has evaluated a range of nutrition education, health promotion, and social marketing programs intended to improve consumers' understanding of the importance of good nutrition. The agency reviewed more than 200 studies that evaluated education research and intervention programs. These studies found that successful programs typically had five common characteristics: · They set behavior change as a specific program goal. · They incorporated motivating communications into the program. · They taught strategies for behavior change. · They included active involvement of both the individual and the community. · They attempted to build health-enhancing environments. The review also highlighted the findings of one evaluation of a school health education program reaching about 30,000 students. This study found that between five and fifteen hours of instruction resulted in enormous gains in students' knowledge about nutritional programs. However, between twenty-five and fifty hours of instruction were required to bring about any change in student behavior and attitudes, and even with this amount of instruction, the effects on attitudes were very small. These findings demonstrate the enormousness of the challenge in influencing behavior change through education. I would also like to comment on the importance of developing effective information-delivery mechanisms. The agencies previously mentioned, along with others, have developed innovative Internet-based programs to provide education and information. Technology can play a big role here, by increasing the efficiency of financial education programs and by centralizing resources into information clearinghouses, which may help to reduce duplicative efforts and better exploit scarce resources. One example involves the Agency for Healthcare Research and Quality (AHRQ), which engages in activities that promote informed consumer decision-making. The agency uses different strategies to provide information to consumers on various health-related issues, including medical conditions and procedures, as well as on the range of choices in health care options and plans. Over the last several years, AHRQ has been developing software and database programs designed to help consumers and others choose among the wide variety of health care plans. This system, the Consumer Assessment of Health Plans, uses computer-driven survey instruments and reporting tools to collect data that permit a better understanding of consumers' sentiments about health care programs and experiences. Such a system could serve as a model for using technology to help consumers assess their financial needs. Let me conclude by repeating how pleased I am to see this group of dedicated professionals meeting and discussing the challenges that face public educators. I would like to thank the Federal Reserve Bank of Atlanta for hosting today's conference and bringing together this group of educators. With your expanded knowledge and new contacts, I encourage you to continue to seek new and innovative ways to further your work and measure the outcomes of your programs. Success in increasing economic and financial literacy will be very important to the individuals you serve, as well as to the overall economy.
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the 33rd Annual Legislative Conference of the Congressional Black Caucus, Washington, DC, 26 September 2003.
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Alan Greenspan: Financial education Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the 33rd Annual Legislative Conference of the Congressional Black Caucus, Washington, DC, 26 September 2003. * * * I am pleased to be here today to discuss the importance of financial education for consumers. Forty years ago, Dr. Martin Luther King, Jr., challenged this nation to fulfill its promise of freedom and equality for all citizens, to ensure that all Americans are able to participate in day-by-day business without being hampered by debilitating discrimination. In those forty years we have witnessed a great deal of change. However, the momentous goal of ensuring that everyone has access to the benefits of our free and efficient market economy has yet to be achieved and remains as relevant today as it was in August of 1963, when marchers gathered around the Lincoln Memorial. Increasing economic prospects for people in traditionally underserved neighborhoods and granting every individual the opportunity to succeed remains crucial to our national well-being. A strong and effective system of education is one fundamental way to strengthen our economy and raise living standards. And education about personal finance that helps consumers of all ages meet the challenges and demands of our increasingly knowledge-based economy is one important component of such a system. Trends in Consumer Finances Today's financial world is highly complex when compared with that of a generation ago. Forty years ago, a simple understanding of how to maintain a checking and savings account at local banks and savings institutions may have been sufficient. Now, consumers must be able to differentiate between a wide range of financial products and services, and providers of those products and services. Previous, less-indebted generations may not have needed a comprehensive understanding of such aspects of credit as the impact of compounding interest and the implications of mismanaging credit accounts. Today, however, the advance of telecommunications technologies and the development of other new technological tools have broadened the availability of credit and other banking services. More generally, these advances mean consumers must be familiar with the role that computers play in the conduct of every traditional financial transaction, from withdrawing funds to borrowing. Data, both empirical and anecdotal, point to trends in consumer financial conditions that have caused concern among some consumer groups. Household debt has risen appreciably in recent years. While analyses suggest that, overall, the level of debt is being serviced adequately, a record number of nonbusiness bankruptcy filings reveals that many consumers are experiencing significant financial distress. Regulators, lenders, community leaders, and consumer advocates also continue to be concerned about abusive home mortgage lending practices and other consumer credit practices that target vulnerable populations. Financial education is especially critical in the effort against these deceptive practices. Consumers empowered with the information to make educated financial choices are less susceptible to fraud and less likely to become entangled in financially devastating credit arrangements. Trends in the Financial Services Industry Some may believe these trends indicate that market forces have hurt consumers. On the contrary, household and business borrowers have benefited from the technological developments that have enhanced financial services, and their remarkable growth. Computer and telecommunications technologies have lowered the cost and broadened the scope of such services. Consequently, specialized lenders and new financial products tailored to meet very specific market needs have proliferated. At the same time, the development of credit-scoring tools and the securitization of loan pools are opening doors to national credit markets for both consumers and businesses. Deregulation has encouraged competition and innovation by opening the marketplace to the entry of new service providers and the expansion of existing service providers. Throughout our banking history, markets have adjusted to respond to demand. These structural changes have heightened competition, resulting in lower costs and the emergence of increasingly diverse and highly specialized organizations. These entities range from banks and brokerage firms that offer their services exclusively through electronic delivery mechanisms to locally based publicprivate partnerships that provide counseling and financing arrangements to low- and moderate-income families. The Role of Financial Education Given the significant changes in the financial marketplace, some consumers may lack sufficient familiarity with the newer financial concepts to make sound decisions. In response, government agencies, major banking companies, grass-roots consumer and community groups, and other organizations have developed a wide variety of financial education programs. Some are tailored to specific products such as credit cards and home equity lines of credit, and others are focused on specific consumers, such as military personnel, college students, or first-time homebuyers. Yet other programs adopt a more comprehensive approach, teaching broad audiences about savings, credit, budgeting, and similar topics. All of these programs are designed to give individuals tools to manage their personal financial affairs and make responsible decisions about products that can improve their economic well-being. The financial services industry maintains a keen interest in financial education programs and provides significant support. A recent nationwide survey of bank-sponsored financial literacy programs at fourteen of the largest twenty-five banks, as well as other smaller banks, noted a consistent increase in the number of financial institutions that support financial education initiatives. Bankers who responded to a 2003 Consumer Bankers Association survey reported that 98 percent offer financial literacy programs or work with partners that support such efforts. Many bankers participate because they want to be recognized as good corporate citizens; however, many other bankers have realized that their activities may help them reach hard-to-serve markets such as immigrants or people without a relationship with a bank. Organizations, including some of the Federal Reserve Banks, working at the community level have established Volunteer Income Tax Assistance (VITA) sites, where instructors not only help people with their tax returns, but also teach them how to budget their income, pay their bills, and manage credit. These programs are especially noteworthy since preliminary research reveals a considerable number households that receive tax refunds intend to save them or invest them in education and other wealthbuilding activities. Building a Foundation for Financial Education Children and teenagers should begin learning basic financial skills as early as possible. Indeed, improving basic financial education in elementary and secondary schools can help prevent students from making poor decisions later, when they are young adults, that can take years to overcome. In particular, it has been my experience that competency in mathematics--both in numerical manipulation and in understanding the conceptual foundations--enhances a person's ability to handle the more ambiguous and qualitative relationships that dominate our day-to-day financial decisionmaking. For example, through an understanding of compounding interest, one can appreciate the cumulative benefit of routine saving. Similarly, learning how to conduct research in a library or on the Internet enhances decisionmaking. Focusing on improving fundamental mathematical and problem-solving skills can develop knowledgeable consumers who can take full advantage of the sophisticated financial services offered in an ever-changing marketplace. While some adults may believe that financial and related mathematical concepts are too complex for younger school children, I was pleased to have an experience that dispels such thinking. In June, I had the opportunity to discuss financial matters with a sixth-grade class that had begun a financial education program sponsored by Operation Hope, a national nonprofit organization. The children's surprisingly precocious questions demonstrated an ability and a desire to learn more about the fundamental principles of money and banking. This encounter and countless others in classrooms and community centers across the country indicate that, in the long run, better basic education at home and in elementary and secondary schools can provide the foundation for a lifetime of learning. But not all have risen to the level of that sixth-grade class. We need to exert especial effort to improve the skills and earning power of those who appear to be falling behind. The Federal Reserve has a keen interest in promoting financial education and increasing the visibility of resources for consumers. In May, the Federal Reserve launched a national campaign to highlight the importance of personal financial education and money management to achieving short- and longterm goals such as pursuing higher education, purchasing a home, or starting a business. This initiative includes a public service announcement, a printed brochure, and a dedicated web site that identifies resources for learning more about financial management products and services. The Federal Reserve also has a long-standing interest in increasing minority access to credit markets. We study access to mortgage and small business credit for underserved populations and have participated in a pilot program teaching mortgage finance at select community colleges. This innovative program, targeted to minority students in underserved communities, trains individuals for a broad array of career opportunities in mortgage lending. We also are interested in measuring the effectiveness of financial education programs. Studies evaluating such programs were presented at the Federal Reserve System's 2003 Community Affairs Research Conference. In addition, the Federal Reserve and the Department of Defense are collaborating on a study of the efficacy of personal financial management education provided to members of the military services and their families. This research will provide insights into what financial education interventions prove most effective with specific audiences and will provide valuable guidance for teachers, employers, and other financial education providers and funders. Building bridges between community organizations, educational institutions, and private businesses is essential to increasing familiarity with new technological and financial tools. And the success of such efforts will bear significantly on how well prepared our society is to meet the challenges of an increasingly knowledge-based economy. In closing, let us remember that education is the primary means for creating new economic and financial opportunity for everyone. If we are able to boost our investment in people, ideas, and processes, just as we do in machines and technology, consumers and the economy can readily adapt to change, providing ever-rising standards of living for all Americans.
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Speech by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the Fall 2003 Banking and Finance Lecture, Widener University, Chester, Pennsylvania, 2 October 2003.
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Ben S Bernanke: Monetary policy and the stock market - some empirical results Speech by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the Fall 2003 Banking and Finance Lecture, Widener University, Chester, Pennsylvania, 2 October 2003. The references for the speech can be found on the Board of Governors of the Federal Reserve System’s website. * * * The ultimate objective of monetary policymakers is to promote the health of the U.S. economy, which we do by pursuing our mandated goals of price stability and maximum sustainable output and employment. However, the effects of our policy instruments, such as the short-term interest rate, on these goal variables are indirect at best. Instead, monetary policy actions have their most direct and immediate effects on the broader financial markets, including the stock market, government and corporate bond markets, mortgage markets, markets for consumer credit, foreign exchange markets, and many others. If all goes as planned, the changes in financial asset prices and returns induced by the actions of monetary policymakers lead to the changes in economic behavior that the policy was trying to achieve. Thus, understanding how monetary policy affects the broader economy necessarily entails understanding both how policy actions affect key financial markets, as well as how changes in asset prices and returns in these markets in turn affect the behavior of households, firms, and other decisionmakers. Studying these links is an ongoing enterprise of monetary economists both within and outside the Federal Reserve System. The link between monetary policy and the stock market is of particular interest. Stock prices are among the most closely watched asset prices in the economy and are viewed as being highly sensitive to economic conditions. Stock prices have also been known to swing rather widely, leading to concerns about possible "bubbles" or other deviations of stock prices from fundamental values that may have adverse implications for the economy. It is of great interest, then, to understand more precisely how monetary policy and the stock market are related. In my talk today, I will report the results of research that I have done on this topic with Kenneth Kuttner of the Federal Reserve Bank of New York, as well as the findings of some related work done both within and outside the Federal Reserve System. The views I will express today, however, are my own and not necessarily those of my colleagues on the Federal Open Market Committee (FOMC) or the Board of Governors of the Federal Reserve System. In our research, Kuttner and I asked two questions. First, by how much do changes in monetary policy affect equity prices? As you will see, we focus on changes in monetary policy that are unanticipated by market participants because anticipated changes in policy should already be discounted by stock market investors and, hence, are unlikely to affect equity prices at the time they are announced. We find an effect of moderate size: Monetary policy matters for the stock market but, on the other hand, it is not one of the major influences on equity prices. Our second question, both more interesting and more difficult, is, why do changes in monetary policy affect stock prices? We come up with a rather surprising answer, at least one that was surprising to us. We find that unanticipated changes in monetary policy affect stock prices not so much by influencing expected dividends or the risk-free real interest rate, but rather by affecting the perceived riskiness of stocks. A tightening of monetary policy, for example, leads investors to view stocks as riskier investments and thus to demand a higher return to hold stocks. For a given path of expected dividends, a higher expected return can be achieved only by a fall in the current stock price. As we will see, this finding has interesting implications for several issues, including the role of stock prices in transmitting the effects of monetary policy actions to the broader economy and the potential effectiveness of monetary policy in "pricking" putative bubbles in the stock market. I will come back to these issues at the end of my talk. I start, however, with the problem of measuring the effect of monetary policy on the stock market. Bernanke and Kuttner (2003); http://home.earthlink.net/~kkuttner/bernanke-kuttner.pdf The Effect of Monetary Policy Actions on the Stock Market Normally, the FOMC, the monetary policymaking arm of the Federal Reserve, announces its interest rate decisions at around 2:15 p.m. following each of its eight regularly scheduled meetings each year. An air of expectation reigns in financial markets in the few minutes before to the announcement. If you happen to have access to a monitor that tracks key market indexes, at 2:15 p.m. on an announcement day you can watch those indexes quiver as if trying to digest the information in the rate decision and the FOMC's accompanying statement of explanation. Then the black line representing each market index moves quickly up or down, and the markets have priced the FOMC action into the aggregate values of U.S. equities, bonds, and other assets. On occasion, if economic conditions warrant, the FOMC may decide to make a change in monetary policy on a day that falls between regularly scheduled meetings, a so-called intermeeting move. Intermeeting moves, typically agreed upon during a conference call of the Committee, nearly always take financial markets by surprise, at least in their precise timing, and they are often followed by dramatic swings in asset prices. Even the casual observer can have no doubt, then, that FOMC decisions move asset prices, including equity prices. Estimating the size and duration of these effects, however, is not so straightforward. Because traders in equity markets, as in most other financial markets, are generally highly informed and sophisticated, any policy decision that is largely anticipated will already be factored into stock prices and will elicit little reaction when announced. To measure the effects of monetary policy changes on the stock market, then, we need to have a measure of the portion of a given change in monetary policy that the market had not already anticipated before the FOMC's formal announcement. Fortunately, the financial markets themselves are a source of useful information about monetary policy expectations. As you may know, the FOMC implements its decisions about monetary policy by changing its target for a particular short-term interest rate, the federal funds rate. The federal funds rate is the rate at which depository institutions borrow and lend reserves to and from each other overnight; although the Federal Reserve does not control the federal funds rate directly, it can do so indirectly by varying the supply of reserves available to be traded in this market. Since October 1988, financial investors have been able to hedge and speculate on future values of the federal funds rate by trading contracts in a futures market, overseen by the Chicago Board of Trade. Investors in this market have a strong financial incentive to try to guess correctly what the federal funds rate will be, on average, at various points in the future. The existence of a market in federal funds futures is a boon not only to investors, such as banks, which want to protect themselves against changes in the cost of reserves, but also to both policymakers and researchers, because it allows any observer to infer from the sale prices of futures contracts the values of the federal funds rate that market participants anticipate at various future dates. Previous research (Krueger and Kuttner, 1996; Owens and Webb, 2001) has shown that participants in this market collectively do a good job of forecasting future values of the funds rate, efficiently incorporating available information about likely future monetary policy actions. By using data from the federal funds futures market, then, it is possible to estimate the value at which financial market participants expect the FOMC to set its target for the federal funds rate on any given date. By comparing this expected value to what the FOMC actually did at each date, we can determine the portion of the Fed's interest rate decision that came as a surprise to financial markets. In our research, Kuttner and I considered all the dates of scheduled FOMC meetings plus all the dates on which the FOMC changed the federal funds rate between meetings, or made intermeeting moves, for the period May 1989 through December 2002, amounting to a total of 131 observations. For each of these dates, we used the expected value of the federal funds rate as inferred from the futures market to divide the actual change in the federal funds rate on that day into the part that was anticipated by The futures contract is based on monthly averages of the federal funds rate, so that some manipulation is needed to obtain the daily expectations of the funds rate used in this paper. See Bernanke and Kuttner (2003) or Kuttner (2001) for further details. Allowing for risk premiums creates another complication; see Sack (2002). I ignore these technicalities here. Other financial instruments, such as eurodollar futures rates, can and have been used to forecast changes in the federal funds rate. Although each of the various alternatives has advantages, Gürkaynak, Sack, and Swanson (2002) find that the federal funds futures rate is the best predictor of monetary policy actions for horizons out to several months. The beginning of the sample corresponds to the availability of the futures data. We excluded the observation corresponding to September 17, 2001, the first day of trading following the September 11 terrorist attacks. the markets and the part that was unanticipated. So, for example, on November 6, 2002, the Federal Reserve cut the federal funds rate by 50 basis points. (A basis point equals 1/100 of a percentage point, so a 50-basis-point cut equals a cut of 1/2 percentage point.) However, this cut in the federal funds rate was not entirely unexpected; indeed, according to the federal funds futures market, investors were expecting a cut of about 31 basis points, on average, from the Fed at that meeting. So, of the 50 basis points that the FOMC lowered its target for the federal funds rate last November 6, only 19 basis points were a surprise to financial markets and thus should have been expected to affect asset prices. Note, by the way, that if the Fed had not changed interest rates at all that day, our method would have treated that action as the equivalent of a surprise tightening of policy of 31 basis points because the Fed would have done nothing while the market was expecting an easing of 31 basis points. To evaluate the effect of monetary policy on the stock market, we looked at how broad measures of stock prices moved on days on which the Fed made unanticipated changes to policy. I can illustrate our method by continuing the example of the Fed's cut in the federal funds rate last November 6. On that day, the broad stock market index we used in our study (the value-weighted index constructed by the Center for Research in Securities Prices at the University of Chicago) rose in value by 0.96 percentage point. Dividing the 96-basis-point gain in the stock market by the 19-basis-point downward surprise in the funds rate, we obtain a value of approximately 5 for the "stock price multiplier" relating policy changes to stock market changes. If this one day were representative, we would conclude that each basis point of surprise monetary easing leads to about a 5-basis-point increase in the value of stocks. Or, choosing magnitudes that might be more helpful to the intuition, we could just as well say that a surprise cut of 25 basis points in the federal funds rate should lead the stock market to rise, on the same day, about 1.25 percentage points--about 120 points on the Dow Jones index at its current value. In fact, applying a formal regression analysis to the full sample from 1989 to 2002, we found a number fairly close to this one, namely, a stock price multiplier for monetary policy of about 4.7. We also found, as expected, that changes in monetary policy that were anticipated by the market had small and statistically unimportant effects on stock prices, presumably because these changes had already been priced into stocks. Although a stock price multiplier of about five for unanticipated changes in the federal funds rate is certainly not negligible, we should appreciate that unexpected changes in monetary policy account for a tiny portion of the overall variability of the stock market. Unanticipated movements in the federal funds rate of 20 basis points or more are relatively rare (we observed only thirteen examples in our fourteen-year sample). Yet the change of one percent or so in the stock market induced by the typical 20-basis-point "surprise" in the funds rate is swamped by the overall variability of stock prices. For example, over the past five years, the broad stock market has moved one percent or more on about 40 percent of all trading days. Thus, news about monetary policy contributes very little to the day-today fluctuations in stock prices. We explored our empirical results with some care. We noted, for example, that a few of the monetary policy changes in our sample were followed by what seemed to be excessive or otherwise unusual stock market responses. A number of these responses occurred rather recently, during the Fed's series of rate cuts in 2001. The Fed's surprise intermeeting cuts of 50 basis points each on January 3 and April 18 of that year were both greeted euphorically by the stock market, with one-day increases in stock values of 5.3 percent and 4.0 percent, respectively. By contrast, the rate cut of 50 basis points That the Federal Reserve has only been formally announcing its policy moves since 1994 added a measure of complexity to our research. Before then, market participants generally did not become aware of the FOMC's policy decisions until those decisions were actually implemented in the market for bank reserves, often the day after the FOMC decision. To the extent possible, we dated the policy change as of the day that the market would have become aware of it, not the day of the decision itself. See the paper for details. Investors would not literally expect the Fed to cut the funds rate by 31 basis points, since the Fed usually moves in 25-basispoint increments. An average expectation of a 31-basis-point cut would be consistent with, for example, 62 percent of investors expecting a 50-basis-point and 38 percent expecting no cut. In principle, news other than the policy decision might affect the federal funds futures contract during the day, so that the measure of unanticipated policy changes we use here might be a "noisy" one. If so, our approach would underestimate the effect of policy changes on the stock market. However, Poole, Rasche and Thornton (2002, pp. 68-69) perform an analysis that suggests that the mismeasurement may be small in practice. Further confirmation is provided by D'Amico and Farka (2002), who find results similar to ours using ten-minute windows around the announcement; the benefit of a tight window is that the policy announcement is highly likely to dominate movements in the contract over that period. on March 20, 2001, was received less enthusiastically. Even though the cut was more or less what the futures market had been anticipating, the financial press reported that many equity market participants were "disappointed" that the rate cut hadn't been an even larger 75-basis-point action. In any event, the market lost more than 2 percent that day. To ensure that our results did not depend on a few unusual observations, or "outliers," we re-ran our regression, omitting the days with the most extreme or unusual market moves. This more conservative analysis led to a smaller estimate of the effect of policy actions on the stock market, a stock price multiplier of about 2.6 rather than 4.7. However, the effect remains quite sharp in statistical terms. We considered other variations as well. For example, we investigated whether the magnitude of the effect on the stock market of a surprise policy tightening (that is, an increase in interest rates) differs from that of a surprise easing of comparable size. It does not. Yet another experiment consisted of asking whether an unanticipated policy change has a larger effect if it is thought by the market to signal a longer-lasting change in policy. We measured the perceived permanence of policy changes by observing the effects of unanticipated policy changes on the expected federal funds rate three months in the future, as measured by the futures market. The stock market multiplier associated with unanticipated policy moves that are perceived to be more permanent is a bit higher, as would be expected; its value is about 6. In short, the statistical evidence is strong for a stock price multiplier of monetary policy of something between 3 and 6, the higher values corresponding to policy changes that investors perceive to be relatively more permanent. That is, according to our findings, a surprise easing by the Fed of 25 basis points will typically lead broad stock indexes to rise from between 3/4 percentage point and 1-1/2 percentage points. Incidentally, similar results obtain for stock values of industry groups: We find almost all industry stock portfolios respond significantly to changes in monetary policy, with telecommunications, high-tech, and durables goods industry stocks being the most sensitive to monetary policy news, and energy, utilities, and health care stocks being the least sensitive. These results can be broadly explained by the tendency of each industry group to move with the broad market, or (to use the language of the standard capital asset pricing theory), by their industry "betas." Why Does Monetary Policy Affect Stock Prices? It is interesting, though perhaps not terribly surprising, to know that Federal Reserve policy actions affect stock prices. An even more interesting question, though, is, why does this effect occur? Answering this question will give us some insight into how monetary policy affects the economy, as well as the role that the stock market should play in policy decisions. A share of stock is a claim on the current and future dividends (or other cash flows, such as stock buybacks) to be paid by a company. Suppose, for just a moment, that financial investors do not care about risk. Then only two types of news ought to affect current stock values: news that affects investor forecasts of current or future (after-tax) dividends or news that affects forecasts of current or future short-term interest rates. News that current or future dividends (which I want to think of here as being measured in real, or inflation-adjusted, terms) are likely to be higher than previously expected--say, because the company is expecting to be more profitable--should raise the current stock price. News Technically, we removed outlier observations based on their so-called influence statistics, which measure the importance of individual observations to the overall results. Another correction was needed because, in the early part of the sample, particularly between 1989 and 1992, it was not uncommon for intermeeting rate cuts to take place on the same day that the government issued weaker-than-expected reports about employment growth. In such cases, our method cannot distinguish cleanly between the effects of the employment news and the effects of the rate cut itself on the stock market. If we eliminate both the outlier observations and the observations in which employment reports coincided with rate changes, we find the multiplier effect of policy changes on the stock market to be about 3.6 and again statistically significant. To focus on policy surprises of longer duration, Rigobon and Sack (2002) derive their measure of the unexpected policy change on the three-month eurodollar deposit rate, rather than the current month's federal funds rate, as in this paper and in Kuttner (2001). Using a methodology that also attempts to correct for two-way causality between the funds rate and asset prices, and data for post-1993 scheduled FOMC meetings and Chairman's testimony dates only, they find comparable though slightly higher values for the effect of monetary policy on the stock market. For example, they find a policy multiplier for the Standard and Poor's 500 index of 7.7. However, when they use data on the federal funds rate futures market to measure policy shocks, Rigobon and Sack find results similar to ours, using their sample and methodology. Using methods similar to ours, Guo (2002) found that the impact of monetary policy actions on stock prices does not seem to depend on firm size. that current or future short-term interest rates (also measured in real, or inflation-adjusted, terms) are likely to be higher than previously expected should depress the stock price. There are two essentially equivalent ways of understanding why expectations of higher short-term real interest rates should lower stock prices. First, to value future dividends, an investor must discount them back to the present; as higher interest rates make a given future dividend less valuable in today's dollars, higher interest rates reduce the value of a share of stock. Second, higher real interest rates make investments other than stocks, such as bonds, more attractive, raising the required return on stocks and reducing what investors are willing to pay for them. Under either interpretation, expectations of higher real interest rates are bad news for stocks. So, to reiterate, in a world in which investors do not care about risk, stock prices should change only with news about current or future dividends or about current or future real interest rates. However, investors do care about risk, of course. Because investors care about risk, and because stocks are viewed as relatively risky investments, investors generally demand a higher average return, relative to other assets perceived to be safer, to hold stocks. Using long historical averages, one finds that, in the United States, a diversified portfolio of stocks has paid 5 to 6 percentage points more per year, on average, than has a portfolio of government bonds. This extra return, known as the risk premium on stocks, or the equity premium, presumably reflects, in part, the extra compensation that investors demand to be willing to hold relatively more risky stocks. Like news about dividends and real interest rates, news that affects the risk premium on stocks also affects stock prices. For example, news of an impending recession could raise the risk premium on stocks in two ways. First, the macroeconomic environment is more volatile than usual during a recession, so stocks themselves may become riskier investments. Second, the incomes and wealth of financial investors tend to fall during a downturn, giving them a smaller cushion to support the lifestyles to which they are accustomed (that is, to make house payments and meet other obligations). With less discretionary income and wealth to absorb potential losses, people may become less willing to bear the risks of more volatile financial investments (Campbell and Cochrane, 1999). For both reasons, the extra return that investors demand to hold stocks is likely to rise when bad times loom. With expected dividends and the real interest rate on alternative assets held constant, the expected yield on stocks can rise only through a decline in the current stock price. We now have a list of three key factors that should affect stock prices. First, news that current or future dividends will be higher should raise stock prices. Second, news that current or future real short-term interest rates will be higher should lower stock prices. And third, news that leads investors to demand a higher risk premium on stocks should lower stock prices. How does all this relate to the effects of monetary policy on stock prices? According to our analysis, Fed actions should affect stock prices only to the extent that they affect investor expectations about dividends, short-term real interest rates, or the riskiness of stocks. The trick is to determine quantitatively which of these sets of investor expectations is likely to be most affected when the Fed unexpectedly changes the federal funds rate. To make this determination, we used a methodology first applied by the financial economist John Campbell, of Harvard University, and by Campbell and John Ammer of the Federal Reserve Board staff (Campbell, 1991; Campbell and Ammer, 1993). Putting the details aside, we can describe the basic idea as follows. Imagine that the expectations of stock market investors can be mimicked by a statistical forecasting model that takes relevant current data as inputs and projects estimated future values of aggregate dividends, real interest rates, and equity risk premiums as outputs. In principle, investors could use such a model to make forecasts of these key variables and hence to estimate what they are willing to pay for stocks. Besides a number of standard variables that have been shown to be helpful in making forecasts of such financial variables, suppose we include in the forecasting model our measure of unanticipated changes in the federal funds rate. That is, we use the The existence of a large equity premium in the past is, of course, no guarantee of an equally large equity premium in the future. The fact that equities are more widely held today than in the past, implying that the risk of equities is more widely shared, is one reason that the equity premium may be lower in the future than it has been in the past. Of course, a looming recession is likely also to lower expected dividends (bad for stocks) and lower interest rates (good for stocks). Generally, stock prices are a leading indicator, falling ahead of recessions and rising in advance of recoveries (although with many false signals). Variables used in our forecasting model, besides the excess return on stocks, the one-month real interest rate, and the unanticipated change in the funds rate, include the relative bill rate (defined as the three-month Treasury bill rate minus its information contained in these unanticipated changes in making our forecasts of future dividends, interest rates, and risk premiums. Now we can consider the following thought experiment. Suppose we have run our computer model, made our forecasts, and inferred the appropriate values for stocks. But then we receive news that the Fed has unexpectedly raised the federal funds rate by 25 basis points. Based on our forecasting model, by how much would that information change our previous forecasts of future dividends, interest rates, and risk premiums? The answer to this question clarifies the channel by which monetary policy affects stock prices. If we were to find, for example, that the news of an unexpected increase in the funds rate significantly changed the forecast of future dividends but did not much affect the forecasts of interest rates or risk premiums, then we could conclude that monetary policy affects stock prices primarily by affecting investor expectations of future dividends. By contrast, if news of the policy action changed the model forecasts for real interest rates but did not change our forecasts for the other two variables, we would decide that unanticipated policy actions affect stock prices primarily by influencing the interest rates expected by stock investors. What we actually found when conducting this statistical experiment was quite interesting. It appears that, for example, an unanticipated tightening of monetary policy leads to only a modest change in forecasts of future dividends and to still less of a change in forecasts of future real interest rates (beyond a few quarters). Quantitatively, according to our methodology, the most important effect of a policy tightening is on the forecasted risk premium. Specifically, an unanticipated tightening of monetary policy raises expected risk premiums on stocks for a protracted period. For a given expected stream of dividend payouts and real interest rates, the risk premium and hence the return to holding stocks can only rise if the current stock price falls. In short, our analysis suggests that an unanticipated monetary tightening lowers stock prices only to a small extent by lowering investor expectations about future dividend payouts, and by still less by raising expected real interest rates. The most powerful effect of an unanticipated monetary tightening is to increase the perceived risk premium on stocks, either by increasing the riskiness of stocks, by reducing people's willingness to bear risk, or both. Reduced willingness of investors to hold relatively more risky stocks drives down stock prices. Our analysis does not explain precisely how monetary policy affects risk, but we can make reasonable conjectures. For example, tighter monetary policy may raise the riskiness of shares themselves by raising the interest costs and weakening the balance sheets of publicly owned firms (Bernanke and Gertler, 1995). In the macroeconomy more generally, by reducing spending and economic activity, tighter money raises the risks of unemployment or bankruptcy faced by individual households or firms. In each case, tighter monetary policy increases risk by reducing financial buffers or otherwise increasing the vulnerability of individuals or firms to future shocks to the economy. Implications of the Results for Monetary Policy So far I have discussed two principal conclusions from the empirical analysis: First, the stock price multiplier of monetary policy is between 3 and 6--in other words, an unexpected change in the federal funds rate of 25 basis points leads, on average, to a movement of stock prices in the opposite direction of between 3/4 percentage point and 1-1/2 percentage points. Second, the main reason that unanticipated changes in monetary policy affect stock prices is that they affect the risk premium on stocks. In particular, a surprise tightening of policy raises the risk premium, lowering current stock prices, and a surprise easing lowers the risk premium, raising current stock prices. What implications do these results have for our broader understanding and for the practice of monetary policy? I will briefly discuss two issues: first, the role of the stock market in the transmission of monetary policy changes to the economy; and second, the efficacy of monetary policy as a tool for controlling stock market "bubbles." A long-held element of the conventional wisdom is that the stock market is an important part of the transmission mechanism for monetary policy. The logic goes as follows: Easier monetary policy, for example, raises stock prices. Higher stock prices increase the wealth of households, prompting 12-month moving average), the change in the bill rate, the smoothed dividend-price ratio, and the spread between 10-year and one-month Treasury yields. consumers to spend more--a result known as the wealth effect. Moreover, high stock prices effectively reduce the cost of capital for firms, stimulating increased capital investment. Increases in both types of spending--consumer spending and business spending--tend to stimulate the economy. This simple story can be elaborated somewhat in light of our results. It is true, as I have discussed, that an easier monetary policy raises stock prices, whereas a tighter policy lowers them. However, easier monetary policy not only raises stock prices; as we have seen, it also lowers risk premiums, presumably reflecting both a reduction in economic and financial volatility and an increase in the capacity of financial investors to bear risk. Thus, our results suggest that easier monetary policy not only allows consumers to enjoy a capital gain in their stock portfolios today, but it also reduces the effective amount of economic and financial risk they must face. This reduction in risk may cause consumers to trim their precautionary saving, that is, to reduce the amount of income that they put aside to protect themselves against unforeseen contingencies. Reduced precautionary saving in turn implies more spending by households. Thus, the reduction in risk associated with an easing of monetary policy and the resulting reduction in precautionary saving may amplify the short-run impact of policy operating through the traditional channel based on increased asset values. Likewise, reduced risk and volatility may provide an extra kick to capital expenditure in the short run, as firms are more likely to undertake investments in new structures or equipment in a more stable macroeconomic environment. A second issue concerns the role of monetary policy in the management of large swings in stock values, or "bubbles." In an earlier speech (Bernanke, 2002), I gave a number of reasons why I believe that using monetary policy--as opposed to microeconomic, prudential policies--is not a good way to address the problem of asset-market bubbles. These included the difficulty of identifying bubbles in advance; the questionable wisdom, in the context of a free-market economy, of setting up the central bank as the arbiter of asset values; the problem that arises when a bubble occurs in only one asset class rather than in all asset classes; and other reasons. A major concern that I have about the bubble-popping strategy, however, is that attempts to bring down stock prices by a significant amount using monetary policy are likely to have highly deleterious and unwanted side effects on the broader economy. The research I have described today allows me to address this issue more concretely. Here I will make just two points. First, this research suggests that relatively small changes in monetary policy would not do much to curb a major overvaluation in the stock market. As we have seen, a surprise tightening of 25 basis points should be expected to lower stock prices by only a little more than 1 percent, which, as already noted, is a trivial movement relative to the overall variability of the stock market. It would not be appropriate to extrapolate these results to try to estimate how much tightening would be needed to correct a substantial putative overvaluation in stock prices, but it seems clear that a light tapping of the brakes will not be sufficient. What we can say is that the necessary policy move would have to be quite large--many percentage points on the federal funds rate--and we would be highly uncertain 15 16 about its magnitude or its ultimate effects on stock prices and the economy. , There is a bit more to this analysis. An additional complexity arises from the fact that, although easier monetary policy allows consumers to enjoy a capital gain in their stock portfolios today, it also "takes back" some of that gain, so to speak, by affording shareholders a lower rate of return on their holdings, on average, in subsequent periods. Research by Sydney Ludvigson and Martin Lettau of New York University and Charles Steindel of the Federal Reserve Bank of New York (Ludvigson, Steindel, and Lettau, 2002; Lettau and Ludvigson, 2001) suggests that, because the gain in share prices induced by a monetary easing is partly transitory, consumers will not increase their spending in response to stock price changes induced by monetary policy as much as they will in response to stock price changes induced by other factors. The estimates in our paper suggest that this differential effect will be relatively small, however. Also, to the extent that the capital gains induced by monetary policy are perceived as partly transitory, the short-run response of investment spending will be strengthened, as firms prefer to invest while stock prices remain high; see Lettau and Ludvigson, 2002, for evidence. In short, if changes in stock values induced by monetary policy are perceived as relatively more transitory, the effects of policy will be concentrated more on investment spending and less on consumption spending than the conventional wisdom suggests. Greenspan (2002) notes several episodes in which increases in the federal funds rate of several hundred basis points did not materially slow stock appreciation. He argues that "such data suggest that nothing short of a sharp increase in shortterm rates that engenders a significant economic retrenchment is sufficient to check a nascent bubble." The late Fischer Black once defined an efficient stock market as one in which prices are between half and double fundamental values; if Black's view is to be believed, then identifiable deviations of prices from fundamentals would have to be quite large indeed. Implicitly I am considering here the case of a central bank that responds only sporadically to stock prices, in those situations in which it perceives a bubble to be forming. Irregular deviations from a policy rule focused on output and inflation seem appropriately modeled as unanticipated movements in policy. An alternative policy strategy would be to incorporate regular Second, we have seen that monetary tightening reduces stock prices primarily by increasing the risk premium for holding stocks, as opposed to raising the real interest rate or lowering expected dividends. The risk premium for stocks will rise only to the extent that broad macroeconomic risk rises, or that people experience declines in income and wealth that reduce their ability or willingness to absorb risk (Campbell and Cochrane, 1999). This evidence supports the proposition that monetary policy can lower stock values only to the extent that it weakens the broader economy, and in particular that it makes households considerably worse off. Indeed, according to our analysis, policy would have to weaken the general economy quite significantly to obtain a large decline in stock prices. Conclusion I have reported today on empirical work, by my coauthor and me as well as by others, about the links between monetary policy and the stock market. I have only touched on a large literature, and I apologize to the many researchers whose work I have not been able to describe today. But I hope that I have given you a flavor of how empirical research can help us to refine our understanding of how monetary policy works and how policy should be conducted. reactions to stock values into the systematic part of the monetary policy reaction function. That strategy has some advantages, but it has the important disadvantage that it does not discriminate between fundamental and nonfundamental sources of changes in stock values. Bernanke and Gertler (2001) present simulations showing that such a strategy is unlikely to be beneficial in terms of overall macroeconomic stability.
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Remarks by Mr Edward M Gramlich, Member of the Board of Governors of the US Federal Reserve System, before the Economic Club of Toronto, Toronto, Canada, 1 October 2003.
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Edward M Gramlich: Maintaining price stability Remarks by Mr Edward M Gramlich, Member of the Board of Governors of the US Federal Reserve System, before the Economic Club of Toronto, Toronto, Canada, 1 October 2003. The references for the speech can be found on the Board of Governors of the Federal Reserve System’s website. * * * One of the remarkable economic developments of the past two decades is the sharp, worldwide reduction in rates of inflation. Before the 1980s, research papers, economic commentary, and textbooks here and abroad were full of discussions of the causes and consequences of high inflation and of the political difficulty of bringing it under control. It looked then like inflation had become a more or less permanent feature of the economic landscape. Concepts associated with deflation such as liquidity traps and the zero bound on nominal interest rates had, for practical purposes, disappeared from economic thought. But, beginning around 1980, central banks around the world seem to have ganged up on inflation, fought the fight, and won. The International Monetary Fund's consumer price index for industrial countries registered an annual rate of inflation exceeding 12 percent in 1980, but by 2002 the rate had dropped to just 1.4 percent. In the United States, consumer price inflation excluding food and energy fell from 12.4 percent in 1980 to 2.4 percent in 2002. Japan has actually had negative rates of inflation for the past four years. The drop in inflation in many prominent emerging-market countries has been even more breathtaking (Rogoff, 2003). Perhaps just as remarkable as the abrupt fall in worldwide inflation is the widespread agreement on the reasons for its fall. Virtually all economic analysts would give a primary role to the implementation of plain old economic theory. Macroeconomists had long understood that, in the famous words of Milton Friedman, "inflation is everywhere and always a monetary phenomenon." But somehow this theoretical agreement never was translated into action. Perhaps because of advances in understanding the inflation process, perhaps because of worrisome increases in inflation rates, perhaps because of a discovery that the economic costs of fighting inflation were not as high as previously believed, central bankers in the 1980s suddenly began to use their monetary control to limit the rate of increase in prices. It is not stretching things to call this a revolution in central banking. Now that something like price stability has arrived, two important policy questions present themselves: · Is a mere determination to achieve price stability adequate for central banks to stabilize prices, or should their determination be backed up by more formal institutional structures, such as in inflation-targeting regimes? · Exactly how stable do we want prices to be--rising at a measured rate of zero or at some other rate? Maintaining Price Stability Price stability is widely understood to be a feasible objective and to be sustainable with little long-run cost in terms of output and unemployment. Indeed, many believe that greater price stability should also stabilize output, and that the improved allocation of resources coming from price stability should promote productivity and raise living standards in the long run. As a part of this consensus, central banks around the developed world are now firmly determined to achieve and maintain price stability. But there is a significant debate about whether determination alone is enough. Much of the world-countries in the British Commonwealth (the United Kingdom, Australia, Canada, and New Zealand), in Scandinavia (Finland, Norway, and Sweden), in eastern Europe (the Czech Republic, Hungary, and Poland) and many emerging-market countries (Brazil, Chile, Colombia, Mexico, Peru, the Philippines, South Africa, and Thailand)--have buttressed this determination to maintain price stability by adopting formal inflation-targeting regimes. The regimes vary, but the key element is an explicit commitment to meet a publicly stated numerical target rate of inflation within a particular time frame. The targets and commitments are accompanied by reports giving inflation forecasts and plans for meeting inflation goals. All regimes provide some leeway in meeting their goals--inflation rates do not have to be brought down to the target levels immediately, and special factors can be taken into account. But the regimes must have a credible plan for meeting inflation targets at least over the medium run. And because these plans are public, they can be embarrassing if not fulfilled. Recently the European Central Bank (ECB) has adopted a system that has some elements of an inflation-targeting regime, though it lacks many of the accountability features. A few industrial countries--the United States, Japan, and Switzerland--have resisted pressures to adopt formal inflation-targeting regimes. Debates continue in these countries about the desirability of adopting more formal inflation-targeting procedures. The inflation targeters point to the advantages of transparency, commitment, and accountability; non-targeters point to the loss of flexibility and the reduction in the ability to meet alternative goals such as high employment and financial stability. Rudebusch and Walsh (1998) give a good summary of this debate. To me, the verdict on theoretical grounds alone has always been a close call. I can see the advantages of transparency and commitment and of giving financial markets some indication about the central bank's inflation goals. I can also see the fear that, in practice, such regimes may in fact constrain actions in ways that could be rigid, inflexible, and perhaps unnecessary in bringing down inflation. Rather than rehash these theoretical issues one more time, let me instead invoke some empirical evidence. There are two ways to evaluate the effect of formal inflation-targeting regimes. One is by time-series analysis; the other by cross-section analysis. In the early days of inflation targeting, a number of researchers took the first approach and compared the inflation performance of targeting countries before and after the inflation-targeting regime was introduced. In these studies, which measured actual inflation rates and inflation premiums on long-term bonds (to measure expected inflation), one could find evidence that inflation targeting seemed to have worked to bring down inflation and its persistence (see, for example, Kuttner and Posen, 1999; and Freeman and Willis, 1995). But these early studies took place at the time of a worldwide drop in inflation rates. Just as inflationtargeting countries could show elements of improved inflation performance, nontargeting countries could as well. The second approach to studying the effect of targeting, cross-section analysis, compares inflation performance for targeting and nontargeting countries. The advent of the ECB created a huge impediment to such studies because it came into being midway through the relevant data period, and it initiated a centralized regime that had aspects of inflation targeting for many of the large countries that had previously not had such a regime. It is difficult to know whether the ECB countries should be considered inflation targeters in the last half of the time-series sample, and it is especially difficult to interpret the experience of these countries. For what they are worth, the raw cross-sectional data are shown in table 1. Over the 1994-2002 period, seven prominent inflation-targeting industrial countries had a mean inflation rate of consumer prices of 2.1 percent per year with a standard deviation of 1.7 percent. Both numbers are slightly higher than the mean and standard deviation of the eleven prominent nontargeting industrial countries. Eliminating the labeled ECB countries from both groups leads to a targeting mean of 2.0 percent and a targeting standard deviation of 1.7 percent, with both numbers again slightly higher than the mean and standard deviation for the three nontargeters. One could consider Japan a special case and eliminate it from the latter group, but the two-country results would still show slightly lower and more stable inflation in the nontargeting countries. Ingenious economists could devise much more elaborate tests. Ball and Sheridan (2003) have done that, also making an adjustment for initial rates of inflation. They again find no significant differences between targeting and nontargeting countries. Their conclusion is similar to an earlier cross-section finding of Cecchetti and Ehrmann (1999) that inflation aversion increased in both targeting and nontargeting countries. To summarize these international data, one might say that something brought inflation down in the 1980s and 1990s, but success was fairly uniform across both the inflation-targeting and nontargeting countries. When one does "before and after" tests for individual inflation-targeting countries spanning this period, inflation targeting often looks successful in bringing about low rates of inflation and in reducing inflation variability and persistence. But by the late 1990s, inflation had fallen in all industrial countries, and it is hard to find much difference in inflation performance between inflation-targeting and nontargeting countries--if anything, inflation has been lower and more stable in the latter group. One is therefore tempted to conclude that the general understanding of the inflation process and a firm determination to achieve price stability, more than the inflation-targeting regime itself, has been the key element in reducing inflation. How Stable Should Prices Be? Collectively, the central banks of the world have done well in reducing inflation, generally moving from an inflationary regime to one of reasonably stable prices. But now the goal question gets harder--how far should these central banks go? All the way to exactly stable prices with a measured inflation rate that averages zero, or somewhat short of that goal? I will argue strongly that central banks should stop short of zero--that a low positive rate of inflation is optimal. There are two strategic reasons for choosing a low, positive rate, and both have been debated extensively in the economic literature. One involves the so-called zero bound on nominal interest rates; the other involves labor markets. Regarding the zero bound, as inflation drops toward zero, nominal interest rates drop toward real rates, which themselves might be low if the reason inflation is dropping involves negative demand shocks. At these low rates, the central bank is poorly positioned to respond to further negative demand shocks. Because of the zero bound, it is impossible for nominal interest rates to decline further, but it is still possible for inflation to decline to below zero--that is, for deflation to set in. The combination implies that real interest rates may actually start to rise in the face of negative demand shocks. In this range, the central bank loses much of its ability to respond to these negative demand shocks by lowering real rates of interest. As many have pointed out, the central bank could still respond to negative demand shocks by expanding money growth in various "nontraditional" ways. But these nontraditional approaches are untested. Macro-model simulations indicate that if the central bank exercises only traditional policy instruments, the zero-bound problem could significantly increase the severity of recessions. The virulence of the Japanese recession also suggests that zerobound problems could be serious. Today the standard thinking is that the central bank can and should avoid dealing with these difficulties by guiding the economy toward a low, positive rate of inflation, not a zero rate. The second argument for avoiding mathematical zero involves labor markets. A good deal of evidence suggests that, in the economy at large, employers are reluctant to cut workers' nominal wages or, at least, downward wage rigidities exceed upward rigidities. The normal market process of reallocation of labor in response to industry or sectoral shifts works by having real wages adjust to keep them in line with workers' marginal products of labor. If nominal wages cannot be cut for workers who, for whatever reason, become less productive, labor market flexibility is enhanced by having low positive overall rates of inflation that effectively cut real wages for these workers. To these strategic reasons for avoiding mathematical zero can be added a measurement reason. One of the great difficulties in compiling price indexes is in adjusting them for changes in the quality of goods and services. How does one measure the value of a new good or of a service that benefits from a new technology? Casual evidence indicates that failure to make accurate adjustments can create a bias that could be quite large--indeed, King (2002) gives some heuristic illustrations that suggest that the true prices of some consumer durables have not risen at all since as far back as 1915! The statistical agencies compiling consumer prices in the United States--the Bureau of Labor Statistics for the consumer price index (CPI) and the Department of Commerce for the personal consumption expenditure deflator (PCE)--try valiantly to deal with these quality-change biases. But the weight of professional opinion is that, even after years of trying to make corrections, the indexes are still biased upward. Since no ready methods exist for correcting some of these biases, it seems appropriate simply to adjust for them. It is generally agreed that the biases are about 1 percentage point per year for the CPI and about 1/2 percentage point per year for the PCE deflator (Lebow and Rudd, 2003). Whichever inflation target one uses, there is again a measurement argument for steering away from mathematical zero and toward a measured rate of inflation of from 1/2 point to 1 point per year above the desired economic cushion. A final argument for steering away from mathematical zero invokes popular preferences, always an elusive topic. When economists have asked people whether inflation is harmful and whether controlling it should be a high priority for government, overwhelming percentages of the population agree. But when people are probed further, their main reason for disliking inflation appears to be the perception that it hurts their standard of living (Shiller,1997). Popular opinion seems to view personal wage increases as given--that is, not related to inflation--and focuses only on price increases, in which case inflation does look like a destroyer of real income. To economists, on the other hand, inflation should be interpreted to mean a general rise in all wages and prices; and the costs of general inflation are the "shoe leather"-type costs of managing cash balances, which the respondents to Shiller's survey viewed as trivial. Hence while inflation is clearly unpopular with the general public, it is not clear that the public is properly identifying the true costs of inflation when making its judgment. A potentially more appropriate way to ascertain the true degree of inflation was suggested by Richard Ruggles of Yale University. I learned about this test in graduate school many years ago, and Ruggles may have made his suggestion many years before that. What inflation rates should really measure is the decline in the utility value of a nation's currency. In principle the right test is to offer a sample of the population a constant amount of currency, say $1,000, along with the opportunity to spend it on a menu of all goods and services available this year or a menu of all goods and services available a while back, say five years ago. If this sample of the population votes in equal numbers for this year's menu and for that available five years ago, one can conclude that prices have been stable over the five-year period. If the majority vote is for the earlier menu of goods and services, one can conclude that prices have risen, or that the utility value of the $1,000 has decreased. If the majority vote is for the recent menu, one can conclude the reverse--that true prices have actually declined. I have seen no rigorous polling evidence on this question. But for years in teaching college macroeconomics courses, and recently at the Fed, I have conducted such a poll among my audiences. All audiences have reported that their understanding of what inflation is all about was much improved by this thought experiment. Generally, college students have voted for the current menu even in times when the aggregate rate of price increase averaged 3 percent or more, implying that they felt that true prices had actually declined. College students may be unusually influenced by fads that do not truly improve goods (narrow or wide ties, etc.), and the implicit bias in measured price indexes may well be overstated by collegiate polls. Since coming to the Fed, I have had the opportunity to talk to and poll many banker groups about inflation, and as one would expect, they are generally more inclined to vote for the earlier menu of goods than were my college students, at any given rate of inflation. But these days, when measured rates of inflation are running at 1.5 percent to 2 percent, even bankers consistently vote for the current menu of goods by fairly wide margins. If even bankers feel that the implicit measurement bias in price indexes exceeds 2 percent, that may be a phenomenon worth noting. The upshot of this highly anecdotal test is that I have long suspected that true price stability might really be achieved in the vicinity of measured inflation rates of 2 percent or even more. It would be desirable to ground this type of information more firmly in modern-day techniques of data collection. Ideally, consumer survey groups would run polls of currency utility and make periodic reports, the way they already do for indicators of consumer confidence and spending plans. Short of that, there is one econometric calculation that provides some support to my informal voting results. Nordhaus (1998) compared real incomes as measured by the CPI with Survey Research Center data in which people were asked how their financial condition changed over the past year. He fitted a regression to the data, finding that equal shares of the population considered themselves better and worse off when the measured inflation rate was 1.5 percent, a result suggesting a 1.5 percent measurement bias in the CPI. Nordhaus's method requires that the entire income distribution move at the same rate. When Krueger and Siskind (1998) modified the test with more fine-grained distributional calculations, the estimated bias was reduced. Summary So where does this leave me on the two policy questions I promised to address? I find myself on the soft side of each of them. The first question is whether the U.S. central bank should adopt a more formal inflation-targeting regime. I personally would not go that far. My reading of the empirical evidence is that the key ingredient in keeping inflation low and stable is that the central bank be firmly determined to achieve and maintain stable prices in the long run. I believe the Fed is already so determined, with every member of the Federal Open Market Committee (FOMC) since I have been here repeating this mantra often. To me, there does not seem to be huge value in further tying down the committee through a formal inflation-targeting regime, and there could be some costs. On the other hand, it may be possible to get some of the transparency and accountability advantages of inflation targeting, and to lock in the gains from having reduced inflation, by going to an intermediate approach. The FOMC might simply announce its preferred long-run range for inflation. This range should be understood as a preferred range that would not bind the committee or override other important objectives of monetary policy. It should clearly be understood as a long-term objective, not a short-term objective. The FOMC would not have to defend any deviations from the preferred range. Perhaps such a step would increase transparency without limiting central bank flexibility to any appreciable degree. If we were to adopt a preferred range, what should it be? In light of the strategic considerations mentioned above, along with quantifiable measurement error, I would personally set the bottom of the range at slightly above 1 percent per year for the core PCE deflator, the Fed's preferred inflation measure. Because of audience polls, and at least until they are replaced by more rigorous information, I would set the top of the range at about 2.5 percent per year. The midpoint of this range is then slightly less than 2 percent per year, which turns out to be about what U.S. core PCE inflation has averaged over the past eight years. But I would stress the range more than the point estimate. I might close by stressing again the uncertainty involved in answering both questions addressed in the paper. There is theoretical uncertainty about how well formal inflation targeting should work and empirical uncertainty about how well it has worked in those countries that have tried it. If we were to move in the direction of a more systematic approach, I personally would go to a preferred range for inflation rather than a particular target and without all of the other trappings of a formal inflationtargeting regime. Finally, if the FOMC were to adopt a preferred range, I feel that efforts to quantify measurement bias in price indexes have, on the whole, been too conservative. My own personal preference is that the top of the range could go as high as 2.5 percent per year. Table 1 Inflation Performance in Selected Industrial Countries, 1994-2002 (Percent annual average; broad index of prices for all consumer goods) Country Mean Standard deviation Inflation targeters Australia 2.7 2.9 Canada 1.7 1.6 Finland (ECB) 1.6 1.3 New Zealand 2.1 1.8 Spain (ECB) 3.1 1.8 Sweden 1.2 1.5 United Kingdom 2.4 .7 Austria (ECB) 1.8 1.1 Belgium (ECB) 1.8 1.4 France (ECB) 1.4 1.0 Germany (ECB) 1.7 1.2 Ireland (ECB) 2.9 1.9 Italy (ECB) 2.9 1.4 Japan .1 1.3 Netherlands (ECB) 2.6 1.3 Portugal (ECB) 3.3 1.3 Switzerland 1.2 1.5 United States 2.3 1.0 Mean, targeters 2.1 1.7 Mean, nontargeters 2.0 1.3 Mean, non-ECB targeters 2.0 1.7 Mean, non-ECB nontargeters 1.2 1.3 Nontargeters Memo: Note: ECB means that as of 1999 the country had joined the European Central Bank and had a common monetary policy.
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Speech by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, at the Future of Financial Services Conference, University of Massachusetts, Boston, 8 October 2003.
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Roger W Ferguson, Jr: The future of financial services - revisited Speech by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, at the Future of Financial Services Conference, University of Massachusetts, Boston, 8 October 2003. * * * It is my pleasure to join you again, five years after I first spoke to this conference on the future of the financial services industry. Today, I want to re-visit the evolution and performance of the financial services industry, not only in light of what I discussed five years ago but also, more importantly, in light of a number of significant events and market developments that have occurred since then. Clearly, I will be able neither to cover all the interesting topics nor to discuss in depth each of those subjects that I do include. But I believe it is useful to step back occasionally and try to take a broad view of our detailed and complex financial landscape. In the interest of full disclosure and for the benefit of those of you who either were not here five years ago or may not have committed my remarks to memory, I will begin by summarizing the conclusions I advanced the last time I spoke at this podium. At that time I highlighted four general conclusions. First, I suggested that the movement toward large financial conglomerates, stimulated by the ongoing blurring of traditional distinctions between financial products provided by commercial banks, investment banks, insurance companies, and other financial intermediaries, might prove to be transitory. Second, I argued that basic financial and risk-management skills would likely remain the most important determinant of a company’s viability and continued success. Third, I maintained that, even in a world of financial conglomerates, there would be room for smaller and, in some cases, morespecialized market participants. Last, I indicated that the supervisory and regulatory structure and practice would need to evolve to meet all of these challenges, and that regulatory authorities would need to remain vigilant in carrying out our duties, particularly in the area of antitrust enforcement. These conclusions still seem reasonable to me. That having been said, events and market forces require that we rethink and refocus our views, and your invitation gives me the opportunity to do so. So, what have been the major factors that have influenced the financial services industry, and especially the banking industry, over the past five years? And how should we interpret these developments with respect to their effects on the recent past and the future? I see at least five broad topics that are worthy of our attention. First, the recession of 2001 and the unusually slow recovery over the past two years have clearly affected the banking and financial services industry. Second, the passage of the Gramm Leach Bliley Act in late 1999 recognized many of the market realities I discussed with you in 1998 and provided increased opportunity for the formation of large financial conglomerates. Third, accounting and corporate governance scandals, symbolized by Enron and WorldCom, and the resulting passage of the Sarbanes-Oxley Act in July 2002, have not left the financial services industry untouched. Fourth, although the dot-com craze has ended, technological change has continued, and its influence on the present and future of financial services is pervasive. Finally, all these developments and others, such as the Russian debt default in the fall of 1998, have accentuated the importance both of risk measurement and management at individual banks and of the need for supervisory policies and procedures to reflect and encourage modern risk management. The Recession of 2001 Turning first to the recent recession and our unusually slow recovery, I think that the most remarkable fact regarding the banking industry during this period is its resilience and retention of fundamental strength, even at those institutions whose earnings were negatively affected by the slowdown. Beginning about the time I last spoke to you, the U.S. financial system suffered a sharp increase in corporate bond defaults, business failures, and investor losses. At commercial banks, troubled loans, including charge-offs, classified loans, and overdue credits, climbed. In sharp contrast to other periods of economic weakness and market volatility, however, during the most recent period the vast majority of commercial banks remained unusually healthy. Strong rates of return on both equity and assets and healthy capital ratios were all maintained. Perhaps most tellingly, the period from 1998 through 2002 averaged only five bank failures per year. Today, market measures of bank risk derived from stock prices, subordinated debt spreads, and credit default swap spreads all signal a healthy banking industry. In contrast, in the last three years of the 1980s, more than 200 banks failed on average each year (not to mention a larger number of savings and loans). Even in 1993, two years after the 1990-91 recession ended, slightly more than 100 banks failed. To what can we attribute the recent outstanding performance, and will it be repeated in future economic slowdowns? In truth, our current good fortune stems from many factors, none of which can we count on recurring but several of which we can somewhat control. One factor is that the most recent recession was relatively short and weak, even though the recovery has been slow. That the Federal Reserve moved early and aggressively to lower interest rates has also been very helpful to banks and other participants in the U.S. economy. I suspect that many of you in this room have refinanced your mortgages, perhaps more than once, over the past two years. Maybe some of you even cashed out, or extracted, some of the equity you had accumulated in your house when you refinanced your old loan. Such mortgage-related activities have helped consumers to maintain their expenditures, have helped the overall economy to grow, and have contributed significantly to the earnings of the banking system. These earnings have helped banks absorb losses elsewhere in their portfolios and to maintain loan loss reserves. Indeed, in the second quarter of this year, the fifty largest U.S. bank holding companies reported record earnings of more than $20 billion, and annualized rates of return on equity and assets were very impressive. Another important factor is that the U.S. banking system entered the current period of stress well capitalized and with strong reserves. No doubt such balance sheets were due in very large part to the economic prosperity of the second half of the 1990s. But I believe that other forces were also at work. Certainly bankers themselves learned many lessons from the banking and thrift crises of the late 1980s and early 1990s, including the importance of having strong capital and reserves and of avoiding obligor and industry concentration of credit risk. Perhaps equally important were the banking reforms put in place in the aftermath of those crises. Of the many reforms, I highlight the emphasis on strong capital positions provided by the Federal Deposit Insurance Corporation Improvement Act of 1991 and other changes in supervisory policy, such as the move toward risk-based capital standards embodied in the 1988 international capital agreement known as the Basel Accord. I hope that bankers and their supervisors will remember these lessons well into the future. I also point to another reason that the U.S. banking system has performed so well over the current economic cycle. This factor is the truly impressive improvement in methods of risk measurement and management and the growing adoption of these technologies by mostly large banks and other large financial intermediaries over the past five years. To be sure, at most banks the application of these methods is still in its infancy, if it has begun at all, and even the most advanced banks have room for improvement. But modern advances in the quantification of risk and in its management have provided bank management with a far more disciplined and structured process for evaluating loans, pricing risks, and deciding which risks to retain. Careful judgment by experienced credit officers or risk managers is still required, but the modern techniques developed by both academics and market practitioners are tools that facilitate a much deeper evaluation of risk than was possible even a decade ago. These developments have been supported and encouraged by the growth of markets for syndicated loans and securitized assets and the creation of new financial instruments, such as credit derivatives, that greatly ease the dispersion of risk to those more willing and able to bear it. Do not misunderstand me. New risk-management techniques and instruments bring their own problems, some of which I will return to in a moment. But, in my view, the successful application by those banks taking advantage of these new management tools and techniques has been an important part of the explanation for why the banking system has remained so strong during our most recent period of stress. Gramm-Leach-Bliley and the Potential for Financial Conglomerates When I spoke to you in the fall of 1998, the financial conglomerate was a very hot topic. Indeed, just a little more than a year after that date, the Congress enacted, and the President signed into law, the Gramm-Leach-Bliley Act. The act recognized the market reality that it was becoming increasingly difficult to maintain traditional distinctions between many of the activities of commercial banks, investment banks, and insurance companies. In response, the Congress relaxed long-standing restrictions on affiliations among these three types of entities. To avoid extending the subsidy implicit in deposit insurance and access to the Fed’s discount window and payment system guarantees to these new activities, the act required that most investment banking and insurance business in banking organizations be conducted in a legally separate financial holding company affiliate of a commercial bank. In addition, the Congress required that, to be a part of a financial holding company, an institution must be well capitalized and well managed. An interesting observation is the slow pace of change since 1999. The slow pace is, no doubt, partly a result of the economic slowdown and the stock market decline. But I suspect that these factors do not fully explain what has happened. Indeed, I suggest that the financial conglomerate, or the financial supermarket, or whatever you want to call it, is in fact much more difficult to implement than many may have thought. True, there were about 600 domestic financial holding companies of the end of 2002. But less than one-third reported actually engaging in any new activities authorized by Gramm-Leach-Bliley, and about 80 percent of these report engaging in insurance agency activities, probably the least “new” and least risky of all the possibilities provided by the act. Only about forty institutions reported broker-dealer assets, around thirty reported insurance underwriting assets, and less than twenty said they held significant merchant banking assets using Gramm-Leach-Bliley authority. Even accounting for the fact that some of these activities are conducted primarily at the largest financial holding companies, and recalling that large bank holding companies were already engaging in some of these activities through the previously authorized section 20 affiliates, we have not been able to uncover any evidence that the overall market structure of these segments of the financial services industry has substantially changed. Of course, while the overall structure has not changed, some firms have gained market share in certain segments. These facts do not suggest that we should be complacent regarding the need to maintain competitive markets in financial services. It is difficult to overstate the benefits of competition, and thus I stand by my admonition of five years ago that policymakers should remain vigilant in antitrust enforcement. Indeed, even though there have not been fundamental changes in the structure, in my judgment what deserves the emphasis is the persistent and even increasing competitiveness of the U.S. banking and financial markets. Let me try to illustrate what I mean. The U.S. banking system has experienced significant consolidation over the past several years. Between 1994 and 2002 there were slightly more than 3,300 bank mergers in the United States, and almost $3 trillion in banking assets were acquired. This consolidation led to considerable increases in national concentration among the largest banking organizations. For example, the share of domestic banking assets held by the top five banking organizations went from 18 percent in 1994 to almost 32 percent in 2002, and the share of the top twenty-five went from 46 percent to 61 percent. However, these numbers tend to hide more than they reveal about the competitiveness of the U.S. banking structure. For example, at the end of 2002 there were still almost 6,500 commercial banking organizations in the United States, not to mention almost 1,400 savings institutions and almost 10,000 credit unions. Moreover, between 1994 and 2002 more than 1,300 new banks were opened in the United States, sometimes in direct response to perceived declines in service resulting from a bank merger. Most importantly, the degree of concentration in local banking markets, both urban and rural, declined modestly, on average, during this period. Local markets are the very markets that are the focus of virtually all of our antitrust analysis because they are the markets where most households and small businesses conduct the vast majority of their banking business. For all of these reasons, and for others that I do not have time to discuss, I would argue that the U.S. banking structure has generally remained competitive, and in some cases has become more competitive, over the recent period of intense merger activity and institutional and legislative change. I am optimistic that this dynamic competitiveness, helped along every now and then by antitrust enforcement, will continue. Accounting and Corporate Governance Many people, myself included, have found the last few years’ revelations of accounting and corporate governance problems at many of our nation’s most well-known corporations both disturbing and unacceptable. The foundations of an efficient and competitive free market economy in a democratic society include accounting transparency, a commitment by owners, managers, and employees to high standards of ethical behavior, and the maintenance of internal organizational structures and incentives that encourage ethical behavior. Unfortunately, some of the cases of unacceptable behavior have occurred in the financial services industry. Inadequate oversight of business lines by boards of directors has been a problem in some instances. In one recent case, this deficiency resulted in transactions with special purpose entities without adequate knowledge on the part of the board and without effective identification and management of risks. More generally, we have seen transactions that elevated form over substance, violated accounting rules, and created serious reputational and legal risks for the institution, all with the apparent approval of outside auditors and lawyers. In an attempt to deal with many of these and other issues, the Sarbanes-Oxley Act was enacted in late July 2002. In addition, the Securities and Exchange Commission, bank regulators, state attorneys general, and others have taken many, sometimes well publicized, actions to improve accounting transparency and corporate governance. Perhaps more important, the market itself has handed out very harsh punishment to some firms that had lost their credibility with investors and customers. In principle, it seems to me that these actions should provide powerful incentives for virtually all market participants to maintain high standards. Technological Change Technological change had become a pervasive influence on our lives long before I first spoke to this conference in 1998. It continues to be so, and surely it will be a force for the foreseeable future. Virtually all industries that have been profoundly affected, and financial services is no exception. I have already mentioned the importance of technological change in improving risk measurement and management at financial institutions as a reason banks have weathered the recent economic downturn. Moreover, I fully agree with the many observers who have highlighted the role of technology in breaking down traditional distinctions between commercial banking, investment banking, and insurance products. In this sense, the Gramm-Leach-Bliley Act can be thought of as a response to technological change. And, technological change can surely throw us some unexpected curves, as the successfully navigated but hugely expensive adjustments to deal with the century date change showed. I will return in a few moments to the role of technological change in risk measurement and management and its influence on supervisory policy. But first I want to spend a few moments discussing some interesting facets of the impact of change on the technologies used by American households to consume financial services. The process by which technological change becomes embedded in production and consumption has long absorbed the attention of economists. Despite this interest, the process remains a considerable mystery, and households’ use of financial services is no exception. For example, many academics, regulators, and bankers have for many years forecast that technological change would end use of the paper check and make the brick-and-mortar bank branch obsolete. However, here we are in October 2003 and the paper check is still very much in use, the smart card has not succeeded as predicted, and the number of brick-and-mortar bank offices is still increasing. Clearly, there is much that we do not understand. I am not here today to propose any definite answers to the question of why households adopt new technologies in financial services more slowly than we sometimes predict. But I would like to present a few facts that we have gathered over time in our triannual Survey of Consumer Finances that shed some light on this complex topic. In 1995, we began asking households about their use of computers to conduct business with their financial institutions. In that year, barely 4 percent of households with a checking account said they used a computer to consume financial services. By 1998, the year of the next survey, the percentage saying they used a computer had risen to more than 6 percent. In contrast, in 1995 the most common technology used by households for interacting with a financial institution was, by a wide margin, the inperson visit to an office. In that year, 87 percent of households said they used this technology. By 1998 the percentage of households using in-person visits had declined to 80 percent, but this was still by far the most common form of access. Still, the data for 1995 and 1998 suggested change was beginning to occur, and the data for 2001 confirmed that trend. In the 2001 survey, the percentage of households with a checking account that said they used the computer to consume financial services jumped dramatically to almost 20 percent. However, use of the most common technology, the in-person visit, declined only modestly, to 78 percent. While one cannot draw any strong conclusions from this small number of facts, they support the view that, in matters of finance, households tend to adopt technological change only gradually. In addition, even when new technologies start to gain more widespread acceptance, old technologies are abandoned rather slowly and many users perhaps view the old and new technologies more as complements than as substitutes. Research conducted by the Federal Reserve Board’s staff reinforces the notion that the adoption of technological change is a highly complex process. For example, it appears that income, education, age, and other factors, perhaps even a household’s attitudes toward risk, play important roles in determining a household’s willingness to adopt new technologies for the consumption of financial services. On balance, I would suggest that strategic planners at financial institutions will need to take a wide variety of factors into account in planning and marketing technological innovations. Risk Measurement and Management and the Implications for Supervisory Policy In the final section of my remarks to you five years ago, I emphasized the need for the Federal Reserve to continually improve the bank supervisory process to ensure that banks adequately manage the risks that could be introduced into the financial system by changes occurring in the financial sector. I have no doubt that this statement remains valid today, although the risk management challenges facing banks have certainly evolved. For example, our experiences with the market disruptions that followed the Russian default and the Asian debt crisis, and the growing importance of financial markets in the risk management processes of both financial and nonfinancial firms have helped to accentuate the importance of market liquidity. Another significant adjustment in our supervisory emphasis is our ongoing effort to revise the Basel Capital Accord. Today, I can give you only a taste of what we are trying to do, but over the past five years, bank supervisors in the United States and other nations have devoted a truly impressive amount of resources to developing a new set of international capital standards. Indeed, in early August of this year the Federal Reserve and the other U.S. bank regulators released some very specific proposals for public comment. The comment period ends in early November. After assessing these comments together with those already received by the Basel Committee, the U.S. banking agencies will seek appropriate changes in the proposals. The need for Basel II, as the proposed revised accord is called, arises because modern risk measurement and management practices, including the increasing ability to securitize assets, have made Basel I increasingly out-of-date, or should I just say, increasingly irrelevant, for our largest and most complex banking organizations. For example, the Basel I capital standards have only four risk categories, and most loans receive the same regulatory capital charge even though loans made by banks encompass a wide spectrum of credit quality. The highly limited differentiation among risks means that regulatory capital ratios are too often uninformative and might well provide misleading information regarding banks with risky or problem credits or, for that matter, with portfolios dominated by very safe loans. Importantly, banks own internal capital models increasingly differentiate risks much more finely than do regulatory capital standards. Another problem with Basel I is that its overly simplistic risk measures, when combined with advances in financial engineering technologies and improved risk measurement and management practices, have given banks the incentive and the means to game the system through so-called regulatory capital arbitrage. Regulatory capital arbitrage is the avoidance of regulatory capital charges through the sale or securitization of bank assets for which the capital requirement that the market would impose is less than the current regulatory capital charge. For example, low-risk residential mortgages are often securitized rather than held on a bank’s books in part because the market requires less capital than does Basel I. This behavior is perfectly understandable, even desirable, in terms of improving economic efficiency. But it means that banks engaging in such arbitrage retain the higher-risk assets for which the regulatory capital charge, calibrated to assets of average quality, is on average too low. The Basel II capital standards seek to improve regulatory capital standards via three broad and interrelated strategies, or “pillars.” The most important pillar, Pillar 1, consists of minimum capital requirements. These requirements are rules by which a bank calculates its minimum capital ratio and by which its supervisor assesses whether the bank complies with the minimum capital threshold. As under Basel I, a bank’s risk-based capital ratio under Basel II would have a numerator representing the capital available to the bank, and a denominator that would be a measure of the risks faced by the bank, referred to as “risk-weighted assets.” What would be radically different is the definition of risk-weighted assets. Under our proposals, the most advanced banks would use modern risk-management techniques, subject to validation by supervisors, to compute the risks in their on- and off-balance-sheet portfolios. These procedures would more closely align regulatory capital requirements with the underlying economic risks of a banking organization. As a result, the safety and soundness and the efficiency of the banking and financial system should be greatly improved. Pillar 2 explicitly addresses supervisory oversight. It embodies the concept that a well-managed bank should seek to go beyond simple compliance with minimum capital requirements to assess whether it has sufficient capital to support its risks. In addition, on the basis of their knowledge of best industry practices at a range of institutions, supervisors would provide constructive feedback to bank managers on their bank’s capital adequacy and its risk measurement and management practices. Lastly, Pillar 3 seeks to complement Pillars 1 and 2 by encouraging stronger market discipline of banking organizations. An important element here is requiring a bank to publicly disclose key measures related to its risk and capital positions. Such disclosures should help uninsured creditors of a bank more accurately assess the risks of investing in the uninsured liabilities of the bank, including taking the opposite side of financial derivatives transactions. Conclusion In closing, I want to thank you again for inviting me to speak to you. The future of the financial services industry is something that should interest us all. It is certainly something that will affect us all, and I look forward to observing and participating in its evolution over the coming years.
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Remarks by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, at the opening of the New England Economic Adventure at the Federal Reserve Bank of Boston, Boston, 8 October 2003.
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Roger W Ferguson, Jr: The New England Economic Adventure Remarks by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, at the opening of the New England Economic Adventure at the Federal Reserve Bank of Boston, Boston, 8 October 2003. * * * It is a pleasure to participate in the opening of the New England Economic Adventure at the Federal Reserve Bank of Boston. The educational possibilities presented by the Adventure are truly exciting. The Federal Reserve System has a long history of involvement in economic education. An understanding of economic principles, especially the workings of markets, is fundamental to good decisionmaking - whether by workers, or employers, or public policymakers. I also confess to some self-interest in this regard. A better understanding of economics by the public makes the task of the Federal Reserve System easier. People may disagree with our policies - some may have different objectives and others may think different approaches to achieving those objectives would be more effective - but at least we are speaking the same language. They know what we are trying to do, and they know why. Historically, much of our education effort has focused on increasing public understanding of the Federal Reserve System itself: how we are structured, the nature and scope of our mission, the monetary policy and supervisory tools at our disposal. Providing information about the Fed remains a key part of our programs. For the past ten or so years, we have been running the Fed Challenge, a competition in which teams of high school students engage in mock Federal Open Market Committee discussions and make recommendations regarding monetary policy. The quality of the analysis and the sophistication of the presentations have been impressive. By comparison, our own FOMC deliberations seem a little dry; for example, we on the FOMC tend to be a little more low tech than the students, who come armed with very colorful computer-driven graphics to support their analysis and arguments. But teaching general economic principles has also been a recurring theme. A number of Federal Reserve Banks work closely with the National Council on Economic Education (NCEE), which has a host of fascinating programs that make teaching and learning economics fun. Gary Stern, the President of the Federal Reserve Bank of Minneapolis, currently chairs the NCEE, and I was privileged to address that group in May, 2002. In recent years, the Federal Reserve has increased its attention to financial literacy, an area that might be seen as the more practical, personal side of economic education. This increased emphasis reflects changes both in financial markets and in the consumer population. The number of financial products and financial service providers has grown dramatically. A widening array of financial choices offers the potential for great benefits to the public, but also poses temptations. More and more people are gaining access to credit; indeed, a host of lenders is probably inundating them with solicitations. The public can also select from a wide variety of savings vehicles, each with its special features. Ideally, the result of this increase in choice is lower costs and products that more closely match consumer needs. But some consumers are not prepared to confront this array of choices. They lack the financial knowledge to evaluate the alternatives and to see future consequences. They may be too trusting of lenders that present a friendly face and promise quick and easy access to funds, and too suspicious of those that are more deliberative but offer much better deals. Newcomers to this country and populations who were previously denied access to credit markets particularly need assistance in coping with the increasingly complex financial system. The Federal Reserve System recently launched a financial literacy campaign that includes a public-service announcement by Chairman Greenspan. We have developed a Personal Financial Education web site that contains links to a large number of national, state, and local consumer education resources. On that site one can find information on such topics as on-line banking, how to http://www.federalreserveeducation.org/fined/index.cfm. buy a home, and accessing credit reports. Individual Reserve Banks have also developed complementary web sites that include resources specific to their Districts. The Federal Reserve Bank of Boston’s video and booklet on identity theft are among the highlights of the System’s financial education offerings. The booklet, in particular, is a best seller. The New England Economic Adventure continues this rich tradition and also breaks new ground. The Adventure, together with the auxiliary lessons and web materials, teaches important economic principles. In particular, it emphasizes the central role of productivity growth in raising standards of living and illustrates what goes into such growth. This is an especially timely lesson right now. As you may know, over most of the past ten years U.S. productivity growth has been about double that of the previous twenty years. Over the long term, productivity growth is the key to economic advancement. By way of illustration, the pickup in productivity growth from an average of just under 1-1/2 percent from 1973 to 1995 to about 2-3/4 percent from 1995 to 2002, if maintained, suggests that living standards could double in twenty-five years rather than fifty years at the lower rate. Thus, the rate of productivity growth in an economy is not just an ivory tower concept. It translates into improvements in people’s well-being over the long term. Understanding how such growth occurs - and having some fun doing it - is what the Adventure is all about. In the short-run, when productivity is growing more rapidly, aggregate demand must also increase more quickly, in order to prevent economic slack from increasing. Over the last several quarters, demand has not been expanding as quickly as the economy’s productive capacity, and the result has been the marked lack of job growth. But as demand accelerates, job growth should improve also. Finally, while I would like to think that all of the Federal Reserve System’s economic education and financial literacy initiatives are lively and engaging, I suspect that the New England Economic Adventure will have special appeal. To many people history has a stronger allure than economics. New England has a particularly fascinating history and provides rich illustrations of economic decisionmaking. Meanwhile, the computer-based interactive investment games link visitors to historical events, providing dramatic tension as well as fun. I have been told by the Boston Fed staff that the Adventure program had to be slowed down a bit to allow time for cheers and moans after winners of the various rounds were displayed. Boston middle school students were particularly enthusiastic. So again, I am delighted to be here to celebrate the opening of the New England Economic Adventure and to stress the importance of economic education and financial literacy.
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Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the Annual Economic Outlook Conference, Middle Tennessee State University, Murfreesboro, Tennessee, 8 October 2003.
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Susan Schmidt Bies: Comments on the current state of the economy Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the Annual Economic Outlook Conference, Middle Tennessee State University, Murfreesboro, Tennessee, 8 October 2003. * * * It is a pleasure to be with you this morning at the Annual Economic Outlook Conference of Middle Tennessee State University to discuss the state of the economy. As you will hear, recent readings on the economy suggest that the pace of economic activity has picked up of late, our financial system is healthy, and inflation pressures remain subdued. Although uncertainties remain, I believe that the economic fundamentals are now in place to generate a sustainable, non-inflationary upturn. As always, the views that I will express are my own and do not necessarily reflect those of the Board of Governors or the staff of the Federal Reserve System. I am going to describe the key factors that have dominated this recession and recovery. Then I will talk about the current state of the household and business sectors. Finally, I want to make some remarks about corporate-sponsored, defined-benefit pension plans. The Recent Economic Cycle Before delving into current events, I think it is helpful to review some of the key aspects of our recent economic history. After a record, ten-year economic expansion, the U.S. economy slipped into recession in March 2001. This recession was unusual in that it was led by a drop in business investment, rather than a decline in consumer spending. According to the National Bureau of Economic Research (the traditional record keeper of U.S. business cycles) the downturn lasted eight months - a bit less than the duration of the average post-war recession. But thereafter, between the trough of the recession in 2001 and the second quarter of this year, real gross domestic product grew at a rather disappointing annual rate of 2-3/4 percent, on average. Although household disposable income and spending increased appreciably over this period, capital spending continued to weaken. Indeed, in the second quarter of this year, real business fixed investment was 4 percent below its level at the trough of the recession - an unusually weak investment performance almost two years into a recovery. Financial conditions undoubtedly played an important role in these developments. In the late 1990s, financial conditions were easy. Very narrow risk premiums in both debt and equity markets and lofty expectations about returns on the part of investors and borrowers greatly reduced the cost of external funds. A frenzy of capital-raising followed, led by telecommunication and Internet firms. Corporate debt and equity issuance soared - adding almost $2 trillion in new debt and equity to the balance sheets of nonfinancial corporations from 1998 through 2000 alone, with a good portion of the money raised by risky firms in the junk bond, venture capital, and initial public offering (IPO) markets. Firms used the proceeds not only to fund investment, but also to finance acquisitions of other companies, stock repurchases, and operating expenses. The spectacular collapse of high-tech equity valuations in the spring of 2000, led by the same telecommunication and Internet firms, wreaked havoc with corporate credit quality in some sectors and began a prolonged retrenchment in financial markets. Subsequently, financial markets were buffeted with a barrage of terrorism, war, and corporate governance shocks that further eroded investor confidence and stoked uncertainty and pessimism. The consequent retreat from risk-taking led to a substantial markdown in asset values, with obvious negative consequences for portfolios. Between early 2000 and the end of 2002, more than $6 trillion of stock-market wealth evaporated, and more than $200 billion of corporate bonds went into default. Many of the telecommunication firms that did IPOs or issued junk bonds during the easy market conditions of the late 1990s went bankrupt. For other firms, debt burdens that had appeared manageable suddenly looked excessive. Investors and lenders rightly responded to these events by becoming more wary, and financial conditions accordingly became more restrictive. Businesses faced a similar set of shocks: bankrupt clients, elevated uncertainty, skeptical investors, and expected rates of return that had plummeted. With limited pricing power and opportunities for sales expansion, businesses had to focus on expense management to increase their earnings. Businesses re-engineered processes. Their inventories and hiring slumped, and demand for funds fell. Although tighter financial conditions contributed, this pullback reflected mainly defensive actions by the borrowers themselves. Surveys of bank loan officers and small businesses support this view. Both groups have consistently pointed to weak business demand as the main factor behind sluggish borrowing during this recovery. In this environment, economists pushed out the expected date of the recovery in capital spending, and concerns grew that the household sector - the mainstay of the economic recovery - might become overextended and curtail its expenditures before capital spending perked up. But this is not evident from recent data. Business investment increased over the spring and summer, and the household sector remains in good financial health and has demonstrated a continued willingness to spend. Let me now discuss these recent economic developments in more detail. Households In the household sector, real personal consumption expenditures rose briskly over the summer, with strength widespread among the various types of goods and services. Supporting these gains have been large increases in real disposable incomes, higher stock prices, and favorable buying attitudes among consumers. The reductions in income tax withholding and the advance refund checks for the child tax credit mailed in late July and August likely added to the magnitude of the spending increases. Homes sales and new residential construction remained very strong during the summer, although the rise in mortgage rates could result in some cooling in the housing sector in coming months. Although households have been borrowing rather heavily to finance the rise in spending, they also have taken steps to keep the repayment burden of that debt in check. Notably, many homeowners have taken advantage of low interest rates to refinance their mortgages, some having done so several times over the past couple of years. In more than one-third of these “refis,” the borrower took cash out during the transaction, often to pay down loans with higher interest rates. The resulting drop in the average interest rate on household debt, combined with the increase in after-tax income, has helped households stay current on their loan obligations. Indeed, delinquency rates on consumer and mortgage loans held by banks have been trending lower, and most other measures of household loan performance have been stable on net this year. Businesses Capital spending by businesses increased at an annual rate of 7-1/4 percent in the second quarter, and orders and shipments of nondefense capital goods - a key indicator of equipment spending - rose briskly over the June-to-August period. Moreover, the tenor of anecdotes from the corporate sector seems more upbeat, as corporate managers see sales picking up and the financing environment improving. Four important factors have contributed to this improvement in financial conditions: a widespread restructuring of corporate liabilities over the past two years, a bounceback in corporate profitability from its trough in 2001, a narrowing in market risk premiums, and low interest rates. I will discuss each factor in turn. First, pulled by low long-term rates and pushed by nervous investors burned by a few high-profile, rapid meltdowns, firms have done a great deal to strengthen their balance sheets. Many firms have refinanced high-interest-rate debt, paring the average interest rate on nonfinancial corporate debt by almost 150 basis points since the end of 2000. At the same time, businesses have replaced short-maturity debt with longer-maturity debt, both to lock in low rates and to improve their ability to withstand a liquidity shock (since long-term debt does not need to be continually rolled over). In addition, many firms - especially in the most troubled industries - have retired debt via equity offerings and asset sales, helping to hold growth of total nonfinancial corporate debt in 2002 to its smallest gain since the early 1990s. Second, firms have significantly tightened their belts. Over the past two years, the drive to cut costs has generated rapid productivity gains, and this greater efficiency has boosted corporate profits despite tepid revenue growth. Profits at Standard & Poor’s 500 corporations grew almost 6 percent in 2002 from depressed 2001 levels and have increased another 10 percent in the first half of this year. Although this growth has been somewhat unevenly distributed across sectors, large-firm profits in the aggregate are now up smartly. Profits at smaller firms, which had fallen more precipitously, also appear to have rebounded sharply. Third, risk premiums have fallen substantially this year as corporate governance scandals are less notable and investor sentiment has turned favorable. Stock prices reflect this brighter view. The broadest index of stock prices - the Wilshire 5000 - has risen about 20 percent so far this year, while the tech-heavy Nasdaq index and the Russell 2000 small-cap index have logged even more impressive gains. Meanwhile, bond spreads have narrowed appreciably - especially for the riskiest firms - and are now back around historical averages. Declining spreads have, no doubt, been helped along by the beneficial effect of the balance sheet improvements on measures of credit quality. Indicators such as rating changes and default rates, though still elevated, have eased notably this year. In another sign of improved sentiment, money has flowed into risky securities - for example, equity mutual funds have registered strong net inflows since March after net outflows in 2002 and early 2003, and extremely large inflows have boosted assets of high-yield bond funds nearly 15 percent over the same period. Offerings of risky securities have also reappeared since March, including a handful of IPOs and many low-tier junk-bond deals among a surge of corporate bond issues. Improved profitability, coupled with subdued capital spending, inventory investment, and hiring, has translated into better corporate cash flow. Looking ahead, this larger income stream can help finance expansion directly out of internal funds or indirectly by supporting firms’ borrowing capacity. Furthermore, over the past year or so, many firms have retained their excess cash and built up liquid assets. Thus, firms will be able to draw not only on improved cash flow but also higher liquid assets. Fourth, and finally, the federal funds rate remains at just 1 percent. As a result, extremely low short-term borrowing costs have helped firms keep their interest expenses down. This is a direct benefit of the accommodative stance of monetary policy. For longer-term debt, the combination of low yields on benchmark Treasury securities and reduced risk spreads has kept borrowing costs attractive. The yield on Moody’s Baa corporate bond index, although up a bit from this spring and summer, is otherwise at its lowest sustained level since 1968. These four points all suggest that financial conditions are capable of supporting a sustained, healthy pickup in economic growth. By and large, firms are well positioned to fund expansion both internally and externally. And, given the successful efforts to pare costs, firms are set to benefit from a further pickup in the growth of revenue. Thus, future rates of return should be favorable. Accordingly, equity analysts are calling for S&P 500 profits to advance 5 percent more in the third quarter and by a similar amount in the fourth quarter of this year, before rising an additional 13 percent in 2004; and profits at small firms are expected to continue outpacing those at large firms. As you know, banks are an important source of external funding for businesses. Although a small number of individual banks have been weakened by the downturn, I do not see a need to worry about banks’ overall health. Banks continue to have strong financial positions and have weathered the credit deterioration in the corporate sector quite well, largely because of the improvement in their risk-management practices over the past decade. In marked contrast to the 1990-91 recession, bank profitability reached record levels in the past two years, and bank capital continues to strengthen. In addition, delinquency rates on most major loan categories have decreased noticeably since the end of 2001. Employment, Productivity and Inflation So far, I have talked about the upbeat part of the current economic picture. The downbeat portion is the lack of any appreciable improvement in the labor market. Although aggregate demand appears to have grown rapidly in the third quarter, nonfarm payrolls continued to fall through August and increased only a bit in September - the result of ongoing efforts by businesses to restructure their operations and boost efficiency. Based on recent economic research at the Federal Reserve and on many anecdotal reports, I suspect that a large part of these net job losses - particularly in manufacturing, airlines, and telecommunications - are permanent and will not be reversed as the economy gains steam. Instead, new jobs will need to be created in other sectors of the economy to replace them. This process will take time. But if history is a guide, in an expanding economy job creation will eventually outstrip job destruction, and lower the unemployment rate. The increase in payrolls in September was a start, and I hope will be followed by larger gains in future months. I will be watching conditions in the labor market closely because an expansion that is sustainable in the long run will require solid growth in employment. The flip side of this so-called jobless recovery is that labor productivity has been increasing very rapidly. Output per hour in the nonfarm business sector rose almost 7 percent in the second quarter, bringing the four-quarter change to more than 4 percent. That pace is quite high by historical standards and suggests to me that the productivity gains of recent years are not cyclical developments that will disappear as labor demand strengthens but are permanent gains in efficiency. That is good news because growth in labor productivity generates growth in real wages of workers and thus raises our nation’s overall standard of living. Strong growth in productivity also has been an element in the low rates of core consumer price inflation in recent years. The personal consumption expenditure price index excluding food and energy increased only 1.3 percent over the twelve months ending in August - about 1/2 percentage point less than in the year-earlier period. In the current environment of excess capacity and intense global competition, most businesses simply do not have the ability to raise prices. As a result, I do not see a large risk of a pickup in the underlying pace of price inflation anytime soon. Pension Obligations Before concluding, I would like to discuss an element of corporate financial statements that has attracted a good deal of negative attention lately - namely company pension obligations. As you know, pension plans come in two varieties, with very different effects on corporate balance sheets and cash flow. Defined-contribution plans, such as the 401(k) and 403(b) plans that many of you are familiar with, are essentially employee savings accounts and generally do not have much effect on corporate reports. But traditional defined-benefit, or DB, plans can have large effects. DB plans, which are more common in older and larger firms, promise workers a stream of benefits during retirement, and companies that sponsor them are required by law to set aside sufficient funds to cover the payments they have promised to their workers. If the investment returns on the pension fund’s assets are not enough to keep up with the growth in pension liabilities, firms must make additional pension contributions. Three years of negative equity returns, combined with sharply falling interest rates, have put considerable stress on some DB plans. Because pension funds typically invest more than half their portfolios in equities, stock market losses significantly eroded pension assets; at the same time, sharply declining interest rates raised the present value of future liabilities, weakening the funding status of many DB plans. Just among the firms in the S&P 500, the combined effect was to subtract nearly half a trillion dollars from pension net asset values from the end of 1999 to the end of 2002. At the end of 1999, about 20 percent of S&P 500 plans were underfunded, meaning that their assets were valued less than their liabilities. But by the end of last year, the figure was 90 percent, and DB plan assets across all S&P 500 firms were more than $200 billion shy of liabilities. The implication is clear: Many companies need to make additional contributions to their pension plans, and in some cases the contributions need to be large. Indeed, last year S&P 500 firms contributed $46 billion to their pension plans, three times more than in either of the previous two years. Some contributions were considerable, and this trend continued in the first half of 2003: Twenty-five sponsors of the most underfunded pension plans have already made contributions this year as large as last year’s. This situation does not mean investors should panic about the financial positions of the firms sponsoring these plans. The bulk of the pension underfunding is concentrated at large firms with good access to capital markets. Among S&P 500 firms last year, about 90 percent of the underfunding occurred in firms with investment-grade debt. In the current market environment, these firms likely would have little difficulty raising funds to replenish their pensions. This suggests that pension contributions will not likely be a major cash flow impediment to corporate investment. That is not to say, however, that many firms - indeed, whole industries - are not struggling with their pension plans. Severe cases can be found in the auto, steel, and airline industries, where long-term business structure issues make the recent business-cycle effects on pension plans more acute. These firms face a confluence of negative trends, including increasing competitive pressures, aging workforces, rapidly growing retiree populations, and a history of collective bargaining agreements that emphasized larger pension benefits over wage increases. Automakers currently face some of the largest dollar amounts of underfunding, but as noted earlier, they generally have good access to credit markets, which has allowed them to weather these difficulties. Steel companies and airlines have had a harder time. In the past two years, a half-dozen large, established steel firms and airlines have declared bankruptcy, and their pension plans either have collapsed or remain mired in uncertainty. Not surprisingly, required pension contributions represent a greater burden on cash flow to the surviving firms in these troubled industries. Although most DB pension contributions are made in cash, some airlines and steel companies have turned to making noncash contributions - company stock, generally - to their pension plans. While this conserves cash for other uses, it increases the risk in plan funding since the value of plan assets will be more correlated with the health of the sponsor. Thus when the company gets into financial difficulties, the ability to contribute to the pension plan will be the weakest just when the declining value of those plan assets requires larger contributions. The recent experiences of the steel and airline industries, in particular, have led to the sudden reversal of fortune for the Pension Benefit Guaranty Corporation, or PBGC - the federally chartered company that partially insures pension benefits by assuming the assets and some of the liabilities of failed plans. Each time the PBGC takes over a bankrupt firm’s plan, it assumes a new claim that comes due as the firm’s workers retire. New claims have skyrocketed in the past few years - from an average of $150 million per year in the late 1990s to $3.3 billion in 2002. This year will be worse. Thanks to several large new bankruptcies, claims exceeded $5 billion in just the first half of fiscal year 2003. These plan failures have had an enormous impact on the PBGC’s balance sheet, which swung from a net positive position of nearly $10 billion in 2000 to a net negative position of nearly $6 billion by July of this year. Despite this negative position, the PBGC does not face an immediate liquidity crisis because of the relatively long duration of its liabilities and its steady stream of premium income from active plans. However, it faces serious challenges beyond those indicated by its current balance sheet, including substantial underfunding that exists at troubled, but still operational, DB plans. Indeed, the PBGC estimates that its annual tally of underfunding in “financially troubled” companies could exceed $80 billion this year. So what is the prognosis for corporate pension plans in the near and long term? For the near term, I see some indications that the stresses have abated somewhat. So far this year, the financial condition of these plans have likely improved due to the rising stock market and higher contributions, although the precise extent of that improvement will not be known until year-end financial statements are released. But under a reasonable set of assumptions, perhaps $50 billion of last year’s S&P 500 funding gap, or about one-quarter of the total, apparently has already been closed by improved market conditions. And what about the longer-term prognosis for S&P 500 firms? Assuming current discount rates and normal pension asset returns, these firms would need to make about $150 billion in contributions to close the funding gap over the next three years. And once the current funding hole is filled, these firms would still need to make contributions to cover their rising liabilities. Indeed, DB plans are increasingly concentrated in mature industries with aging workforces, for which the growth rate of liabilities is relatively high (and rising), while their duration is relatively low (and falling). These longer-term challenges remain even if market conditions improve. Conclusion In summary, recent indicators suggest the pace of economic activity has picked up, the banking system is healthy, corporate financial conditions are strengthening, and inflationary pressures remain subdued. Although uncertainties remain, I believe the fundamentals are in place to generate sustainable economic growth.
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Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the Federal Reserve Bank of Dallas Conference on the Legacy of Milton and Rose Friedman's Free to Choose, Dallas, Texas, 24 October 2003.
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Ben S Bernanke: The influence of Milton Friedman’s monetary framework on contemporary monetary theory and practice Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the Federal Reserve Bank of Dallas Conference on the Legacy of Milton and Rose Friedman’s Free to Choose, Dallas, Texas, 24 October 2003. * * * It is an honor and a pleasure to have this opportunity, on the anniversary of Milton and Rose Friedman’s popular classic, Free to Choose, to speak on Milton Friedman’s monetary framework and his contributions to the theory and practice of monetary policy. About a year ago, I also had the honor, at a conference at the University of Chicago in honor of Milton’s ninetieth birthday, to discuss the contribution of Friedman’s classic work with Anna Schwartz, A Monetary History of the United States (Bernanke, 2002). I mention this earlier talk not only to indicate that I am ready and willing to praise Friedman’s contributions wherever and whenever anyone will give me a venue, but also because of the critical influence of A Monetary History on both Friedman’s own thought and on the views of a generation of monetary policymakers. In their Monetary History, Friedman and Schwartz reviewed nearly a century of American monetary experience in painstaking detail, providing an historical analysis that demonstrated the importance of monetary forces in the economy far more convincingly than any purely theoretical or even econometric analysis could ever do. Friedman’s close attention to the lessons of history for economic policy is an aspect of his approach to economics that I greatly admire. Milton has never been a big fan of government licensing of professionals, but maybe he would make an exception in the case of monetary policymakers. With an appropriately designed licensing examination, focused heavily on the fine details of the Monetary History, perhaps we could ensure that policymakers had at least some of the appreciation of the lessons of history that always informed Milton Friedman’s views on monetary policy. Today I will pass over Friedman’s contributions to our knowledge of monetary history and focus instead on how his ideas have influenced our understanding both of how monetary policy works and how it should be used. That is, I will discuss both the positive and the normative implications of Friedman’s thought. The usual disclaimer applies, that is, I speak for myself and not necessarily for my colleagues at the Federal Reserve. In preparing this talk, I encountered the following problem. Friedman’s monetary framework has been so influential that, in its broad outlines at least, it has nearly become identical with modern monetary theory and practice. I am reminded of the student first exposed to Shakespeare who complained to the professor: “I don’t see what’s so great about him. He was hardly original at all. All he did was string together a bunch of well-known quotations.” The same issue arises when one assesses Friedman’s contributions. His thinking has so permeated modern macroeconomics that the worst pitfall in reading him today is to fail to appreciate the originality and even revolutionary character of his ideas, in relation to the dominant views at the time that he formulated them. To illustrate, I begin with the descriptive or positive side of Friedman’s work on monetary policy. Here is a short summary of Friedman’s own list of eleven key monetarist propositions, as put forth in the conclusion to his 1970 (note well that date) lecture, “The Counter-Revolution in Monetary Theory”. These propositions are a reasonable description, I believe, of Friedman’s basic views on how money affects the economy. Here they are (in my summary of slightly more detailed language in the original): 1. There is a consistent though not precise relationship between the rate of growth of money and the rate of growth of nominal income. 2. That relationship is not obvious, however, because there is a lag between money growth and nominal income growth, a lag that itself can be variable. 3. On average, however, the lag between money growth and nominal income growth is six to nine months. 4. The change in the rate of nominal income growth shows up first in output and hardly at all in prices. 5. However, with a further lag of six to nine months, the effects of money growth show up in prices. 6. Again, the empirical relationship is far from perfect. 7. Although money growth can affect output in the short run, in the long run output is determined strictly by real factors, such as enterprise and thrift. 8. Inflation is always a monetary phenomenon, in the sense that it can be produced only by money growth more rapid than output. However, there are many possible sources of money growth. 9. The inflationary impact of government spending depends on its financing. 10. Monetary expansion works by affecting prices of all assets, not just the short-term interest rate. 11. Monetary ease lowers interest rates in the short run but raises them in the long run. Let me emphasize again that these propositions reflected Friedman’s view as of some thirty-five years ago. At the time, they were far from being the conventional wisdom, as suggested by the term “Counter-Revolution” in the essay’s title. What do we make of these propositions today? First, the empirical description of the dynamic effects of money on the economy given in the first six propositions would be viewed by most policymakers and economists today as being, as the British would put it, “spot on”. As a minor illustration of this point, in my own academic research I contributed to a large modern econometric literature that has used vector autoregression and other types of time series models to try to quantify how monetary policy affects the economy. The economic dynamics estimated by these methods correspond very closely to those outlined in Friedman’s propositions. These methods confirm that a monetary expansion (for example) leads with a lag of one to two quarters to an increase in nominal income. Perhaps more importantly, as Friedman emphasized, the responses of the quantity and price components of nominal income have distinctly different timing. In particular, as Friedman told us, a monetary expansion has its more immediate effects on real variables such as output, consumption, and investment, with the bulk of these effects occurring over two to three quarters. (I was going to say, as Friedman first told us, but perhaps the credit for that should go to David Hume. Milton’s work is, after all, part of a long and great tradition of classical monetary analysis.) These real effects tend to dissipate over time, however, so that at a horizon of twelve to eighteen months the effects of a monetary expansion or contraction are felt primarily on the rate of inflation. The same patterns have been found in empirical studies for virtually all countries, not only by vector autoregression analysis but by more structural methods as well. They are reflected in essentially all contemporary econometric models used for forecasting and policy analysis, such as the FRBUS model at the Federal Reserve. The lag between monetary policy changes and the inflation response is the reason that modern inflation-targeting central banks, such as the Bank of England, set a horizon of up to two years for achieving their inflation objectives. Thus Friedman’s description of the economic dynamics set in train by a monetary expansion or contraction, summarized in his first six propositions, has been largely validated by modern research. What about the other propositions? Friedman’s seventh point, that money affects real outcomes in the short run but that in the long run output is determined entirely by real factors, such as enterprise and thrift, is of particular importance for both theory and policy. The proposition that money has no real effects in the long run, referred to as the principle of long-run neutrality, is universally accepted today by monetary economists. When Friedman wrote, however, the conventional view held that monetary policy could be used to affect real outcomes - for example, to lower the rate of unemployment - for an indefinite period. The idea that monetary policy had long-run effects - or, in technical language, that the Phillips curve relationship between inflation and unemployment could be exploited in the long run proved not only wrong but quite harmful. Attempts to exploit the Phillips curve tradeoff, which persisted despite Friedman’s warnings in his 1968 presidential address to the American Economic Association, contributed significantly to the Great Inflation of the 1970s - after the Great Depression, the second most serious monetary policy mistake of the twentieth century. The diagnosis of inflation in Friedman’s eighth proposition, also controversial when he wrote, is likewise widely accepted today. Of course, as we all know, Friedman noted the close connection between inflation and money growth, though carefully acknowledging that excessive money growth could have many causes. As Milton and Rose discussed in Chapter 9 of the 1980 edition of Free to Choose, popular views in the 1960s and 1970s (and even the views of some Federal Reserve officials) held that inflation could arise from a variety of non-monetary sources, including the power of unions and corporations and the greediness of oil-producing countries. An unfortunate implication of these views, whose deficiencies were revealed by bitter experience under President Nixon, was that wage-price controls and other administrative measures could successfully address inflation. We understand today that the Great Inflation would simply not have been possible without the excessively expansionist monetary policies of the late 1960s and 1970s. Some of Friedman’s descriptive propositions remain the subject of active research. For example, much research has investigated both theoretically and empirically the interactions of fiscal policy, monetary policy, and inflation. Friedman’s view that fiscal deficits are inflationary only if they result in money creation, his ninth proposition, remains broadly accepted, but work by scholars such as Thomas Sargent, Neil Wallace, and Michael Woodford has shown that these links can be subtle. For example, Sargent and Wallace’s “unpleasant monetarist arithmetic” suggested that a near-term tightening of monetary policy, by making the long-term fiscal situation less tenable, could (in principle at least) lead to inflation, because the public will anticipate that the fiscal deficit must be financed eventually by money creation. More recently, Woodford’s fiscal theory of the price level suggests that nonsustainable fiscal policies can drive inflation, even if the central bank resists monetization. Following Woodford, Olivier Blanchard has recently argued that tight money policies in Brazil, by raising the government’s financing costs and thus worsening the fiscal situation, might have had inflationary consequences. Although this subsequent work has refined our understanding of the relationship between monetary and fiscal policy, these analyses are not inconsistent with the spirit of monetarist propositions, which place the blame for inflation on overissuance of nominal government liabilities. Another area of pressing current interest derives from Friedman’s tenth proposition, that monetary policy works by affecting all asset prices, not just the short-term interest rate. This classical monetarist view of the monetary transmission process has become highly relevant in Japan, for example, where the short-term interest rate has reached zero, forcing the Bank of Japan to use so-called quantitative easing methods. The idea behind quantitative easing is that increases in the money stock will raise asset prices and stimulate the economy, even after the point that the short-term nominal interest rate has reached zero. There is some evidence that quantitative easing has beneficial effects (including evidence drawn from the Great Depression by Chris Hanes and others), but the magnitude of these effects remains an open and hotly debated question. The only aspect of Friedman’s 1970 framework that does not fit entirely with the current conventional wisdom is the monetarists’ use of money growth as the primary indicator or measure of the stance of monetary policy. Clearly, monetary policy works in the first instance by affecting the supply of bank reserves and the monetary base. However, in the financially complex world we live in, money growth rates can be substantially affected by a range of factors unrelated to monetary policy per se, including such things as mortgage refinancing activity (in the short run) and the pace of financial innovation (in the long run). Hence, it would not be safe to conclude (for example) that the recent decline in M2 is indicative of a tight-money policy by the Fed. The imperfect reliability of money growth as an indicator of monetary policy is unfortunate, because we don’t really have anything satisfactory to replace it. As emphasized by Friedman (in his eleventh proposition) and by Allan Meltzer, nominal interest rates are not good indicators of the stance of policy, as a high nominal interest rate can indicate either monetary tightness or ease, depending on the state of inflation expectations. Indeed, confusing low nominal interest rates with monetary ease was the source of major problems in the 1930s, and it has perhaps been a problem in Japan in recent years as well. The real short-term interest rate, another candidate measure of policy stance, is also imperfect, because it mixes monetary and real influences, such as the rate of productivity growth. In addition, the value of specific policy indicators can be affected by the nature of the operating regime employed by the central bank, as shown for example in empirical work of mine with Ilian Mihov. The absence of a clear and straightforward measure of monetary ease or tightness is a major problem in practice. How can we know, for example, whether policy is “neutral” or excessively “activist”? I will return to this issue shortly. Besides describing the effects of money on the economy, Friedman also made recommendations for monetary policy - the normative part of his framework. I will discuss just three of the most important of these. First, Friedman has emphasized the Hippocratic principle for monetary policy: “First, do no harm.” Chapter 9 of Free to Choose contains a famous quote of John Stuart Mill, as follows: “Like many other kinds of machinery, (money) only exerts a distinct and independent influence of its own when it gets out of order.” On this quote, Milton and Rose commented: “Perfectly true, as a description of the role of money, provided we recognize that society possesses hardly any other contrivance that can do more damage when it gets out of order.” Friedman’s emphasis on avoiding monetary disruptions arose, like many of his other ideas, from his study of U.S. monetary history. He had observed that, in many episodes, the actions of the monetary authorities, despite possibly good intentions, actively destabilized the economy. The leading case, of course, was the Great Depression, or as Friedman and Schwartz called it, the Great Contraction, in which the Fed’s tightening in the late 1920s and (most importantly) its failure to prevent the bank failures of the early 1930s were a major cause of the massive decline in money, prices, and output. It is likely that Friedman’s study of the Depression led him to look for means, such as his proposal for constant money growth, to ensure that the monetary machine did not get out of order. I hope, though of course I cannot be certain, that two decades of relative monetary stability have not led contemporary central bankers to forget the basic Hippocratic principle. A second normative recommendation, worth recalling here, was Friedman’s preference for floating rather than fixed exchange rates. At times, at least in popular writing, Friedman rationalized this position as following from free market principles. This argument is a bit disingenuous, I think, as a fixed nominal exchange rate is just one method of anchoring the aggregate price level and is perfectly consistent with free adjustment of the relative prices of goods and services. In a more serious vein, Friedman understood that, in a world in which monetary policymakers put domestic economic stability above balance of payments considerations, a fixed exchange rate system is likely to be unstable during periods of economic stress. He saw that this was the case during the 1930s, when the world was on a modified gold standard called the gold exchange standard, and it was likewise the case under the postwar Bretton Woods system. To reconcile a fixed exchange rate and an emphasis on domestic stability, policymakers must impose capital controls or restrictions on trade, which have undesirable effects on economic efficiency. If policymakers’ first priority is stability of the domestic economy, Friedman reasoned, then why not adopt a system - namely, flexible exchange rates - that provides the necessary monetary independence without restrictions on the flow of capital or goods? When Friedman wrote about fixed and flexible exchange rates, a switch from the Bretton Woods fixed-exchange-rate system to a floating-rate system seemed quite unlikely. In this, as in many other matters, he was prescient, as the major currencies have now been successfully floating since the breakup of the Bretton Woods system in the early 1970s. These two recommendations have had major effects on institutional design and policy practice. However, in my view, the most fundamental policy recommendation put forth by Milton Friedman is the injunction to policymakers to provide a stable monetary background for the economy. I take this to be a stronger statement than the Hippocratic injunction to avoid major disasters; rather, there is a positive argument here that monetary stability actively promotes efficiency and growth. (Hence Friedman’s suggestion that the long-run Phillips curve, rather than vertical, might be positively sloped.) Also implicit in Friedman’s focus on nominal stability is the view that central banks should avoid excessively ambitious attempts to manage the real economy, which in practice may exacerbate both nominal and real volatility. In Friedman’s classic 1960 work, A Program for Monetary Stability, he suggested that monetary stability might be attained by literally keeping money stable: that is, by fixing the rate of growth of a specific monetary aggregate and forswearing the use of monetary policy to “fine-tune” the economy. Do contemporary monetary policymakers provide the nominal stability recommended by Friedman? The answer to this question is not entirely straightforward. As I discussed earlier, for reasons of financial innovation and institutional change, the rate of money growth does not seem to be an adequate measure of the stance of monetary policy, and hence a stable monetary background for the economy cannot necessarily be identified with stable money growth. Nor are there other instruments of monetary policy whose behavior can be used unambiguously to judge this issue, as I have already noted. In particular, the fact that the Federal Reserve and other central banks actively manipulate their instrument interest rates is not necessarily inconsistent with their providing a stable monetary background, as that manipulation might be necessary to offset shocks that would otherwise endanger nominal stability. Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation. On this criterion it appears that modern central bankers have taken Milton Friedman’s advice to heart. Over the past two decades, inflation has fallen sharply and stabilized around the world, not only in the industrialized nations but in emerging-market economies and in even the poorest developing nations. Some central banks, so-called inflation targeters, have set explicit, quantitative targets for inflation; but all central banks, certainly including the Federal Reserve, have emphasized the importance of achieving and maintaining price stability. On the issue of inflation control, Friedman may be judged to have been a bit too pessimistic; his concerns that central banks would have neither the technical ability nor the correct incentives to control inflation led him to recommend his money-growth rule, for which a central bank could certainly be held accountable. Evidently, however, determined central banks can stabilize inflation directly, at least they have been able to do so thus far. However, on the benefits of monetary stability, or as I would prefer to say, nominal stability, Friedman was not wrong. Many theories popular even today might lead one to conclude that increased stability in inflation could be purchased only at the cost of reduced stability in output and employment. In fact, over the past two decades, increased inflation stability has been associated with marked increases in the stability of output and employment as well, both in the United States and elsewhere. It has been argued that a lower incidence of exogenous shocks explains these favorable developments, and that may be part of the story. But I believe that there is an important causal relationship as well. For example, low and stable inflation has not only promoted growth and productivity, but it has also reduced the sensitivity of the economy to shocks. One important mechanism has been the anchoring of inflation expectations. When the public is confident that the central bank will maintain low and stable inflation, shocks such as sharp increases in oil prices or large exchange rate movements tend to have at most transitory price-level effects and do not result in sustained inflationary surges. In contrast, when inflation expectations are poorly anchored, as was the case in the 1970s, shocks of these types can destabilize inflation expectations, increasing the inflationary impact and leading to greater volatility in both inflation and output. In summary, one can hardly overstate the influence of Friedman’s monetary framework on contemporary monetary theory and practice. He identified the key empirical facts and he provided us with broad policy recommendations, notably the emphasis on nominal stability, that have served us well. For these contributions, both policymakers and the public owe Milton Friedman an enormous debt.
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the Federal Reserve P...
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Alan Greenspan: The payments system in transition Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the Federal Reserve Payments System Development Committee 2003 Conference, Washington, DC, 29 October 2003. * * * Introduction It is a pleasure to be with you this morning and to add my welcome to this very important conference on the payments system being hosted by the Federal Reserve's Payments System Development Committee. The name of the conference--The Payments System in Transition--captures not only the state of the financial services that we all use to make payments, but also the expectations of many payments system participants as they look to the future. Decades of incremental change have had significant cumulative effects on both our check and electronic payments systems. Recent data show that the number of checks written in the United States began to decline in the mid-1990s. In contrast, electronic payments, particularly debit cards and automated clearinghouse (ACH ) transactions, have grown substantially and now total about 40 billion per year. Overall, the number of electronic payments has increased almost fivefold in two decades and, this year or next, may well exceed the number of checks written. During the past few weeks, after substantial work by Congress and the financial industry, the Check Clearing for the 21st Century Act, popularly known as the Check 21 Act, was passed. The new law was signed yesterday by the President and will become effective next October. Passage of this greatly anticipated statute is an important event for the financial industry. In preparing for the new law, the industry has begun to discuss the types of check products and services it will provide to the public as the infrastructure and rules for clearing and settling checks evolve. Against this background of a system in transition, the participants in this conference will be debating the future of the products, services, and infrastructure that support our broad and heterogeneous national payments system. I hope we will all be enriched by this discussion and take home ideas that will help shape the thinking of users of the payments system, suppliers of payments and financial services, and public authorities, as they all work to improve and modernize the payments system over the next few years. Historical Perspective For most of the post-World War II period, cash and checks have been the predominant instruments for making retail and commercial payments in the United States. Public confidence in these instruments and their usefulness for conducting transactions was built up over a long period of time, which spanned national debates about the proper instruments and institutions to support a sound national monetary system. A very large infrastructure for handling these paper instruments has been developed and maintained by the private and public sectors. In the case of checks, for example, this infrastructure includes offices, equipment, and staff for rapidly processing, shipping, and presenting checks throughout the country, literally overnight. The foundation of much of the current payments system infrastructure was laid in the 1960s. At that time, a paperwork crisis was overwhelming the financial markets, as the rapid growth in financial activity outpaced the system's ability to clear and settle financial transactions and payments using traditional, manual processes. The response of both the financial industry and government was twofold. Automation was applied to paper-based clearing activities. In addition, new electronic systems for creating transactions and making payments were established where this seemed practical. In the payments arena, the ACH and bank credit card systems and the beginnings of debit card systems date from this era. Reacting to these developments and new systems, commentators of the time predicted the advent of the "cashless" and "checkless" society. We know the history of these predictions. In reality, the 1970s saw a burst of creativity in the establishment of electronic payments systems but a relatively slow rate of adoption by consumers and businesses. More recently, the 1990s saw a new burst of creativity, including ideas for creating products called "electronic cash" and "electronic checks," adapting existing forms of payment to the Internet, and experimenting with entirely new payments systems. Work also began on projects to convert checks to ACH or other electronic payments, at the point of sale or at lockboxes, to reduce the costs of processing and to speed the collection of funds. Some of the results of these experiments are now gaining increasing acceptance in the marketplace. Many more have not succeeded. Many lessons have been learned from these experiences, and I am sure you will be discussing them during the next two days. It would be easy to dismiss the experiments and predictions from the 1990s about change in the payments system as hyperbole reminiscent of the 1970s. I believe, however, that the situations today and in the 1970s are very different. First, although data on the use of cash in transactions is notoriously poor, the nominal value of per capita holdings of small-denomination bank notes--those used heavily in domestic commerce--is now growing very slowly, and the inflation-adjusted per capita value has recently declined somewhat. More important for this audience, data from surveys conducted for the Federal Reserve show that the use of checks in our society has now begun to decline. Second, data on credit card, debit card, and ACH usage show very strong and sustained growth, to the extent that electronic payments now account for about half of the number of all noncash payments. Third, through the use of electronic payments, retailers and billers are continuing to seek productivity gains and cost reductions in their transactions with consumers. Fourth, data from the Federal Reserve's surveys of consumer finances show that over time households across most age and income categories have been adopting basic electronic payment instruments, although, as might be expected, younger households are in the forefront. Finally, the U.S. government is actively working on new technologies and services to increase the use of electronics in both its payments and collections. Taken together, these factors point to increasing use of electronic payments, when and where economic factors press this outcome. Public-policy perspective From the perspective of public policy, the key objectives for the payments system have always been economic efficiency and safety as well as confidence. Indeed, these broad objectives, which include the goals of integrity, security, reliability, and accessibility, have been endorsed by the G-10 central banks as international objectives for major payment systems in key reports published by the Bank for International Settlements and used widely by the International Monetary Fund and World Bank. The challenge is to bring these abstract ideas to bear on particular payments systems issues during this time of transition. Efficiency. Turning first to efficiency, in the area of check collection, both the financial industry and the Federal Reserve Banks face classic issues involving the adjustment of infrastructure to declining demand. Moreover, various programs to convert checks to electronic payments at the point of sale or the lockbox, or to truncate checks early in the collection stream, imply that the pace of decline in the volume of paper-check clearings could well accelerate. However, checks also remain a highly convenient payment instrument with a long and tested history; they are unlikely to be completely eliminated as a major payment instrument any time soon. As a result, the financial industry and the Federal Reserve Banks face the prospect of declining demand for paper-check processing, but also significant uncertainty about the extent and timing of the decline. Nevertheless, we know that over time the efficient use of resources will require reductions in excess production and processing capacity as the market demand for checks and check processing declines. In addition to managing resources to meet declining demand, the financial industry is also producing innovations in check clearing and storage centered on the development of digital imaging and the development of archives for these images. The passage of the Check 21 Act is likely to invigorate these efforts and also to encourage a range of new check-clearing techniques that are only now being envisioned. Overall, these changes suggest not only a reduction in the scale of overall check clearing, but also a shift to new technologies and services to meet remaining demand. In passing, I would like to encourage banking organizations to participate in a new survey on check usage that the Federal Reserve will be conducting in 2004--a follow-up to a similar survey conducted in 2001. Improved data on check usage are very important in helping the financial industry and the public adjust smoothly to the changes that are now in process. In the area of electronic payments, the industry faces the opposite challenge from that in check services. Continuing to meet the growth of electronic payment processing with highly reliable service is an obvious priority from a public-policy perspective. However, simply accommodating growth may not be sufficient, and consideration should also be given to meeting the changing needs of the users of these systems. One of the common misconceptions in the analysis of payments systems is that only production or processing costs--that is, conditions of supply--matter from a market or public-policy standpoint. A problem in early predictions of the growth of electronic payments was the lack of attention to the needs of users, including the fact that electronic payments could be quite inconvenient and costly for many purposes. In retrospect, it has taken years of investments in electronic infrastructure at homes and businesses to support the use of electronic payments as a convenient and relatively low-cost alternative to checks. The emphasis in this conference on bringing users of the payments system together with the providers of financial services demonstrates the importance of a balanced approach as we examine challenges for the payments system. A number of these topics illustrate the need to identify the attributes that users value and demand in payments systems--both in current systems and in the next generation of these systems--and to determine how that demand will be met. A particularly important topic is how electronic payments systems can better meet the needs of business users. Business people frequently report that, from their perspective, a payment is only one part of an overall transaction or relationship with a counterparty. Other parts include orders, confirmations, shipping documents, invoices, and a variety of accounting and other information that supports a transaction or relationship. The complexity of this situation has created challenges for businesses as they integrate corporate information systems with electronic payment capabilities, and this complexity has likely slowed the adoption of electronic payments for a wide range of business purposes. I hope this conference will help underscore the need for businesses, financial institutions, technology vendors, and payments system operators to find common approaches and standards for addressing this issue. Turning to questions of infrastructure, I particularly encourage you to discuss ideas for the future design of the core U.S. electronic payments systems, including those of the Federal Reserve. Some of the current designs date back several decades, and significant changes have taken place in both technologies and business needs since that time. The markets will undoubtedly shape the use of payments systems. However, there are only a handful of core systems and it is very important that these systems be well designed so that they do not block market innovation. I am particularly pleased that the Payments System Development Committee has over time focused on barriers to such innovation. The overall payments system is built on complex rules, business practices, and technologies. Change can often be difficult. In this situation, structures built up in the past can become barriers to the implementation of new ideas. Where barriers do exist, it is important to address them and, when appropriate, remove them, so that the market can provide us with new and useful payment and financial products and services. From a broad perspective, the Check 21 Act continues the work of our society to ensure that the marketplace can respond flexibly to fundamental shifts in our technologies. The act--appropriately-does not mandate that checks be truncated and turned into electronic payments, nor does it mandate that all payments be made electronically. Instead, it strengthens a market-based approach to innovation in the check-collection system. The act allows depository institutions to take digital images of checks and truncate the original check, provided that they, or a subsequent institution, are also willing to create a substitute paper check if one is demanded, and to bear the liability for doing so. The act essentially removes an important barrier to innovation and frees depository institutions to apply new technologies and market-based ideas to traditional check-clearing activities. Safety and confidence. Safety and confidence are the other basic public-policy objectives for payments systems. Sound designs, rules, and risk-management practices promote the safety of payments for users and their financial institutions. Central banks have an ongoing interest in the safety and integrity of payments systems, because they provide the infrastructure for transferring money in the economy. Public confidence in the payments system is a closely related concern. As I noted earlier, confidence in the integrity of our basic paper payment instruments and payments systems was built up over a very long period of time. It is not surprising that society has, at times, been cautious in adopting new payment ideas. Attitudes toward payments systems are often closely linked to attitudes about money, since such systems are the means of transferring money to meet a wide range of obligations. If payments systems do not work well, that can have serious consequences for the wealth, plans, and reputations of many individuals and businesses. In this context, it seems highly likely that prudent users will require new systems to earn confidence with strong evidence that these systems will meet their needs in both normal and exceptional circumstances. As we have seen, the process of building confidence can take years, and most suppliers realize that confidence is an asset to be guarded vigorously. Recently payments systems have faced a number of challenges in the area of risk and risk management. For example, as payments systems such as the ACH have been more widely used to make payments over the telephone and the Internet, fraudulent transactions have reportedly increased. Recent initiatives have apparently improved the situation, but the financial industry has continued to express concerns about fraud and the need to address it. I trust that all conference participants will focus on appropriate future risk designs and riskmanagement practices. While the risk designs of some large-value payments systems have changed significantly over the past few years, the risk designs for core retail payments systems have changed less. Indeed, some of these designs continue to be based on concepts dating back to the 1970s. Limited change may be the appropriate response. However, past designs and strategies should not themselves become barriers to the development of future payments systems that are more aligned with new forms of commerce and technology. Another important issue in the post-September 11 environment is the degree of resilience of not only our large-value payments systems but also our retail systems. Today, the mix of paper and electronic payment options helps mitigate the risk of disruptions to retail payments in the event of terrorist attacks, power blackouts, telecommunications disruptions, or similar infrastructure problems. As the United States increasingly relies on electronic payments for retail transactions, however, the financial system will increasingly need to ensure confidence in the resilience of these systems in a variety of adverse circumstances. As always, heightened resilience has costs. If, however, high resilience is built into new system designs and technologies as they are developed, it may be possible to mitigate these costs while strengthening our infrastructure. Conclusion Over the next two days, you doubtless will be having many very useful discussions. This conference provides an opportunity to address a range of significant topical issues, including the implementation of the Check 21 Act, the direction of the financial industry as it adjusts to lower volumes of checks, and the adoption of new technologies and business practices for electronic check collection. In the area of electronic payments, there will be a variety of views on the development of services, designs, and infrastructure for the next generation of systems. The challenge is both to have vision for the future and to be grounded in the realities of the marketplace. Your insights on these topics will help inform the ideas and actions of both the industry and public authorities during this historic period of the payments system in transition.
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the Securities Indust...
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Alan Greenspan: Outlook for the United States economy Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the Securities Industry Association annual meeting, Boca Raton, Florida, 6 November 2003. * * * I am pleased to join you today to discuss the outlook for the United States economy.1 About a year ago, the uncertainties surrounding a possible war in Iraq began to have a perceptible macroeconomic effect. Those uncertainties, coupled with the lingering concerns that had been created by corporate governance scandals, were among the key factors causing the performance of the U.S. economy late last year and early this year to be lackluster. Risk spreads on corporate bonds peaked in the fall of 2002 at the highest levels observed in at least a decade. Business fixed investment then stalled in the first quarter of this year, and many firms, particularly outside the motor vehicle sector, were content to meet some of the increase in demand by drawing down inventories. Fortunately, a vibrant housing market lifted construction activity and, by facilitating home equity extraction, provided extra support to consumer spending. When hostilities commenced in March, uncertainties related both to the potential for damage to Iraq’s oil fields and to the possibility of broader turmoil in the Middle East rapidly dissipated. Risk spreads fell sharply as did the price of oil. Stock prices rose. Economic activity perked up in late spring and then accelerated further this summer as tax cuts provided a substantial boost to the disposable incomes of households. For the third quarter as a whole, real GDP, our broadest measure of output, is reported to have increased 7-1/4 percent at an annual rate, the fastest quarterly rate of growth in nearly twenty years and obviously a pace not sustainable over the longer run. Even though consumer spending evidently slowed somewhat this fall, new orders received by manufacturers of nondefense capital goods, excluding aircraft, have been rising as have unfilled orders - developments that suggest some further increase in equipment spending is likely in train. There have been some signs in recent weeks that the labor market may be stabilizing. However, viewed from the perspective of the past couple of years, the jobs picture has been weak. Indeed, since November 2001 - the estimated trough of this cycle - total payroll employment is currently reported to have declined by 1 million, and aggregate hours worked in the nonfarm business sector have come down 1-1/2 percent. The combination of growing output and falling hours worked was made possible by a startlingly large rise in productivity. Indeed, since the fourth quarter of 2001, output per hour in the nonfarm business sector has increased 5 percent at an annual rate. And during the second and third quarters of this year, output per hour increased at the astonishing average annual pace of about 7-1/2 percent. This outcome has been associated with a dramatic increase in profits despite little evidence of corporate pricing power. The explanations of the past two years’ surge in productivity are wide-ranging. One hypothesis is that some of the increase represents a temporary rise in the level of productivity reflecting a view that an unusual amount of caution is leading businesses to press workers and facilities to a greater degree than can be sustained over the longer haul. By this hypothesis, as that caution dissipates, employment growth will pick up and the level of output per hour will drop back. Another hypothesis is that the level of productivity has undergone a one-time permanent upward shift. This hypothesis builds on the idea that the heavy emphasis on exploiting new and expanding markets from 1995 to 2000 likely diverted some corporate management from the hard work of controlling costs. The payoffs from cost control doubtless seemed small relative to those thought to attend big-picture expansion. But with tepid sales growth, uncertainty about the strength of future demand, and a fierce discipline exerted by financial markets, companies have been forced to search aggressively for ways The views I will be expressing are my own and not necessarily those of the Federal Reserve Board. to use resources more efficiently, to cut costs, and restore operating profit margins. The extent to which businesses have succeeded in boosting output with fewer labor hours and minimal capital investment over the past two years points up the possibility that a considerable stock of inefficiencies accumulated in the boom years and that this stock is still being worked off. Finally, yet another hypothesis stresses a more-lasting increase in the growth of output per hour. This notion focuses on the considerable lag between the introduction of new technologies and their full integration into production processes and business practices. To reap the full benefits of technological innovation takes learning time, especially if there are large synergies through network effects. Of course, given the exceptionally high rate of growth in output per hour over the past two years, some combination of short-term and longer-term productivity-enhancing forces seems likely to have been at work. In any event, one consequence of these improvements in efficiency has been a temporary ability of many businesses to meet increases in demand while paring existing workforces and continuing to exercise restraint on capital spending. *** If businesses are to spend and hire more vigorously, they will need to be convinced that economic growth can be sustained beyond the short run. One prominent concern is that, if the labor market remains weak, household confidence will suffer, with detrimental consequences for spending. Although layoffs seem to be diminishing, surveys indicate that households continue to be worried about the condition of labor markets. While real after-tax personal income increased at more than a 7 percent annual rate in the third quarter, most of that gain reflected the influence of this year’s cut in taxes. Unless hiring picks up and layoffs ease, assuaging the latent job security fears of many of those currently employed, the share of income spent could decline, a development that would hamper the vigor of the expansion. The odds, however, do increasingly favor a revival in job creation. The surge in final demand in recent months has been met in part by drawing down inventories. In many industries, available data suggest that inventories have become low relative to sales, and purchasing managers’ perceptions of their customers’ inventories corroborate that view. Any swing from inventory liquidation to accumulation would add significantly to the level of GDP. Efforts to rebuild inventories and a dwindling pool of possible efficiencies seem a combination that could generate a notable pickup in hiring should growth in final sales remain firm. *** A critical factor distinguishing the current economic environment from much of the previous experience of the past half century is the inflation backdrop. In previous recessions since the 1960s, the underlying rate of inflation at economic troughs remained clearly above any level that could be associated with effective price stability. As a consequence, with some risk to economic activity, monetary policy typically had to move aggressively in the uncertain early stages of past economic recoveries to ensure that inflation would be contained. By contrast, in the current episode, core consumer price inflation as measured in the national income and product accounts has been running only a little more than 1 percent over the last year, and firms exhibit scant evidence that they are gaining appreciable pricing power despite the pickup in the pace of economic growth. Indeed, the Federal Open Market Committee has judged that the probability, though minor, of an unwelcome fall in inflation exceeds that of a rise in inflation from its already low level. In these circumstances, monetary policy is able to be more patient. That said, no central bank can ever afford to be less than vigilant about the prospects for inflation. *** The foregoing relatively optimistic short-term outlook for the U.S. economy is playing out against a backdrop of growing longer-term concern in financial markets about our federal budget. As you know, the Congressional Budget Office is projecting that, if current policies remain in place, the unified budget will post deficits throughout the remainder of this decade - a sharp turnaround from the large and growing surpluses projected just a few years ago. Given the events of the past three years - the economic downturn, the retrenchment in equity markets, the increased need for spending on homeland security, and the wars in Afghanistan and Iraq - some deterioration in the federal budget balance was probably unavoidable, particularly in the short term. One source of deterioration - the buildup of a larger military force structure - will not persist indefinitely. Merely maintaining a given force structure rather than increasing it will remove an important factor driving the deficit higher. Of course, the deterioration in the fiscal balance has already increased the level of debt relative to GDP, and thus has elevated the starting point from which policymakers will soon have to address the budget implications of the impending retirement of the baby-boom generation. Recent budget deliberations are not encouraging. The current debate appears to be about how much to cut taxes or how much to increase spending. No significant constituency seems to support taking the actions that will be necessary to move toward, and one hopes achieve, budget balance. In retrospect, the emergence of budget surpluses in the late 1990s eroded the discipline that emerged as a consequence of the earlier fear of ever rising and, hence, potentially destructive deficits. Indeed, many of the rules that helped to discipline budgetary decisionmaking in the 1990s - in particular, the statutory limits on discretionary spending and the so-called PAYGO rules - were allowed to expire. Many analysts properly continue to be concerned that, without these enforcement mechanisms and the fundamental political will they signal, the built-in bias in favor of red ink will once again become entrenched. Policymakers have become all too aware that government spending programs and tax preferences can be easy to initiate but extraordinarily difficult to shut down once constituencies develop that have a stake in maintaining the status quo. The now-expired major provisions of the Budget Enforcement Act of 1990, and the act’s later modifications and extensions, provided a set of rules that helped translate a general commitment to fiscal discipline into the actions necessary to achieve it. Remember that in just five years the first cohort of the baby-boom generation will reach 62, the earliest age at which social security retirement benefits may be claimed and the age at which about half of the prospective beneficiaries choose to retire. In about 2008, the proportion of the working-age population that will retire is projected to begin escalating. Almost surely, the social security and Medicare benefits that are promised under current law to future retirees cannot be financed with existing tax rates. Budget simulations by a broad range of analysts (including those at the Office of Management and Budget and the Congressional Budget Office) suggest that the rapid increase in the unified budget deficits that would occur under current law as the baby-boom generation retires could set in motion an unsustainable dynamic in which large deficits result in growing interest payments that augment deficits in future years. Such a development could have notable, destabilizing effects on the economy. Increased productivity growth, while helpful, does not alter that conclusion, because when productivity growth increases, so do social security obligations and, indirectly, Medicare benefits as well. Productivity would have to grow at a rate far in excess of the historical average to fully resolve the long-term financing problems of social security and Medicare. Tax rate increases of sufficient dimension to deal with our looming fiscal problems arguably pose significant risks to economic growth and the revenue base. The exact magnitude of such risks are very difficult to estimate, but they are of enough concern, in my judgment, to warrant aiming to close the fiscal gap primarily, if not wholly, from outlay restraint. At the same time, the dimension of the challenge, especially in later years, cannot be underestimated. The one certainty is that the resolution of this situation will require difficult choices, and the future performance of the economy will depend on those choices. History has shown that, when faced with large challenges, elected officials have risen to the occasion. In particular, looking back over the past twenty years or so, it has been evident that the prospect of large deficits generally has led to actions to narrow them. I trust that the recent deterioration in the budget outlook and the fast-approaching retirement of the baby-boom generation will be met with similar determination and effectiveness.
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Remarks by Mr Roger W Ferguson, Jr, Vice Chairman of the Board of Governors of the US Federal Reserve System, at the confer...
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Roger W Ferguson, Jr: The proposed U.S. approach to regulatory capital - an update Remarks by Mr Roger W Ferguson, Jr, Vice Chairman of the Board of Governors of the US Federal Reserve System, at the conference on The Changing Regulatory Capital Regime in Europe: A Challenging New Business Concept, Brussels, Belgium (via videoconference), 13 November 2003. * * * Good afternoon. I would like to thank you for the opportunity to join you at this impressive conference. You asked me to provide some thoughts about Basel II, particularly its application in the United States. Before doing that, I would like to inform you of our progress in developing the new accord. As most of you know, we are in a very important stage of the process. Over the past six weeks there have been some crucial developments as a result of the discussions among member regulators, a demonstration once again of the Basel Committee’s determination to listen to comments and make those modifications necessary to deliver the best accord possible. The proposal for a capital standard based on unexpected losses submitted by the committee for public comment is a good example of this earnestness in seeking an improved final product. Other issues are still being discussed, including securitization, retail credit, and credit risk mitigation. One should not forget that, on a parallel track, member countries still have to complete their own domestic efforts to translate the accord into national regulation. As you probably know, the comment period for the initial U.S. proposal for Basel II - known as the advance notice of proposed rulemaking (ANPR) - just ended earlier this month. U.S. supervisors are reviewing the comments carefully. If supportable arguments are given for further accord alterations, we will develop proposed changes to present to our colleagues on the committee. In the United States, after this next round of discussions there will still be additional procedural steps before a final rule is in place, with opportunity for comment at each stage. To be clear, the need for more procedural steps in the United States should not be taken as an indication of our lack of commitment to the Basel process. Rather, it is a sign of our attempt to develop these proposals on as transparent a basis as possible and to hear a wide range of comments. The Congress of the United States has also held hearings on the development of the new accord. The interest and oversight by our Congress in these discussions is appropriate and welcome, particularly for an undertaking as extensive as Basel II. The U.S. regulators appreciate the fact that we are able to operate as independent agencies but also realize that we have an obligation to keep the elected representatives informed of our progress in this major effort. Of course, it is expected that other countries and the European Union will be following their own procedures as well. Overall, I have been impressed by the efficacy of the comment process and believe it offers an open forum for all parties to voice their opinions. Debate and discussion on such an important undertaking are essential, and - if solid and convincing arguments are put forth - provide a real opportunity for enhancements to the final product. The current proposal is better because the comments have elicited good ideas that have been taken seriously. Future comments based on sound thought and evidence will create further modifications. But I must say that simple assertions will not carry very much weight. At the same time, we do need to ensure that momentum is maintained. In October, the committee members committed to work promptly to resolve outstanding issues by mid-2004. In January, the Basel Committee will meet to address further analysis of outstanding issues and review the timetable for completing and implementing the committee’s work on the accord. Using the agreement reached in the committee as a template, U.S. supervisors then plan to conduct another Quantitative Impact Study (QIS) to gauge more clearly the impact of the Basel proposals. We believe it is critical that we carefully test the new proposal to determine its effects on individual institutions and to ascertain the need to fine-tune the proposal further, a process that could include recalibrating some of the risk-weight functions. It is our sense that other countries will be doing the same. Because timing is a function of the degree of changes required by the QIS, the U.S. agencies will then conduct a full notice of proposed rulemaking once again to seek and then evaluate public comments before adopting a final rule. U.S. proposals for Basel II Against that background, let me turn to a number of topics that some have raised about Basel II. The U.S. banking agencies have, as you know, proposed to implement Basel II somewhat differently than other nations have. These differences are perfectly consistent with the spirit and letter of the proposal, and reflect the particular characteristics of the U.S. banking system and the rules and regulations under which it operates. While our approach is best for the United States, it is not necessarily best for other nations. The U.S. banking agencies propose that only the most advanced approaches under Basel II be offered for banking organizations in the United States: the advanced internal ratings-based approach for credit risk, known as A-IRB, and the advanced measurement approach for operational risk, known as AMA. As indicated in the ANPR, the standardized approach and the foundation IRB approach to Basel II would not be permitted for credit risk. Nor would the basic indicator approach or standardized approach be available for operational risk. The banking agencies took considerable time to develop the advanced proposals, which we believed would clearly be the best option for the U.S. banking system. The complex operations of the largest banks have outgrown the existing capital regime, and for them Basel I has become less and less effective. Indeed, in the view of U.S. supervisors, an overhaul of the regulatory capital system for our largest banks would be worthwhile only if the most advanced approaches were used. Because of the heterogeneous nature of the U.S. banking system, some balance in the application of Basel II would be necessary. On the one hand, the size, scale and complexity of the internationally active U.S. banks requires, in the opinion of the U.S. supervisors, that these entities operate with the best feasible risk measurement and management procedures, and these procedures are most consistent with the advanced versions of Basel II. On the other hand, the U.S. agencies do not want to impose the higher costs of the advanced version of Basel II on institutions for which it is clearly not suited. In the end, the U.S. banking agencies tried to allow as much choice as possible, while ensuring that banks are still meeting domestic regulatory obligations, avoiding private-sector costs that do not produce some clear and convincing level of benefits, abiding by the evolving Basel II agreement, and, most important, maintaining a safe and sound U.S. banking system. The U.S. banks that would be required to adopt Basel II, as well as those that we expect to choose or opt in to the new regulatory capital rules, are those that, because of size and complexity, should operate with the most sophisticated risk-management practices. The ANPR lays out objective criteria, including asset size and foreign exposure, to identify the large, internationally active banks that would be considered mandatory banks. Naturally, there are also thousands of banks in the United States that do not qualify as large and internationally active and for which the advanced approach of Basel II may not necessarily be appropriate. The overwhelming majority of these banks are significantly less complex and have a scale of operations and market that generally does not extend beyond the United States. As I will discuss, these entities need not be covered by the revised accord to meet international obligations or our own regulatory responsibilities. Thus, the U.S. banking agencies have proposed that those banks not operating under Basel II advanced approaches would remain under the current U.S. regulatory capital rules. An important factor in our decision to retain the current capital regime for those entities that are neither large nor significant global competitors is the scale and nature of the existing capital regime in the United States. The U.S. supervisory regime already contains the substantial elements of Pillar Two under Basel II, including evaluations of internal capital adequacy processes. U.S. supervisors have for many years conducted extensive and thorough on-site supervisory reviews, a process which we believe has contributed to a sound banking and financial system. In addition, the culture of disclosure within the United States already comes close to, and in some areas exceeds, the Pillar Three requirements of the accord revisions. For those U.S. institutions with public debt or equity, requirements by the Securities and Exchange Commission, as well as demands by the market, translate into fairly extensive public disclosure. Moreover, these small and medium-sized banks for the most part already hold capital well in excess of the supervisory minima under both the current and proposed capital regimes. Indeed, the overwhelming majority of U.S. banks maintain capital above the well-capitalized criteria of 10 percent of risk-weighted assets under the U.S. prompt corrective action rules, and generally the smaller the bank, the larger the proportionate capital cushion. Nearly 95 percent of all small and medium-sized banks have regulatory capital ratios of at least 10 percent, and thus it is likely that their current ratios would essentially meet or surpass proposed requirements under Basel II. Therefore, we believe that the current approach to determining regulatory minimum capital in the United States is at least as prudent as Basel II. While U.S. supervisors see no need to require Basel II for banks not considered large or internationally active, the proposal would allow any bank to adopt the accord revisions if it so desired. Of course, any bank wishing to adopt Basel II would have to meet the same high standards applied to mandatory institutions, particularly the internal measurement and management of risk for its exposures. For some large nonmandatory regional institutions, moving to Basel II may be a good choice, and we anticipate that at least ten, and perhaps more, may do so. In effect, the approach proposed in the United States requires that those institutions that would not be required by scale or global activities to adopt the A-IRB version of Basel II would have to conduct their own cost-benefit analysis to determine if they should opt in or wait, perhaps for the costs of implementation to come down through vendor and other developments, or, alternatively, if they should remain under the current capital regime. Initially, some of our colleagues on the Basel Supervisors’ Committee criticized the U.S. agencies’ approach to scope of application, claiming that the application was too limited or inconsistent with the proposed accord. But this criticism has faded with better understanding of the structure of the U.S. banking system: More than two-thirds of the assets of U.S. banking organizations are likely to be covered by Basel II, as well as more than 99 percent of the foreign claims held by U.S. banking organizations. Potential competitive effects The U.S. agencies have increasingly focused on the potential competitive effects of Basel II on U.S. banks. As the ANPR outlines, policymakers will be attentive to the competitive concerns of both the institutions expected to adopt Basel II in the United States, and those that might not. We are of course interested in the evidence developed from the ANPR. In addition, Fed staff members are now conducting empirical research to try to determine if the bifurcated approach has any implications for possible acquisition strategies to be used by advanced Basel II banks in acquiring non-Basel II banks. Moreover, we are also trying to determine empirically the evidence for the competitive implications of the U.S. implementation proposals on credit for small and medium-sized business, residential mortgage, and credit card markets. If that empirical evidence indicates a high probability of general competitive imbalances, we will then review our options for addressing the problem. But we first need to see the evidence that a problem exists and then determine how large it may be. That these issues surfaced, I might add, illustrates the benefits of a transparent comment period. Standards for Basel II One would hope that, by now, no one misunderstands the extensive requirements for any institution adopting Basel II, particularly for the advanced approaches that will be the only option in the United States. Because capital requirements under the advanced approaches will be based on bank inputs, the bar will clearly have to be raised, particularly for risk management and control systems. For most banks - in fact, I would say for all banks moving to the advanced versions of Basel II - meeting these standards and requirements will be very challenging and will require substantial resources. Managers at some institutions may believe that their institution is already very close to meeting all the prerequisites for Basel II. Although our rules and standards are not yet final, on the basis of pilot reviews and discussions with line supervisors here in the United States, I would advise any institution thinking it has little work remaining to make a careful and frank reassessment of where it stands. In the United States we are developing a set of supervisory guidance to accompany our rulemaking. This supervisory guidance, which will be developed for all A-IRB credit portfolios of Basel II as well as for the AMA, is intended to provide additional clarity and interpretation of the rule, and to more clearly define supervisory expectations. And the guidance, by describing in more detail what it will take to satisfy U.S. supervisors, should assist nonmandatory banks in deciding whether to opt in. Initial drafts of supervisory guidance for corporate A-IRB and for AMA were published for comment in concert with the ANPR. U.S. regulators are already reviewing feedback on this draft supervisory guidance and, as with the ANPR, remain open to suggestions for altering that guidance if we are presented with valid arguments for doing so. Draft guidance for other A-IRB portfolios, such as retail, is being developed and will be published for comment as well. This is also a good opportunity for me to add a few initial thoughts about the possible nature of qualifying examinations for Basel II in the United States. As I noted, we still need to reach an agreement in Basel and complete the process for formulating a final rule in the United States before we can start assessing institutions vis-à-vis new standards related to Basel II. However, the U.S. agencies are starting to identify, on a joint basis, what a qualification process for Basel II would encompass, both for mandatory and opt-in banking organizations. This will not be an easy task, in part because our particular regulatory structure has different supervisors overseeing different banks and legal entity types. And it will be complicated by the need to coordinate qualification internationally with host jurisdictions to minimize the burden on banking organizations supervised by agencies from multiple countries. Cooperation among the U.S. agencies on this and other matters relating to Basel II implementation has been excellent. There is, of course, no expectation that under Basel II the U.S. regulatory structure will change in terms of the legal mandates assigned to each agency. As the ANPR states, an institution’s primary federal supervisor would have responsibility for determining an institution’s readiness for an advanced approach and ultimately would be responsible, after consultation with other relevant supervisors, for determining whether the institution satisfies the supervisory expectations for the advanced approaches. And this procedure will obviously apply at both the bank and bank holding company level in the United States. Given the significance of Basel II, enhanced communication and cooperation among U.S. supervisory agencies - and between U.S. supervisors and affected host country supervisors - will be necessary. We are already in agreement that the U.S. qualification process will be intensive, rigorous, and lengthy, because of the nature of what we are about to embark upon. But in the end we believe that a rigorous qualification process will create a more risk-sensitive regulatory capital regime and improve risk management. Cross-border issues The accord revisions wisely contain a certain amount of flexibility to account for differences in the banking systems of member countries. These so-called national discretion elements, combined with different approaches that member countries might choose for their banking system, mean that maintaining a level playing field across countries is a challenge. Achieving an acceptable level of consistency in implementation is something that the Basel Committee takes seriously and is the reason it formed the Accord Implementation Group (AIG) two years ago. The AIG comprises line supervisors from member countries and is charged with identifying potential implementation issues and creating as much consistency as possible across countries. These issues, which are referred to as “cross border” or “home/host” issues, cover both credit and operational risk. Cross-border issues are particularly complicated because the new accord will apply to both consolidated banking organizations in home countries as well as subsidiary bank and bank holding companies in host countries. This August the AIG issued a set of high-level principles for cross-border implementation of the accord. These principles lay the groundwork for further cooperation and coordination for implementation among member countries. They clearly identify the need to respect both home and host country rules and regulations, the need for enhanced and pragmatic cooperation between both types of supervisors, and the desire for supervisors to minimize the burden on banking groups as much as possible. The U.S. agencies believe that their choice for scope of application is consistent with these principles. For example, the proposal to allow only the advanced approaches in the United States also extends to any U.S. banking subsidiaries of foreign banking organizations and reflects our legitimate role as host country supervisors and the principles of national treatment. At the same time, we understand that other countries may offer approaches that are different from those offered in the United States. So a consolidated banking organization not based in the United States may choose to operate under an approach not offered in our country - such as foundation IRB for credit risk or basic indicator for operational risk - even though the advanced approaches would be the only ones available to its U.S. bank and bank holding company subsidiaries. And if those U.S. subsidiaries are not considered mandatory Basel II institutions, they also have the option of remaining on the current U.S. regulatory capital regime. By the same logic, foreign banking subsidiaries of U.S.-based organizations would have to abide by the local rules and regulations of host country supervisors, even if their consolidated entity is operating under different rules. These differences between approaches offered in host versus home countries present challenges for global banking organizations, both foreign-based and U.S.-based. As a result, U.S. supervisors need to work very closely with supervisors from other member countries to assist banking organizations in meeting the various requirements. The AIG has already begun to foster this type of collaboration. For this issue the bottom line is that legal mandates across countries are not going to change, and supervisors realize that they have an added responsibility to keep complexity to a minimum. One of the most challenging home/host issues that has arisen of late is the allocation of operational risk capital within a consolidated banking organization. This issue, similar to other cross-border issues, goes right to the heart of home/host supervision. The conflict arises because host supervisors may require subsidiary banks at the local level to hold a certain amount of capital which, when aggregated across both geography and entity type, may be greater than what the consolidated organization deems necessary, because of diversification effects. This is clearly a difficult issue. As Chairman Caruana commented last month, it may well take some time for our efforts to converge to an acceptable solution in this matter, and that solution may not be completely satisfactory for all parties. Right now the AIG is working with the Committee’s Risk Management Group (RMG) to develop a set of possible solutions to the problem. My expectation is that reaching a solution will require a slow and steady effort, but in the end, we will reach an acceptable compromise. In that sense, this issue reflects much of what the Basel II process is all about - identifying challenging issues, listening carefully to comments, conducting analysis to find a range of possible options, and then reaching an acceptable compromise solution that is consistent with safety and soundness. Finally, I would like to turn to the AIG’s work on consistency of standards. Because member countries have different supervisory regimes, there is the possibility for Basel II rules to be applied in a variety of ways. While some variety in standards across countries may be unavoidable, we believe that maintaining as much consistency as possible is a worthwhile objective. It benefits no one if there is an appearance that countries vary considerably in their application of standards. The entire accord is undermined if a set of banks from one country appears to be subject to softer standards. We are already happy with the progress we have seen within the AIG on this issue and believe that pursuing the goal of consistent standards will truly bring about a better and safer global banking system. Concluding thoughts I thank you for the opportunity to share some of my thoughts on Basel II. As I stated, I consider the recent decisions reached by the Basel Committee to be a very good example of how supportable and valid arguments for alterations in the accord proposals are taken seriously. In the United States, additional opportunities still remain for comments to be heard and for possible modifications as the United States continues its rulemaking processes. That said, we do not expect to slacken the high standards expected of banks operating under the advanced approaches for Basel II. The U.S. agencies have tailored the application of Basel II to the particular characteristics of the U.S. banking system, while maintaining both the letter and spirit of the accord. We expect other countries to act similarly with regard to their own banking systems. We understand that a number of cross-border issues relating to Basel II implementation pose challenges, and that it may take some time to resolve them. This will of course mean that supervisors across countries must work even more closely together. But I hope it is evident that the fervent efforts among member countries to heed comments and to find solutions underscore our commitment to craft the best accord revisions possible, while maintaining a safe and sound global banking system.
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board of governors of the federal reserve system
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the 21st Annual Monet...
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Alan Greenspan: The evolving international payments imbalance of the United States and its effect on Europe and the rest of the world Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the 21st Annual Monetary Conference, Cosponsored by the Cato Institute and The Economist, Washington, DC, 20 November 2003. * * * Among the major forces that will help shape the euro’s future as a world currency will be the international evolution of the euro area’s key financial counterparty, the United States. I will leave the important interplay between the euro and the dollar - and particularly forecasts of the dollar-euro exchange rate - to more venturesome analysts. My experience is that exchange markets have become so efficient that virtually all relevant information is embedded almost instantaneously in exchange rates to the point that anticipating movements in major currencies is rarely possible.1 I plan this morning to head in what I hope will be a more fruitful direction by addressing the evolving international payments imbalance of the United States and its effect on Europe and the rest of the world. I intend to focus on the eventual resolution of that current account imbalance in the context of accompanying balance-sheet changes. I conclude that spreading globalization has fostered a degree of international flexibility that has raised the probability of a benign resolution to the U.S. current account imbalance. Such a resolution has been the general experience of developed countries over the past two decades. Moreover, history suggests that greater flexibility allows economies to adjust more smoothly to changing economic circumstances and with less risk of destabilizing outcomes. Indeed, the example of the fifty states of the United States suggests that, with full flexibility in the movement of labor and capital, adjustments to cross-border imbalances can occur even without an exchange rate adjustment. In closing, I raise the necessity of containing the forces of protectionism to ensure the flexibility needed for a benign outcome of our international imbalances. *** The current account deficit of the United States, essentially net exports of goods and services, has continued to widen over the past couple of years. The external deficit receded modestly during our mild recession of 2001 only to rebound to a record 5 percent of gross domestic product earlier this year. Our persistent current account deficit is a growing concern because it adds to the stock of outstanding external debt that could become increasingly more difficult to finance. These developments raise the question of whether the record imbalance will benignly defuse, as it largely did after its previous peak of about 3-1/2 percent of GDP in 1986, or whether the resolution will be more troublesome. *** Current account balances are determined mainly by countries’ relative incomes, by product and asset prices including exchange rates, and by comparative advantage. To pay for the internationally traded goods and services that underlie that balance, there is a wholly separate market in financial instruments the magnitudes of which are determined by the same set of asset prices that affects trade in goods and services. In the end, it is the balancing of trade and financing that sets international product and asset prices and global current account balances. The buildup or reduction in financial claims among trading countries - that is, capital flows - are hence exact mirrors of the current account balances. And just as net trade and current accounts for the world The exceptions to this conclusion are those few cases of successful speculation in which governments have tried and failed to support a particular exchange rate. Nonetheless, despite extensive efforts on the part of analysts, to my knowledge, no model projecting directional movements in exchange rates is significantly superior to tossing a coin. I am aware that of the thousands who try, some are quite successful. So are winners of coin-tossing contests. The seeming ability of a number of banking organizations to make consistent profits from foreign exchange trading likely derives not from their insight into future rate changes but from making markets and consistently being able to buy at the bid and sell at the offering price, pocketing the spread. as a whole necessarily sum to zero, so do net capital flows. Because for any country the change in net claims against all foreigners cumulates to its current account balance (abstracting from valuation adjustments), that balance must also equal the country’s domestic saving less its domestic investment. *** In as much as the balance of goods and services is brought into equality with the associated capital flows through adjustments in prices, interest rates, and exchange rates, how do we tell whether trade determines capital flows or whether capital flows determine trade? Answering this question is difficult because the balancing process is simultaneous rather than sequential, so that there is no simple unidirectional causality between trade and capital flows. For example, increased demand for dollar assets may lower interest rates and equity premiums in the United States and thus engender increased demand for imports. But the need for import financing may raise domestic interest rates and thereby attract the required additional capital inflows to the United States. Nonetheless, as the U.S. current account deficit rose from 1995 to early 2002, so too did the dollar’s effective exchange rate. Evidently, upward pressure on the dollar was spurred by rising expected rates of return that resulted in private capital investments from abroad that chronically exceeded the current account deficit. The pickup in U.S. productivity growth in the mid-1990s - the likely proximate cause of foreigners’ perception of increased rates of return on capital in the United States - boosted investment spending, stock prices, wealth, and assessments of future income. Those favorable developments led, in turn, to greater consumer spending and lower saving rates. The resulting widening gap between domestic investment and domestic saving from 1995 to 2000 was held partly in check by higher government saving as rising stock prices drove up taxable income. When, in 2002, that effect reversed and the federal budget slipped back into deficit, and as the U.S. economy emerged from its downturn, the gap in the current account balance widened further. After contracting in the aftermath of the U.S. stock market decline of 2000, private capital from abroad was apparently again drawn to the United States in substantial quantities by renewed perceptions of relatively high rates of return. In addition, during the past year or so the financing of our external deficit was assisted by large accumulations of dollars by foreign central banks. *** Even before the productivity surge of the late 1990s, the United States had become particularly prone to current account deficits and rising external net debt because of the historical tendency on the part of U.S. residents to import, relative to income, at a significantly higher rate than our trading partners, at least for U.S. goods and services.2 If all economies were to grow at the same rate, such differential propensities would produce an ever-widening trade deficit for the United States and a corresponding surplus for our trading partners, failing offsetting adjustments in relative prices. In the 1960s or 1970s, because our trading partners were growing far faster than we were, a trade gap did not surface. When, in the 1980s, the difference in growth rates narrowed while the dollar rose, our trade and the associated current account deficits widened dramatically. By the late 1980s, we had become a net debtor nation, ending seven decades as a net creditor. While most recent data reaffirm our above-average propensity to import, there is evidence to suggest that its magnitude has diminished. *** There is no simple measure by which to judge the sustainability of either a string of current account deficits or their consequence, a significant buildup in external claims that need to be serviced. Financing comes from receipts from exports, earnings on assets, and, if available, funds borrowed from foreigners. In the end, it will likely be the reluctance of foreign country residents to accumulate additional debt and equity claims against U.S. residents that will serve as the restraint on the size of tolerable U.S. imbalances in the global arena. Unlike the financing of payments from export and income receipts, reliance on borrowed funds may not be sustainable. By the end of September 2003, net external claims on U.S. residents had risen to This anomaly was first identified more than three decades ago; see H.S. Houthakker and Stephen P. Magee, “Income and Price Elasticities in World Trade,” The Review of Economics and Statistics vol. 51 (May 1969), 111-25. an estimated 25 percent of a year’s GDP, still far less than claims on many of our trading partners but rising at the equivalent of 5 percentage points of GDP annually. However, without some notion of our capacity for raising cross-border debt, the sustainability of the current account deficit is difficult to estimate. That capacity is evidently, in part, a function of globalization since the apparent increase in our debt-raising capacity appears to be related to the reduced cost and increasing reach of international financial intermediation. The significant reduction in global trade barriers over the past half century has contributed to a marked rise in the ratio of world trade to GDP and, accordingly, a rise in the ratio of imports to domestic demand. But also evident is that the funding of trade has required, or at least has been associated with, an even faster rise in external finance. Between 1980 and 2002, for example, the nominal dollar value of world imports rose 5-1/2 percent annually, while gross external liabilities, largely financial claims, also expressed in dollars, apparently rose considerably faster.3 This observation does not reflect solely the sharp rise in the external liabilities of the United States that has occurred since 1995. For other OECD economies, imports rose about 2 percent annually from 1995 to 2002; external liabilities increased 8 percent. Less-comprehensive data suggest that the ratio of global debt and equity claims to trade has been rising since at least the beginning of the post-World War II period.4 From an accounting perspective, part of the increase in finance relative to trade in recent years reflects the continued marked rise in tradable foreign currencies held by private firms as well as a very significant buildup of international currency reserves of monetary authorities. Rising global wealth has apparently led to increased demand for diversification of portfolios by including greater shares of foreign currencies. More generally, technological advance and the spread of global financial deregulation has fostered a broadening array of specialized financial products and institutions. The associated increased layers of intermediation in our financial system make it easier to diversify and manage risk, thereby facilitating an ever-rising ratio of domestic liabilities (and assets) to GDP, and gross external liabilities to trade.5 These trends seem unlikely to reverse, or even to slow materially, short of an improbable end to the expansion of financial intermediation that is being driven by cost-reducing technology. Uptrends in the ratios of external liabilities or assets to trade, and therefore to GDP, can be shown to have been associated with a widening dispersion in countries’ ratios of trade and current account balances to GDP.6 A measure of that dispersion, the sum of the absolute values of the current account balances estimated from each country’s gross domestic saving less gross domestic investment (the current account’s algebraic equivalent), has been rising as a ratio to GDP at an average annual rate of about 2 percent since 1970 for the OECD countries, which constitute four-fifths of world GDP. The long-term increase in intermediation, by facilitating the financing of ever-wider current account deficits and surpluses, has created an ever-larger class of investors who might be willing to hold cross- Gross liabilities include both debt and equity claims. Data on the levels of gross liability have to be interpreted carefully because they reflect the degree of consolidation of the economic entities they cover. Were each of our fifty states considered as a separate economy, for example, interstate claims would add to both U.S. and world totals without affecting U.S. or world GDP. Accordingly, it is the change in the gross liabilities ratios that is the more economically meaningful concept. For the United States, for example, the ratio of external liabilities to imports of goods and services rose from nearly 1-1/2 in 1948 to close to 2 in 1980. The comparable ratios for the United Kingdom can be estimated to have been in the neighborhood of 2-1/2 or lower in 1948 and about 3-3/4 in 1980. For the United States, for example, even excluding mortgage pools, the ratio of domestic liabilities to GDP rose at an annual rate of 2 percent between 1965 to 2002. For the United Kingdom, the ratio of debt liabilities to GDP increased 4 percent at an annual rate during the more recent 1987-2002 period. If the rate of growth of external assets (and liabilities) exceeds, on average, the growth rate of world GDP, under a broad range of circumstances the dispersion of the change in net external claims of trading countries must increase as a percent of world GDP. But the change in net claims on a country, excluding currency valuation changes and capital gains and losses, is essentially the current account balance. Of necessity, of course, the consolidated world current account balance remains at zero. Theoretically, if external assets and liabilities were always equal, implying a current account in balance, the ratio of liabilities to GDP could grow without limit. But in the complexities of the real world, if external assets fall short of liabilities for some countries, net external liabilities will grow until they can no longer be effectively serviced. Well short of that point, market prices, interest rates, and exchange rates will slow, and then end, the funding of liability growth. border claims. To create liabilities, of course, implies a willingness of some private investors and governments to hold the equivalent increase in claims at market-determined asset prices. Indeed, were it otherwise, the funding of liabilities would not be possible. With the seeming willingness of foreigners to hold progressively greater amounts of cross-border claims against U.S. residents, at what point do net claims (that is, gross claims less gross liabilities) against us become unsustainable and deficits decline? Presumably, a U.S. current account deficit of 5 percent or more of GDP would not have been readily fundable a half-century ago or perhaps even a couple of decades ago.7 The ability to move that much of world saving to the United States in response to relative rates of return would have been hindered by a far lower degree of international financial intermediation. Endeavoring to transfer the equivalent of 5 percent of U.S. GDP from foreign financial institutions and persons to the United States would presumably have induced changes in the prices of assets that would have proved inhibiting. *** There is, for the moment, little evidence of stress in funding U.S. current account deficits. To be sure, the real exchange rate for the dollar has, on balance, declined more than 10 percent broadly and roughly 20 percent against the major foreign currencies since early 2002. Yet inflation, the typical symptom of a weak currency, appears quiescent. Indeed, inflation premiums embedded in long-term interest rates apparently have fluctuated in a relatively narrow range since early 2002. More generally, the vast savings transfer has occurred without measurable disruption to the balance of international finance. In fact, in recent months credit risk spreads have fallen and equity prices have risen throughout much of the global economy. *** To date, the widening to record levels of the U.S. ratio of current account deficit to GDP has been seemingly uneventful. But I have little doubt that, should it continue, at some point in the future adjustments will be set in motion that will eventually slow and presumably reverse the rate of accumulation of net claims on U.S. residents. How much further can international financial intermediation stretch the capacity of world finance to move national savings across borders? A major inhibitor appears to be what economists call “home bias.” Virtually all our trading partners share our inclination to invest a disproportionate percentage of domestic savings in domestic capital assets, irrespective of the differential rates of return. People seem to prefer to invest in familiar local businesses even where currency and country risks do not exist. For the United States, studies have shown that individual investors and even professional money managers have a slight preference for investments in their own communities and states. Trust, so crucial an aspect of investing, is most likely to be fostered by the familiarity of local communities. As a consequence, home bias will likely continue to constrain the movement of world savings into its optimum use as capital investment, thus limiting the internationalization of financial intermediation and hence the growth of external assets and liabilities.8 Nonetheless, during the past decade, home bias has apparently declined significantly. For most of the earlier postwar era, the correlation between domestic saving rates and domestic investment rates across the world’s major trading partners, a conventional measure of home bias, was exceptionally high.9 For OECD countries, the GDP-weighted correlation coefficient was 0.97 in 1970. However, it fell from 0.96 in 1992 to less than 0.8 in 2002. For OECD countries excluding the United States, the recent decline is even more pronounced. These declines, not surprisingly, mirror the rise in the It is true that estimates of the ratios of the current account to GDP for many countries in the nineteenth century are estimated to have been as large as, or larger, than we have experienced in recent years. However, the substantial net flows of capital financing for those earlier deficits were likely motivated in large part by specific major development projects (for example, railroads) bearing high expected rates of return. By contrast, diversification appears to be a more salient motivation for today’s large net capital flows. Moreover, gross capital flows are believed to be considerably greater relative to GDP in recent years than in the nineteenth century. (See Alan M. Taylor, “A Century of Current Account Dynamics,” Journal of International Money and Finance, 2002, 725-48, and Maurice Obstfeld and Alan Taylor, “Globalization and Capital Markets,” NBER Working Paper 8846, March 2002.) Without home bias, the dispersion of world current account balances would likely be substantially greater. See Martin Feldstein and Charles Horioka, “Domestic Saving and International Capital Flows,” The Economic Journal, June 1980, 314-29. differences between saving and investment or, equivalently, of the dispersion of current account balances over the same years. The decline in home bias probably reflects an increased international tendency for financial systems to be more transparent, open, and supportive of strong investor protection.10 Moreover, vast improvements in information and communication technologies have broadened investors’ scope to the point that foreign investment appears less exotic and risky. Accordingly, the trend of declining home bias and expanding international financial intermediation will likely continue as globalization proceeds. *** It is unclear whether debt-servicing restraints or the rising weight of U.S. assets in global portfolios will impose the greater restraint on current account dispersion over the longer term. Either way, when that point arrives, what do we know about whether the process of reining in our current account deficit will be benign to the economies of the United States and the world? According to a Federal Reserve staff study, current account deficits that emerged among developed countries since 1980 have risen as high as double-digit percentages of GDP before markets enforced a reversal.11 The median high has been about 5 percent of GDP. Complicating the evaluation of the timing of a turnaround is that deficit countries, both developed and emerging, borrow in international markets largely in dollars rather than in their domestic currency. The United States has been rare in its ability to finance its external deficit in a reserve currency.12 This ability has presumably enlarged the capability of the United States relative to most of our trading partners to incur foreign debt. *** Besides experiences with the current account deficits of other countries, there are few useful guideposts of how high our country’s net foreign liabilities can mount. The foreign accumulation of U.S. assets would likely slow if dollar assets, irrespective of their competitive return, came to occupy too large a share of the world’s portfolio of store of value assets. In these circumstances, investors would seek greater diversification in non-dollar assets. At the end of 2002, U.S. dollars accounted for about 65 percent of central bank foreign exchange reserves, with the euro second at 15 percent. Approximately half of private cross-border holdings were denominated in dollars, with one-third in euros. More important than the way that the adjustment of the U.S. current account deficit will be initiated is the effect of the adjustment on both our economy and the economies of our trading partners. The history of such adjustments has been mixed. According to the aforementioned Federal Reserve study of current account corrections in developed countries, although the large majority of episodes were characterized by some significant slowing of economic growth, most economies managed the adjustment without crisis. The institutional strengths of many of these developed economies - rule of law, transparency, and investor and property protection - likely helped to minimize disruptions associated with current account adjustments. The United Kingdom, however, had significant adjustment difficulties in its early postwar years, as did, more recently, Mexico, Thailand, Korea, Russia, Brazil, and Argentina, to name just a few. Can market forces incrementally defuse a worrisome buildup in a nation’s current account deficit and net external debt before a crisis more abruptly does so? The answer seems to lie with the degree of flexibility in both domestic and international markets. In domestic economies that approach full flexibility, imbalances are likely to be adjusted well before they become potentially destabilizing. In a Research indicates that home bias in investment toward a foreign country is likely to be diminished to the extent that the country’s financial system offers transparency, accessibility, and investor safeguards. See Alan Ahearne, William Griever, and Frank Warnock, “Information Costs and Home Bias” Board of Governors of the Federal Reserve System, International Finance Discussion Paper No. 691, December 2000. Caroline Freund, “Current Account Adjustment in Industrialized Countries,” Board of Governors of the Federal Reserve System, International Finance Discussion Paper No. 692, December 2000. Less than 10 percent of aggregate U.S. foreign liabilities are currently denominated in nondollar currencies. To have your currency chosen as a store of value is both a blessing and a curse. Presumably, the buildup of dollar holdings by foreigners has provided Americans with lower interest rates as a consequence. But, as Great Britain learned, the liquidation of sterling balances after World War II exerted severe pressure on its domestic economy. similarly flexible world economy, as debt projections rise, product and equity prices, interest rates, and exchange rates could change, presumably to reestablish global balance. The experience over the past two centuries of trade and finance among the individual states that make up the United States comes close to that paradigm of flexibility even though exchange rates among the states have been fixed. Although we have scant data on cross-border transactions among the separate states, anecdotal evidence suggests that over the decades significant apparent imbalances have been resolved without precipitating interstate balance-of-payments crises. The dispersion of unemployment rates among the states, one measure of imbalances, spikes during periods of economic stress but rapidly returns to modest levels, reflecting a high degree of adjustment flexibility. That flexibility is even more apparent in regional money markets, where interest rates that presumably reflect differential imbalances in states’ current accounts and hence cross-border borrowing requirements have, in recent years, exhibited very little interstate dispersion. This observation suggests either negligible cross-state-border imbalances, an unlikely occurrence given the pattern of state unemployment dispersion, or more likely very rapid financial adjustments. *** We may not be able to usefully determine at what point foreign accumulation of net claims on the United States will slow or even reverse, but it is evident that the greater the degree of international flexibility, the less the risk of a crisis.13 The experience of the United States over the past three years is illustrative. The apparent ability of our economy to withstand a number of severe shocks since mid-2000, with only a small decline in real GDP, attests to the marked increase in our economy’s flexibility over the past quarter century.14 *** In evaluating the nature of the adjustment process, we need to ask whether there is something special in the dollar being the world’s primary reserve currency. With so few historical examples of dominant world reserve currencies, we are understandably inclined to look to the experiences of the dollar’s immediate predecessor. At the height of sterling’s role as the world’s currency more than a century ago, Great Britain had net external assets amounting to some 150 percent of its annual GDP, most of which were lost in World Wars I and II. Early post-World War II Britain was hobbled with periodic sterling crises as much of the remnants of Empire endeavored to disengage themselves from heavy reliance on holding sterling assets as central bank reserves and private stores of value. The experience of Britain’s then extensively regulated economy, harboring many wartime controls well beyond the end of hostilities, provides testimony to the costs of structural rigidity in times of crisis. *** Should globalization be allowed to proceed and thereby create an ever more flexible international financial system, history suggests that current imbalances will be defused with little disruption. And if other currencies, such as the euro, emerge to share the dollar’s role as a global reserve currency, that process, too, is likely to be benign. I say this with one major caveat. Some clouds of emerging protectionism have become increasingly visible on today’s horizon. Over the years, protected interests have often endeavored to stop in its tracks the process of unsettling economic change. Pitted against the powerful forces of market competition, virtually all such efforts have failed. The costs of any new such protectionist initiatives, in the context of wide current account imbalances, could significantly erode the flexibility of the global economy. Consequently, it is imperative that creeping protectionism be thwarted and reversed. Although increased flexibility apparently promotes resolution of current account imbalances without significant disruption, it may also allow larger deficits to emerge before markets are required to address them. See Alan Greenspan, remarks before a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 30, 2002.
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board of governors of the federal reserve system
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Remarks by Mr Roger W Ferguson, Jr, Vice Chairman of the Board Remarks by Mr Roger W Ferguson, Jr, Vice Chairman of the Board of Governors of the US Federal Reserve System, at the Executives¿ Club of Chicago, Chicago, 21 November 2003.
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Roger W Ferguson, Jr: Economic outlook Remarks by Mr Roger W Ferguson, Jr, Vice Chairman of the Board of Governors of the US Federal Reserve System, at the Executives’ Club of Chicago, Chicago, 21 November 2003. * * * It is a pleasure to be with you today to speak about the U.S. economy. As always, the views I will be expressing are my own and do not necessarily represent those of the other members of the Board of Governors or the Federal Open Market Committee. My last formal speech on the economy was in November 2002. And in preparing my remarks for today, I was struck both by how much has happened over the past year and by how much economic conditions have changed. Think back to the economic situation of a year ago. After growing moderately over the first three quarters of 2002, the economy was about to stall out. The lingering effects of the corporate governance scandals, rising oil prices, and growing uncertainties about the economic consequences of a possible war in Iraq were holding back the nascent recovery from the 2001 recession. The pessimism that had gripped the business community since the summer of 2000 intensified, and firms renewed their focus on restructuring rather than expanding their operations. The result was another round of job cuts and continued sluggishness in capital spending. Intense geopolitical risks and uncertainties continued to weigh on the economy until major combat operations in Iraq ended this past spring. Shortly thereafter, the Congress enacted additional reductions in personal income taxes and extended the enhanced corporate expensing provisions for new investment. Moreover, the Federal Reserve eased monetary policy an additional 25 basis points in June. By early this summer, a significant amount of monetary and fiscal stimulus was in place, and although there was no evidence in hand at the time, most forecasters anticipated a step-up in the pace of economic activity. In the event, the economy rebounded faster than even the most optimistic of prognosticators had predicted. Real gross domestic product rose at an annual rate of 3¼ percent in the second quarter of this year and surged at a rate of more than 7 percent in the third quarter. The labor market, which heretofore had continued to deteriorate, appears to have stabilized during the summer, and almost 300,000 new jobs were created over the July-to-October period. Although the economy now appears to have turned the corner, much additional progress needs to be made before our country’s labor and capital resources are fully utilized. Indeed, until the most recent employment report, many commentators had described this period as the “jobless recovery”. Since the cyclical trough in November 2001, nonfarm payrolls have actually fallen ½ percent. This decline compares with a 1¼ percent rise over a period of comparable length in the preceding jobless recovery from the recession of 1990-91 and an average 7 percent increase in the other seven post-war recovery periods. A similar picture emerges for industrial production, which is up only 2 percent from its cyclical trough, compared with 6½ percent in 1990-91 and almost 20 percent on average after the other seven post-war recessions. Are jobless recoveries now the norm? These developments are striking departures from past cyclical behavior, and they raise the question of whether some facet of the U.S. economy has changed. Given the very slow employment growth in the two years after the past two recessions, should we consider “jobless recoveries” to be the new norm? Proponents of this view cite the widespread cost cutting and restructuring that has occurred in the past two recoveries, the continuing outsourcing of jobs overseas, and an ongoing focus of business decision makers on improving efficiency rather than expanding capacity. I suspect that the differential behavior of the past two recoveries reflects more the nature of the shocks that hit the economy during these periods than a fundamental shift in the structure of the economy. Let me elaborate on this hypothesis. Glance at the textbook descriptions of business-cycle fluctuations between 1946 and 1990, and you will find repeated references to swings in aggregate demand induced by so-called “stop-go” economic policies - policies that alternated between being excessively stimulative and excessively restrictive. These descriptions often portray the Federal Reserve as one of the villains in this process, first by spiking the proverbial punch bowl to get the party rolling and then preemptively removing it once everyone was having a bit of fun. During this period, monetary policy attempted to manage cyclical shocks to aggregate demand and aggregate supply to first control inflation and then to confront any excess slack in resource utilization that might follow from these initial actions. However, the recessions of 1990-1991 and 2001 were different than this prototypical postwar downturn. Both involved unusual economic circumstances that placed additional strains on the economy. In 1990, a credit crunch was layered on top of the usual cyclical dynamics. The collapse of savings and loan institutions and the need to repair the capital structure of the banking industry led to a period in which the flow of credit to businesses was impaired. Although the Federal Reserve cut interest rates to confront these “headwinds”, a prolonged adjustment period was still needed to correct the financial imbalances that had emerged in the late 1980s. Facing limited access to the credit markets, businesses - especially small businesses - were unable to expand, and hiring lagged far behind that of the typical postwar recovery. In my view, this credit-supply shock and the associated efforts of businesses to repair their balance sheets proved to be the characteristic of the 1990-1991 recession-and-recovery period that distinguished it from earlier cycles and led to its jobless features. The 2001 recession was an unusual investment-led downturn that followed the boom of the late 1990s and early 2000. The exuberance that accompanied the growth of information technology and the Internet led some to overestimate the potential of this revolutionary hardware and software to generate productivity gains and extra-normal rates of return. An important step-up in the rate of productivity growth occurred during this period, but not all players in the game were capable of achieving the extra normal rates of return that flowed to some of the more innovative companies. Young start-up companies that had never made a profit (and never would) attracted copious amounts of financing from venture capitalists and the initial public offering market. Analysts began to question whether established “bricks and mortar” businesses could ever compete with this new Internet business model, and many of these more-traditional firms felt compelled to accelerate their own on-line strategies. In the end, the bubble burst, but not before huge sums of money had been spent on new (and subsequently unneeded) capacity. The ultimate fallout was severe, especially in segments of manufacturing that had geared up to satisfy the anticipated demand for high-technology products. The bursting of the bubble wiped out significant amounts of financial wealth, prompting adjustments throughout the economy. Firms slashed payrolls, and capital spending projects were abandoned. As with the process of adjustment to the 1990 credit crunch, a long period of time has been required to get employment and capacity back to more viable levels. And some industries - such as telecommunications - still appear to be struggling. As a footnote, I should mention that the successful efforts of many companies to ready their computer systems for the year 2000 date change probably added to the length of this adjustment period in some high-technology industries. The new equipment and rewritten software that were put in place by the end of 1999 seem to have greatly exceeded expectations both in terms of longevity and associated productivity gains. We continue to hear from businesses that they have been able to extend the useful service life of this equipment and to reap additional productivity gains by fine-tuning their automation systems. Although this extended replacement and upgrade cycle has helped to support the profitability of technology-consuming businesses, it obviously has been bad for the bottom line of the producers of these high-tech goods and services. Although the boom-bust in capital spending was a unique feature of the most recent business cycle, the U.S. economy was also hit by the terrorist attacks of 2001, the corporate governance scandals of 2002, and the 2003 war in Iraq. In hindsight, it is clear that such an uncertain and risky environment was not conducive either to the creation of new jobs or to the expansion of capacity. Indeed, I am amazed that the U.S. economy could cope with such a severe sequence of negative economic shocks without even greater economic pain. That, to me, is testimony to the underlying strength and flexibility of our economic system. Current conditions Given the disappointments of the past two years, what do I see today in the economic data that makes me think that the economy has more likely than not turned the corner? The rate of growth of real GDP in the third quarter was impressive, and even more so, when you look at the contributions of final demand. The household sector has been the driving force in this expansion. For example, in the third quarter, real personal consumption expenditures increased at an annual rate of 6½ percent, while real residential investment surged 20 percent. Last quarter’s strength in consumer spending was fueled by the midyear tax cuts, the waning influence of negative wealth effects from the past slide in equity prices, and some improvement in consumer sentiment from the war-related lows registered in March. In addition, very generous incentives on autos and light trucks boosted light vehicle sales to annual rate of 17½ million units in the third quarter. After such substantial increases last quarter, it has not been surprising that consumer spending has softened as we moved into the fourth quarter. Still, the fundamental determinants of consumer spending remain favorable, and consumer sentiment is increasingly upbeat. Housing markets remain very strong even though mortgage rates have moved up somewhat from the very low levels seen at the beginning of the summer. Single-family housing starts jumped to an annual rate of 1.62 million units in October, a record high for this series. Moreover, sales of both new and existing homes have also held near historical highs. As I noted before, the business sector has been the locus of weakness in this expansion. However, the extreme caution that had been gripping firms now appears to be dissipating. Real outlays for equipment and software rose at an annual rate of 15½ percent in the third quarter, after an increase of 8¼ percent in the second quarter. Moreover, businesses also are hiring again. Private non-farm payrolls increased at an average pace of about 120,000 per month in September and October, and further declines in initial claims for unemployment insurance suggest that this improvement in the labor market has continued into November. Finally, manufacturing production is perking up. Although light vehicle assemblies have slipped from the very high levels of the summer, production of other goods rose 0.2 percent in September and an additional 0.4 percent in October, reflecting fairly widespread gains across industries. The sustainability of the recovery will depend importantly on future trends in employment, household spending, and business investment. Twice before in this recovery we have seen short periods of strong growth, followed by a return to sluggish, subpar growth. Given the strength of the incoming data that I have just outlined, the risk that the economy will again stall out must be given a smaller probability than that assigned just a few months ago, but the risk cannot be discounted completely. For example, the strength in consumer spending in the third quarter might prove to be temporary - a one-time surge related to the fiscal stimulus. Indeed, analysts who subscribe to this view would take some solace in the latest data on non-auto retail sales. Under these circumstances, businesses likely would remain very cautious about the demand conditions they expect to prevail in the year ahead. This would make them reluctant to expand and hire new workers - factors that would hold down economic expansion in 2004. While the consensus forecast for next year calls for a growth rate of 4 percent (on a fourth-quarter-to-fourth-quarter basis), which seems reasonable, a weaker outcome than that is not hard to imagine. Productivity, potential growth and inflation One of the most prominent characteristics of this economic expansion has been the rapid gains in labor productivity. Output per hour rose at an annual rate of 4½ percent in the first half of this year and at an extraordinary 8 plus-percent rate in the third quarter. In part, these gains are cyclical and reflect firms’ unwillingness, until recently, to expand their payrolls. In addition, the productivity gains have translated into an improvement in businesses’ income statements: Real wages have not kept up with the growth in productivity, and with businesses generally reluctant to spend, corporate profitability has improved markedly this year. This development has allowed firms to reduce the debts inherited from the 1990s. Some slowing in productivity growth from the third-quarter pace is almost inevitable. However, looking beyond the quarter-to-quarter movements, I remain optimistic that we have seen a permanent step-up in the underlying rate of labor productivity growth. As I noted before, businesses have achieved considerable efficiency gains through the information technology that they have installed since 1995. Moreover, as my Y2K example illustrated, I believe companies are continuing to adapt their operations to take advantage of the capabilities of these technologies and are seeing a payoff for these actions in their bottom lines. The apparent step-up in the underlying rate of productivity growth in recent years implies that the nation’s rate of potential output growth - the rate of growth in real GDP that is consistent over time with a stable rate of inflation - has also risen. That’s good news because it means that the economy can grow at a faster pace than in the past without generating upward pressure on prices. Moreover, the level of potential output is still well above that of actual GDP, and this output gap is likely to persist for some time even if real GDP grows in excess of its potential pace. Finally, let me say a few words about inflation. Although the overall consumer price index has been buffeted by swings in food and energy prices, the core measure that excludes these components has slowed noticeably over the past year. The core CPI is up only 1¼ percent from its level of a year ago. This performance means that the U.S. economy has reached effective price stability. That is an achievement that owes to many factors: economic slack, faster productivity growth, stable inflation expectations, and the general public’s belief that the Federal Reserve is committed to keeping inflation under control. Moreover, recent research has shown that, as inflation has been brought down over the past two decades, the sensitivity of prices to the level of resource utilization has also fallen. This finding implies that, unlike in past periods, the specter of rising inflation is less likely to haunt the economy as activity improves and the output gap shrinks. Indeed, inflation still seems more likely to move lower than to increase. Under these circumstances, the central bank has the luxury to monitor events before it has to confront the need to return the stance of policy to a neutral position. Conclusion In conclusion, the macroeconomic fundamentals seem to be in place for an increase in the pace of economic growth. Although I do not expect a repetition of the extraordinary economic performance of the third quarter, I do expect growth to be sustained. However, this expectation will have to be reexamined periodically during the upcoming period - in light of evolving economic circumstances. Even if the growth is sufficient to make meaningful progress in reducing the slack in our nation’s labor and capital resources, that pool of underutilized resources is large and it will take some time to be worked off completely. Fortunately, as the economy has experienced cyclical turns and surprising shocks, it has proved to be quite resilient, and we have benefited from a step-up in productivity that has left the economy well positioned to provide for the long-term welfare of our fellow citizens.
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board of governors of the federal reserve system
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Remarks by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve System, at the annual meeting of the US Federal Reserve System, at the annual meeting of the National Conference of Insurance Legislators, Santa Fe, 22 November 2003.
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Mark W Olson: Functional regulation and financial modernization Remarks by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve System, at the annual meeting of the National Conference of Insurance Legislators, Santa Fe, New Mexico, 22 November 2003. * * * Introduction My thanks to the National Conference of Insurance Legislators (NCOIL) for inviting me to speak to you today, and special thanks to my former senator, Cal Larson, for being my host. You’ve asked me to provide some thoughts on financial modernization and functional regulation, and to discuss more specifically how these issues may, from the perspective of the Federal Reserve Board, relate to insurance. I’d like to discuss first the importance of cooperation between the Federal Reserve System and state insurance supervisors. Then I’ll describe some of the lessons we at the Fed have learned as participants in the dual banking system. I hope that hearing about our experiences will be useful as you consider initiatives to enhance the state insurance supervisory system. My comments today are my own and do not necessarily represent the views of my fellow Board or Federal Open Market Committee members. Cooperation between the Federal Reserve and the state insurance supervisors The McCarran-Ferguson Act has long kept supervision of insurance within the exclusive domain of the states. For most of the past century, we - that is, the Federal Reserve and state insurance professionals - have traveled in completely different circles for practical reasons as well. The Federal Reserve has had very little to do with insurance issues because the banks and bank holding companies for which we are responsible have had little involvement in insurance. In fact, the federal legislation that charges the Federal Reserve with supervising bank holding companies - the Bank Holding Company Act of 1956 - was enacted in large part to prevent the affiliation of one of the largest banks in this country with a large insurance underwriter. Congress went on to strengthen the separation of banking and insurance in 1982 with an amendment to that act generally prohibiting bank holding companies from engaging in insurance agency activities. At that point the insurance underwriting and sales activities of banking organizations were constrained to four limited categories: Banking organizations were permitted to underwrite and sell credit-related insurance; some statechartered banks could engage in insurance sales under state law that either granted explicit permission or contained implicit authority for these activities; national banks could engage in insurance sales from small towns; and a limited number of bank holding companies were grandfathered and thus were allowed to continue insurance activities that they had started prior to enactment of the 1982 amendment. The historic statutory separation of banking and insurance was altered in 1999 when the Congress enacted the Gramm-Leach-Bliley Act (GLB Act) and allowed well-managed and well-capitalized banks to affiliate with insurance underwriters and insurance agencies. That brings the Federal Reserve and state insurance professionals into the same circle. To date, about 630 bank holding companies have chosen to become financial holding companies, the vehicle under the GLB Act through which bank, insurance, and securities affiliations may take place. Of those, about 165 (more than 25 percent) use the new GLB Act authority to engage in insurance agency activities while only 26 (fewer than 5 percent) are engaged in underwriting insurance that is unrelated to credit. All of these companies must comply with state laws governing the sales and underwriting of insurance. The significant interest by banking organizations in selling insurance makes sense. The banking system is still dominated, in number, by small banking organizations. More than 90 percent of the banks in this country have total assets of less than $500 million each. Banks of all sizes have quite large branch networks - as of the end of last year there were almost 67,500 branches of the more than 7,800 commercial banks in this country. Entering the insurance market as an agent, not as an underwriter, fits naturally with the nature of banking as an industry dominated by smaller providers. More broadly, banking organizations have developed good networks and systems for delivering financial products to consumers - a business model that does not always require manufacture of the product. Insurance is increasingly viewed not just as a product that stands on its own, but as an important item on a menu of financial vehicles that help consumers create a portfolio of financial assets, manage their financial risks, and plan for their financial security. Many consumers prefer to make their financial decisions and purchase financial planning products at a single location that offers a full package of financial services. Thus, banking organizations are a natural alternative delivery system for insurance underwriters looking to expand their customer base. The affiliation of banks and insurance underwriters has been more modest. One large banking organization has affiliated with a large insurance underwriter, and one large insurance underwriter has acquired a small bank. In addition, several foreign banks with insurance operations abroad have begun to offer both insurance and banking products in the United States. Before the GLB Act, these foreign banking organizations were required to choose between operating as a bank in the United States or engaging in insurance activities in the United States; they generally could not do both. Whether the affiliation of insurance underwriters and banking organizations will become more common is unclear. Insurance underwriting involves a much larger commitment of resources than insurance sales and, apart from underwriting credit insurance, seems so far to have little synergy with banking. Banks and insurance companies so far seem not to have determined whether it makes business sense to mesh the manufacturing and distribution of insurance with the manufacturing and distribution of more traditional banking products. The experimentation has begun in ways you would expect. For example, insurance companies have long thought that the trust and fiduciary powers of banks would offer them an opportunity to manage insurance payouts and other assets of large estates. And a few banking organizations are experimenting with manufacturing the insurance products they deliver. These trial runs need time to work themselves out. What is important is that federal law no longer prevents the marketplace from evolving and the industry from experimenting. The result can only be beneficial to consumers. With these developments have come new supervisory challenges. As I mentioned earlier, we at the Federal Reserve have little expertise in supervising insurance companies. While some types of risks are common to both banking organizations and insurance companies, the products, business practices, and historical framework of the insurance industry are unique and outside our experience. Similarly, the risks and operations of banks and bank holding companies, which are in our area of expertise, are quite different from those typically seen in the domain of insurance supervisors. The obvious supervisory approach suggested by these different risks and regulatory schemes is cooperative functional regulation that matches supervisory expertise with the risks encountered by the regulated entity. This cooperation and a functional regulatory scheme are required by the GLB Act. But they also make good supervisory and business sense. It is crucial that supervisors talk to each other in order to understand the risks posed by functionally regulated entities, one to the other. It is also important that supervisors not overburden organizations with duplicative and conflicting regulation that destroys the very cost savings and consumer benefits of affiliation. Consequently, we do not examine insurance underwriters or the insurance agency business of bank holding companies. Instead, we defer to the appropriate state insurance authorities. We also rely on reports and other information that insurance companies provide to state insurance authorities to understand the activities and financial strength of the insurance company, rather than imposing our own reporting requirements on insurance companies. Importantly, we have established very successful partnerships with the National Association of Insurance Commissioners (NAIC) and with many state insurance supervisors to enhance our mutual understanding of our supervisory frameworks and to facilitate the sharing of supervisory information and consumer complaints. To date, we have information-sharing agreements with nearly all of the states and the District of Columbia. While not all of these agreements have been spurred by an important affiliation that requires information sharing, the process of establishing these agreements has introduced us to the appropriate authorities in these states and begun a relationship that will improve our supervisory cooperation and effectiveness if difficulties develop down the road. It is important to have open lines of communication among supervisors and a framework and relationship with the states that prepare us to respond to developments as needed. We are also working with the NAIC and the state insurance supervisors to compare supervisory approaches for identifying and resolving troubled organizations. Banks and insurance companies must comply with very different minimum capital requirements - requirements that are tailored to their businesses. It is important that in circumstances in which affiliated banks and insurance companies are experiencing financial stress, the bank and insurance supervisors be able to work cooperatively to resolve that stress without taking steps that help one regulated institution at the expense of the other. We think that efforts to understand each other’s supervisory tools and processes for identifying and resolving troubled institutions will allow functional regulators to work more effectively and cooperatively to find an early and effective solution to troubled institutions. To improve our own understanding of the issues developing in the insurance industry, we have also established resource centers at the Board and at the Federal Reserve Bank of Boston to monitor developments in the insurance industry. We particularly value the fruitful relationships that we have had with organizations such as the NAIC, which has welcomed our input and worked to help educate us on important insurance issues, and with various state insurance supervisors, who have fostered cross-training opportunities for us. State regulation of multi-state entities When Senator Neil Breslin, chairman of NCOIL’s State-Federal Relations Committee, testified earlier this month before the House Financial Services Committee, he identified several initiatives that the states are taking to address issues involving modernization of state insurance regulation. NCOIL is to be commended for initiating these efforts. While there are many structural differences between the banking and insurance industries, I would like to share with you the experience of the banking supervisors in maintaining a viable state banking supervision option in an increasingly interstate banking environment. Until the early 1980s, banks were prohibited by a combination of federal and state law from establishing branches, or even bank affiliates, across state lines. In the mid-1980s, several states began to experiment with interstate compacts that allowed banks to affiliate with banks in other states. By 1994, there was consensus that interstate banking was important enough to both banks and consumers that Congress repealed the federal prohibition on interstate affiliations and established a framework for interstate branching. At the same time, Congress greatly limited the ability of states to restrict interstate entry by out-of-state banks. As a result, the banking industry has flourished and customers have benefited. Banks can now provide products and services seamlessly to customers nationally, including customers that have wide geographic operations and customers that move geographically. And customers have gained the convenience afforded by banks that have a wide footprint of branches. At the same time, interstate expansion has posed challenges for us as supervisors. Although the Federal Reserve is not limited geographically, we partner in our supervisory efforts with state authorities that are constrained by state lines. Interstate expansion in a supervisory framework tied to state boundaries means that state-chartered banks that operate on an interstate basis face the possibility of regulation by their chartering state as well as by each state in which the bank establishes a branch office, plus an overarching federal supervisor. In addition to the potential for conflict and burdensome duplication that having multiple supervisors presents, state banks operating on a multistate basis must compete with nationally chartered banks that are supervised on a national basis by a single regulator. To meet this challenge, we have worked with the state supervisors to develop a more uniform and seamless approach to supervision. Under the auspices of the Conference of State Bank Supervisors, the various state banking supervisors have developed a protocol for cooperation in examining and collecting information from multistate banks. This protocol deals with examinations of two types. Responsibility for safety and soundness examinations rests with the chartering or “home” state for the bank. However, the protocol recognizes that the states into which a bank has branched - the so-called host states - also have a legitimate interest in monitoring the safety and soundness of banks that operate within their borders. Thus, it allows host states to conduct safety and soundness examinations of out-of-state banks that branch into the state. It contemplates however that the host state will conduct safety and soundness examinations only in emergency situations or as part of the examination conducted by the home-state supervisor. The protocol relies on robust information sharing and coordination between state supervisors and the federal banking agencies to take the place of these examinations. Responsibility for compliance with applicable consumer protection laws is divided among state supervisors, with each state supervisor responsible for monitoring compliance with local law by local offices. Examination for compliance with federal consumer laws in some instances is left to the federal banking agencies and in others is shared with state bank supervisors. In addition to building on the strength of our system of state bank supervisors, we realized that supervising large interstate operations requires different and significantly more sophisticated techniques than we employ for our smaller local banks. For example, our bank examination practices for many years focused on the review of a sizable number of individual loan files at each bank. This is an amazingly intrusive and time-consuming process. And it became increasingly obvious that as institutions grew in size, the technique was not practical on a large scale. Over time, we have had to develop more-sophisticated sampling techniques as well as methods for identifying and focusing our examinations on areas of greatest risk to the banking organization. We continue to review the policies and efforts that each bank employs to identify the risks it faces, to set and implement standards to address those risks, and to monitor the effectiveness of its riskmanagement practices. This approach involves the examination of policies and procedures and the review of statistics on loan default experiences for entire portfolios rather than large numbers of individual transactions. We are in the process of developing a more-sophisticated approach to capital as well. The current “Basel” capital standard was developed in 1988 through negotiations conducted by bank supervisory authorities under the auspices of the Bank for International Settlement in Basel, Switzerland. Current efforts to replace this capital accord with a new version (called Basel II) take a decidedly more riskfocused approach to measuring risk. The proposed approach would build on techniques used by the largest banks worldwide and should produce results that are much more consistent than the existing standard with market perceptions of risk. It would separate risks into their component parts and should give supervisors important new tools for evaluating not only the level of risk, but also the performance and responsiveness of bank management. Although the proposed standard will be a challenge to implement and enforce, it will also provide important and necessary incentives to managers of our largest institutions to adopt more-sophisticated practices for measuring and managing risk. We have also developed more risk-focused techniques for reviewing compliance with applicable consumer and other laws. At the same time, we - like the state insurance commissioners - have established consumer complaint divisions in each of the federal banking agencies to monitor and investigate individual consumer complaints. To be sure, our system of risk-focused supervision of banking organizations relies heavily on cooperation among multiple state and Federal supervisors, and it is not perfect. But it is working, and we think working effectively. State-chartered banks remain competitive and strong, and the asset share of state-chartered banks has remained relatively constant. While the banking industry’s continued consolidation is widely recognized and the total number of U.S. commercial banks continues to decline, less evident is the consistent chartering of new banks - roughly one new charter for every three consolidations. Seventy-five percent of these newly chartered banks are state banks. The state charter is apparently no less attractive than before banks gained new powers to expand nationwide. Certainly, we could not have postponed interstate banking until we had devised the perfect system for supervising it. The marketplace was moving, and we had to adjust our role to take account of that. The system we have developed in the banking arena is an evolutionary one, and one we will continue to work to improve. I know that you have been working hard at similar efforts in the insurance industry. I understand that here in Sante Fe, you have a number of important efforts underway, including proposals involving model laws that would govern Market Conduct Surveillance and Property and Casualty Insurance regulation. The institutions we supervise face the same challenges: competition on a growing number of fronts from unregulated entities, and consumers who are more sophisticated about choosing financial products. Regulated institutions must be allowed to respond to changes in the marketplace or they will not survive. Less-regulated institutions will prevail and in the process diminish the very protections that the regulations sought to preserve. At the same time, of course, we cannot forget that we are required by law to supervise the entities under our jurisdictions, to protect the public, and to preserve the strength of the financial system. To conclude, I will offer one final thought on the important subject of financial regulation and legislation. While we as regulators and legislators have the responsibility for setting and maintaining standards of safety and soundness for the benefit of consumers, we cannot ignore the power of market forces to cause the continual development of consumer financial products. Improvements in technology and consumer techno-literacy have prompted dramatic changes in all financial industries. Yet with all the changes we have seen, we are likely still in the early stages of realizing the full benefit of technological innovation. Our efforts as regulators and legislators will continue to be relevant only when they are consistent with these changing market forces.
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board of governors of the federal reserve system
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Remarks by Mr Roger W Ferguson, Jr, Vice Chairman of the Board of Governors of the US Federal Reserve System, at the ICBI Risk Management 2003 Conference, Geneva, Switzerland, 2 December 2003.
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Roger W Ferguson, Jr: Concerns and considerations for the practical implementation of the New Basel Accord Remarks by Mr Roger W Ferguson, Jr, Vice Chairman of the Board of Governors of the US Federal Reserve System, at the ICBI Risk Management 2003 Conference, Geneva, Switzerland, 2 December 2003. * * * I am pleased to participate in this conference on such an important subject as the proposed new Basel Accord. Your topical agenda and the expertise of your speakers are impressive, and I am sure that the discussions will provide new insights. I have been asked to talk today about some of the issues associated with the practical implementation of Basel II. Before I start, let me reiterate that I remain optimistic that a new accord will emerge from the Basel Committee in a timely fashion, so that national review procedures can go forward. Although I will discuss concerns and considerations, these will not, in my judgment, threaten the basic momentum of the process. Basel I There is no better place to begin a discussion of some of the practical concerns and considerations of the new accord than at the beginning - with Basel I. Many have forgotten that the first accord had its origins in complaints that the globalization of banking had distorted competitive balance. Banks domiciled in jurisdictions whose supervisors required a more prudent level of capital perceived that they were disadvantaged, certainly in their home markets, by banks whose home supervisors were less aggressive in their minimum capital standards. Basel I was intended to level the playing field for banks that operated across national boundaries by establishing consistent standards on how minimum regulatory capital was to be determined in individual countries and what was to constitute capital. We should not lose sight of the continuing imperative, both economic and political, to ensure that a revised accord is perceived by all to maintain a level playing field for banks operating not only across national boundaries but also domestically. I will return to this issue later. Basel I - on which the world’s regulatory capital regime has been based for more than ten years - was a genuine step forward for most countries’ capital rules and a watershed for international cooperation among the world’s supervisors. But it is certainly clear to those of you at this meeting that globalization, technology, and innovation have accelerated so dramatically that Basel I cannot provide the industrial world’s largest and most-complex banking organizations with a regulatory capital requirement that reflects their underlying risk exposures. Basel I, with its modest risk sensitivity, treats most loans as if they come from one quality category. It ignores techniques that the largest banks have adopted to mitigate risk. It erroneously treats some transactions that only appear to reduce risk as if they in fact do. Its overly simple risk weights induce large banks to game the rules by shifting to the market those exposures that the market judges require less capital than the regulations do and by retaining exposures with a regulatory capital charge that is lower than the market perceives is necessary. Such capital arbitrage has greatly reduced the usefulness of regulatory capital ratios at the largest banks and provides little useful information to the public or the supervisor. For these institutions, the regulatory rules must be changed. This is the practical reality that bank supervisors face. Change and Complexity, Flexibility and Comparability This audience is well aware of the reality that I have just described. But a second practical problem is that no one likes change, at least change imposed on them. Change can be expensive and, worse, requires new constructs that have the potential for unintended implications. For this reason, more than any other, the development of Basel II has taken a long time. Not only are the issues complicated, but also the banks and their supervisors have engaged in a continuing conversation about this complexity and its implications. Both parties have shared a common goal of trying to develop a cost-efficient and workable system. On occasion they have differed on the tradeoffs between cost and complexity and between comparability and flexibility. Another practical problem is that the world’s supervisors are trying to do more than develop a better risk-based capital standard. They are also trying to harness modern risk-measurement and risk management techniques to the regulatory system, and they are trying to construct a framework that can evolve as the science and the art of risk measurement and management evolve. I have previously called this evolutionary potential of Basel II its “evergreen” element, and I believe it is one of the many attractive features of the proposal. Modern asset-pricing theory may have begun in academia, but its growth and application have quickly taken root in money, capital, and banking markets in new ways of thinking about risk, ways that essentially meant measuring risk in quantifiable ways. The largest banks, operating in multiple product and geographic markets, simply could not operate without applying the new evolving principles in measuring, shifting, and managing their risks. Several implications follow. Harnessing large banks’ internal practices to the supervisory process implies that supervisors could use such cutting-edge risk measures to evaluate bank risk profiles and relate them to a truly risk-sensitive capital standard. It also suggests that a bank’s adoption of best-practice risk measurement and management could be used as a supervisor-imposed prerequisite for the application of the new capital standard; setting such a prerequisite would accelerate the development and adoption of these new techniques, which counterparties are increasingly demanding in any event. Stating the point more directly: Basel II is designed to harness the best new techniques but also to ensure their application by those banks that have been less aggressive in adopting them. That is, Basel II, at least in its more advanced form, is as much a proposal for strengthening risk management as it is a proposal for improving capital standards; these considerations are, as they should be, inseparable. That inseparability, in turn, as I will discuss later, is an important factor leading to the bifurcated application of Basel II proposed in the United States. The use of the more advanced techniques does not go far enough for those sophisticated organizations that want to use their own models to estimate their own risk functions, particularly their estimates of portfolio correlation effects. Some are also concerned that the hard-wired risk functions and correlation parameters will prohibit better practices when they are available. In my view, a full models regime could not, over the planning period for Basel II, produce capital charges that would be sufficiently comparable for a regulatory capital standard. Specifically, determinations of portfolio correlation effects tend to be as much art as science; and their subjectivity makes them difficult, if not impossible, to validate credibly. To ensure broad comparability of regulatory capital ratios across banks, therefore, the risk functions embedded in the internal risk-based (IRB) framework employ correlation parameters that are specified by the Basel Committee. In effect, we have sacrificed some flexibility and potential risk sensitivity for greater comparability. We have faced similar tradeoffs repeatedly during the development of the Basel II proposals, and in many ways one of the Basel Committee’s greatest challenges has been reaching consensus on the right balance between flexibility and comparability. In addition, there is evidence that credit risk models at many large, complex banking organizations have not attained the sophistication and robustness that would be consistent with their use for regulatory capital. Although the state of the art is progressing rapidly, many banks still must resolve some fundamental questions and finish compiling sufficient data before they can adopt their own full credit models that produce reliable and accurate results. Ultimately, Basel II proposes a capital standard that implies the need for reasonable comparability across banks and across boundaries to ensure the competitive balance to which I referred earlier. Nonetheless, looking beyond the current proposals, I believe that over time the regulatory capital functions we have hard-wired into Basel II, along with their embedded correlation assumptions, will give way to individual bank-developed models that are verifiable by supervisors. That development will probably be a central part of the evergreen process. But the time for individual bank models is not now, and I see no reason to hold up improving the regulatory capital regime until the state of the art permits that innovation. Until then, I think we have developed a workable balance between flexibility and comparability. As the old saying goes, the perfect should not be the enemy of the good. Level Playing Fields: Treating Comparable Banks Comparably Basel II, as I noted, tries to develop a standard so that banks’ risk exposures can be treated comparably. Such a standard is central to the required level playing field. But comparability requires not that all banks be treated the same but rather that comparable banks be treated comparably, raising practical issues of definition, of unintended consequences in competitive markets, and of unavoidable differences in national regimes. General Issues. As you know, Basel II proposes three options from which banks in national jurisdictions may choose - the standardized, the foundation, and the advanced internal risk-based (A-IRB) approaches. The increasing risk sensitivity of the three options has the potential for the application of different capital charges across banks for the same exposures and implies that banks with a more or less average mix of corporate and retail exposures may have reductions in their overall minimum regulatory capital requirements as they move across the three options. Any differences in regulatory capital charges have the potential to distort both national competitive positions, an issue for domestic authorities, and international competition, an issue for both national authorities and the Basel Committee. In considering all of these issues, one must, of course, make a distinction among minimum regulatory capital based on regulatory rules; economic capital based on the bank’s own assessment of risk and capital needs; and actual capital held, which includes buffers above both the other capital measures for reasons varying from reduced cost of funding to counterparty demands and to desired contingency flexibility. Minimum regulatory capital is the lowest of the three capital “requirements,” and thus the degree to which it may or may not affect competition across banks is an important conceptual and practical issue involving, at bottom, the way the price of credit gets determined. When all is said and done, the nations participating in the Basel Committee are now developing a proposal to establish a revised capital standard for banking organizations that compete across national boundaries. Basel I was negotiated on the same basis. After Basel I, all the participating nations nevertheless chose to apply the new standard to all the banking organizations under their jurisdiction. The Europeans and the Japanese apparently have made the same decision for the proposed Basel II. In contrast to Basel I, however, all banking organizations will be subject to Basel II, but each organization will choose among the three variants. Application in the United States. The U.S. authorities have made a somewhat different decision. Consistent with the letter and the spirit of the Basel II proposal, the latest U.S. proposal states that all U.S. banking organizations with meaningful cross-border exposures - at least $10 billion - will be required to adopt Basel II. In addition, any banking organization with consolidated assets of at least $250 billion will similarly be required to adopt Basel II. If these criteria were applied today, about ten or so U.S. entities would meet one or both of these criteria and hence would be among the “core” group of U.S. banking organizations required to adopt Basel II. To be sure, the actual number of mandatory U.S. banks may change before actual implementation - and among them could be U.S. subsidiaries of foreign banking organizations that meet the core bank standards. In addition, we initially assumed that about ten other large entities might choose to opt in to Basel II; we now believe that number may well be an underestimate, but we are still in the process of surveying our larger banks to determine their plans. Even the twenty banks counted currently as mandatory and opt-in would account, we estimate, for more than 99 percent of the foreign exposure of U.S. chartered banks and more than two-thirds of the domestic assets of these entities. Any non-mandatory bank in the United States that can estimate the internal risk parameters for its credit exposures - that is, measure and manage its risk exposure to the satisfaction of the supervisor may opt in to Basel II in the United States. But if a bank chooses not to meet this test or not to adopt Basel II, it will remain under the current, unchanged, capital regime. Banks that are required or that choose to adopt the Basel II rules in the United States will have only one option: the A-IRB approach for credit risk and the advanced measurement approach (AMA) for operational risk. Neither the standardized and foundation approaches for credit risk nor the basic indicator and standardized approaches for operational risk will be available in the United States. The authorities in the United States proposed the bifurcated application of Basel II (with one group under Basel II and most banks remaining under the current capital requirements) and rejected the trifurcated approach (with banks choosing for themselves among the three Basel II variants for credit risk, as well as three variants for operational risk), which looks to be preferred in other countries, for three basic reasons. First, Basel II, as I noted, requires that those adopting it apply it to their internationally active banks. The data to which I referred are evidence that the U.S. framework for applying Basel II would meet that test. Second, as I also noted earlier, Basel II capital requirements are intended not only to be more sensitive to risk but also to link that risk-sensitivity to a significant increase in the standards for risk measurement and management at larger banks. Only the A-IRB and the AMA approaches fully impose that prerequisite on the large entities. The U.S. authorities believe that the largest U.S. banking organizations should adopt best-practice risk measurement and management for reasons of safety and soundness. Third, Basel II is not without cost. Most of the thousands of U.S. banks that are neither in the core set nor in the likely opt-in set have operations that, in the U.S. authorities’ view, would not require the dramatic changes in credit risk measurement and management associated with either the A-IRB or the foundation approach. Additionally, the increased risk sensitivity of the standardized version seemed modest to us relative to the additional costs of system changes. Regarding operational risk, the arguments are even stronger that the AMA would impose undue burden on smaller banks. In short, Basel II does not seem to have a favorable cost-benefit ratio for most American banks. The decision that most banks would remain under the current regime in the United States was also conditioned on some institutional facts that were perhaps not well known elsewhere. Minimum Basel I requirements are not the only capital regulations in the United States. They are supplemented by benefits established by statute for banks with higher tier 1 and tier 2 capital ratios and by legislatively imposed minimum tier 1 leverage ratios. In addition, statutory prompt corrective action has induced banks to carry buffer capital to avoid losing regulatory benefits that come with holding capital above regulatory minimums. Moreover, the market demands that our thousands of smaller banks hold substantial equity capital, an amount significantly above the minimum standards. Nearly 95 percent of U.S. small and medium-sized banks have capital ratios in excess of 10 percent and most likely would not be required to hold more under Basel II. U.S. supervision of these banks already includes substantial Pillar 2 elements, and of course, these banks operate almost totally within the United States. The arguments that banks other than core banks, and especially the small and medium-sized banks, ought to be free to choose between Basel II and their current regulatory requirements seemed overwhelmingly convincing to us. That is, banks should be free to choose to bear the costs of implementation for the benefits of greater capital risk-sensitivity. Neither for international agreement nor for domestic supervisory reasons did imposing Basel II on all U.S. banks seem reasonable. But for international agreements and for domestic supervisory reasons it seems only reasonable for us to require nothing less than A-IRB and AMA for those banks that adopt Basel II. Unintended Consequences and Competitive Distortions. Having made our bifurcated proposal in the United States, public comments and congressional oversight have made clear the purely domestic concern that banks remaining under the current regime, even though they avoid the costs of adoption, may be disadvantaged relative to Basel II banks. Specifically, the argument goes, Basel II will give the largest banks, if not a lower overall capital requirement, then lower capital charges on certain credits with which banks not adopting Basel II will have to compete. Focus has been placed on residential mortgages, small business loans, and credit cards. Concern has also been voiced that Basel II banks will use any newly created excess regulatory capital to acquire smaller banks, whose capital can be used more efficiently by the larger Basel II banks. In short, creating international competitive balance under Basel II carries the potential that domestic competitive balance will become distorted. At bottom, these concerns raise empirical questions about how credit is priced, about the locus of competition, about the determinants of actual capital held, and about other matters. Questions have been raised in the comment and oversight process and these questions will have to be addressed. We are still reviewing the evidence presented to us, and Federal Reserve staff members are conducting empirical research on the issues that will be made public in the months ahead. We will need to review the available options for addressing any of these concerns that are supported by the evidence. These options include changes in U.S. Basel II rules, where national discretion is allowed; modifications to the proposed bifurcated application; and changes in the current capital regime in the United States. We will look seriously at each and all of these steps and will not be precluded from proposing any measure that we believe is necessary to ensure a level playing field in our domestic banking market. But first, as I noted, we must examine the evidence, just as other nations are undoubtedly reviewing the unintended consequences of a trifurcated application in their own markets. Even though the objective is a level playing field internationally, the practical problem that differing supervisory regimes and procedures may distort international competitive positions remains. Frankly, the U.S. authorities hear arguments that some foreign supervisors have neither the resources nor the experience to apply the rules as rigorously as they anticipate will be the case in the United States. And foreign authorities have heard complaints from their banks about the competitive implications that will be created by U.S. insistence on A-IRB and AMA treatment for their large U.S. subsidiaries that meet the cross-border or scale criteria to be core banks. Real and perceived differential treatment existed under Basel I, and it will remain under Basel II. However, the Accord Implementation Group (AIG) in Basel, made up of line supervisors from member countries, has already had some success in trying to ensure similar - or at least consistent treatments across national boundaries under the new proposal. Tensions in applications by different national authorities are a fact of life that we have to address when we can. The test is whether we will be better off and whether competition will be fairer under Basel II even though it is not perfect. Level Playing Fields: Home and Host Issues As I just said, treating comparable banks comparably within a national jurisdiction may have unintended consequences for foreign banks. U.S. subsidiary banks owned by foreign parent organizations will be subject to the same criteria as those for mandatory A-IRB banks in the United States. Others may feel it desirable to opt in to such versions for their U.S. operations. Such national treatment in the host country - treating comparable banks comparably - is reasonable, but it may create genuine operational complexities if these banks plan to use one of the other Basel II options in their home or in third countries. For their part, the U.S. authorities have clearly stated that they will be flexible during a transition period so that the relevant foreign banks can more easily meet the required standards, but national treatment policies will apply. Discussions within the AIG on this issue - as well as bilateral discussions with affected banks and their supervisors - have been productive, and I think the associated problems will be addressed. However, one issue appears to be particularly difficult in more than one jurisdiction: the allocation of capital for operational risk among the legal entities within and across jurisdictions. Problems do not come more practical than this. Operational risk is generally measured on a consolidated basis, often by business line. That diversification benefits exist on a consolidated basis suggests that operational risk estimated from the bottom up - by, say, legal entity - would not only be more difficult but might well add up to more than the total from the top down. The problem is only made more complicated by the understandable focus of supervisors in each jurisdiction on ensuring that the entities under their supervision are sufficiently capitalized to absorb risk. We have come a long way in global banking, with deference to home consolidated supervisors, but the legal entity supervisor still needs the assurance that capital is protecting risk in the individual unit. Basel II is not going to succeed or fail on this practical problem or on similar problems - and this will certainly not be the last. Through the AIG a compromise will be developed on the issue of operational risk capital to ensure that capital is sufficient and is allocated in a reasonable way. Other issues, including home-host tensions, will be resolved in similar ways as the member countries hear comments, conduct analysis, and then seek out a viable compromise solution. The Process The practical give and take of discussions is exactly how the first and now the second capital accord have been and will be developed. We are at a critical stage of that process with changes in significant provisions being studied and modified. Examples are the shift in standard to unexpected loss only and the review of securitization, credit card, and credit risk mitigation, all of which are now being actively studied. It may seem strange that this far into the process - approaching year six - that such changes are being made. These changes, however, show how seriously the Basel Committee and its participating national authorities regard the public comment process and benefit from the analysis of bankers and other interested parties. When analysis and evidence were put forward, the committee responded. The United States is considerably through its review of public comments on its own advanced notice of proposed rulemaking (ANPR), and other countries are going through their own process of translating a consensus proposal into rules. The processes in the United States and in other nations may well bring up further proposals for change, provided that supportable arguments are forthcoming. In the United States, after this next round of committee discussions, additional procedural steps still are required, with opportunity for comment at each stage, before a final rule is in place. To be clear, the need for more procedural steps in the United States should not be taken as an indication of a lack of commitment to the Basel process. Rather, it is a sign of our attempt to develop these proposals on as transparent a basis as possible and to hear a wide range of comments. The Congress of the United States has also held hearings on the development of the new accord. The interest and oversight by our Congress in these discussions is appropriate and welcome, particularly for an undertaking as extensive as Basel II. The U.S. regulators appreciate the fact that we are able to operate as independent agencies but also realize that we have an obligation to keep the elected representatives informed of our progress in this major effort. Of course, it is expected that other countries and the European Union will be following their own procedures as well. Overall, I have been impressed by the efficacy of the comment process and believe it offers an open forum for all parties to voice their opinions. Debate and discussion on such an important undertaking are essential, and they provide an opportunity for enhancements to the final product. The current proposal is better because the comments have elicited good ideas that have been seriously considered. At the same time, we do need to ensure that momentum is maintained. In October, the committee members committed to work promptly to resolve outstanding issues by mid-2004. In January, the Basel Committee will meet to address further analysis of outstanding issues and review the timetable for completing and implementing the committee’s work on the accord. Using the agreement reached in the committee as a template, U.S. supervisors then plan to conduct another Quantitative Impact Study (QIS) to gauge more clearly the effect of the Basel proposals. We believe that we must carefully test the new proposal to determine its effects on individual institutions and to ascertain the need to fine-tune the proposal further, a process that could include recalibrating some of the risk-weight functions. Our sense is that other countries will be doing the same. Because timing is a function of the degree of changes required by the QIS, the U.S. agencies will then conduct a full notice of proposed rulemaking once again to seek and then evaluate public comments before adopting a final rule. Conclusions Basel I is no longer a viable supervisory tool for the large, complex banking organizations of the industrial world and needs to be replaced as soon as feasible by a new capital accord. The proposal being developed at Basel builds on best-practice risk- measurement and risk-management techniques and, at least in its advanced versions, is as much about ensuring that banks use such techniques as it is about a more risk-sensitive capital approach. Indeed, these considerations are two sides of the same coin. Any complex change will induce opposition and concern, in part because of fear of change and comfort with the known rules, in part because of preference for other alternatives by those affected, and in part because of anxiety that it may upset current competitive positions. But Basel II builds upon modern techniques and is entirely consistent with the directions that both large banks and their counterparties are now moving. And it can use future advances to evolve into an even more flexible and sophisticated supervisory tool. Basel I and the proposed Basel II are designed to provide a level competitive playing field for banking organizations meeting in international competition. And though proposed application procedures - both the bifurcated approach in the United States and the trifurcated approach in other countries - by and large maintain that objective, they may have the unintended consequence of distorting domestic competitive equity. The empirical analysis on whether they will, especially when banks maintain capital well in excess of regulatory minimums, is yet to be completed, but the authorities are required to investigate these concerns and adjust the proposal if the analysis requires it. Tensions in cross-border applications exist and cannot be avoided in a world of national regulatory authorities, especially where separate legal entities exist within national jurisdictions that apply national treatment. The AIG has been successful so far in smoothing differences that may develop in cross-border application, but these will inevitably involve compromises on difficult issues.
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board of governors of the federal reserve system
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the World Affairs Council of Greater Dallas, Dallas, Texas, 11 December 2003.
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Alan Greenspan: The widened trade deficit of recent years, in the context of a prolonged bout of job loss in the United States Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the World Affairs Council of Greater Dallas, Dallas, Texas, 11 December 2003. * * * Interest in issues of trade, tariffs, and protectionism has ebbed and flowed in this country since our founding. The widened trade deficit of recent years, in the context of a prolonged bout of job loss, has again elevated cries of distress to special prominence. The sensitivity of our economy to foreign competition does appear to have intensified recently as technological obsolescence has continued to foreshorten the expected profitable life of the nation’s capital stock. The more rapid turnover of our equipment and plant, as one might expect, is mirrored in an increased turnover of jobs. A million workers leave their jobs every week, two-fifths involuntarily, often in association with facilities that have been displaced or abandoned. A million, more or less, are also newly hired or returned from layoffs every week, in part as new facilities come on stream. Related to this process, jobs in the United States have been perceived as migrating over the years, to low-wage Japan in the 1950s and 1960s, to low-wage Mexico in the 1990s, and most recently to low-wage China. Japan, of course, is no longer characterized by a low-wage workforce, and many in Mexico are now complaining of job losses to low-wage China. In the United States, conceptual jobs, fostered by cutting-edge technologies, especially information technologies, are occupying an ever increasing share of the workforce and are gradually replacing work requiring manual skills. Those industries in which labor costs are a significant part of overall costs have been under increasing competition from foreign producers with labor costs, adjusted for productivity, less than ours. This process is not new. For generations American ingenuity has been creating industries and jobs that never existed before, from vehicle assemblers to computer software engineers. With those jobs come new opportunities for workers with the necessary skills. In recent years, competition from abroad has risen to a point at which our lowest skilled workers are being priced out of the global labor market. This diminishing of opportunities for such workers is why retraining for new job skills that meet the evolving opportunities created by our economy has become so urgent in this country. A major source of such retraining has been our community colleges, which have proliferated over the past two decades. We can usually identify somewhat in advance which tasks are most vulnerable to being displaced by foreign or domestic competition. But in economies on the forefront of technology, most new jobs are the consequence of innovation, which by its nature is not easily predictable. What we do know is that over the years, more than 94 percent of the workforce, on average, has been employed as markets matched idled workers seeking employment to new jobs. We can thus be confident that new jobs will displace old ones as they always have, but not without a high degree of pain for those in the job-losing segment of our massive job turnover. The American economy has been in the forefront of what Joseph Schumpeter, the renowned Harvard professor, called “creative destruction,” the continuous scrapping of old technologies to make way for the new. Standards of living rise because the depreciation and other cash flows of industries employing older, increasingly obsolescent, technologies are marshaled, along with new savings, to finance the production of capital assets that almost always embody cutting-edge technologies. Workers migrate with the capital. This is the process by which wealth is created, incremental step by incremental step. It presupposes a continuous churning of an economy in which the new displaces the old, a process that brings both progress and stress. Disoriented by the quickened pace of today’s competition, some in our society look back with nostalgia to the seemingly more tranquil years of the early post-World War II period, when tariff walls were perceived as providing job security from imports. Were we to yield to such selective nostalgia and shut out a large part, or all, of imports of manufactured goods and produce them ourselves, our overall standards of living would fall. In today’s flexible markets, our large, but finite, capital and labor resources are generally employed most effectively. Any diversion of resources from the market-guided activities would, of necessity, engender a less productive mix. For the most part, we as a nation have not engaged in significant and widespread protectionism for more than five decades. The consequences of moving in that direction in today’s far more globalized financial world could be unexpectedly destabilizing. A likely fall in wage incomes and profits could lead, ironically, to a fall in jobs and job security in the shorter term. So, yes, we can shut out part or all foreign competition, but we would pay a price for doing so - perhaps a rather large price. *** I do not doubt that the vast majority of us would prefer to work in a less stressful, less competitive environment. Yet, in our roles as consumers, we seem to relentlessly seek the low product prices and high quality that are prominent features of our current frenetic economic structure. In particular, America’s discount retailers have responded by learning to profit as intermediaries between consumers and low-cost producers, whether located in Guangdong province in China or Peoria, Illinois. Retailers who do not choose their suppliers with price and quality uppermost in mind risk finding themselves in liquidation. If a producer can offer quality at a lower price than the competition, retailers are pressed to respond because the consumer will otherwise shop at the retailer who does. Retailers are afforded little leeway in product sourcing. If consumers are stern taskmasters of their marketplace, business purchasers of capital equipment and production materials inputs have taken the competitive paradigm a step further and applied it on a global scale. Understandably, as a consequence, trade discussions under the aegis of the World Trade Organization have become increasingly contentious. After four decades of more or less successful negotiations, the “low-hanging trade agreement fruit,” so to speak, has already been picked. Current trade negotiators, accordingly, now must grapple with the remaining, more difficult issues, such as intellectual property rights and agricultural subsidies. Debates over trade restrictions have understandably become far more confrontational than in earlier years. For example, a strain of so-called conventional wisdom has attributed the weak labor market in the United States to the widening trade deficit, and a loss of jobs since the beginning of the recession of 2001 to low-priced competition from abroad (often deemed “unfair”) and increased foreign outsourcing on the part of corporate America. In fact, as Council of Economic Advisers Chairman Greg Mankiw recently pointed out, U.S. “job losses are ... more closely related to declines in domestic investment and weak exports than to import competition.”1 In addition, of course, increased productivity has enabled ongoing demand to be met with fewer workers. Noteworthy is the singling out of a particular exchange rate, the Chinese renminbi, as a significant cause of American job loss. The renminbi is widely believed to be markedly undervalued, and it is claimed that a rise in the renminbi will slow exports from China to the United States, which according to some, will create increased job opportunities for Americans at home. The story on trade and jobs, in my judgment, is a bit more complex, especially with respect to China, than this strain of conventional wisdom would lead one to believe. If the renminbi were to rise, presumably U.S. imports from China would fall as China loses competitive position to other low-wage economies. But would, for example, reduced imports of textiles from China induce increased output in American factories? Far more likely is that our imports from other low-wage countries would replace Chinese textiles. Despite the very large surplus of China’s trade with the United States, overall Chinese trade is much closer to balance. Chinese exports, a majority of which are from foreign-owned firms or affiliates, many American, depend on purchases from East Asian companies that supply inputs to the products the Chinese sell to the United States and elsewhere. Emerging Asia used to manufacture many goods that were then directly exported to the United States. However, a growing fraction of these goods are now partially assembled with capital-intensive, high-value-added manufacturing in the rest of emerging Asia; exported to China, where final processing is done - typically with labor-intensive, lower-value-added manufacturing; and then exported to the United States. This situation implies a deterioration in the Chinese trade balance with the rest of emerging Asia, along with a growing surplus with the United States. In large part, the increase in China’s share of U.S. imports has come at the expense of other East Asian exporters. Statement to the Committee on Ways and Means, U.S. House of Representatives, October 30, 2003. China’s imports overall have risen dramatically over this year, from approximately $25 billion per month a year ago to $33 billion per month more recently, as China has become a major consumer of the world’s commodities. Doubtless, part of the recent firmness in non-high-tech commodity prices is attributable to China’s voracious appetite for raw materials. *** A rise in the value of the renminbi would be unlikely to have much, if any, effect on aggregate employment in the United States, but a misaligned Chinese currency, if that is indeed the case, could have adverse effects on the global financial market and, hence, indirectly on U.S. output and jobs. In order to maintain the tight relationship with the dollar initiated in the 1990s, the Chinese central bank has had to purchase large quantities of U.S. Treasury securities with renminbi. What is not clear is how much of the unquestioned current upward pressure on the renminbi results from underlying market forces, how much from capital inflows due to speculation on potential revaluation, and how much from capital controls that suppress Chinese residents’ demand for dollars. No one truly knows whether easing or ending of capital controls would ease pressure on the currency without central bank intervention and, in the process, also eliminate inflows from speculation on a revaluation. Many in China, however, fear that an immediate ending of controls could induce capital outflows large enough to destabilize the nation’s fragile banking system. Others believe that decontrol, but at a gradual pace, could conceivably temper such concerns. Central bank purchases of dollars, unless offset, threaten an excess of so-called high-powered money expansion and consequent overheating of the Chinese economy. The Chinese central bank this year has indeed offset, that is, sterilized, much of its heavy dollar purchases by reducing its loans to commercial banks, by selling bonds, and by increasing reserve requirements. But currency and commercial bank reserves have been rising enough to support a growth of the money supply well in excess of a 20 percent annual rate so far this year. Should this pattern continue, the central bank will be confronted with the choice of an overheated economy, with its potential recessionary consequences, or a curtailing of dollar asset purchases. The latter presumably would allow the renminbi to appreciate against the dollar. China has become an important addition to the global trading system. A prosperous China will bring substantial positive benefits to the rest of the trading world. It is, thus, important to all of us that they succeed in navigating through their current economic and financial imbalances. *** The challenges represented by China’s large surplus with the United States and the efforts to repair a recent breach in the current round of trade negotiations have engaged the attention of policymakers worldwide. But these are subplots in a much larger debate about the benefits and costs of expanding globalization. At the risk of oversimplification, I would separate the parties in that debate into three groups. First, there are those who believe that relatively unfettered capitalism is the only economic organization consistent with individual and political freedom. In a second group are those who accept capitalism as the only practical means to achieve higher standards of living but who are disturbed by the seeming incivility of many market practices and outcomes. In very broad terms, the prevalence with which one encounters allegations of incivility defines an important difference in economic views that distinguishes the United States from continental Europe - two peoples having deeply similar roots in political freedom and democracy. A more pronounced distinction separates both of these groups from a third group, which views societal organization based on the profit motive and corporate culture as fundamentally immoral. This group questions, in particular, whether the distribution of wealth that results from greater economic interactions among countries is, in some sense, “fair.” Here terms such as “exploitation,” “subversion of democratic choice,” and other value-charged notions dominate the debate. These terms too often substitute for a rigorous discussion of the difficult tradeoffs that we confront in advancing the economic welfare of our nations. Such an antipathy to “corporate culture” has sent tens of thousands into the streets to protest what they see as “exploitive capitalism” in its most visible form - the increased globalization of our economies. As solutions to these alleged failures of globalization, dissidents frequently appear to favor politically imposed systems, employing the power of the state to override the outcomes arrived at through voluntary exchange. The historical record of such approaches does not offer much encouragement. One would be hard pressed to cite examples of free and prosperous societies that suppressed the marketplace. *** Setting aside the arguments of the protesters, even among those committed to market-oriented economies, important differences remain about capitalism and the role of globalization. These differences are captured most clearly for me in a soliloquy attributed to a prominent European leader several years ago. He asked, “What is the market? It is the law of the jungle, the law of nature. And what is civilization? It is the struggle against nature.” While acknowledging the ability of competition to promote growth, many such observers, nonetheless, remain concerned that economic actors, to achieve that growth, are required to behave in a manner governed by the law of the jungle. In contrast to these skeptical views, others argue for the ethical merits of market-driven outcomes posited on the value preferences of individuals as reflected in their choices in a free marketplace. The ultimate arbiter of an economy’s ethics is, or should be, the material welfare of the individuals in a society. The crux of the largely laissez-faire argument is that, because unencumbered competitive markets reflect the value preferences of consumers, the resulting price signals direct a nation’s savings into those capital assets that maximize the production of goods and services most valued by consumers. Wages, profits, and other sources of income are determined, for the most part, by how successfully the participants in an economy contribute to the welfare of consumers. Clearly not all activities undertaken in markets are civil. Many, though legal, are decidedly unsavory. Violation of law and breaches of trust do undermine the efficiency of markets. But the legal foundations and the discipline of the marketplace are sufficiently rooted in a rule of law to limit these aberrations. It is instructive that despite the egregious breaches of trust in recent years by a number of the nation’s business and financial leaders, productivity, an important metric of corporate efficiency, has accelerated. On net, vigorous economic competition over the years has produced a significant rise in the quality of life for the vast majority of the population in market-oriented economies, including those at the bottom of the income distribution. The highly competitive free market paradigm, however, is viewed by many at the other end of the philosophical spectrum as obsessively materialistic and largely lacking in meaningful cultural values. This view gained adherents with the recent uncovering of much scandalous business behavior during the boom years of the 1990s. But is there a simple tradeoff between civil conduct, as defined by those who find raw competitive behavior demeaning, and the quality of material life they, nonetheless, seek? It is not obvious that such a tradeoff exists in any meaningful sense when viewed from a longer-term perspective. During the past century, for example, economic growth created resources far in excess of those required to maintain subsistence. That surplus in democratic capitalist societies has been, in large measure, employed to improve the quality of life along many dimensions. To cite a short list: greater longevity, owing first to the widespread development of clean, potable water and later to rapid advances in medical technology; (2) a universal system of education that enabled greatly increased social mobility; (3) vastly improved conditions of work; and (4) the ability to enhance our environment by setting aside natural resources rather than having to employ them to sustain a minimum level of subsistence. At a fundamental level, Americans have used the substantial increases in wealth generated by our market-driven economy to purchase what many would view as greater civility. *** Debates on the pros and cons of market capitalism have waged for generations. The collapse of the Soviet empire, and with it central planning, has left market capitalism as the principal, but not universally revered, model of economic organization. The vigorous debates on how economies should be organized and by what rules individuals’ trading should be governed surfaced most prominently in the latter part of the eighteenth century. Those debates appear destined to continue through the twenty-first century and presumably beyond.
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board of governors of the federal reserve system
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the meetings of the American Economic Association, San Diego, 3 January 2004.
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Alan Greenspan: Risk and uncertainty in monetary policy Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the meetings of the American Economic Association, San Diego, 3 January 2004. * * * This morning I plan to sketch the key developments of the past decade and a half of monetary policy in the United States from the perspective of someone who has been in the policy trenches. I will offer some conclusions about what I believe has been learned thus far, though I suspect, as is so often the case, the passing of time, further study, and reflection will deepen our understanding of these developments. This is a personal statement; I am not speaking for my current colleagues on the Federal Open Market Committee (FOMC) or the many others with whom I have served over these many years.1 *** The tightening of monetary policy by the Federal Reserve in 1979, then led by my predecessor Paul Volcker, ultimately broke the back of price acceleration in the United States, ushering in a two-decade long decline in inflation that eventually brought us to the current state of price stability. The fall in inflation over this period has been global in scope, and arguably beyond the expectations of even the most optimistic inflation fighters. I have little doubt that an unrelenting focus of monetary policy on achieving price stability has been the principal contributor to disinflation. Indeed, the notion, advanced by Milton Friedman more than thirty years ago, that inflation is everywhere and always a monetary phenomenon is no longer a controversial proposition in the profession. But the size and geographic extent of the decline in inflation raises the question of whether other forces have been at work as well. I am increasingly of the view that, at a minimum, monetary policy in the last two decades has been operating in an environment particularly conducive to the pursuit of price stability. The principal features of this environment included (1) increased political support for stable prices, which was the consequence of, and reaction to, the unprecedented peacetime inflation in the 1970s, (2) globalization, which unleashed powerful new forces of competition, and (3) an acceleration of productivity, which at least for a time held down cost pressures. I believe we at the Fed, to our credit, did gradually come to recognize the structural economic changes that we were living through and accordingly altered our understanding of the key parameters of the economic system and our policy stance. The central banks of other industrialized countries have grappled with many of the same issues. But as we lived through it, there was much uncertainty about the evolving structure of the economy and about the influence of monetary policy. Despite those uncertainties, the trauma of the 1970s was still so vivid throughout the 1980s that preventing a return to accelerating prices was the unvarying focus of our efforts during those years. In recognition of the lag in monetary policy’s impact on economic activity, a preemptive response to the potential for building inflationary pressures was made an important feature of policy. As a consequence, this approach elevated forecasting to an even more prominent place in policy deliberations. *** After an almost uninterrupted stint of easing from the summer of 1984 through the spring of 1987, the Fed again began to lean against increasing inflationary pressures, which were in part the indirect result of rapidly rising stock prices. We had recognized the risk of an adverse reaction in a stock market that had recently experienced a steep run-up - indeed, we actively engaged in contingency planning against that possibility. I, nonetheless, wish to thank my colleagues David Stockton, David Wilcox, Don Kohn, Ben Bernanke and John Taylor for their many suggestions and reminiscences. In the event, the crash in October 1987 was far more traumatic than any of the possible scenarios we had identified. Previous planning was only marginally useful in that episode. We operated essentially in a crisis mode, responding with an immediate and massive injection of liquidity to help stabilize highly volatile financial markets. However, most of our stabilization efforts were directed at keeping the payments system functioning and markets open. The concern over the possible fallout on economic activity from so sharp a stock price decline kept us easing into early 1988. But the economy weathered that shock reasonably well, and our easing extended perhaps longer than hindsight has indicated was necessary. That period was followed by a preemptive tightening that brought the federal funds rate close to 10 percent by early 1989. In the summer of that year, we sensed enough softening of activity to warrant beginning a series of rate reductions. However, the weakening of demand already under way, some pullback of credit by lenders, and the spike in oil prices associated with Iraq’s invasion of Kuwait were sufficient to produce a marked contraction of activity in the fall of 1990. But perhaps aided by our preemptive action, the recession was, to then, the mildest in postwar history. However, the recovery also was more modest than usual, in large measure because of the notable financial “headwinds” that confronted businesses. Those headwinds were primarily generated by the constriction of credit in response to major losses at banks, associated with real-estate and foreign lending, coupled with a crisis in the savings and loan industry that had its origins in a serious maturity mismatch as interest rates rose. With their access to managed funds threatened and the quality of their loan portfolio - and hence their capital - uncertain, these depositories were most reluctant to lend. Policy eased gradually but persistently to counter the effects of these developments, with the funds rate falling to 3 percent by September 1992, its lowest level since the early 1960s. The uptilt to the term structure of interest rates in a generally low interest rate environment restored bank profitability and, eventually, bank capital. The credit crunch slowly lifted. By early 1994, as the headwinds of financial restraint abated, it became clear that underlying price pressures were again building. If we had left those pressures unchecked, we would have put at risk some of the hard-won gains that had been achieved over the preceding decade and a half. So, starting from a real federal funds rate that was close to zero, a preemptive tightening was initiated. The resulting rise in the funds rate of 300 basis points over twelve months apparently defused those nascent inflationary pressures. Though economic activity hesitated in early 1995, it soon steadied, confirming the achievement of a historically elusive soft landing. The success of that period set up two powerful expectations that were to influence developments over the subsequent decade. One was the expectation that inflation could be controlled over the business cycle and that price stability was an achievable objective. The second expectation, in part a consequence of more stable inflation, was that overall economic volatility had been reduced and would likely remain lower than it had previously. Of course, these new developments brought new challenges. In particular, the prospect that a necessary cyclical adjustment was now behind us fostered increasing levels of optimism, which were manifested in a fall in bond risk spreads and a rise in stock prices. The associated decline in the cost of equity capital further spurred already developing increases in capital investment and productivity growth, both of which broadened impressively in the latter part of the 1990s. The rise in structural productivity growth was not obvious in the official data on gross product per hour worked until later in the decade, but precursors had emerged earlier. The pickup in new bookings and order backlogs for high-tech capital goods in 1993 seemed incongruous given the sluggish economic environment at the time. Plant managers apparently were reacting to what they perceived to be elevated prospective rates of return on the newer technologies, a judgment that was confirmed as orders and profits continued to increase through 1994 and 1995. Moreover, even though hourly labor compensation and profit margins were rising, prices were being contained, implying increasing growth in output per hour.2 That growth was showing through in gross income per hour. An increasingly negative statistical discrepancy was masking the rise in productivity as measured by the official data that relied on gross product per hour. As I indicated in the fall of 1994, “we are observing . . . [an] opening up of margins . . . But unit labor costs apparently have been so well contained by productivity gains at this stage that cost pressures have not flowed into final goods prices.” (FOMC transcripts, September 27, 1994, pg. 37) As a consequence of the improving trend in structural productivity growth that was apparent from 1995 forward, we at the Fed were able to be much more accommodative to the rise in economic growth than our past experiences would have deemed prudent. We were motivated, in part, by the view that the evident structural economic changes rendered suspect, at best, the prevailing notion in the early 1990s of an elevated and reasonably stable NAIRU. Those views were reinforced as inflation continued to fall in the context of a declining unemployment rate that by 2000 had dipped below 4 percent in the United States for the first time in three decades. Notions that prevailed for a time in the 1970s and early 1980s that even high single-digit inflation did not measurably impede economic growth were gradually abandoned as the evidence of significant benefits of low inflation became increasingly persuasive. Moreover, the variance of GDP growth markedly lessened as inflation tumbled from its double-digit high in the early 1980s. To preserve these benefits, we engaged in our most recent preemptive tightening in early 1999 that brought the funds rate to 6-1/2 percent by May 2000. Our goal of price stability was achieved by most analysts’ definition by mid-2003. Unstinting and largely preemptive efforts over two decades had finally paid off. Throughout the period, a key objective has been to ensure that our response to incipient changes in inflation was forceful enough. As John Taylor has emphasized, in the face of an incipient increase in inflation, nominal interest rates must move up more than one-for-one.3 *** Perhaps the greatest irony of the past decade is that the gradually unfolding success against inflation may well have contributed to the stock price bubble of the latter part of the 1990s.4 Looking back on those years, it is evident that technology-driven increases in productivity growth imparted significant upward momentum to expectations of earnings growth and, accordingly, to stock prices.5 At the same time, an environment of increasing macroeconomic stability reduced perceptions of risk. In any event, Fed policymakers were confronted with forces that none of us had previously encountered. Aside from the then-recent experience of Japan, only remote historical episodes gave us clues to the appropriate stance for policy under such conditions. The sharp rise in stock prices and their subsequent fall were, thus, an especial challenge to the Federal Reserve. It is far from obvious that bubbles, even if identified early, can be preempted at lower cost than a substantial economic contraction and possible financial destabilization - the very outcomes we would be seeking to avoid. In fact, our experience over the past two decades suggests that a moderate monetary tightening that deflates stock prices without substantial effect on economic activity has often been associated with subsequent increases in the level of stock prices.6 Arguably, markets that pass that type of stress test are presumed particularly resilient. The notion that a well-timed incremental tightening could have See, for example, “A Half-Century of Changes in Monetary Policy,” John B. Taylor, remarks delivered at the conference in honor of Milton Friedman, November 8, 2002, pp 9-10, manuscript, Department of the Treasury. It is notable, that in the United States, surges in price-earnings ratios, a presumed essential characteristic of an equity price bubble, are not observed with elevated inflation expectations. But, as the Federal Reserve indicated in congressional testimony in July 1999, “... productivity acceleration does not ensure that equity prices are not overextended. There can be little doubt that if the nation’s productivity growth has stepped up, the level of profits and their future potential would be elevated. That prospect has supported higher stock prices. The danger is that in these circumstances, an unwarranted, perhaps euphoric, extension of recent developments can drive equity prices to levels that are unsupportable even if risks in the future become relatively small. Such straying above fundamentals could create problems for our economy when the inevitable adjustment occurs.” Testimony of Alan Greenspan before the Committee on Banking and Financial Services, U.S. House of Representatives, July 22, 1999. For example, stock prices rose following the completion of the more than 300 basis point rise in the federal funds rate in the twelve months ending in February 1989. And during the year beginning in February 1994, when the Federal Reserve again raised the federal funds target 300 basis points, stock prices initially flattened. But as soon as that round of tightening was completed, prices resumed their marked upward advance. From mid-1999 through May 2000, the federal funds rate was raised 150 basis points. However, equity price increases were largely undeterred during that period despite what now, in retrospect, was the exhausted tail of a bull market. Stock prices peaked in March 2000, but the market basically moved sideways until September of that year. Such data suggest that nothing short of a sharp increase in short-term rates that engenders a significant economic retrenchment with all its attendant risks is sufficient to check a nascent bubble. Certainly, 300 basis points proved inadequate to even dent stock prices in 1994. been calibrated to prevent the late 1990s bubble while preserving economic stability is almost surely an illusion.7 Instead of trying to contain a putative bubble by drastic actions with largely unpredictable consequences, we chose, as we noted in our mid-1999 congressional testimony, to focus on policies “to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion.”8 *** During 2001, in the aftermath of the bursting of the bubble and the acts of terrorism in September 2001, the federal funds rate was lowered 4-3/4 percentage points. Subsequently, another 75 basis points were pared, bringing the rate by June 2003 to its current 1 percent, the lowest level in 45 years. We were able to be unusually aggressive in the initial stages of the recession of 2001 because both inflation and inflation expectations were low and stable. We thought we needed to be, and could be, forceful in 2002 and 2003 as well because, with demand weak, inflation risks had become two-sided for the first time in forty years. There appears to be enough evidence, at least tentatively, to conclude that our strategy of addressing the bubble’s consequences rather than the bubble itself has been successful. Despite the stock market plunge, terrorist attacks, corporate scandals, and wars in Afghanistan and Iraq, we experienced an exceptionally mild recession - even milder than that of a decade earlier. As I discuss later, much of the ability of the U.S. economy to absorb these sequences of shocks resulted from notably improved structural flexibility. But highly aggressive monetary ease was doubtless also a significant contributor to stability.9 *** The Federal Reserve’s experiences over the past two decades make it clear that uncertainty is not just a pervasive feature of the monetary policy landscape; it is the defining characteristic of that landscape. The term “uncertainty” is meant here to encompass both “Knightian uncertainty,” in which the probability distribution of outcomes is unknown, and “risk,” in which uncertainty of outcomes is delimited by a known probability distribution. In practice, one is never quite sure what type of uncertainty one is dealing with in real time, and it may be best to think of a continuum ranging from well-defined risks to the truly unknown. As a consequence, the conduct of monetary policy in the United States has come to involve, at its core, crucial elements of risk management. This conceptual framework emphasizes understanding as much as possible the many sources of risk and uncertainty that policymakers face, quantifying those Some have asserted that the Federal Reserve can deflate a stock-price bubble - rather painlessly - by boosting margin requirements. The evidence suggests otherwise. First, the amount of margin debt is small, having never amounted to more than about 1-3/4 percent of the market value of equities; moreover, even this figure overstates the amount of margin debt used to purchase stock, as such debt also finances short sales of equity and transactions in non-equity securities. Second, investors need not rely on margin debt to take a leveraged position in equities. They can borrow from other sources to buy stock. Or, they can purchase options, which will affect stock prices given the linkages across markets. Thus, not surprisingly, the preponderance of research suggests that changes in margins are not an effective tool for reducing stock market volatility. It is possible that margin requirements inhibit very small investors whose access to other forms of credit is limited. If so, the only effect of increasing margin requirements is to price out of the market the very small investor without addressing the broader issue of stock price bubbles. If a change in margin requirements were taken by investors as a signal that the central bank would soon tighten monetary policy enough to burst a bubble, then there might be the appearance of a causal effect. But it is the prospect of monetary policy action, not the margin increase, that should be viewed as the trigger. In a similar manner, history tells us that “jawboning” asset markets will be ineffective unless backed by action. Op. cit. Some have argued that, as a consequence of the 1995-2000 speculative episode, long-term imbalances remain, having been only partly addressed since early 2001, the peak of the post-bubble business cycle. For example, large residues of household and external debt are perceived as barriers to future growth. But in the past, imbalances that led to business contractions were rarely fully reversed before the subsequent economic upturn began. Presumably they were fully reversed in later periods, or they continued to fester, but not by enough to halt economic growth. Even if imbalances still persist in our current environment, the business decline that began in March 2001 came to an end in November of that year, according to the National Bureau of Economic Research. We experienced tepid recovery until the second half of last year, when GDP accelerated considerably. Hence, when the next recession arrives, as it inevitably will, it will be a stretch to attribute it to speculative imbalances of many years earlier. risks when possible, and assessing the costs associated with each of the risks. In essence, the risk management approach to monetary policymaking is an application of Bayesian decisionmaking. This framework also entails devising, in light of those risks, a strategy for policy directed at maximizing the probabilities of achieving over time our goals of price stability and the maximum sustainable economic growth that we associate with it. In designing strategies to meet our policy objectives, we have drawn on the work of analysts, both inside and outside the Fed, who over the past half century have devoted much effort to improving our understanding of the economy and its monetary transmission mechanism. A critical result has been the identification of a relatively small set of key relationships that, taken together, provide a useful approximation of our economy’s dynamics. Such an approximation underlies the statistical models that we at the Federal Reserve employ to assess the likely influence of our policy decisions. However, despite extensive efforts to capture and quantify what we perceive as the key macroeconomic relationships, our knowledge about many of the important linkages is far from complete and, in all likelihood, will always remain so. Every model, no matter how detailed or how well designed, conceptually and empirically, is a vastly simplified representation of the world that we experience with all its intricacies on a day-to-day basis. Given our inevitably incomplete knowledge about key structural aspects of an ever-changing economy and the sometimes asymmetric costs or benefits of particular outcomes, a central bank needs to consider not only the most likely future path for the economy but also the distribution of possible outcomes about that path. The decisionmakers then need to reach a judgment about the probabilities, costs, and benefits of the various possible outcomes under alternative choices for policy. A policy action that is calculated to be optimal based on a simulation of one particular model may not, in fact, be optimal once the full extent of the risks surrounding the most likely path is taken into account. In general, different policies will exhibit different degrees of robustness with respect to the true underlying structure of the economy. For example, policy A might be judged as best advancing the policymakers’ objectives, conditional on a particular model of the economy, but might also be seen as having relatively severe adverse consequences if the true structure of the economy turns out to be other than the one assumed. On the other hand, policy B might be somewhat less effective in advancing the policy objectives under the assumed baseline model but might be relatively benign in the event that the structure of the economy turns out to differ from the baseline. A year ago, these considerations inclined Federal Reserve policymakers toward an easier stance of policy aimed at limiting the risk of deflation even though baseline forecasts from most conventional models at that time did not project deflation; that is, we chose a policy that, in a world of perfect certainty, would have been judged to be too loose. As this episode illustrates, policy practitioners operating under a risk-management paradigm may, at times, be led to undertake actions intended to provide insurance against especially adverse outcomes. Following the Russian debt default in the autumn of 1998, for example, the FOMC eased policy despite our perception that the economy was expanding at a satisfactory pace and that, even without a policy initiative, it was likely to continue doing so.10 We eased policy because we were concerned about the low-probability risk that the default might trigger events that would severely disrupt domestic and international financial markets, with outsized adverse feedback to the performance of the U.S. economy. The product of a low-probability event and a potentially severe outcome was judged a more serious threat to economic performance than the higher inflation that might ensue in the more probable scenario. That possibility of higher inflation caused us little concern at the time, largely because increased productivity growth was resulting in only limited increases in unit labor costs and heightened competition, driven by globalization, was thwarting employers’ ability to pass through those limited cost increases into prices. Given the potential consequences of the Russian default, the benefits of the unusual policy action were judged to outweigh its costs. Such a cost-benefit analysis is an ongoing part of monetary policy decisionmaking and causes us to tip more toward monetary ease when a contractionary event, such as the Russian default, seems especially likely or the costs associated with it seem especially high. See minutes of the FOMC meeting of September 29, 1998. The 1998 liquidity crisis and the crises associated with the stock market crash of 1987 and the terrorism of September 2001 prompted the type of massive ease that has been the historic mandate of a central bank. Such crises are precipitated by the efforts of market participants to convert illiquid assets into cash. When confronted with uncertainty, especially Knightian uncertainty, human beings invariably attempt to disengage from medium to long-term commitments in favor of safety and liquidity. Because economies, of necessity, are net long - that is, have net real assets - attempts to flee these assets cause prices of equity assets to fall, in some cases dramatically. In the crisis that emerged in the autumn of 1998, pressures extended beyond equity markets. Credit-risk spreads widened materially and investors put a particularly high value on liquidity, as evidenced by the extraordinarily wide yield gaps that emerged between on-the-run and off-the-run U.S. Treasuries. The immediate response on the part of the central bank to such financial implosions must be to inject large quantities of liquidity - or as Walter Bagehot put it, describing such policies of the Bank of England more than a century ago, in a panic the Bank should lend at very high rates of interest “to all that bring good securities quickly, freely, and readily.”11 This was perhaps an early articulation of a crisis risk management policy for a central bank. *** The economic world in which we function is best described by a structure whose parameters are continuously changing. The channels of monetary policy, consequently, are changing in tandem. An ongoing challenge for the Federal Reserve - indeed, for any central bank - is to operate in a way that does not depend on a fixed economic structure based on historically average coefficients. We often fit simple models only because we cannot estimate a continuously changing set of parameters without vastly more observations than are currently available to us. Moreover, we recognize that the simple linear functions underlying most of our econometric structures may not hold outside the range in which adequate economic observations exist. For example, it is difficult to have much confidence in the ability of models fit to the data of the moderate inflations of the postwar period to accurately predict what the behavior of the economy would be in an environment of aggregate price deflation. In pursuing a risk-management approach to policy, we must confront the fact that only a limited number of risks can be quantified with any confidence. And even these risks are generally quantifiable only if we accept the assumption that the future will, at least in some important respects, resemble the past. Policymakers often have to act, or choose not to act, even though we may not fully understand the full range of possible outcomes, let alone each possible outcome’s likelihood. As a result, risk management often involves significant judgment as we evaluate the risks of different events and the probability that our actions will alter those risks. For such judgment, policymakers have needed to reach beyond models to broader - though less mathematically precise - hypotheses about how the world works. For example, inferences about how market participants and, hence, the economy might respond to a monetary policy initiative may need to be drawn from evidence about past behavior during a period only roughly comparable to the current situation. Some critics have argued that such an approach to policy is too undisciplined - judgmental, seemingly discretionary, and difficult to explain. The Federal Reserve, they conclude, should attempt to be more formal in its operations by tying its actions solely, or in the weaker paradigm, largely, to the prescriptions of a simple policy rule. Indeed, rules that relate the setting of the federal funds rate to the deviations of output and inflation from their respective targets, in some configurations, do seem to capture the broad contours of what we did over the past decade and a half. And the prescriptions of formal rules can, in fact, serve as helpful adjuncts to policy, as many of the proponents of these rules have suggested. But at crucial points, like those in our recent policy history - the stock market crash of 1987, the crises of 1997-98, and the events that followed September 2001 - simple rules will be inadequate as either descriptions or prescriptions for policy. Moreover, such rules suffer from much of the same fixed-coefficient difficulties we have with our large-scale models. To be sure, sensible policymaking can be accomplished only with the aid of a rigorous analytic structure. A rule does provide a benchmark against which to assess emerging developments. However, any rule capable of encompassing every possible contingency would lose a key aspect of its attractiveness: simplicity. On the other hand, no simple rule could possibly describe the policy action to Walter Bagehot, Lombard Street: A Description of the Money Market, (Orion Editions, 1873) p. 85. be taken in every contingency and thus provide a satisfactory substitute for an approach based on the principles of risk management. As I indicated earlier, policy has worked off a risk-management paradigm in which the risk and costbenefit analyses depend on forecasts of probabilities developed from large macromodels, numerous submodels, and judgments based on less mathematically precise regimens. Such judgments, by their nature, are based on bits and pieces of history that cannot formally be associated with an analysis of variance. Yet, there is information in those bits and pieces. For example, while we have been unable to readily construct a variable that captures the apparent increased degree of flexibility in the United States or the global economy, there has been too much circumstantial evidence of this critically important trend to ignore its existence. Increased flexibility is a likely source of changing structural coefficients. Our problem is not, as is sometimes alleged, the complexity of our policymaking process, but the far greater complexity of a world economy whose underlying linkages appear to be continuously evolving. Our response to that continuous evolution has been disciplined by the Bayesian type of decisionmaking in which we have engaged. *** While all, no doubt, would prefer that it were otherwise, there is no way to dismiss what has to be obvious to every monetary policymaker: The success of monetary policy depends importantly on the quality of forecasting. The ability to gauge risks implies some judgment about how current economic imbalances will ultimately play out. Thus, both econometric and qualitative models need to be continually tested. The first signs that a relationship may have changed is usually the emergence of events that seem inconsistent with our hypotheses of the way the economic world is supposed to behave. The anomalous rise in high-tech capital goods orders in 1993, to which I alluded earlier, is one such example. The credit crunch of the early 1990s is another. The emergence of inflation targeting in recent years is an interesting development in this regard. As practiced, it emphasizes forecasts, but within a more rule-like structure that skews monetary policy toward inflation containment as the primary goal. Indeed, its early applications were in high-inflation countries where discretionary monetary policy fell into disrepute. Inflation targeting often originated as a fairly simple structure concentrating solely on inflation outcomes, but it has evolved into more-discretionary forms requiring complex judgments for implementation. Indeed, this evolution has gone so far that the actual practice of monetary policy by inflation-targeting central banks now closely resembles the practice of those central banks, such as the European Central Bank, the Bank of Japan, and the Federal Reserve, that have not chosen to adopt that paradigm. In practice, most central banks, at least those not bound by an exchange rate peg, behave in roughly the same way. They seek price stability as their long-term goal and, accounting for the lag in monetary policy, calibrate the setting of the policy rate accordingly. Central banks generally appear to have embraced a common model of the channels through which monetary policy functions, although the specifics and emphasis given to those channels vary according to our particular circumstances. All banks ease when economic conditions ease and tighten when economic conditions tighten, even if in differing degrees, regardless of whether they are guided by formal or informal inflation targets. As yet unresolved is whether the mere announcement that a central bank intends to engage in inflation targeting increases the credibility of the central bank’s inclination to maintain price stability and, hence, assists in the anchoring of inflation expectations. The Bank of England’s recent experiences may be encouraging in this regard. But, presumably, we will not know for sure the significance of formal inflation targeting as a tool until the world economy is subjected to shocks of sufficient magnitude to assess the differential performance of those who do not employ formally announced inflation targets. To date, inflation has fallen for formal targeters, but it has fallen for others as well. *** Under the rubric of risk management are a number of specific issues that we at the Fed had to address over the past decade and a half and that will likely resurface to confront future monetary policymakers. Most prominent is the appropriate role of asset prices in policy. In addition to the narrower issue of product price stability, asset prices will remain high on the research agenda of central banks for years to come. As the ratios of gross liabilities and gross assets to GDP continue to rise, owing to expanding domestic and international financial intermediation, the visibility of asset prices relative to product prices will itself rise. There is little dispute that the prices of stocks, bonds, homes, real estate, and exchange rates affect GDP. But most central banks have chosen, at least to date, not to view asset prices as targets of policy, but as economic variables to be considered through the prism of the policy’s ultimate objective. *** As the transcripts of FOMC meetings attest, making monetary policy is an especially humbling activity. In hindsight, the paths of inflation, real output, stock prices and exchange rates may have seemed preordained, but no such insight existed as we experienced it at the time. In fact, uncertainty characterized virtually every meeting, and, as the transcripts show, our ability to anticipate was limited. From time to time the FOMC made decisions, some to move and some not to move, that we came to regret. Yet, during the last quarter century, policymakers managed to defuse dangerous inflationary forces and dealt with the consequences of a stock market crash, a large asset price bubble, and a series of liquidity crises. These events did not distract us from the pursuit and eventual achievement of price stability and the greater economic stability that goes with it. As we confront the many unspecifiable dangers that lie ahead, the marked improvement in the degree of flexibility and resilience exhibited by our economy in recent years should afford us considerable comfort.12 Assuming that it will persist, the trend toward increased flexibility implies that an evergreater part of the resolution of economic imbalances will occur through the actions of business firms and households. Less will be required from the risk-laden initiatives of monetary policymakers. Each generation of policymakers has had to grapple with a changing portfolio of problems. So while we eagerly draw on the experiences of our predecessors, we can be assured that we will confront different problems in the future. The innovative technologies that have helped us reap enormous efficiencies will doubtless present us with challenges that we cannot currently anticipate. We were fortunate, as I pointed out in my opening remarks, to have worked in a particularly favorable structural and political environment. But we trust that monetary policy has meaningfully contributed to the impressive performance of our economy in recent decades. See testimony of Alan Greenspan before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, February 11, 2003.
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board of governors of the federal reserve system
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Speech by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, at the meetings of the American Economic Association, San Diego, 4 January 2004.
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Roger W Ferguson, Jr: Lessons from past productivity booms Speech by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, at the meetings of the American Economic Association, San Diego, 4 January 2004. The references for the speech can be found on the Board of Governors of the Federal Reserve System’s website. * * * As we are all well aware, the United States has been enjoying significantly faster productivity growth for the past eight years or so than it did over the preceding two decades. Since 1995, labor productivity has risen at an average annual rate of about 3 percent, up from an average annual rate of around 1-1/2 percent between 1973 and 1995. And in the past two years alone, output per hour has increased more than 5 percent per year. The significance of the improvement since 1995 can hardly be overstated, even after taking into account the cyclical component of the most recent quarters. If productivity were to continue to improve at an average annual rate of 3 percent, the standard of living in the United States would double roughly every twenty-four years. If, on the other hand, productivity growth were to revert to an average annual pace of 1-1/2 percent, a doubling in the standard of living would occur only every forty-seven years. Many observers-including some economists-argue that the present era of robust trend productivity growth will soon come to an end. Others are more optimistic and argue that the potential gains to productivity from the technological advances associated with the computer revolution are far from complete.1 Because productivity growth is critical to economic welfare, assessing the likelihood of these alternative outcomes is of considerable interest. In thinking about this issue, it is worth recognizing that periods of strong trend productivity growth, although perhaps novel to many of us, are not new to the U.S. economy. In fact, three earlier periods seem to stand out from the historical record as especially worthy of further scrutiny for the lessons they may offer regarding the current episode: a period in the late 1800s from roughly the end of the Civil War to around 1890; the decade or so between the end of World War I and the onset of the Great Depression; and the period from about 1950 to the early 1970s.2 Of particular note is that in at least two of the earlier episodes, heightened productivity growth lasted for an extended period - roughly twenty years or so. Thus, one objective in examining these previous productivity booms is to see whether we can glean any insights into the best ways to sustain the current episode of strong productivity growth. To be sure, each period mentioned can be associated with particular advances in technology, implying that technological progress is a necessary component of trend productivity growth. But significant technological advances were also evident in periods when productivity growth was less robust. Thus, a natural question to ask is whether other complementary factors - including aspects of the labor market, of the business environment, or of government policies - combine to render technological change especially potent or help to foster the transmission of technological change into real gains in the efficiency of the production process. Similarly, examining the historical record may shed light on the sustainability of the current boom. Do productivity booms simply run out of steam and die natural deaths? Or are they cut short by economic imbalances, exogenous shocks, or detrimental government policies? And, if the latter, are these cessations inevitable? At the outset, I should note that this lecture is co-authored with William Wascher, who is a member of the staff at the Board of Governors. To provide a roadmap of where we intend to go, I want to start by setting out some basic facts about previous periods of strong productivity growth in the United States. I will, of course, begin with some numbers. But I also want to discuss some of the technological For a recent assessment of the new economy, see Martin Baily’s Distinguished Lecture on Economics in Government (Baily 2002). Others will undoubtedly disagree with this taxonomy. Robert Gordon (2000), for example, argues that the historical record of productivity growth in the United States is best seen as one big “wave” that begins its rise in the late 1800s and tapers off in the late 1960s and early 1970s. And from a standpoint of technological advance, that characterization may well be appropriate. But for assessing the diffusion of technology and the forces that contributed to the speed of the diffusion, a focus on narrower periods of labor productivity booms is arguably more appropriate. innovations that contributed to these productivity booms and about the supportive roles played by changes in the organization of American businesses and the structure of financial markets, and by the U.S. education system. Finally, I will spend some time on the lessons that we think can be learned from what, in many ways, are striking similarities across the three previous episodes and the current one. Identifying previous productivity booms I should also note at this point that even the basic facts about economic growth, not to mention the interpretation of those facts, are sometimes subject to considerable debate. Some of these disagreements undoubtedly result from the lack of consistent information on U.S. productivity before data from the Bureau of Labor Statistics (BLS) became available in 1948. For this earlier period, we use data developed in the early 1960s by John Kendrick, who constructed estimates of GDP consistent with the prevailing definitions in the National Income and Product Accounts going back to the 1870s (which had as their basis estimates made by Simon Kuznets in the 1940s).3 These estimates are often cited as the best available measure of U.S output and productivity growth for that period. Although subsequent researchers - notably Balke and Gordon (1989) and Romer (1989) have refined these estimates in different ways, the additional refinements focus primarily on the cyclical properties of output and do not significantly alter the qualitative statements about long-run growth made here. A number of economic historians - most notably Robert Gallman - have estimated U.S. GDP for the period before the Civil War.4 However, given that their estimates are surely less reliable than those for the later, more industrialized period, we have elected to limit the focus of this lecture to the post-Civil War period. These caveats aside, average growth rates of productivity over various periods are presented in the table. We will focus on labor productivity (the first column) because that measure is the best indicator of improvement in the nation’s standard of living. For the entire period from 1870 to 2003, labor productivity has risen at an average rate of around 2 percent per year. However, productivity growth has not proceeded in a steady fashion. We have chosen time periods for our analysis that smooth through the business cycle, which is a significant source of shorter-term changes in rates of productivity growth. More important for this discussion is the variation in labor productivity growth that has occurred over longer stretches of time, with periods of robust growth interspersed with periods of more modest productivity gains. Using the Kendrick data as a guide and recognizing that the choice of any particular period is somewhat subjective, we take as the first episode of strong productivity growth - or productivity boom, if you will - roughly the period from 1873 to 1890. During this period, labor productivity rose more than 2-1/2 percent per year, a rate thought to be considerably higher than the average growth experienced over the first 100 years of the United States.5 An important element of the analysis of this and other periods is the decomposition of output per hour into its underlying sources, including the contributions of multifactor productivity, capital deepening, and labor quality. In this regard, Kendrick’s decomposition suggests that labor productivity growth in the late 1800s was fueled importantly by capital investment.6 During the next three decades, from 1890 to 1917, the growth rate of labor productivity slowed to an average pace of only 1-1/2 percent per year, with modest rates of growth both in the capital stock and in multifactor productivity. The United States then enjoyed a relatively brief spurt in productivity until about 1927, with labor productivity rising about 3-3/4 percent per year and multifactor productivity up around 2 3/4 percent per year. This productivity boom was led by the expansion of the automobile industry and robust productivity gains in manufacturing more generally. Productivity growth was markedly slower through the Great Depression and World War II, largely reflecting a lack of capital See Kendrick (1961) and Kuznets (1946). See, for example, Gallman (1966) and Rhode (2002). This estimate of productivity growth is the change from Kendrick’s estimate of the average level of productivity in the 1870s to the level of productivity in 1890. Decompositions of productivity growth before 1948 are the subject of some debate, and thus estimates of multifactor productivity for these earlier periods should probably be viewed as less reliable than are the estimates of labor productivity. deepening. Multifactor productivity rose at a relatively solid pace - albeit not as fast as earlier in the century - despite the weak economy during much of that period. Productivity growth since World War II is more familiar to us and is based on more reliable data - those constructed as part of the multifactor productivity program at the BLS. According to these data, labor productivity rose at an annual rate of close to 3 percent from 1948 to 1973 - a period sometimes referred to as the golden age of productivity growth. During this period, productivity accelerated across a broad range of industries, and both capital deepening and gains in multifactor productivity contributed to the strong pace of growth. The productivity slowdown of the 1970s and 1980s is also well known to us, and its possible causes have been the subject of much research. Labor productivity growth slowed to an average pace of 1.4 percent per year over this period, while multifactor productivity growth fell to a pace of 0.4 percent, the slowest pace of any of the periods shown on the table. Finally, labor productivity growth has averaged about 3 percent at an annual rate since 1995, with higher rates of both capital deepening and multifactor productivity growth contributing to the pickup. Sources of past productivity booms: technological change Although the productivity booms of the past century and a quarter obviously differed in many respects, each episode can readily be associated with the introduction of one or more new technologies. The boom after the Civil War, for instance, appears to have had its genesis in technological improvements that increased the flexibility of production and reduced transportation costs, which allowed firms to take advantage of economies of scale in production and distribution. In particular, the widespread introduction of steam engines and machinery driven by new sources of energy enabled firms to move away from sources of waterpower and closer to areas where inputs including labor and raw materials - were more readily available. The Midwest - where sources of waterpower were less abundant but coal was more abundant - benefited greatly from this development, and indeed within a few decades became known as the “industrial heartland” of the United States. This regional shift in economic activity is illustrated by a sharp rise in the share of personal income generated in the Midwest between 1840 and 1880 (from 20 percent to 35 percent), and the commensurate decline in the share of income generated in the Northeast (from 43 percent to 31 percent).7 The increase in the importance of railroad transportation also helped raise productivity growth in the second half of the nineteenth century.8 Improved methods of steel production - notably, the Bessemer process, and later, Siemens’s open hearth method - enabled railroads to lay longer-lasting steel track rather than iron track. And the growth of telegraphy enabled railroads to better coordinate the movement of trains over a wider area. As a result, railroads expanded their geographic coverage significantly after the Civil War: From 1860 to 1890, the number of main track miles operated by railroad companies more than quintupled, from 31,000 miles to 167,000 miles, while the number of freight cars in operation jumped from 185,000 to more than 1 million.9 The expansion of the railroads drove transportation costs sharply lower and allowed a significant increase in market size. Whereas, in 1830, the transportation of goods from New York to Chicago had required three weeks even during the warmer months of the year, by 1870, it could be accomplished in three days any time of the year.10 In addition, the construction of new rail lines in western states opened those markets to a wide range of East Coast and Midwest manufacturers. Moreover, some of the benefits of the productivity improvements in the railroad industry were passed on to producers in the form of lower costs of transporting goods. Freight rates fell from 2-1/4 cents per ton-mile in 1860 to less than 1 cent per ton-mile by 1890. As a result, the quantity of goods transported by rail increased sharply, from about 12 billion ton-miles in 1870 to 80 billion ton-miles in 1890.11 Easterlin (1961). How much the railroad contributed to economic growth in the late nineteenth century is the subject of some disagreement. See, for example, David (1969), Fishlow (2000), and Fogel (1979). U.S. Census Bureau (1997), Series Q321, and Fishlow (1966). See Paullin (1932). Before the railroads, goods were transported by canals, which often did not operate during the winter. Estimates of track construction, freight rates, and ton-miles transported are taken from Fishlow (1966 and 2000). Another major technological advance in the mid-1800s was the telegraph. Besides aiding the expansion of railroads by improving the coordination of rail traffic, the telegraph sharply reduced the costs of communicating in many other industries. And judging from the rapid growth in its use - the number of messages handled rose from about 9 million in 1870 to nearly 56 million in 1890 - the telegraph undoubtedly contributed to better decisionmaking and higher productivity throughout the economy.12 Agriculture also was increasingly mechanized in the decades immediately after the Civil War, though the change was not as impressive as in the industrial sector. The abundance of land in western states limited the interest among farmers in raising land productivity. However, labor services were more difficult to obtain, so farmers were quite willing to invest in labor-saving machinery. As a result, the better plows, seed drills, reapers, and threshers developed by manufacturers were in high demand by farmers, and the amount of labor required to farm an acre of land fell sharply for many crops.13 In the productivity boom of the early twentieth century, the chief technological innovation was most likely the spread of electrification to the factory floor. As Paul David and others have extensively documented, the use of electric motors in the production process increased substantially in the first quarter of the century.14 In particular, the amount of mechanical energy derived from electric motors rose from 475,000 horsepower in 1899 to nearly 34 million horsepower in 1929, and the fraction of overall factory horsepower produced with electricity rose from less than 5 percent to more than 80 percent over that period.15 A major benefit of electric motors was that they enabled each machine in a factory to be powered by its own motor. This allowed manufacturing plants to be organized in a way that maximized the efficient movement of materials rather than the efficient transmission of power, and it facilitated the spread of continuous processing techniques and the assembly lines made popular by Henry Ford. Indeed, as electric power became less costly - aided by a steep reduction in regulated electricity rates after World War I - its use increased sharply, and factory productivity rose significantly. By one estimate, productivity growth in the manufacturing sector as a whole rose about 5-1/2 percent per year between 1919 and 1929.16 Of course, other technological innovations also contributed to productivity growth during this period. Notable among them were the telephone - which by the 1920s had largely replaced the telegraph; the internal combustion engine, the use of which in motorized vehicles led to sizable productivity gains in the transportation and agriculture sectors; and a variety of technological advances in machine tools. In addition, the early 1900s were characterized by the first wave of office automation equipment, including the portable typewriter and adding and duplicating machines. These machines improved the efficiency of a wide range of management and accounting tasks, and the demand for such equipment rose quite sharply between 1900 and the late 1920s. Indeed, in real terms, business investment in office equipment increased from about $50 million (in 1929 dollars) in 1899 to nearly $500 million in 1929, with a particularly large jump evident in the 1920s.17 The productivity gains of the 1950s and 1960s, in part, had their roots in the technological innovations arising out of research sponsored by the military during World War II.18 For example, although research advances in synthetic polymerization chemistry (most notably, the introduction of catalytic cracking in the processing of crude oil) were made in the 1920s and 1930s, the synthetic rubber program launched during the war led to mass production of the first synthetic polymer from petroleumbased feedstocks. Similarly, production of polyethylene, a petrochemical-based plastic discovered in the 1930s, jumped sharply in the 1940s because of its widespread use in military equipment. And, the military’s need for large stocks of penicillin led to a production process for it that turned out to have applicability to a wide range of pharmaceuticals. U.S. Census Bureau (1997), Series R48. See Atack, Bateman, and Parker (2000). See, for example, David (1990) and Mowery and Rosenberg U.S. Census Bureau (1997), Series P70. Kendrick (1961), p. 152. See Cortada (1993), figure 3.1. This section draws from Mowery and Rosenberg (2000). The commercialization of these wartime innovations sharply increased the number of products made wholly or partly from newly developed plastic polymers and other synthetic materials. The use of polyethylene, for example, grew sharply after the war, while additional technological advances isolated new forms of synthetics and further reduced production costs for chemicals and pharmaceuticals. Overall, production in the rubber and plastic products industry rose nearly 7 percent per year between 1947 and 1970, while the output of the chemical products industry rose more than 8 percent annually over the same period.19 Two other notable technological advances during this period were the invention of the transistor in 1947 and the use of the jet engine in commercial aircraft. Commercial applications of the transistor, initially in solid state consumer electronic products, were stimulated by improvements in the fabrication process (in 1954) and by the introduction of the integrated circuit (in 1958). With the rise in demand, semiconductor production jumped markedly, rising nearly 20 percent per year during the 1960s.20 Similarly, the introduction of the Boeing 707 in 1958 sharply reduced the time and cost of transporting passengers and freight. In particular, according to estimates by Gordon (1992), productivity in the commercial airline industry rose 7 percent per year during the 1960s, well above the rate of labor productivity growth for the economy as a whole.21 For purposes of comparison, the technological origins of the more recent computer revolution also bear a brief mention. Obviously, the invention of the transistor and the development of the mainframe computer were precursors of the technological advances that contributed to the current productivity boom. However, the real drivers of the productivity gains in the 1990s were the related high-tech innovations of the 1970s and 1980s, including the personal computer, fiber optics, wireless communications, and the Internet. Many of the recent technological innovations have significantly altered how firms interact with their customers, in ways that have raised the productivity of the economy. In the retail sector, the Internet stores made popular by Amazon.com have been adopted by nearly all large retail chains; in banking, it is now routine for customers to pay bills online; and for airlines, Internet reservations and e-tickets are the norm. Moreover, throughout the goods economy, from manufacturing to retailing, innovations in inventory management practices made possible by new technologies have substantially reduced costs. An important point about technological change is that, in most cases, the invention of the technologies that stimulated the productivity growth in these boom periods took place well before the productivity gains were realized. For example, the steam engine was invented in the 1700s, well before it had any measurable effect on the production process in the United States. Similarly, railroads were being built in the 1840s, and the first electric power plant was built in 1882. And as we all know, the absence of a significant contribution to productivity growth from computers, which were first introduced in 1945, was a puzzle to many economists as late as the mid-1990s. What then facilitated the translation of these innovations into gains in productivity? At one level, the delay reflected the challenges of developing commercial applications for the new technologies. The lag from a new invention to a new product or process was sometimes quite long because of the additional scientific research required to demonstrate its practicality. In addition, in many cases, new technologies diffused into the capital stock relatively slowly. Replacing older machines with equipment that embodied the new technologies was often not immediately profitable, and thus firms frequently took some time before making the capital investments required to take full advantage of technological progress. Board of Governors of the Federal Reserve System, Indexes of Industrial Production. By comparison, overall manufacturing IP rose about 4-1/2 percent per year from 1947 to 1970. Board of Governors of the Federal Reserve System, Indexes of Industrial Production. Of course, the invention and commercial use of the airplane itself was a technological innovation that predated the jet engine. In particular, the introduction of commercial air travel in the late 1920s represented a substantial improvement over existing forms of passenger transportation. The estimates of Gordon (1992) show that productivity in airline transportation rose about 7 percent per year between 1935 and 1959 as well. Sources of past productivity booms: organizational change A careful examination of past productivity booms also points to substantial changes in business practices and in the organization of firms as a key factor enabling businesses to achieve the potential productivity gains associated with new technologies.22 In many cases, these organizational changes went hand in hand with the technological advances - the changes both being made possible by the new technologies and being necessary to achieve the additional productivity associated with the use of these technologies. For example, before the Civil War, most businesses were either sole proprietorships or partnerships serving local markets and consisted of small shops employing skilled workers involved in each aspect of the production process. At the same time that the spread of railroads lowered transportation costs and increased the size and number of potential markets, the greater availability of steam power enabled manufacturers to set up factories to take advantage of economies of scale in production. As a result, the optimal firm size rose substantially in many industries. In the cotton industry, for example, the median firm size (measured as the annual value of gross production in 1860 dollars) rose from $31,000 in 1850 to nearly $100,000 in 1870; similarly, in the iron industry, median firm size rose from $24,000 in 1850 to more than $200,000 in 1870.23 In addition, large wholesalers (and later, retailers) emerged to take advantage of increased distributional efficiencies to sharply reduce the costs of moving commodities and manufactured goods from the farm or factory to retailers’ shelves. These larger enterprises typically had to confront communications challenges not faced by smaller businesses. In particular, effective internal information flows were often crucial to the success of firms producing or distributing large volumes of inputs and outputs. The telegraph and the railroad-based postal service made prompt communication over great distances possible. But firms also had to set up hierarchical management systems to control the production process and to coordinate the flow of goods across the distribution system in order to take advantage of the economies of scale presented by technological change. Advances in production processes in the early 1900s led to new challenges and opportunities for business organization. As noted above, the diffusion of the electric motor throughout the factory increased the use of continuous-process methods and the assembly line and thus accelerated the trend toward mass production. In addition, as early as the 1880s, manufacturers had begun to integrate forward into distribution; one noteworthy example was the meatpacking industry, in which firms purchased refrigerated rail cars that allowed shipment of beef from centralized slaughterhouses to branch houses that served local markets. The advances in mass production techniques and the increasing complexity of many manufactured products led firms in other industries to integrate forward not only into distribution but also into retailing; this vertical integration reduced transactions costs even more and further increased the optimal size of firms. Indeed, many of the large corporations that arose at this time - Ford, General Motors, and General Electric, for example - are still with us today. The vertical integration of these large corporations, in turn, led to a greater emphasis on nonproduction activities.24 To compete in retail markets, firms needed to understand what products consumers wanted and to enable consumers to associate specific products with a particular firm; in addition, firms needed to establish accounting systems to keep track of a wider range of activities. As a result, marketing and advertising departments arose within large corporations, as did accounting departments. Also, with large corporations now more sensitive to their market share and their cost advantage over their competitors, they began to develop applied research departments to foster innovations in their industries. After World War II, changes in the organization of the firm took two forms. The first was an increasing tendency by corporate managers to split the firms’ operations into separate divisions, each with its own manufacturing and marketing departments. This multidivisional approach was well suited to the technological changes of the 1940s and 1950s, as many innovations during that period led to the Chandler (1977) provides a detailed discussion of such changes. Atack (1986). This section draws from Galambos (2000). manufacturing of diverse product lines by a single company, DuPont and Monsanto being key examples.25 This multidivisional structure also turned out to be an effective method of handling corporate operations in different geographic areas; and indeed, the second major organizational innovation during this period was the rise of the multinational corporation. After World War II, new trade agreements and efforts to revitalize Europe and Japan allowed American firms to make significant inroads into foreign markets. To handle these long-distance operations more easily, corporations often set up foreign subsidiaries that could adapt quickly to changing circumstances in the host country’s marketplace. By one estimate, such multinational corporations accounted for nearly 35 percent of total U.S. corporate assets by 1966.26 Organizational structure during the productivity boom of the late 1990s has, in some respects, shifted away from the large corporations that dominated the U.S. economy during much of the twentieth century. To be sure, the marketplace in many industries is still dominated by large, well-established firms. And in some industries - the financial services sector comes to mind - recent technological innovations have, if anything, increased the scale of business. But in other industries, intense global competition has motivated many corporations to narrow their focus to core production-related activities and to outsource other functions. Increasingly, these supporting firms are providing their services from overseas, taking advantage both of lower labor costs there and of the revolution in communications. At the same time, much of the rapid technological innovation in this period has occurred outside the large corporate sector, and the success of that innovation has boosted the pace at which new ventures are being created. For example, more than 700,000 new businesses were incorporated each year, on average, in the 1990s, about double the pace of the 1970s.27 Of course, as we know from the dot-com experience, many of these firms failed. However, many others either grew or were bought by larger firms better able to market and distribute the most promising innovations. Sources of past productivity booms: financial market change A third major ingredient in promoting the productivity gains associated with technological innovation has been a complementary set of innovations in the financial sector that have changed the financial landscape in ways that were especially appropriate to the predominate form of business organization in each period.28 For example, before the Civil War, most nonfinancial business investment was financed internally with retained earnings, with capital provided by family or friends, or through partnerships formed with other proprietors. The chief exceptions were the canals and railroads, which were actively issuing stocks and bonds in the 1850s.29 With the need for greater capital investments and the sharp increases in the scale of operations of many firms after the Civil War, however, businesses in other industries also began to look more toward external sources of financing. The main sources of funding in the decades after the Civil War were debt and preferred stock.30 Debt often took the form of secured loans, in large part because investors were concerned about the informational asymmetries they faced in evaluating the bankruptcy risk of particular firms. In addition, the owners of many firms often preferred financing with debt rather than common stock because they did not want to see their equity diluted or their control of the enterprise diminished. Similarly, preferred stock, which reduced bankruptcy risk but did not dilute the equity of the owners of the firm, was often used when assets were insufficient to secure the loan. Thus, despite the prevalence of information problems, financial intermediaries were able to provide firms with external sources of funds, making possible the rapid buildup in the capital stock that took place in the late 1800s. For example, the total Baskin and Miranti (1997). U.S. Bureau of Economic Analysis (1966). U.S. Census Bureau (2001). This section draws from Baskin and Miranti (1997) and White (2000). Chandler (1977). As Fishlow (2000) notes, an exception to this were railroad companies, which sold sizable amounts of common stock to investors seeking large capital gains following the completion of new construction projects. value of bank loans rose from less than $1 billion in 1870 to more than $6 billion in the early 1890s, a notable increase in nominal value during a time when, if anything, the aggregate price level was falling.31 In contrast, the years after World War I were characterized by an increase in the importance of equity markets. At the New York Stock Exchange alone, the volume of stock sales rose from 186 million shares in 1917 to more than 1 billion shares in 1929.32 And, by one estimate, the number of individuals holding stock increased from 500,000 in 1900 to 10 million by 1930.33 The rise in the public’s interest in common stock occurred for several reasons. First, and probably most importantly, the profitability of large corporations during the early 1900s was accompanied by an expanding middle and upper class that wanted to take part in the economic gains associated with the introduction of new technologies such as the internal combustion engine and the electric motor. As the main way to share in these capital gains was to purchase some ownership in those corporations, these individuals increasingly looked to invest their savings in the stock market. At about the same time, the informational problems that had constrained interest in common stock through the early 1900s were being reduced. Rising demand from investors in the late 1800s for information about railroad companies had led to the proliferation of newsletters watching developments in that industry, and similar publications soon sprang up to provide information on other traded securities. These newsletters eventually evolved into ratings agencies covering a wide range of individual corporations, with Moody’s issuing the first bond ratings in 1909. Although these agencies’ ratings focused on corporate bond issues, many also provided economic forecasting services and more detailed information about the relative risk of specific companies. In addition, with a greater recognition of the need to address investors’ concerns about risk, more public companies regularly issued audited financial statements.34 Interest in common stock was also boosted by the tendency to imbue them with characteristics similar to those associated with debt, with which investors were more familiar. For example, businesses frequently attempted to establish steady dividend streams in order to boost investors’ confidence about the future profitability of the firm and encourage holdings of their securities. Finally, the marketing of securities to the household sector became more aggressive in the 1920s, led by investment trusts - which offered investors a means of diversifying individual portfolios - and retail brokerage firms. Given the relative prosperity of the post-World War II period, nonfinancial corporations were able to generate significant increases in internal funds. Even so, the growth of investment spending over this period noticeably outpaced the rise in retained earnings, and thus these corporations turned to the capital markets to fill the widening gap. In response, both bond and equity issuance rose rapidly in absolute terms, and the ratio of external financing to overall capital spending increased from an average of around 30 percent in the late 1940s to more than 40 percent in the early 1970s.35 There were two specific developments in financial markets during this period that bear mentioning. First, the late 1950s and 1960s saw the rise of the Eurodollar market - a market for U.S. dollar deposits and loans outside the United States, and at least initially in Europe. Although the origin and early development of the Eurodollar market is attributed, in part, to a desire by holders of dollars to avoid U.S. regulations, including the Regulation Q interest rate ceilings, that market subsequently became a useful source of short-term financing - complementary to the commercial paper market - for large corporations seeking alternatives to more costly domestic commercial bank loans.36 Second, the 1950s and 1960s were characterized by a sharp rise in the importance of large institutional investors especially pension funds - in the stock and bond markets. This rise, coupled with the growth of mutual U.S. Census Bureau (1997), Series X581. U.S. Census Bureau (1997), Series X531. Hawkins (1963). Miranti (2001). Board of Governors of the Federal Reserve System, Flow of Funds Accounts. See Johnston (1982) and Kindleberger (1993). Although no direct data on the size of the Eurodollar market are available, flow of funds data indicate that foreign holdings of U.S. corporate bonds rose from about $500 million in the mid-1950s to about $2 1/2 billion in 1970. funds and brokerage houses, enabled smaller investors (either explicitly or implicitly) to further diversify their portfolios. More recently, financial markets have continued to evolve to meet the financing needs of the business sector and the concerns of investors. In particular, in response to the proliferation of start-up businesses and, for many firms, a riskier economic environment, financial intermediaries have expanded the range of financing alternatives available to businesses and have made marked improvements in quantifying and managing risk. For larger lower-rated corporations that have significant default risk, the expansion of the so-called junk bond market has offered the capability to raise funds even when other sources of financing were less available. For example, junk bond issuance rose from about $11 billion in 1984 to more than $100 billion in 2001, while the par value of outstanding junk-rated debt has increased from less than $100 billion in the mid 1980s to nearly $700 billion today.37 For smaller and yet-riskier firms, venture capital and initial public offerings have been important sources of financing. For example, venture capital investments, which were negligible in the early 1980s, rose to more than $100 billion in 2000, although they have since dropped back.38 Similarly, initial public offerings for nonfinancial companies (excluding spinoffs and leveraged buyouts) exploded from less than $5 billion per year in the late 1980s to roughly $30 billion in 2000.39 In terms of managing risk, many large financial institutions have, over the past decade, increasingly adopted internal credit-risk models to improve their ability to assess in real time the riskiness of their portfolios. In addition, financial-market innovations, including securitizations, credit derivatives, and an improved secondary loan market, have allowed these institutions to better manage their exposure to such risks. These improvements in risk management may help to explain why financial institutions weathered the recent economic downturn so well relative to their difficulties in previous recessions. Sources of past productivity booms: human capital accumulation The fourth ingredient underlying the productivity booms of the past involves labor input-specifically, the availability of a workforce capable of bringing to fruition the possibilities opened up by the technological innovations. Technological advances have not increased the demand for all skill sets equally. For example, the shift in manufacturing production from artisanal shops in the mid-1800s to factories after the Civil War led to a disproportionate increase in the demand for unskilled labor to operate the new machines. But, as I noted earlier, increases in the optimal size of firms and the growth of businesses dedicated to mass distribution and mass production also increased the demand for workers who could perform clerical and managerial tasks. Indeed, the percent of men who were employed in white-collar occupations rose from less than 5 percent in 1850 to nearly 18 percent by 1900.40 The demand for white-collar workers continued to increase in the early twentieth century with the further expansion in corporate size and the new focus on activities outside traditional production. In particular, these additional activities required a new set of managers to control and coordinate the diverse functions of the corporation and an increase in clerical workers to process the increased flow of information associated with vertical integration. As a result, nonproduction workers as a share of the total labor force rose from 6-1/2 percent in 1880 to nearly 25 percent by 1930.41 Moreover, contrary to what had been true earlier, manufacturing firms that were using more advanced technologies in the early 1900s also tended to hire more-capable and more highly educated workers. In particular, in the 1920s, the industries that were more likely to employ high-school-educated bluecollar workers tended to be the same industries that were further along in adopting the new technologies, suggesting that the basic reading and mathematics skills acquired in high schools were Based on data from Thompson Financial Securities Data Corporation and Moody’s Investors Service. PricewaterhouseCoopers/Thomson Venture Economics/National Venture Capital Association, MoneyTree Survey. Thompson Financial Securities Data Corporation. Margo (2000), pp. 215-16. Beniger (1986). valued by firms in these industries. That wage levels in these industries tended to be higher than for the manufacturing sector as a whole is a further indication that they employed workers with more skills.42 Similarly, throughout the rest of the twentieth century, skilled labor and new technologies appeared to be complements in production. The 1950s and 1960s saw a significant increase in the share of the workforce in professional and technical occupations, with especially rapid growth among engineers and technicians.43 And the 1980s and 1990s saw a rise in the wage premium for higher-skilled workers, as well as a sharp increase in the demand for workers with computer-related skills. In contrast, lower-skilled workers have suffered in recent years from competitive pressures that are related in part to the outsourcing of low-skilled jobs abroad. The institution of universal education in the United States has allowed our workforce to adapt to the changing skill requirements of the economy. In the late 1800s, school enrollment rates among children held steady at about 50 percent and high school graduation rates remained below 5 percent, a pattern consistent with the absence of a significant wage premium for educated labor. However, as the premium for education widened in the early 1900s, enrollment rates in secondary schools increased steadily, and the high school graduation rate rose to more than 25 percent by the late 1920s. Similarly, partly reflecting rising demand for college-educated labor in the 1950s and 1960s, the percentage of 18 to 24 year olds enrolled in college rose from about 14 percent in 1950 to roughly 25 percent in 1970.44 After stagnating in the 1970s and 1980s, college enrollment rates among youths began to rise again in the 1990s, reflecting a further widening in the skill premium for workers with a college degree. Moreover, enrollments at community colleges increased about 30 percent between 1985 and 2000, and the percent of adults attending an education program rose from 33 percent in 1991 to 45 percent in 1999, with a particularly large increase evident for the unemployed.45 These changes likely reflect, in part, efforts by lesser-skilled adults to retool their skills. In sum, the productivity booms of the past seem to have involved four key ingredients: technological innovation; the willingness and ability of owners and corporate managers to reengineer the internal organization of their firms to take maximum advantage of those innovations; complementary innovations in the financial sectors specifically tailored to the forms of business organization predominating at the time; and the availability of a workforce sufficiently educated to actualize the potential implicit in the technological innovations. From the standpoint of economic policy, we undoubtedly stand to learn a number of valuable lessons from these similarities, but let me touch on a few that I think are particularly important. Lessons from past productivity booms First, many of the technological innovations associated with past productivity booms were general purpose technologies (GPTs) with widespread applicability. Such technologies have operated through a variety of channels, raising productivity not only in production, but also in distribution and business practices. In many cases - railroads and computers, for example - the productivity improvements were initially most pronounced in the production of the capital equipment embodying the new technologies. In particular, Fishlow (1966) estimates that multifactor productivity in the railroad industry rose nearly 4 percent per year, on average, between 1840 and 1900, as compared with increases of around 1 percent per year for the economy as a whole. And, Oliner and Sichel (2002) estimate that since 1990, efficiency gains in the production of high-tech equipment have accounted for about half of overall multifactor productivity growth in the nonfarm business sector. In addition, such general purpose technologies typically draw in substantial amounts of new investment capital. For example, See Goldin and Katz (1998). U.S. Census Bureau (1997), Series D233-D682. U.S. Census Bureau (1997), Series H433, H701. The increase in college enrollments during this period likely was also boosted by the use of college deferments during the Vietnam War. U.S. Department of Education, Digest of Education Statistics. Owing to data limitations, this measure includes adults enrolled in personal development programs. In 1999, for which more detailed information is available, roughly one-third of adults were participating in post-secondary education or career-related courses. Fishlow (2000) points out that in the 1870s, investment in transportation facilities amounted to more than 15 percent of capital formation. Similarly, in 2003, investment in high-tech equipment as a share of overall business fixed investment stood at 42 percent, up from 19 percent in 1980.46 The importance of general purpose technologies raises the question of whether governments should attempt to stimulate the development of particular GPTs, perhaps through some type of industrial policy. To be sure, government intervention has, at times, contributed to specific technological innovations. Government support in the 1800s - through federal land grants and state and local aid was one source of financing for railway construction in the 1850s and after the Civil War. Military support for chemical research that focused on developing new materials during World War II obviously contributed to productivity gains in the private sector in the 1950s and 1960s. And, the Department of Defense supported the development in the 1960s of the ARPANET, the predecessor of the Internet of today. However, many, if not most, of the general purpose technologies of the past two centuries have had their genesis in the private sector. The steam engine, the electric motor, and the computer were developed and diffused through the economy largely as a result of the profit opportunities afforded by those new technologies. And, even for railroads, external financing came primarily from private domestic or foreign sources; estimates place the proportion of government funding in nominal investment by railroad companies at less than 10 percent after the Civil War.47 In the United States, the government has contributed most effectively to technological change by promoting an economic, financial, and legal environment that is conducive to innovation and to the diffusion of new technologies. Federal funding of basic research, often in research universities or federal laboratories, obviously comprises an important part of this contribution. However, another key component of this environment has been the protection of intellectual property rights. Patent laws in the United States have encouraged innovation by attempting to strike a careful balance - allowing the inventors of new technologies to reap the benefits of their innovations, while at the same time encouraging the timely diffusion of new technologies and limiting the damage from monopoly power.48 In the past, patent laws have primarily emphasized protection of the new technologies or production processes associated with invention. Given that recent innovations have, to an increasing extent, encompassed the transformation of electronic data to create new methods of business practices, the challenge today is to ensure that such innovations are afforded the appropriate degree of protection ensuring that innovators are rewarded for their ideas but not granting them so wide a range of territory in the property-rights battlefield that they acquire a stranglehold on the economy and, perversely, are allowed to choke off the innovation that they helped create.49 Similarly, allowing businesses the flexibility to reorganize their operations in ways that permitted them to take maximum advantage of new technologies has been instrumental in translating technological innovations into higher productivity in all four episodes. Likewise, U.S. labor markets have been quite effective at reallocating the workforce in response to technological changes. Of course, some government regulation of business and labor markets is absolutely essential, but such regulatory policies must be designed taking account not only of perceived advantages but also of economic costs. For example, it seems clear in retrospect that the deregulation of a number of industries in the 1970s and 1980s, such as airlines, trucking, financial services, and natural gas, ultimately provided an important boost to productivity growth by allowing businesses in those industries to operate with fewer constraints and more flexibility.50 Fishlow (2000) and Mowery and Rosenberg (2000) also note the importance of intersectoral linkages between new technologies and other industries. In the nineteenth century, for example, the construction of railroads had backward linkages to the coal, iron and steel, and machinery industries and forward linkages to the distribution sector. Likewise, in the twentieth century, the innovations in electricity, chemistry, and the development of the internal combustion engine led both to widespread productivity improvements in mature industries and the creation of new industries. Fishlow (2000). Engerman and Sokoloff (2000). Some observers have also emphasized that technological diffusion can be effectively achieved through the sharing of information or collective invention. See Meyer (2003), who points to the technological improvements in steel production in the 1800s and in personal computers in the 1970s as examples of such networking gains. For a discussion of patent policy in the context of financial market innovations, see Ferguson (2003). See Winston (1998) for a summary of the evidence. In a different vein, one must note the ongoing debate about whether protectionist measures - such as tariffs and quotas - might also be helpful in raising long-run productivity growth by encouraging the diffusion of new technologies into the domestic capital stock. For example, the tariffs that protected domestic markets from foreign competition in the 1800s are viewed by some observers as having provided manufacturers the opportunity to expand more rapidly.51 However, even then, the American economy benefited considerably from free trade in intellectual property by exploiting technologies that had been invented abroad. Moreover, the experience of other periods of American history demonstrates that protectionist measures are not an effective means of promoting the diffusion of technology in a more developed economy. The detrimental economic effects associated with the passage of the Smoot-Hawley tariffs in 1930 provide one important example. And, in the post-World War II period, the relaxation of trade restrictions opened up important foreign markets to the new products being developed by U.S. corporations. More generally, the United States has, over time, consistently and successfully responded to competitive pressures from abroad, often through technological innovations that create new markets and opportunities. Another lesson from past productivity booms is that the willingness of investors to hold securities is crucial for firms to raise the working capital they need to take advantage of the productivity potential of new technologies. For instance, as I noted earlier, the information problems of the late 1800s and early 1900s constrained interest in common stock, and this reluctance by investors to hold equity presumably raised the overall cost of capital. Similarly, unless the corporate governance issues of the past few years are aggressively addressed, the damage to the financial intermediation process will undoubtedly result in a higher cost of capital. In this regard, prudent regulation of financial markets is extremely important, and a crucial aspect of this regulation has been the requirement that firms provide information that is extensive, accurate, and interpretable in a straightforward manner. Government involvement in providing broad access to education has also played an important role in stimulating economic growth by continually improving the ability of the workforce to adapt to technical change. In the past, a basic facility for reading and arithmetic were essential to workers in a wide range of occupational settings, and American schools effectively provided these skills to our youths. In the economy of the future, the educational requirements of the population will be even greater. Not only will workers need basic skills in math and language, but they also will increasingly require knowledge of basic and applied science - as well as the ability to acquire new skills when required by their jobs. As a result, continued public recognition of the value of education as well as ongoing efforts to ensure widespread access to a high caliber of schooling at all levels will be indispensable. Of course, I would be remiss if I did not also comment on the importance of sound macroeconomic policies in promoting long-run economic growth. Evidence clearly points to a correlation between low inflation and strong productivity growth. And while it is difficult to identify a strong causal relationship between a healthy economy and productivity, a couple of casual empirical observations are suggestive of a link. First, the number of patent applications tends to be higher in good economic times than during recessions.52 If patenting is a valid measure of technological change, such a correlation suggests that innovation is stimulated by healthy economic conditions. Second, and perhaps more important, business fixed investment - and thus the diffusion of new technologies through renewal of the capital stock - is likely to be better maintained in an economic environment characterized by the robust profit opportunities and lower uncertainties afforded by sustainable economic growth and low inflation. Why do productivity booms end? To complete my discussion, I want to turn briefly to the question of why periods of strong trend productivity growth come to an end. Several hypotheses have been put forth, including (1) that successful new technologies eventually lead to financial imbalances and overinvestment associated with excess optimism, (2) that periods of strong productivity growth eventually run out of steam as the There is considerable debate on this issue. See Lipsey (2000) for a brief summary. Engerman and Sokoloff (2000) point out that the growth in patenting was especially high in the 1850s and 1880s, both periods of rapid economic growth. Similarly, Griliches (1990) finds a positive coefficient on real GDP growth in a regression relating the growth in patent applications to changes in real GDP and gross private domestic investment for the period 1880 to 1987. Geroski and Walters (1995) find a similar result for the United Kingdom. productivity - increasing opportunities associated with new technologies are exhausted, and (3) that exogenous shocks bring an end to boom periods. Although elements of these three hypotheses can be seen in the past episodes of productivity booms, no clear pattern emerges. Regarding the first hypothesis, support can be found in the soaring stock prices of the late 1870s, the 1920s and the late 1990s, which in all three cases were coincident with a period of very rapid productivity growth and were followed (eventually) in the first two cases by a collapse in stock prices and economic depression. In contrast, the steady rise in equity values during the 1960s did not appear to be associated with the emergence of any significant financial imbalance, and the subsequent decline in stock prices in the mid-1970s may owe importantly to the failure of economic policy to react to the changing dynamics of the economy and thus to control inflation. Similarly, in certain industries - most notably automobiles and electric utilities - a speculative rise in capital spending during the 1920s arguably did result in a significant overbuilding of capacity by the end of that decade. But such instances are more difficult to find in the late 1800s and in the 1960s. And, while there does appear to have been an overinvestment in high-tech and telecommunications equipment in the late 1990s, the recent productivity data certainly do not suggest that this overinvestment has ended the current productivity boom. The hypothesis that productivity booms end when innovation and technical change levels off is difficult to test for the 1800s and early 1900s because of a lack of data. Arguments along this line, which surfaced to explain the productivity slowdown of the 1970s, pointed to the deceleration in the growth of research and development (R&D) spending in the late 1960s as evidence. However, Griliches has argued convincingly that this shortfall in R&D spending was not of sufficient magnitude to contribute very much to the productivity slowdown. But, even if the notion that technological innovations are eventually exhausted is valid, we have no evidence that this is as yet a significant risk to the current productivity boom. Both industrial R&D and patent applications have risen rapidly in recent years, suggesting that innovation - and the potential productivity gains associated with technological progress - will likely remain an important source of economic growth in the United States in coming years. Finally, some role for exogenous shocks is also evident in past episodes, depending on how broadly one defines an exogenous shock. The 1973 oil shock is perhaps is the most convincing example, although the extent to which this ended the “golden era” is still the subject of much discussion. In addition, the bank panic of 1893 is viewed by some as an important contributor to the depression of the 1890s; however, whether this event is an exogenous shock or an indication of earlier economic excess (as in 1929) is debatable. Of course, we have also experienced significant exogenous shocks in recent years - including 9/11, the Iraq conflict, and a variety of corporate scandals. It is encouraging that the economy seems to have successfully weathered these recent shocks with no significant harm to productivity growth. Conclusion All of us as government economists, policymakers, and citizens have a stake in learning the lessons from past productivity booms. As I have said, productivity improvements translate directly into improvements in the standard of living. Economists will continue to debate the relative importance of various factors underlying productivity growth. But our experience in the United States clearly suggests that periods of relatively rapid trend productivity growth are characterized by innovations in technology that are accompanied by changes in organizational structure and in business financing arrangements and by investments in human capital. Productivity booms in the United States have been of varying duration, but we have seen two of them last as long as twenty years. We do not know definitively what brings these booms to an end. In our experience, however, periods of elevated increases in trend productivity are best fostered in an environment of economic and personal freedom and government policies that are focused on erecting sound and stable macroeconomic conditions that are most conducive to private-sector initiative. US Productivity growth, 1873-2003 (Average annual percent change) Labor Multifactor Capital deepening and other 1873-2003 2.02 1.33 0.73 Episode I 1873-90 2.6 0.9 1.7 1890-1917 1.5 0.8 0.7 Episode II 1917-27 3.8 2.8 1.0 1927-48 1.8 1.7 0.1 Episode III 1948-73 2.9 1.9 1.0 1973-95 1.4 0.4 1.0 Episode IV 1995-2003 2.92 1.03 1.63 Period Includes changes in labor composition. Based on data through 2003:Q3. Based on data through 2001. Source: Kendrick (1961) and U.S. Bureau of Labor Statistics.
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board of governors of the federal reserve system
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Speech by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the meetings of the American Economic Association, San Diego, 4 January 2004.
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Ben S Bernanke: Monetary policy and the economic outlook - 2004 Speech by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the meetings of the American Economic Association, San Diego, 4 January 2004. The references for the speech can be found on the Board of Governors of the Federal Reserve System’s website. * * * The turn of the year is the traditional time to review the high and low points of the year just past and to contemplate the challenges that lie ahead in the year just begun. In that spirit, I will provide a brief progress report on the economic recovery, as well as some remarks on the evolution of monetary policy. As always, the views I will express are my own and are not to be attributed to my colleagues on the Board of Governors or the Federal Open Market Committee.1 It is beginning to appear that 2003 was a watershed year for the American economy, following what had been, on many dimensions, a subpar performance for the better part of three years. Though officially the recession lasted only eight months, from March to November 2001, a period of economic underperformance began with the sharp decline in stock prices and business investment in mid-2000 and continued through the months leading up to the Iraq war this past spring. To a degree that is unusual for postwar recessions, the economic weakness of the period was most apparent in the business sector, even as consumer spending and residential construction remained robust. Businesses radically pared their spending on new capital goods and cut the ratio of inventory stocks to sales to historical lows. In an effort to restore profitability in an environment of weak demand and nonexistent pricing power, businesses also worked hard to improve efficiency and cut costs. These efforts have paid off in terms of remarkable increases in productivity, but, together with insufficient growth in aggregate demand, they also contributed to a significant decline in employment. Like the aftermath of the 1990-91 recession, the two years since the recession trough in November 2001 have been described as a “jobless recovery.” Indeed, the lag between the recovery in output and the recovery in employment has been significantly greater this time than it was after the 1990-91 downturn. Monetary policy was deployed to support the weakening economy, as the Federal Open Market Committee (FOMC) aggressively cut rates in 2001 and has continued its policy of accommodation since then. Fiscal policy, including two rounds of tax cuts, has also been highly stimulative. However, despite some early promise, initially the upturn proved halting and erratic. Policymakers and privatesector economists recognized early on that a balanced recovery would require willingness on the part of the business sector to begin investing and hiring again, but forecasts of improved business sentiment repeatedly proved wrong, or at least premature. In some sectors, such as nonresidential construction and communications, capital overhangs and capital misallocation, the result of the earlier boom, reduced both the need and the financial capacity to invest. Importantly, the economy was also hit by a succession of shocks - notably the September 11, 2001, terrorist attacks, the corporate governance and accounting scandals of the summer of 2002, and the Iraq war in the spring of 2003 each of which created new uncertainties and left its mark on business confidence. Despite all this adversity, there could never have been any doubt that the diversified and resilient U.S. economy, assisted by ample monetary and fiscal stimulus, would eventually stage a comeback. After several false starts, it now appears that that comeback began in earnest in the summer of 2003. As you know, the third quarter of the year displayed near-record levels of real economic growth, in the vicinity of 8 percent at an annual rate, and growth appears to have continued strong in the fourth quarter of 2003. The most heartening aspect of this vigorous expansion is that, finally, the business sector appears to have emerged from its funk. Corporate investment has been strong, particularly in equipment and software, and there are some recent signs that both inventory investment and hiring have begun to pick up. Of course, downside risks to the economy remain: The recovery in capital investment may prove less durable than it now appears, the moderation of fiscal stimulus in the latter part of next year could Thanks are due to Sandy Struckmeyer and members of the Board staff for useful comments and assistance, but they are likewise not responsible for the views expressed here. adversely affect household spending, or new unfavorable shocks - geopolitical or otherwise - may yet appear. Still, the incoming data have continued for the most part to surprise on the upside, and the odds accordingly have increased that 2003 will be remembered as the year when this recovery turned the corner. Private-sector forecasters generally expect real growth to be approximately 4 percent in 2004, and they foresee modest improvements in the unemployment rate this year and continued reductions in unemployment in 2005. I think these predictions are broadly reasonable, and indeed I would not be surprised if the pace of real growth next year exceeded 4 percent. With this generally upbeat scenario in mind, some observers in the markets and the media have questioned the appropriateness of the current stance of monetary policy. Certainly, the policy stance we have today is historically unusual. More than two years after the recession trough, and following several quarters of strong growth, the historically normal pattern would be for the Fed to be well into the process of tightening policy by now. Instead, the FOMC has held its policy instrument rate, the federal funds rate, at the very low level of 1 percent. I would like to take some time now to explain why I believe this policy remains appropriate, despite its historically unusual character. The positive case for maintaining an accommodative monetary policy at this stage of the recovery has three elements, some of which will be familiar to many of you, at least in broad outline. First, core inflation rates in the United States are as low today as they have been in forty years, and they have been trending downward. For example, the twelve-month inflation rate as measured by the consumer price index, current-methods basis and excluding food and energy prices, was 2.7 percent at the recession trough in November 2001. This measure of core inflation fell to 2.0 percent as of November 2002 and to only 1.1 percent as of November 2003. Other measures of core inflation, such as the one based on the chain price index for personal consumption expenditures, have displayed a similar pattern. Inflation is not simply low; for my taste, it is very nearly at the bottom of the acceptable range for (measured) inflation. In contrast, in previous episodes of recovery, inflation was above the range consistent with price stability, so that a tightening of monetary policy at an earlier stage of the expansion represented the prudent response to inflation risks. Because inflation is so low today, monetary policy can afford to be more patient to ensure that the recovery is self-sustaining. The second unusual aspect of the current situation relevant for monetary policy is the truly remarkable increase in labor productivity that firms and workers have achieved in recent years. Those productivity increases affect the inflation outlook in two related ways: first, by raising potential output and thus (for given growth in aggregate demand) the size of the output gap; and, second, by reducing the costs of production, which puts downward pressure on prices. I will first address the effect of productivity on costs, returning later to the link of productivity and the output gap. Labor costs account for the lion’s share, about two-thirds, of the cost of producing goods and services. The labor cost of producing a unit of output depends, first, on the dollar cost per hour (including wages and benefits) of employing a worker and, second, on the quantity of output that each worker produces per hour. When the cost per hour of employing a worker rises more quickly than the worker’s hourly productivity - the historically normal situation - then the dollar labor cost of producing each unit of output, the so-called unit labor cost, tends to rise. Recently, however, labor productivity has grown even more quickly than the costs of employing workers, with the result that unit labor costs have declined in each of the past three years. Indeed, in the second and third quarters of 2003, unit labor costs in the nonfarm business sector are currently estimated to have declined by a remarkable 3.2 and 5.8 percent, respectively, at annual rates. Again, because labor costs are such a large part of overall costs, and because capital costs have also been moderate, the business sector has enjoyed a net decline in total production costs. A decline in production costs must result in lower prices for final consumers, an increased price-cost markup for producers, or both. In practice, both have occurred in recent years: Firms have passed on part of the reduction in costs on to final consumers in the form of lower (or more slowly rising) prices, and pricecost markups (as best we can measure them) have risen well above their historical averages. The high level of markups is an important and perhaps insufficiently recognized feature of the current economic situation. To the extent that firms can maintain these markups, profits will continue to be high, supporting investment and equity values. To the extent that product-market competition erodes these markups, as is likely to occur over time, downward pressure will be exerted on the inflation rate, even if, as is likely, the recent declines in unit labor cost do not persist.2 The third unusual factor is the persistent softness of the labor market. As I already noted, fully two years after the official recession trough, we are only just beginning to see significant gains in employment. Of course, the unemployment rate, at about 6 percent of the labor force, is not exceptionally high by historical standards, and one can debate the degree to which structural change and other factors may have affected the level of employment that can be sustained without overheating the economy. Assessing the amount of slack in the labor market is very difficult and ultimately a matter of judgment. Reasonable people can certainly disagree. However, my sense is that, when one looks at the full range of information available, the labor market looks (if anything) weaker than a 6 percent unemployment rate suggests. For example, it appears that workers who have lost their jobs in the past couple of years have been more likely to withdraw from the labor force (rather than report themselves as unemployed) than were job losers in previous recessions. Indeed, the labor force participation rate fell sharply between 2000 and 2003, from a little over 67 percent to about 66-1/4 percent. Similarly, the ratio of employment to the working-age population, a statistic that reflects both those who become unemployed and those who leave the labor force, has fallen significantly, by 2.8 percentage points between its peak in April 2000 and its trough this past September. The tendency of recent job losers to leave the labor force likely masks some of the effects of job cuts on the unemployment rate, so that the current measured level of unemployment may understate the extent of job loss or the difficulty of finding new work. Of course, a labor market that is slack and improving only slowly is likely to produce continued slow growth in nominal wages, contributing to continued moderate growth in costs. Why has the labor market remained relatively weak, despite increasingly rapid growth in output? I addressed the causes of the “jobless recovery” in an earlier talk (Bernanke, 2003). Although many factors have affected the rate of job creation, I concluded in my earlier analysis that the rapid rate of productivity growth, already discussed in relation to unit labor costs, has also been an important reason for the slow pace of recovery in the labor market. All else equal, strong productivity gains allow firms to meet a given level of demand with fewer employees. Thus, for given growth in aggregate spending, a higher rate of productivity growth implies a slower rate of growth in employment.3 To summarize, then, the current economic situation has three unusual aspects, which together (in my view) rationalize the current stance of monetary policy. First, inflation is historically low, perhaps at the bottom of the acceptable range, and has recently continued its decline. Second, rapid productivity growth has led to actual declines in nominal production costs, which reduce current and future inflationary pressures. Finally, the labor market remains soft, reflecting the fact that growth in aggregate demand has been so far insufficient to absorb the increases in aggregate supply afforded by higher productivity. A soft labor market will keep a lid on the growth in the cost of employing workers. An accommodative monetary policy is needed, in my view, to support the ongoing recovery, particularly in the labor market. At the same time, the risks of policy accommodation seem low, as inflation is low and inflation pressures seem quite subdued. These arguments notwithstanding, I realize that some remain unconvinced that the FOMC is pursuing the right course. Citing factors such as the rise in commodity prices and the decline of the dollar, a number of observers have warned that the Federal Reserve’s policies risk re-igniting inflation. I would like to address these concerns briefly. Naturally, I will try to show why these arguments are not of immediate concern, given the three points I made earlier in support of the current accommodative policy. Before I do that, though, I would like to emphasize to those uncomfortable with the Fed’s policy stance that, speaking for myself at least, their views are being heard and taken seriously. Achieving price stability in the United States was an historic accomplishment, and preserving that legacy is crucially important. I say that not only because I think that price stability promotes long-run growth and efficiency, which I do, but also because I believe that low inflation and well-anchored inflation As employment begins to pick up and the recovery matures, productivity growth is likely to decelerate, perhaps markedly. Nevertheless, slow growth in wages and the return to normal of price-cost markups should help keep inflation low. Of course, all else is not necessarily equal. In general, one would expect strong productivity growth to expand aggregate demand, for example, by stimulating capital formation. However, the stimulative effect of productivity growth on demand appears to have been weaker than normal in recent years (Kohn, 2003). Also, the conclusion that productivity growth has contributed to weak job growth in the short run is in no way inconsistent with the view that productivity growth raises wages and living standards in the long run, when full employment has been restored. expectations are critical to maintaining economic stability in the short run. Price stability is of utmost importance to the nation’s economic health, and I believe that the FOMC will do whatever is necessary to be sure that inflation remains well contained. With that preface, I will address briefly a few concerns of those who worry that inflation is poised to rise, beginning with the recent behavior of commodity prices. A number of commodity price indexes have indeed risen sharply over the past couple of years, including a large jump in the past several months. This acceleration has been broadly mirrored in the behavior of the core producer price indexes (PPIs) for crude and intermediate materials, probably the best and most comprehensive measures of prices at early stages of processing. Specifically, over the past two years, the twelve-month change in the core PPI for crude materials has risen rather dramatically, from –9.4 percent to 17.1 percent, and the twelve-month change in the core PPI for intermediate materials has risen from –1.3 percent to 1.8 percent. Do these developments imply a significant increase in inflation risk at the level of the final consumer? The answer is almost certainly not. Two points should be made. First, the recent movements in commodity prices are hardly surprising; they are in fact quite normal for this stage of the business cycle. The acceleration in the core PPI for crude materials that we have seen is about what should have been expected, given the increases that have occurred recently in both domestic and worldwide economic activity.4 The increase in the demand for commodities from China alone has been substantial; for example, that country’s share of world copper consumption is estimated to have risen from less than 5 percent in 1990 to 20 percent in 2003. The much more moderate acceleration in intermediate goods prices can likewise be traced to the increase in economic activity, with some additional effect coming from the decline in the dollar and the indirect impact of increases in energy prices. Second, the direct effects of commodity price inflation on consumer inflation are empirically minuscule, both because raw materials costs are a small portion of total cost and because part of any increase in the cost of materials tends to be absorbed in the margins of final goods producers and distributors. Accelerations in commodity prices comparable to or larger than the most recent one occurred following the 1981-82 and 1990-91 recessions, as well as in 1986-87 and 1999, with no noticeable impact on inflation at the consumer level.5 A reasonable rule of thumb is that a permanent 10 percent increase in raw materials prices will lead to perhaps a 0.7 percent increase in the price of intermediate goods and to less than a 0.1 percent increase in consumer prices. Thus the recent acceleration in commodity prices, even if it were to persist (and futures prices suggest that it will not), would likely add only a tenth or two to the core inflation rate. In short, rising commodity prices are a better signal of strengthening economic activity than of inflation at the consumer level. Two specific commodity prices that often command attention are the prices of gold and crude petroleum. The price of gold has increased roughly 60 percent since its low in April 2001, from about $255 per ounce to about $410 per ounce. A portion of that increase simply reflects dollar depreciation, which I will discuss momentarily. Gold also represents a safe haven investment, however, and I agree that there have been periods in the past when the fear that drove investors into gold was the fear of inflation. But gold prices also respond to geopolitical tensions; these tensions have certainly heightened since 2001 and, in my view, can account for the bulk of the recent increase in the real price of gold. Oil prices are relatively high, in the range of $33/barrel, but they have been elevated for most of the past four years, despite a broadly disinflationary environment. According to futures markets, oil prices are expected to decline gradually over the next two years, despite accelerating economic activity, as new supplies are brought on line. Of course, there is considerable uncertainty about what the price of oil will do, given the possibility of supply disruptions. But if it follows the course projected by the futures market, the price of oil should have a modest disinflationary effect on overall consumer prices in the next couple of years. A part of the increase in the core crude PPI also reflects indirect effects of energy prices (direct effects of energy prices are excluded from core inflation measures by construction). The depreciation of the dollar, discussed below, may also have played some role. Commodity prices are also well below previous peaks - indeed, about 15 percent or more below the peaks reached in 1977, 1980, 1989, and 1995, when weighted by U.S. import shares. Let me turn now to the recent depreciation of the dollar and its implications for inflation. The dollar has fallen dramatically against some major currencies, notably the euro, against which the dollar has declined roughly 30 percent from its recent peak in the first quarter of 2002. However, looking at movements of the dollar against a single currency can be misleading about overall trends; broader measures of dollar strength show somewhat less of a decline. For example, an index of the dollar’s real value against the currencies of important U.S. trading partners, weighted by trade shares, has fallen only about 12 percent from its peak in the first quarter of 2002. Notably, this broader index of dollar value remains about 7 percent above its average value in the 1990s and 17 percent above the low it reached in the second quarter of 1995. Moreover, the direct effects of dollar depreciation on inflation, like those of commodity price increases, appear to be relatively small. In part, the small effect reflects the modest weight of imports in the consumer’s basket of goods and services. Perhaps more importantly, however, the evidence suggests that foreign producers tend to absorb most of the effect of changes in the value of the dollar rather than “passing through” these effects to the prices they charge U.S. consumers. A reasonable estimate of the portion of changes in the value of the dollar passed through to U.S. consumers is about 30 percent. The extent of passthrough also appears to have declined over time, suggesting that foreign producers also lack “pricing power” in the current low-inflation environment in the United States. Overall, on rough estimates, a 10 percent decline in the broad value of the dollar would be expected to add between one and three tenths to the level of core consumer prices (not the inflation rate), spread out over a period of time. I haven’t said anything yet about the rate of growth of the money supply, another indicator that is sometimes cited by those concerned about inflation, largely because there is not too much to say. Growth in standard monetary measures such as the base and M2 has been moderate (and declining) in recent years, certainly well within expected ranges given the growth of nominal GDP and normal variation in velocity. For example, for 2003 as a whole, growth in both the monetary base and M2 should be about equal to growth in nominal GDP. Even should money growth rates accelerate, however, I would caution against making strong inferences about the likely behavior of inflation, except in the very long run. Money growth has not proven to be especially useful for predicting inflation in the short run, in part because various institutional factors unrelated to monetary policy often affect the growth rate of money. A striking example of the way special factors can affect money growth rates is the fact that M2 growth has actually been sharply negative, at about -5 percent at an annual rate, for the past three months for which data are available. Factors such as the falloff in mortgage refinancing activity and outflows from retail money market funds into equities and other investments are the proximate explanations for the decline in M2. Certainly, this short-term decline in broad money is not to be taken as evidence of tight monetary policy!6 To summarize, 2003 seems to have marked the turning point for the U. S. economy, and we have reason to be optimistic that 2004 will see even more growth and continued progress in reducing unemployment. The remarkable strength and resiliency of the American economy - an economy that has shown the capacity to grow and become more productive in the face of serious adverse shocks deserve most of the credit for these developments. Highly stimulative monetary and fiscal policies have also played a role, of course. The Federal Reserve enters 2004 with monetary policy that is unusually accommodative in historical terms, relative to the stage of the business cycle. That accommodation is justified, I believe, by the current very low level of inflation, and by the productivity gains and the weakness in the labor market, both of which suggest that inflation is likely to remain subdued. In my view, weighing the relative costs of the upside and downside risks also favors accommodation; in particular, it is important that we ensure, as best we can, that the current expansion will become self-sustaining and that the inflation rate does not fall further. On the other side, as I have already noted, the achievement of price stability must not and will not be jeopardized. We at the Federal Reserve will closely monitor developments in prices and wages, as well as conditions in the labor market and the broader economy, for any sign of incipient inflation. We The difficulties with using the monetary base as an inflation indicator are even greater than those with using M2. The base is nearly all (97 percent) currency, about half to two-thirds of which circulates outside the United States. Hence, to a significant degree, base growth is determined by the foreign demand for dollars, rather than by economic conditions in the United States. will also look at the information that can be drawn from surveys and financial markets about inflation expectations. For now, I believe that the Federal Reserve has the luxury of being patient. However, I am also confident that, when the time comes, the Fed will act to ensure that inflation remains firmly under control.
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Speech by Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve System, at the Federal Reserve Bank of Atlanta's Public Policy Dinner, Atlanta, Georgia, 7 January 2004.
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Donald L Kohn: The United States in the world economy Speech by Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve System, at the Federal Reserve Bank of Atlanta’s Public Policy Dinner, Atlanta, Georgia, 7 January 2004. * * * No public policy issues facing the United States today in the economic realm are more important or prominent than those that touch on our place in the world economy. The greater attention to global economic issues is partly just a natural byproduct of the increasing interdependencies of all national economies. But this focus has been accentuated of late by the potential effects of two trends that have intensified in recent years. One is the emergence of several developing countries - most prominently China and India - as global economic forces and the consequent reorganization of production processes and change in the nature and location of jobs here and abroad. The second is our burgeoning trade and current account deficits and the possibility that they cannot be sustained at these levels. Like most interesting policy issues, these are difficult and complex, and they therefore carry a considerable risk that policy prescriptions will be ineffective or even counterproductive.1 The two developments are related, but only to a limited and indirect extent. Importantly, they arise from very different underlying sources. Job reorganization results from the integration of China and other developing countries into the world economy. The increase in our current account deficit has numerous roots, including, most prominently, stronger growth here than in our trading partners. But trade and exchange rate relationships with emerging-market economies are a small part of the story. The deficit does mean that the United States has been spending more than we produce, and the rest of the world has done the opposite. Because they have different causes, these developments have different public policy implications. Their implications for Federal Reserve policy are indirect. We cannot affect the pace of job restructuring nor correct the current account deficit, and that limitation is important to understand. Nonetheless, how these phenomena evolve and how they are addressed are critical background factors for us as we conduct monetary policy. They can influence the balance of aggregate supply and demand and the functioning of the economy - its flexibility and resiliency and its capacity to advance standards of living. Let’s look at these developments separately. Job restructuring I think it is useful to look at job restructuring as the adaptation to a much larger development - a huge increase in global productive capacity. The major increase in global productivity has two main causes. The first is the spreading recognition in recent decades, reinforced by the collapse of the Soviet Union, that market economies work best - that responses to market signals by private parties trying to make profits and raise standards of living are far more effective and efficient than government-directed allocation of resources. Hence not only countries in Eastern Europe, where governments were overturned, but also China and India, where political stability has been maintained, have been shifting toward economic systems that place greater reliance on market transactions among private parties. This trend is unleashing huge productive potential. The shift to market-based systems has been interacting with a second force - a heightened pace of technological change, especially the declining cost of generating and transmitting information. We can see the effects of technological change here at home, where it has considerably boosted the growth rate of productivity since the mid-1990s. Globally, cheaper access to more information has eased the integration and coordination of geographically diverse production processes. This development has opened up opportunities to transfer production to locations in which the work can be accomplished The views are my own and do not necessarily represent the views of other members of the Federal Open Market Committee or the Board. less expensively, and the trend toward market-based economies has multiplied the number of feasible locations. This type of shifting has been occurring in manufacturing for a long time in response to technical innovation and economic development. But what seems to be different is that, because of the new applications of information technology and telecommunications, an increasing variety of services that used to be attached to a particular business location can be carried out anywhere in the world. For example, call centers have moved to India and elsewhere. Routine back office accounting work such as handling accounts receivable is also shifting overseas and becoming centralized for global corporations. Many types of routine programming can be carried out around the clock, handed off from time zone to time zone by e-mail. The interaction of these forces has led to a major restructuring of production processes - at home and abroad - and a redistribution of these processes and associated jobs geographically around the globe. It is a beneficial development that will raise standards of living everywhere. In the newly emerging economies, of course, hundreds of millions of people now have a chance to escape grinding poverty. But the benefits will be felt in the industrial world as well. Workers in the United States and other advanced economies will need to shift toward industries specializing in the types of goods and services we produce relatively more efficiently. Typically, production of these goods and services involve more complex processes, often those that are more rooted in the higher knowledge and skills of our workers. As workers shift to higher value-added employment, real wages will rise commensurately. In addition, U.S. residents are getting access to less costly goods produced abroad. As a consequence, more toys appeared under the Christmas tree, and we have a greater choice of inexpensive clothes. I would guess that the less well-off among us probably benefit disproportionately from the availability of many of the types of less-expensive goods coming in from abroad. They are better able to clothe and feed their families and have more income available for other necessities, such as housing and medical care. International trade is not a zero sum game in which one country’s gains are another country’s loss. By specializing in what they do best, workers in all countries can be winners. Even if one country can be more efficient at producing all goods and services than another, each will gain by specializing in what it does relatively better. This is the result of what economists call comparative advantage. Increased trade should redistribute jobs, but it should not create or destroy jobs in the aggregate over the long run. Long-run levels of employment are determined by the available supply of labor and the flexibility of the labor market. Keeping employment reasonably close to its long-term, sustainable level is the job of macroeconomic policy - especially monetary policy. To be sure, individuals do get hurt in the transition, but within a country gains should exceed losses over the longer run. Unfortunately, from a political perspective, the gains are often widely disbursed, accrue over time, and are hard to measure whereas the losses are concentrated and palpable. Those whose jobs are restructured face a difficult adjustment. Even if it is possible, climbing the value-added chain may not be easy, and the dislocations are costly for those involved. People often are unemployed for a considerable time, and a significant portion end up settling for jobs that pay less than the one they left. Trying to protect those particular jobs through tariffs or quotas on imported goods may help those workers who face loss, but that protection will likely prove temporary and will reduce the standard of living for the country as a whole. When considering public policy responses to job restructuring, we must keep the pace of change in perspective and remember the flexibility and resiliency of our labor and product markets. Indeed, economists cannot even agree on whether job restructuring has accelerated. One study finds that, since the early 1980s, job loss has had a much larger structural component; another study fails to find any such trend.2 Manufacturing employment has been in a long-term downtrend for decades, likely because of the substantial advances in productivity as well as the rising preference for services in an increasingly wealthy country. We should also recall that the shifting of some jobs to Japan in the Erica L. Groshen and Simon Potter, “Has Structural Change Contributed to a Jobless Recovery?” Federal Reserve Bank of New York, Current Issues in Economics and Finance, vol. 9, no. 8, August 2003. On the Federal Reserve Bank of New York web site. Ellen R. Rissman, “Can Sectoral Labor Reallocation Explain the Jobless Recovery?” (680KB PDF) Federal Reserve Bank of Chicago, Chicago Fed Letter: Essays on Issues, no. 197, December 2003. On the Federal Reserve Bank of Chicago web site. 1980s and to East Asia and Mexico in the 1990s aroused considerable concern. These developments did not prevent a drop in the unemployment rate to a thirty-year low in the late 1990s. Moreover, the new jobs have not been lower paying. Higher productivity growth has meant that, on average, real wages and compensation rose substantially in the second half of the 1990s and have continued to increase in the past few years, albeit more slowly, despite the recent recession and jobless recovery. One difficulty of assessing trends in job restructuring in recent years has been the weak cyclical position of the economy. We must not confuse nor conflate cyclical and structural issues, especially when thinking about policy implications. A lot of today’s pain in manufacturing and in the overall economy is cyclical - a consequence of inadequate demand, not of a shift of jobs to other countries. Because this business cycle was led by capital goods both in its boom and bust stages, manufacturing has been especially hard hit over the last few years. In fact, until the economy comes much closer to full employment, we will not be able to isolate the structural issues with any confidence. Authorities here and abroad have the tools to get economies back to high levels of employment and production, even as we adjust to higher productivity growth and shifting production processes. Getting economies on track seems to be requiring unusually accommodative fiscal and monetary policies - but these policies finally appear to be bearing fruit. Indeed, over time, high productivity growth here and rising productive capacity abroad can increase demand for goods and services even more than they increase supply. We saw considerable strength in demand in the United States in the 1990s, when productivity accelerated, and we are beginning to see it in China, where rising demand for imports is eroding the country’s large trade surplus and boosting the economies of some of its trading partners. People experiencing much brighter economic prospects will want much more in the way of consumer goods. Businesses here and in China will need capital equipment to expand, and no country does a better job of producing sophisticated capital equipment than does the United States. The key to easing adjustment for the individuals affected is training and education. We must do a better job of giving our current workers and the next generations the skills needed to grab the highly productive, knowledge-based jobs to which demand will continue to shift. I cannot tell you exactly in what sectors or industries these jobs will be; government is not good at picking winners and losers. The market system will sort that out and, in the process, will signal our workers as to which skills are becoming more highly valued. Government needs to make sure that the opportunities and resources are available for obtaining those skills. I recognize that, unfortunately, not every country always plays by the rules. Some job restructuring occurs not because of relative efficiencies but because of subsidies of certain industries or discrimination against foreign goods. We need to work together with all countries to eliminate impediments, wherever they might be, to realizing the benefits of the global increase in productive capacity. It would be counterproductive to increase protectionist measures, which in effect would reduce the flexibility of our economy, lock people into inferior jobs, and end up raising costs for consumers especially those among us who can least afford to pay more. The trade and current account deficits Our current account deficit has been growing both in dollar terms and relative to the size of our economy, reaching 5 percent of GDP last year. This is a record for us; when the deficit approached this magnitude in the past, markets had generally already begun to adjust to reduce it.3 The deficit reflects the fact that spending in the United States exceeds what we produce. We meet the extra demand by importing more than we export. We pay for the added imports by using the savings of people in other countries - that is, they lend us money to buy their goods and services. Using more goods and services than one produces is not a bad deal. We could do so indefinitely, provided that foreigners were willing to continue increasing their loans and investments in the United States. Even then, of course, we would have ever-rising debts to service, and foreigners would own a Caroline Freund, “Current Account Adjustment in Industrialized Countries, ”FRB: IFDP paper - number 692 Board of Governors of the Federal Reserve System, International Finance Discussion Paper No. 692, December 2000. growing proportion of our capital stock. We have indeed become a large net debtor in global capital markets, but so far, the net servicing of the debt has been very small. For quite a while, global investors seemed willing to increase the proportion of the total assets they hold as claims on the United States, denominated in dollars. Through the 1990s and into the early 2000s foreigners expected returns here to be so high that they willingly sent us larger and larger amounts of savings - in effect, financing a goodly part of our investment boom. The strong demand for dollar assets was evidenced by a rising exchange rate, which in turn fed the increase in the current account and trade deficits. This point is important to keep in mind. We did not seek to run a current account deficit, nor did we make policy mistakes that brought it on. The current account and trade deficits became so large mostly because we had a more-dynamic, faster-growing economy than everyone else had - one with a higher expected return on investment, which induced a rising demand for dollar claims on our increasingly productive capital stock. But although the U.S. economy continues to be far more vigorous than most others, foreign investors may be becoming less willing to finance the gap between what we spend and what we produce. With the current account deficit climbing, that gap is growing fast - evidently faster than the appetite for U.S. assets. Private capital flows into the United States have ceased expanding rapidly. Governments especially those of Japan and China - have taken up the slack by purchasing U.S. assets, but the shortfall in the desire to supply savings to fund our deficit has been reflected in a significant drop in the dollar on foreign exchange markets since early 2002. It is to be expected, at least for economies with exchange rates that truly float, that a shortfall of demand for a country’s assets will be reflected at first primarily in the exchange rate. The lower exchange rate in turn stimulates exports and damps imports, and so the current account deficit and the associated need for foreign capital are also reduced, matching the lower appetite of foreign investors. To date, this adjustment process has not been a problem for the United States. Because we are operating with spare capacity in our factories and labor markets, higher exports and lower imports are fine. They help boost U.S. production to more fully utilize labor and capital and should not add to sustained inflation pressures, even with import prices moving a little higher and competitive pressure on import-competing industries easing a bit. Some have feared that lagging demand for our assets would show up in lower prices for the assets themselves - that is, in increases in bond yields and declines in equity prices - as well as in lower exchange rates. However, for the most part, these assets are traded in highly liquid markets, where even large decreases in demand can be accommodated with very small changes in prices. In such markets, interest rates and equity prices tend to reflect investors’ perceptions of fundamentals such as expected inflation, profits, risk, and real growth. In fact, over recent months, as the dollar has continued to drop, equity prices have risen, and yields on corporate bonds are unchanged to a little lower. To be sure, foreign authorities have acquired a large quantity of dollar assets, but their purchases tend to be concentrated in Treasury and agency securities, not in privately issued equity or debt.4 The global economy does face a potential longer-term structural issue. If investors are reaching a point at which assets denominated in U.S. dollars are becoming as large a share of their portfolios as they see appropriate, our trade deficit will need to shrink. We will not be able to call so much on an increasing share of world saving to finance our spending, and that spending will need to match our production much more closely. At the Federal Reserve we will continue to work to foster a full employment level of production, one as high as the economy can generate on a sustainable, noninflationary basis. Relative to that level of production, demand or spending in the United States will need to be considerably more restrained on both domestic and foreign goods, and more U.S. production will need to be exported abroad. This fact - this implication of the simple arithmetic of As Chairman Greenspan has argued, increased liquidity in financial markets, greater willingness of investors to look at opportunities outside their home countries, and enhanced flexibility of economies all suggest less pressure than in the past to correct large current account deficits in a short period and greater likelihood that any such adjustment will be smooth. See Alan Greenspan, remarks at the Twenty-first Annual Monetary Conference, cosponsored by the Cato Institute and The Economist, Washington, D.C., November 20, 2003. smaller trade and current account deficits - raises important policy questions for both the United States and the rest of the world. In the United States the tough questions are just what kind of spending will feel the brunt of the restraint and to what extent will production have to shift to accommodate a new mix of spending. In particular, without added doses of foreign saving, we are going to need to generate more of our own if we wish to fund high levels of business investment in capital goods and household purchases of new houses and durable goods. If we do not increase our saving, investment will have to be cut back. We can get that savings from the private sector by decreasing consumption relative to income or from the public sector by decreasing spending relative to taxes. In that context, the prospect of large federal government deficits stretching out into the future looks worrisome. In the second half of the 1990s, we had both foreign and government savings to finance investment; a few years from now we may have less of the former and none of the latter - indeed, the government sector is projected to be a net user of savings not a net supplier. The fiscal stimulus of the past few years has been quite helpful in promoting recovery, but we do need to consider the longerterm implications of the policies put in place. If the fiscal path does not change, unless private savings rise considerably to compensate, interest rates will be higher than they otherwise would be to ration the scarcer savings, and we will have slower growth in the capital stock and in the number of houses and autos. Slower growth in the capital stock means slower growth in productivity and in our economic potential. Constraints on trend growth would be a concern at any time, but they are especially so over the coming years. We are on the cusp of a wave of retirements, which will leave a smaller workforce to generate the goods and services those of us looking forward to retirement will consume even as we contribute less and less to their production. We need to be saving and investing to build our economic potential and to alleviate the burden on our children and grandchildren. This is not a task for monetary policy. In the long run, monetary policy cannot do anything about the current account deficit or about the lack of savings from government policy or private choices. Our manipulation of the overnight interest rate helps to keep the overall economy in balance - promoting price stability and production at the economy’s potential. But on the Federal Open Market Committee Jack and I can do nothing to promote savings other than to provide a stable backdrop for private decisions. Promoting savings is a job for fiscal and tax policy. If our trade and current account deficits move toward balance, foreign economies will face the questions of how to replace the demand that will no longer be coming from the United States and to reallocate production to a new mix of spending. The U. S. current account will not correct in isolation. The United States has been, in effect, exporting its demand overseas, supporting economic activity in foreign economies by importing more goods and services than we export. If our imports fall and exports rise, just the opposite will occur in the rest of the world. As our domestic demand is restrained relative to production, demand elsewhere will have to increase to foster global high employment. How that is to be achieved is an open question: Structural reforms that improve the flexibility of the labor force and production and that foster growth abroad are a desirable way to contribute to better global balance, but macroeconomic policy adjustments to promote more domestic demand may also be required. It is simply not possible for all countries to enjoy stimulus from net exports; some countries will need to be net importers, especially if the United States no longer fills that role. And so my two issues become related. The development strategies of countries such as China and other Asian nations, to be successful, must be compatible with the pattern of adjustment in global demand that is required by the consumption, saving, and investment decisions made by market participants everywhere. Conclusion The global economy seems to be facing major adjustments in several dimensions simultaneously. Successful adaptation to changing circumstances will require flexibility on several fronts. No one can anticipate how events will unfold - the evolving geography and technology of the production of goods and services, the shifting balances between spending and producing as current accounts change. My fear is that poorly formed diagnoses and incorrect policy prescriptions will have unintended adverse consequences for our economy. Any elements of rigidity - in exchange rates, in labor and product markets, in quotas and tariffs on international trade - limit the channels through which the adjustment process can work. Rigidity concentrates stresses, increases the risk of market disruptions, impedes economic resiliency, and limits the world’s ability to realize the full potential of the rise in global productivity to lift standards of living.
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Speech by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the meetings of the American Economic Association, San Diego, 3 January 2004.
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Ben S Bernanke: Fedspeak Speech by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the meetings of the American Economic Association, San Diego, 3 January 2004. The references for the speech can be found on the Board of Governors of the Federal Reserve System’s website. * * * There was a time when central bankers did not talk to the public. Montagu Norman, the Governor of the Bank of England for a quarter of a century after the First World War and a highly influential figure in his time in central banking circles, was notorious for his reclusiveness, both personal and professional. According to his biographer, Norman lived by the maxim, “Never explain, never excuse” (Boyle, 1967, p. 217). Norman was hardly unique. Central bankers long believed that a certain “mystique” attached to their activities; that making monetary policy was an arcane and esoteric art that should be left solely to the initiates; and that letting the public into the discussion would only usurp the prerogatives of insiders and degrade the effectiveness of policy. In contrast to this tradition of secrecy, central banks around the world have become noticeably more open and transparent over the past fifteen years or so. Policymaking committees have adopted various mechanisms to enhance their communication with the public, including more informative policy announcements, post-meeting press conferences, expanded testimony before the legislature, the release of the minutes of policy meetings, and the regular publication of reports on monetary policy and the economy. This increased openness is a welcome development, for many reasons. Perhaps most important, as public servants whose policy actions affect the lives of every citizen, central bankers have a basic responsibility to give the public full and compelling explanations of the rationales for those actions. Besides satisfying the principle of democratic accountability, a more open policymaking process is also likely to lead to better policy decisions, because engagement with an informed public provides central bankers with useful feedback in the form of outside views and analyses. Yet another benefit of full and timely release of information about policy decisions and their rationales is a reduced risk that market-sensitive information will dribble out through inappropriate channels, giving unfair advantage to some financial market participants. Admittedly, for many central banks, including the Federal Reserve, progress toward greater transparency has come in halting steps and not without trepidation. For example, the decision to announce changes in the target for the federal funds rate immediately after meetings of the Federal Open Market Committee (FOMC) was implemented only in phases and after considerable soulsearching by FOMC members. In retrospect, however, I think that most central bankers, both in the United States and abroad, would agree that greater openness has been beneficial to central banks as institutions and for the advancement of their policy objectives. Although the presumption today is that - absent compelling reasons to the contrary - central banks should strive for transparency, some basic questions about what, how, and to what end central banks should communicate with the public remain decidedly open. In my talk today I will put aside broader considerations such as democratic accountability and consider these questions as they bear on the ability of central banks to make monetary policy more effective and to improve macroeconomic performance. Before proceeding, I should emphasize that the views I will express today are not necessarily those of my colleagues on the Board of Governors or the Federal Open Market Committee. Why central bank communication matters for policy effectiveness Can central bank talk - Fedspeak, in the vernacular of the U.S. media and financial markets - make monetary policy more effective and improve economic outcomes? To see why communication may be an integral part of good monetary policymaking, recall that the Federal Reserve directly controls only a single short-term interest rate, the overnight federal funds rate. Relative to the enormous size of global financial markets, the market for federal funds - the market in which commercial banks borrow and lend reserves on a short-term basis - is insignificant. Control of the federal funds rate is therefore useful only to the extent that it can be used as a lever to influence more important asset prices and yields - stock prices, government and corporate bond yields, mortgage rates - which in turn allow the Fed to affect the overall course of the economy. Of course, basic financial theory implies that a link does exist between short-term interest rates, such as the federal funds rate, and longer-term rates, such as Treasury bond yields and mortgage rates. In particular, longer-term yields should depend in part on market expectations about the future course of short-term rates. For example, with the current setting of the funds rate held constant, any arriving news that leads bond market participants to expect higher future values of the funds rate will tend to raise bond yields and lower bond prices. The link between long-term bond yields and market expectations of future monetary policy actions is familiar to all financial-market participants and has been well supported by recent empirical research. For example, Antulio Bomfim has demonstrated that the shape of the term structure of Treasury yields can be effectively described by a two-factor model, in which the first factor corresponds to the current setting of the funds rate and the second factor closely approximates medium-term monetary policy expectations (Bomfim, 2003). The fact that market expectations of future settings of the federal funds rate are at least as important as the current value of the funds rate in determining key interest rates such as bond and mortgage rates suggests a potentially important role for central bank communication: If effective communication can help financial markets develop more accurate expectations of the likely future course of the funds rate, policy will be more effective (in a precise sense that I will explain further soon), and risk in financial markets should be reduced as well. It is worth emphasizing that the predictability of monetary policy actions has both short-run and long-run aspects. A central bank may, through various means, improve the market's ability to anticipate its next policy move. Improving short-term predictability is not unimportant, because it may reduce risk premiums in asset markets and influence shorter-term yields. But signaling the likely action at the next meeting is not sufficient for effective policymaking. Because the values of long-term assets are affected by the whole trajectory of expected short-term rates, it is even more vital that information relevant to estimating that trajectory be communicated. As I will argue later, this can usually be done only by providing information about the central bank's objectives, assessment of the economy, and policy strategy. Communication, asymmetric information and learning Ideally, what should central bank communication try to achieve? In an important analysis of the issue of central bank transparency, my FOMC colleague William Poole laid out a benchmark case in which the potential benefits of communication would be fully realized (Poole, 2003). In this benchmark case, the central bank has well-defined objectives and pursues regular and systematic policies consistent with those objectives. More important for our purposes, in this idealized world, financial markets are highly efficient and well informed. In particular, financial-market participants have access to all the information that the central bank uses in making policy decisions. Let us call the premise that the central bank has no significant information advantage over the private sector the assumption of symmetric information. If the conditions of systematic policymaking, financial-market efficiency, and symmetric information all held, then one might hope that the economy would converge to a rational expectations equilibrium, in which participants in financial markets would need only to analyze incoming, publicly available economic data to make efficient forecasts of future Federal Reserve actions.1 In this benchmark case, there would be no marginal benefit to central bank communication, beyond whatever was necessary to support this equilibrium in the first place. Of course, to describe this idealized benchmark case is to recognize that it is at best an approximate description of the economy in which we live. In practice, financial-market participants generally do not have as much information as monetary policymakers do about a number of key inputs to policymaking, including the policymakers' own objectives, their (possibly implicit) model of the economy and the monetary transmission mechanism, their assessment of the economic situation (including both forecasts and the risks to the forecast), and their policy strategy. To the extent that this asymmetry of As my discussion later will make clear, convergence to a full rational expectations equilibrium may also require that the economy's underlying structure be “learnable” by both the central bank and the public. information between the central bank and the financial markets is quantitatively important - and I will present some evidence on this point shortly - financial markets will not price bonds and other assets efficiently (relative to the information possessed by the central bank), and scope may exist for central bank communication to improve the effectiveness of monetary policy and the overall performance of the economy. A skeptic might argue that noise and other sources of pricing inefficiency pervade the financial markets, so that improving the predictability of monetary policy is of limited importance in practice, except perhaps to a few brokers and traders. To the contrary, there is good reason to believe that information asymmetries between the central bank and financial markets may matter a great deal for economic welfare. A theoretical basis for this view is provided by the lively recent literature on adaptive learning and monetary policy. This work has shown that, when the public does not know but instead must estimate the central bank's reaction function and other economic relationships using observed data, we have no guarantee that the economy will converge - even in infinite time - to the optimal rational expectations equilibrium.2 In general, the problem is that the public's learning process itself affects the behavior of the economy - for example, as when expectational errors by bond traders affect interest rates and thus a wide range of economic decisions. The feedback effect of learning on the economy, this literature has shown, can in principle lead to unstable or indeterminate outcomes. More generally, the dynamic behavior of an economy with asymmetric information and learning may be radically different from the behavior of the same economy in the optimal rational expectations equilibrium. A particularly interesting analysis of the implications of learning for monetary policy and central bank communication has been provided in a series of papers by Athanasios Orphanides and John C. Williams (2003a, 2003b). Orphanides and Williams study model economies in which the public is assumed to know the general nature of the economy's underlying structure but not the precise quantitative magnitudes describing that structure. Specifically, these authors consider a model in which the public is assumed to know the form of the equation describing the dynamic behavior of inflation but not the parameters of that equation, which depend on the (unobserved by the public) objectives and preferences of the central bank. Orphanides and Williams assume that, to learn the parameters of the process that generates inflation, people must apply standard statistical methods to observed data on inflation and other macroeconomic variables. Obviously, in assuming that people know the true economic structure with certainty, and that they infer the underlying parameters of that structure using formal statistical methods, Orphanides and Williams and others in this literature are attributing much greater knowledge and sophistication to the public than exist in the real world. Nevertheless, the behavior of their model economies with learning can be quite different from that of the rational expectations analogue, in which the public is assumed to have full and symmetric information. For example, these authors show that the economy with learning is prone to episodes of stagflation, or combinations of high inflation and low output. The logic is as follows: When people are learning about the inflation process, an increase in inflation that would be only temporary and would leave expectations unaffected in a rational expectations world, may instead lead the public to infer that the long-run average rate of inflation is higher than previously thought. The rise in the public's inflation expectations affects wage- and price-setting and other economic decisions and thus raises actual inflation. In a vicious cycle, the higher rate of realized inflation further increases inflation expectations, forcing the central bank to tighten policy. The result is inflation that is unnecessarily high and output that is unnecessarily low. Several insights come from this and other contributions to the literature on adaptive learning in macroeconomics. First, the fact that the public must learn about underlying economic relationships changes the nature of the optimal monetary policy. In general, with learning, the central bank's optimal policy involves exerting a tighter control on inflation than it might otherwise exert, to avoid the possibility that inflation expectations will drift randomly higher (or lower). Thus, this approach formalizes the idea that a central bank should work actively to “anchor” inflation expectations within a narrow range. Second, efficient policy in this world requires that policymakers pay attention to information (for example, from surveys) about the public's expectations of inflation and other variables; if these appear not to be converging toward the desired levels, then a policy response may be See Evans and Honkapohja (2003a) for a survey of relevant results. Evans and Honkapohja (2001) provide an extensive analysis of macroeconomic models with learning. Kaushik and Mitra (2002) argue that central banks should restrict themselves to policies that are “learnable” by the public. warranted.3 Finally, and most important for my purpose today, communication by the central bank may play a key role in helping improve economic performance. For example, in the models analyzed by Orphanides and Williams, the provision of information by the central bank about its long-run inflation objective or its economic forecasts generally leads to more favorable policy tradeoffs and better economic outcomes. The work on adaptive learning by Orphanides and Williams and others is largely theoretical, but in my view it is highly relevant to understanding modern U.S. monetary history. A leading example is the stagflationary period of the 1970s, in which astute observers recognized that high and unstable public expectations of inflation, themselves generated by poor macroeconomic policies that allowed inflation to get out of control, greatly increased the complexity and cost of restoring stability.4 More recently, Marvin Goodfriend (1993) has identified several instances of what he calls “inflation scares,” apparently autonomous increases in inflation expectations that raised long-term bond yields and forced a tightening of monetary policy that could have been avoided if expectations had been better anchored. The view that adaptive learning and asymmetric information are crucial to understanding recent monetary history is apparently shared by the developers of the Federal Reserve's primary econometric model, the FRBUS model, which relies heavily on these assumptions (Brayton et al., 1997). Simulations of that model suggest both that adaptive learning is needed to explain the observed responses of the financial market and the economy to monetary policy actions, and that asymmetric information and adaptive learning lead systematically to inferior macroeconomic outcomes, as implied by the work of Orphanides and Williams and others. Of course, the situation in the United States is much better today than in the 1970s; both inflation and inflation expectations are much more stable, and better economic outcomes have been the result. But is there still scope for improvement? I will present some evidence to suggest that there is and then conclude by discussing how communications policies could help anchor and stabilize the system more firmly. Evidence on the effectiveness of Fed communication In the past decade, the Federal Reserve has taken a number of significant steps toward increased transparency, including announcing decisions about the federal funds rate promptly after FOMC meetings, indicating first a policy “bias” and then a “balance of risks” assessment in post-meeting statements, and making the minutes of policy meetings publicly available (with a lag of about eight weeks). Members of the FOMC have also made greater use of vehicles such as testimony and speeches to convey their assessments of the economy and their policy inclinations to the public. How effective have these efforts been? I earlier distinguished between short-run and long-run predictability of policy. Fairly strong evidence supports the conclusion that the short-run predictability of policy has increased in recent years. For example, Joe Lange, Brian Sack, and William Whitesell (2003) have shown that, since the late 1980s and early 1990s, monetary policy actions over short horizons have been predicted increasingly well by financial instruments such as three- and six-month Treasury bills and federal funds futures contracts. These authors attribute at least part of this improvement to greater transparency on the part of the Federal Reserve. Poole, Rasche, and Thornton (2002) reach a similar conclusion.5 However, the more important question is whether the Federal Reserve has improved the ability of the public to forecast its policies at long horizons. Long-horizon forecastability of policy has a number of dimensions, of course. One that has received particular attention in the literature, and which is closely Evans and Honkapohja emphasize this point in a series of papers; see, for example, Evans and Honkapohja (2003b). Sack (2003) provides evidence that U.S. monetary policy does respond to inflation expectations, as measured by the yields on nominal and inflation-indexed Treasury securities. Erceg and Levin (2003) model the disinflation process of the early 1980s using the assumption that the public learns optimally about inflation. They show that learning and the consequently slow adjustment of inflation expectations help to explain the severe economic contraction of the period. Kohn and Sack (2003) studied the effect of the release of post-meeting FOMC statements on the term structure and found that the release of statements generated a response in short-term interest rates (up to two years' maturity), independent of the effects of any accompanying policy actions. They interpret this finding as supporting the view that statements contain information (over and above that inherent in the policy action) for near-term monetary policy. Of course, a fortiori, their findings are also evidence against the view that information relevant to monetary policy is approximately symmetric. related to theoretical models that assume adaptive learning, is the question of whether the public is able to infer the Federal Reserve's implicit long-run inflation objective.6 Uncertainty about this objective bears directly on the market's ability to price long-term assets, as well as on the capacity of wage- and price-setters to strike efficient long-term agreements and of firms and households to make long-term economic plans. Various types of evidence bear on this question. For example, some recent research has considered expectations of inflation and other variables as measured by surveys. One clear finding is that, as inflation has come under control and has stabilized in the United States in recent years, long-term inflation expectations have stabilized as well, suggesting reduced uncertainty about the Fed's ultimate inflation objective. For example, a cross-country study of inflation expectations by staff of the European Central Bank found that, since 1990, both the average level of expected inflation and the volatility of reported expectations of inflation in the United States have declined, the latter quite significantly (especially since 1999).7 However, as an aside, it is interesting that both surveys and the inflation compensation priced into the yields on indexed bonds suggest that today long-term inflation expectations in the United States remain in the vicinity of 2-1/2 to 3 percent, above the range of inflation that many observers believe to represent the FOMC's implicit target. Possibly, this observation indicates an ongoing process of adaptive learning. A subtler issue is the degree to which inflation expectations in the United States are anchored. Specifically, to what extent would inflation expectations rise if actual inflation increased for some reason? To address this question, Andrew Levin, Fabio Natalucci, and Jeremy Piger (2003) examined U.S. private-sector forecasts of inflation since 1994. They found that medium- and long-term forecasts of inflation in the United States are strongly correlated with three-year moving average of lagged inflation, a finding that suggests that inflation expectations are not entirely anchored but are instead subject to adaptive learning. As a supporting piece of evidence, Levin, Natalucci, and Piger show that, compared to other industrial countries, shocks to inflation tend to be relatively persistent in the United States, an implication of models with adaptive learning.8 Bond markets provide fertile ground in which to search for evidence on the importance of adaptive learning and the degree to which expectations are well anchored. For example, Refet Gurkaynak, Brian Sack, and Eric Swanson (2003) show that distant forward rates (e.g., the implied one-year forward rate ten years in the future) move significantly in response to the unexpected components of both monetary policy decisions and a number of macroeconomic data releases. Because they do not find the same result for inflation-indexed securities (that is, real forward rates do not respond to policy or data surprises), they conclude that long-term expectations of inflation must not be tightly anchored in the United States. Kevin Kliesen and Frank Schmid (2003) support these findings by showing directly that ten-year inflation expectations, as derived from inflation-indexed bonds, respond significantly to policy surprises as well as to the unexpected components of macroeconomic data releases.9 Interesting work by Sharon Kozicki and Peter Tinsley (2001a, 2001b) bears directly on the importance of asymmetric information and learning in financial markets. Kozicki and Tinsley incorporate alternative specifications of the evolution of inflation expectations in a standard model of the term structure (see Campbell, Lo and MacKinlay, 1997). Kozicki and Tinsley show that by far the best fit is obtained when inflation expectations are modeled as evolving by adaptive learning, in which inflation expectations adjust slowly to actual inflation. When inflation expectations are modeled this way, and only when they are modeled this way, the expectations theory of the term structure performs well and estimated term premiums are relatively small. In related research, Glenn Rudebusch and Tao Wu (2003) show empirically that a two-factor model of the term structure can be closely linked to monetary policy The working assumption here is that U.S. monetary policy is conducted “as if” there were a numerical inflation objective, even though there is no explicit agreement on the FOMC as to what that objective should be. Castelnuovo, Efrem, Sergio Nicoletti-Altimari and Diego Rodriguez Palenzuela (2003). Kohn (2003) notes that the volatility of long-term inflation expectations in the United States has declined and is similar to that of industrial countries, including those that formally target inflation. For example, the model of Erceg and Levin (2003) has that implication. Some care must be taken when using inflation-indexed bonds to measure inflation expectations, however. These bonds were introduced in the United States relatively recently, and the secondary market remains less liquid that those for other Treasury securities. Changes in measured inflation compensation drawn from this market may thus sometimes reflect changes in liquidity or risk premiums as well as changes in market expectations of inflation. fundamentals, but only on the assumption that the medium-term inflation expectations held by market participants are time-varying. All the cited findings apply to recent data, as well to earlier observations. The evidence for asymmetric information and adaptive learning, at least in regard to the Fed's inflation objective, thus seems quite strong. Implications for central bank communication So far I have discussed why central bank communication is important for financial market efficiency and good macroeconomic performance, and I have presented a few pieces of evidence that suggest that asymmetry of information between the Federal Reserve and the public may be an important phenomenon. What implications does all this have for the communication policies of the Fed? In an ideal world, the Federal Reserve would release to the public a complete specification of its policy rule, relating the FOMC's target for the federal funds rate to current and expected economic conditions, as well as its economic models, data, and forecasts. Using this information, financial-market participants would be able to forecast future values of the policy rate and efficiently price long-term bonds and other assets. Unfortunately, as stressed by Poole (2003) as well as by Chairman Greenspan (2003) in his talk at the most recent Jackson Hole conference, specifying a complete and explicit policy rule, from which the central bank would never deviate under any circumstances, is impractical. The problem is that the number of contingencies to which policy might respond is effectively infinite (and, indeed, many are unforeseeable). While specifying a complete policy rule is infeasible, however, there is much that a central bank can do - both by its actions and its words - to improve the ability of financial markets to predict monetary policy actions. With respect to actions, the central bank should behave in as systematic and as understandable a way as possible, given the macroeconomic and financial environment. That is, although monetary policy cannot be made by a mechanical rule, policy can and should have “rule-like” features. Obviously, the more systematic and the more consistent with a few basic principles the conduct of monetary policy becomes, the easier it will be for the public to understand and predict the Fed’s behavior.10 However, because the world is complex and ever changing, policy actions alone, without explanation, will never be enough to provide the public with the information it needs to predict policy actions. Words are also necessary. What then should the Fed talk about? In general, the research I have discussed today suggests that the central bank should do what it can to make information symmetric, providing the public to the extent possible with the same information that the FOMC uses in making its decisions.11 More specifically, the strongest implication of the adaptive learning literature is that the Fed should be as explicit as possible about its policy objectives. Without clear information about policy objectives, the public's problem of predicting future monetary policy actions becomes extremely difficult. For example, without this information, it would be hard for the public to know whether an unexpected policy move signals a change in the policymakers' objectives, a change in their economic outlook, or both. As also suggested by the adaptive learning literature, a potential advantage of having an explicit objective for inflation in particular is that it may help to anchor the public's expectations.12 Besides its policy objectives, the central bank can make other useful information available to the public, including its economic forecasts, its assessment of the economic risks, and (if possible) the models or analytical frameworks that underlie its diagnosis of the economy. The Federal Reserve currently provides information on each of these elements. For example, the so-called “central tendency” forecasts of the FOMC are released twice a year, as part of the Chairman's semiannual testimony before Congress; the statements following FOMC meetings provide some assessment of the perceived risks to the forecast; and the active research programs conducted at the Board and the Reserve banks, including publications and conferences, provide observers insights into the underlying analytical frameworks that inform monetary policymaking. “Rule-like” policies may also improve the central bank's credibility and ability to commit to future actions. Note that this suggestion brings us full circle back to Poole's (2003) benchmark case of rational expectations and symmetric information, discussed earlier. See Bernanke (2003a, 2003b) for discussions of the case for an explicit long-run objective for inflation. We should continue to seek improvement in each of these areas. For example, FOMC forecasts might be released more frequently and for a longer horizon. Additional variables could be forecasted, notably core inflation, a key factor in FOMC policy decisions. More controversially, the FOMC might consider forecasting future values of the short-term interest rate, as is currently done by the Reserve Bank of New Zealand. The difficulty would be to make clear that an interest-rate forecast is not the same as a policy commitment. The use of “fan charts” to indicate the range of uncertainty would be helpful in this regard; and indeed, providing more information about the range of uncertainty for all FOMC forecasts would be a useful innovation. In my talk today I have often adopted the common convention of speaking of the central bank as if it were a single actor. In reality, policymaking at most central banks is done by a committee. In the United States, nineteen people (twelve of whom get to vote at any given meeting) have seats at the FOMC table. The diversity of views and opinions likely to exist among the members of a large committee create further challenges for effective communication. However, vehicles do exist to help convey the breadth of opinion on the Committee. For example, the minutes of FOMC meetings describe the range of viewpoints and many of the key considerations underlying policy decisions. In my view, releasing these minutes more promptly than is now done would provide useful and more timely information for the public. Although at times it feels cacophonous, the willingness of FOMC members to present their individual perspectives in speeches and other public forums provides the public with useful information about the diversity of views and the balance of opinion on the Committee. Other possibilities for improved transparency may exist. Importantly, as we think about these, we should not simply take the view that more information is always better. Indeed, irrelevant or badly communicated information may create more noise than signal; and some types of information provision - an extreme example would be televising FOMC meetings - risk compromising the integrity and quality of the policymaking process itself. Rather, the key question should be whether the additional information will improve the public's understanding of the Fed’s objectives, economic assessments, and analytical framework, thus allowing them to make better inferences about how monetary policy is likely to respond to future developments in the economy. Communication that meets this criterion will lead to better monetary policy and better economic performance.
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board of governors of the federal reserve system
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Bundesbank Lecture 2004, Berlin, 13 January 2004.
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Alan Greenspan: Globalisation Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Bundesbank Lecture 2004, Berlin, 13 January 2004. * * * Globalization has altered the economic frameworks of both developed and developing nations in ways that are difficult to fully comprehend. Nonetheless, the largely unregulated global markets do clear and, with rare exceptions, appear to move effortlessly from one state of equilibrium to another. It is as though an international version of Adam Smith’s “invisible hand” is at work. One key aspect of the recent globalization process is the apparent persistent rise in the dispersion of current account balances. Although for the world as a whole the sum of surpluses must always match the sum of deficits, the combined size of both, relative to global gross domestic product (GDP), has grown markedly since the end of World War II. This trend is inherently sustainable unless some countries build up deficits that are no longer capable of being financed. Many argue that this has become the case for America’s large current account deficit. There is no simple measure by which to judge the sustainability of either a string of current account deficits or their consequence, a significant buildup in external claims that need to be serviced. In the end, the restraint on the size of tolerable U.S. imbalances in the global arena will likely be the reluctance of foreign country residents to accumulate additional debt and equity claims against U.S. residents. By the end of 2003, net external claims on U.S. residents had risen to approximately 25 percent of a year’s GDP, still far less than net claims on many of our trading partners but rising at the equivalent of 5 percentage points of GDP annually. However, without some notion of America’s capacity for raising cross-border debt, the sustainability of the current account deficit is difficult to estimate. That capacity is evidently, in part, a function of globalization since the apparent increase in our debt-raising capacity appears to be related to the reduced cost and increasing reach of international financial intermediation. The significant reduction in global trade barriers over the past half century has contributed to a marked rise in the ratio of world trade to GDP and, accordingly, a rise in the ratio of imports to domestic demand. But also evident is that the funding of trade has required, or at least has been associated with, an even faster rise in external finance. Between 1980 and 2002, for example, the nominal dollar value of world imports rose 5-1/2 percent annually, while gross external liabilities, largely financial claims also expressed in dollars, apparently rose nearly twice as fast.1 This observation does not reflect solely the sharp rise in the external liabilities of the United States that has occurred since 1995. Excluding the United States, world imports rose about 2-3/4 percent annually from 1995 to 2002; external liabilities increased approximately 8 percent. Less-comprehensive data suggest that the ratio of global debt and equity claims to trade has been rising since at least the beginning of the post-World War II period, though apparently at a more modest pace than in recent years.2 From an accounting perspective, part of the increase in the ratio of world gross claims to trade in recent years reflects the continued marked rise in tradable foreign currencies held by private firms as well as a very significant buildup of international currency reserves of monetary authorities. Rising global wealth apparently has led to increased demand for diversification of portfolios by including greater shares of assets denominated in foreign currencies. Gross liabilities include both debt and equity claims. Data on the levels of gross liabilities have to be interpreted carefully because they reflect the degree of consolidation of the economic entities they cover. Were each of our fifty states considered as a separate economy, for example, interstate claims would add to both U.S. and world totals without affecting U.S. or world GDP. Accordingly, it is the change in the gross liabilities ratios that is the more economically meaningful concept. For the United States, for example, the ratio of external liabilities to imports of goods and services rose from nearly 1-1/2 in 1948 to close to 2 in 1980. The comparable ratios for the United Kingdom can be estimated to have been in the neighborhood of 2-1/2 or lower in 1948 and about 3-3/4 in 1980. More generally, technological advance and the spread of global financial deregulation has fostered a broadening array of specialized financial products and institutions. The associated increased layers of intermediation in our financial systems make it easier to diversify and manage risk, thereby facilitating an ever-rising ratio of both domestic liabilities and assets to GDP and gross external liabilities to trade.3 These trends seem unlikely to reverse, or even to slow materially, short of an improbable end to the expansion of financial intermediation that is being driven by cost-reducing technology. Uptrends in the ratios of external liabilities or assets to trade, and therefore to GDP, can be shown to have been associated with the widening dispersion in countries’ ratios of trade and current account balances to GDP to which I alluded earlier.4 A measure of that dispersion, the sum of the absolute values of the current account balances estimated from each country’s gross domestic saving less gross domestic investment (the current account’s algebraic equivalent), has been rising as a ratio to aggregate GDP at an average annual rate of about 2 percent since 1970 for the OECD countries, which constitute four-fifths of world GDP. The long-term increase in intermediation, by facilitating the financing of ever-wider current account deficits and surpluses, has created an ever-larger class of investors who might be willing to hold crossborder claims. To create liabilities, of course, implies a willingness of some private investors and governments to hold the equivalent increase in claims at market-determined asset prices. Indeed, were it otherwise, the funding of liabilities would not be possible. With the seeming willingness of foreigners to hold progressively greater amounts of cross-border claims against U.S. residents, at what point do net claims (that is, gross claims less gross liabilities) against the United States become unsustainable and deficits decline? Presumably, a U.S. current account deficit of 5 percent or more of GDP would not have been readily fundable a half-century ago or perhaps even a couple of decades ago.5 The ability to move that much of world saving to the United States in response to relative rates of return would have been hindered by a far lower degree of international financial intermediation. Endeavoring to transfer the equivalent of 5 percent of U.S. GDP from foreign financial institutions and persons to the United States would presumably have induced changes in the prices of assets that would have proved inhibiting. *** There is, for the moment, little evidence of stress in funding U.S. current account deficits. To be sure, the real exchange rate for the dollar has, on balance, declined about 15 percent broadly and roughly 25 percent against the major foreign currencies since early 2002. Yet inflation, the typical symptom of a weak currency, appears quiescent. Indeed, inflation premiums embedded in long-term interest rates apparently have fluctuated in a relatively narrow range since early 2002. More generally, the vast savings transfer has occurred without measurable disruption to the balance of international finance. Certainly, euro area exporters have been under considerable pressure, but in recent months credit risk spreads have fallen, and equity prices have risen, throughout much of the global economy. *** For the United States, for example, even excluding mortgage pools, the ratio of domestic liabilities to GDP rose at an annual rate of 2 percent between 1965 and 2002. For the United Kingdom, the ratio of domestic liabilities to GDP increased 4 percent at an annual rate during the 1987-2002 period. If the rate of growth of external assets (and liabilities) exceeds, on average, the growth rate of world GDP, under a broad range of circumstances the dispersion of the change in net external claims of trading countries must increase as a percentage of world GDP. But the change in net claims on a country, excluding currency valuation changes and capital gains and losses, is essentially the current account balance. Of necessity, of course, the consolidated world current account balance remains at zero. Theoretically, if external assets and liabilities were always equal, implying a current account in balance, the ratio of liabilities to GDP could grow without limit. But in the complexities of the real world, if external assets fall short of liabilities for some countries, net external liabilities will grow until they can no longer be effectively serviced. Well short of that point, market prices, interest rates, and exchange rates will slow, and then end, the funding of liability growth. It is true that estimates of the ratios of the current account to GDP for many countries in the nineteenth century are estimated to have been as large as, or larger, than we have experienced in recent years. However, the substantial net flows of capital financing for those earlier deficits were likely motivated in large part by specific major development projects (for example, railroads) bearing high expected rates of return. By contrast, diversification appears to be a more salient motivation for today’s large net capital flows. Moreover, gross capital flows are believed to be considerably greater relative to GDP in recent years than in the nineteenth century. (See Alan M. Taylor, “A Century of Current Account Dynamics,” Journal of International Money and Finance, 2002, 725-48, and Maurice Obstfeld and Alan Taylor, “Globalization and Capital Markets,” NBER Working Paper 8846, March 2002.) To date, the widening to record levels of the U.S. ratio of current account deficit to GDP has been, with the exception of the dollar’s exchange rate, seemingly uneventful. But I have little doubt that, should the rise in the deficit continue, at some point in the future further adjustments will be set in motion that will eventually slow and presumably reverse the rate of accumulation of net claims on U.S. residents. How much further can international financial intermediation stretch the capacity of world finance to move national savings across borders? A major inhibitor appears to be what economists call “home bias.” Virtually all our trading partners share our inclination to invest a disproportionate percentage of domestic savings in domestic capital assets, irrespective of the differential rates of return. People seem to prefer to invest in familiar local businesses even where currency and country risks do not exist. For the United States, studies have shown that individual investors and even professional money managers have a slight preference for investments in their own communities and states. Trust, so crucial an aspect of investing, is most likely to be fostered by the familiarity of local communities. As a consequence, home bias will likely continue to constrain the movement of world savings into its optimum use as capital investment, thus limiting the internationalization of financial intermediation and hence the growth of external assets and liabilities.6 Nonetheless, during the past decade, home bias has apparently declined significantly. For most of the earlier postwar era, the correlation between domestic saving rates and domestic investment rates across the world’s major trading partners, a conventional measure of home bias, was exceptionally high.7 For OECD countries, the GDP-weighted correlation coefficient was 0.97 in 1970. However, it fell from the still elevated 0.96 in 1992 to less than 0.8 in 2002. For OECD countries excluding the United States, the recent decline is even more pronounced. These declines, not surprisingly, mirror the rise in the differences between saving and investment or, equivalently, of the dispersion of current account balances over the same years. The decline in home bias doubtless reflects, in part, vast improvements in information and communication technologies that have broadened investors’ scope to the point that foreign investment appears less exotic and risky. Moreover, there has been an increased international tendency for financial systems to be more transparent, open, and supportive of strong investor protection.8 Accordingly, the trend of declining home bias and expanding international financial intermediation will likely continue as globalization proceeds. *** It is unclear at what point the rising weight of U.S. assets in global portfolios will impose restraint on world current account dispersion. When that point arrives, what do we know about whether the process of reining in our current account deficit will be benign to the economies of the United States and the world? According to a Federal Reserve staff study, current account deficits that emerged among developed countries since 1980 have risen as high as double-digit percentages of GDP before markets enforced a reversal.9 The median high has been about 5 percent of GDP. Complicating the evaluation of the timing of a turnaround is that deficit countries, both developed and emerging, borrow in international markets largely in dollars rather than in their domestic currency. The United States has been rare in its ability to finance its external deficit in a reserve currency.10 This Without home bias, the dispersion of world current account balances would likely be substantially greater. See Martin Feldstein and Charles Horioka, “Domestic Saving and International Capital Flows,” The Economic Journal, June 1980, 314-29. Research indicates that home bias in investment toward a foreign country is likely to be diminished to the extent that the country’s financial system offers transparency, accessibility, and investor safeguards. See Alan Ahearne, William Griever, and Frank Warnock, “Information Costs and Home Bias” Board of Governors of the Federal Reserve System, International Finance Discussion Paper No. 691, December 2000. Caroline Freund, “Current Account Adjustment in Industrialized Countries,” Board of Governors of the Federal Reserve System, International Finance Discussion Paper No. 692, December 2000. Less than 10 percent of aggregate U.S. foreign liabilities are currently denominated in nondollar currencies. To have your currency chosen as a store of value is both a blessing and a curse. Presumably, the buildup of dollar holdings by foreigners has provided Americans with lower interest rates as a consequence. But as Great Britain learned, the liquidation of sterling balances after World War II exerted severe pressure on its domestic economy. ability has presumably enlarged the capability of the United States relative to most of our trading partners to incur foreign debt. *** Besides experiences with the current account deficits of other countries, there are few useful guideposts of how high America’s net foreign liabilities can mount. The foreign accumulation of U.S. assets would likely slow if dollar assets, irrespective of their competitive return, came to occupy too large a share of the world’s portfolio of store of value assets. In these circumstances, investors would seek greater diversification into nondollar assets. At the end of 2002, U.S. dollars accounted for about 65 percent of central bank foreign exchange reserves, with the euro second at 19 percent. Approximately half of the much larger private cross-border holdings were denominated in dollars, with one-third in euros. More important than the way that the adjustment of the U.S. current account deficit will be initiated is the effect of the adjustment on both the U.S. economy and the economies of our trading partners. The history of such adjustments has been mixed. According to the aforementioned Federal Reserve study of current account corrections in developed countries, although the large majority of episodes were characterized by some significant slowing of economic growth, most economies managed the adjustment without crisis. The institutional strengths of many of these developed economies--rule of law, transparency, and investor and property protection--likely helped to minimize disruptions associated with current account adjustments. The United Kingdom, however, had significant adjustment difficulties in its early postwar years, as did, more recently, Mexico, Thailand, Korea, Russia, Brazil, and Argentina, to name just a few. Can market forces incrementally defuse a worrisome buildup in a nation’s current account deficit and net external debt before a crisis more abruptly does so? The answer seems to lie with the degree of flexibility in both domestic and international markets. By flexibility I mean the ability of an economy to absorb shocks, stabilize, and recover. In domestic economies that approach full flexibility, imbalances are likely to be adjusted well before they become potentially destabilizing. In a similarly flexible world economy, as debt projections rise, product and equity prices, interest rates, and exchange rates could change, presumably to reestablish global balance. The experience over the past two centuries of trade and finance among the individual states that make up the United States comes close to that paradigm of flexibility, especially given the fact that exchange rates among the states have been fixed and, hence, could not be part of an adjustment process. Although we have scant data on cross-border transactions among the separate states, anecdotal evidence suggests that over the decades significant apparent imbalances have been resolved without precipitating interstate balance-of-payments crises. The dispersion of unemployment rates among the states, one measure of imbalances, spikes during periods of economic stress but rapidly returns to modest levels, reflecting a high degree of adjustment flexibility. That flexibility is even more apparent in regional money markets, where interest rates that presumably reflect differential imbalances in states’ current accounts and hence cross-border borrowing requirements have, in recent years, exhibited very little interstate dispersion. This observation suggests either negligible cross-state-border imbalances, an unlikely occurrence given the pattern of state unemployment dispersion, or more likely very rapid financial adjustments. *** We may not be able to usefully determine at what point foreign accumulation of net claims on the United States will slow or even reverse, but it is evident that the greater the degree of international flexibility, the less the risk of a crisis.11 The experience of the United States over the past three years is illustrative. The apparent ability of our economy to withstand a number of severe shocks since mid-2000, with only a small, temporary decline in real GDP, attests to the marked increase in our economy’s flexibility over the past quarter century.12 Although increased flexibility apparently promotes resolution of current account imbalances without significant disruption, it may also allow larger deficits to emerge before markets are required to address them. See Alan Greenspan, remarks before a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 30, 2002. In evaluating the nature of the adjustment process, we need to ask whether there is something special in the dollar’s being the world’s primary reserve currency. With so few historical examples of dominant world reserve currencies, we are understandably inclined to look to the experiences of the dollar’s immediate predecessor. At the height of sterling’s role as the world’s currency more than a century ago, Great Britain had net external assets amounting to some 150 percent of its annual GDP, most of which were lost in World Wars I and II. Early post-World War II Britain was hobbled with periodic sterling crises, as much of the remnants of Empire endeavored to disengage themselves from heavy reliance on holding sterling assets as central bank reserves and private stores of value. The experience of Britain’s then extensively regulated economy, harboring many wartime controls well beyond the end of hostilities, testifies to the costs of structural rigidity in times of crisis. *** Should globalization be allowed to proceed and thereby create an ever more flexible international financial system, history suggests that current imbalances will be defused with little disruption. And if other currencies, such as the euro, emerge to share the dollar’s role as a global reserve currency, that process, too, is likely to be benign. I say this with one major caveat. Some clouds of emerging protectionism have become increasingly visible on today’s horizon. Over the years, protected interests have often endeavored to stop in its tracks the process of unsettling economic change. Pitted against the powerful forces of market competition, virtually all such efforts have failed. The costs of any new protectionist initiatives, in the context of wide current account imbalances, could significantly erode the flexibility of the global economy. Consequently, it is imperative that creeping protectionism be thwarted and reversed. The question of whether globalization will be allowed to proceed rests largely on the judgment of whether greater economic freedom, and the often frenetic competition it encourages, is deemed by leaders in societies to enhance the interests, one hopes the long-term interests, of their populations. Such broad judgments in the end determine how societies are governed. The reasons that some economies prosper and others sink into long-term stagnation consequently has been the object of intense interest in recent decades. Agreement is growing among economic analysts and policymakers that those economies that have been open to cross-border trade have, in general, prospered. Those economies that chose to eschew such trade have done poorly. Most economists have long stipulated that, for a society based on a division of labor to prosper, the exchange of goods and services must be subject to a rule of law--specifically, to laws protecting the rights of minorities and property. Presumably to be effective such arrangements must be perceived as just by an overwhelming majority of a society. Thus, a rule of law arguably requires democracy. Clearly, ideas shape societies and economies. Indeed, I have maintained over the years that the most profoundly important debate between conflicting theories of optimum economic organization during the twentieth century was settled, presumably definitively, here more than a decade ago in the aftermath of the dismantling of the Berlin Wall. Aside from the Soviet Union itself, the economies of the Soviet bloc had been, in the prewar period, similar in many relevant respects to the market-based economies of the west. Over the first four decades of postwar Europe, both types of economies developed side by side with limited interaction. It was as close to a controlled experiment in the viability of economic systems as could ever be implemented. The results, evident with the dismantling of the Wall, were unequivocally in favor of market economies. The consequences were far-reaching. The long-standing debate between the virtues of economies organized around free markets and those governed by centrally planned socialism, one must assume, is essentially at an end. To be sure, a few still support an old fashioned socialism. But for the vast majority of previous adherents it is now a highly diluted socialism, an amalgam of social equity and market efficiency, often called market socialism. The verdict on rigid central planning has been rendered, and it is generally appreciated to have been unqualifiedly negative. There was no eulogy for central planning; it just ceased to be mentioned, and a large majority of developing nations quietly shifted from socialism to more market-oriented economies. Europe has accepted market capitalism in large part as the most effective means for creating material affluence. It does so, however, with residual misgivings. The differences between the United States and continental Europe were captured most clearly for me in a soliloquy attributed to a prominent European leader several years ago. He asked, “What is the market? It is the law of the jungle, the law of nature. And what is civilization? It is the struggle against nature.” While acknowledging the ability of competition to promote growth, many such observers, nonetheless, remain concerned that economic actors, to achieve that growth, are required to behave in a manner governed by the law of the jungle and are hence driven to an excess of materialism. In contrast to these skeptics, others, especially in the United States, believe the gains in material wealth resulting from market-driven outcomes facilitate the pursuit of broader values. They support a system based on voluntary choice in a free marketplace. The crux of the largely laissez-faire argument is that, because unencumbered competitive markets reflect the value preferences of consumers, the resulting price signals direct a nation’s savings into those capital assets that maximize the production of goods and services most valued by consumers. Incomes earned from that production are determined, for the most part, by how successfully the participants in an economy contribute to the welfare of consumers, the presumed purpose of a society’s economy. Clearly, not all activities undertaken in markets are civil. Many, though legal, are decidedly unsavory. Violation of law and breaches of trust do undermine the efficiency of markets. But the legal foundations and the discipline of the marketplace are sufficiently rooted in a rule of law to limit these aberrations. It is instructive that despite the egregious breaches of trust in recent years by a number of America’s business and financial leaders, productivity, an important metric of corporate efficiency, has accelerated. *** On net, most economists would agree that vigorous economic competition over the years has produced a significant rise in the quality of life for the vast majority of the population in market-oriented economies, including those at the bottom of the income distribution. The highly competitive free market paradigm, however, is viewed by many at the other end of the philosophical spectrum, especially among some here in Europe, as obsessively materialistic and largely lacking in meaningful cultural values. Those that still harbor a visceral distaste for highly competitive market capitalism doubtless gained adherents with the recent uncovering of much scandalous business behavior during the boom years of the 1990s. But is there a simple tradeoff between civil conduct, as defined by those who find raw competitive behavior demeaning, and the quality of material life they, nonetheless, seek? It is not obvious from a longer-term perspective that such a tradeoff exists in any meaningful sense. During the past century, for example, economic growth created resources far in excess of those required to maintain subsistence. That surplus, even in the most aggressively competitive economies, has been in large measure employed to improve the quality of life along many dimensions. To cite a short list: (1) greater longevity, owing first to the widespread development of clean, potable water and later to rapid advances in medical technology; (2) a universal system of education that enabled greatly increased social mobility; (3) vastly improved conditions of work; and (4) the ability to enhance our environment by setting aside natural resources rather than having to employ them to sustain a minimum level of subsistence. At a fundamental level, Americans, for example, have used the substantial increases in wealth generated by our market-driven economy to purchase what many would view as greater civility. *** The collapse of the Soviet empire, and with it central planning, has left market capitalism as the principal, but not universally revered, model of economic organization. Nevertheless, the vigorous debate on how economies should be organized in our increasingly globalized society and what rules should govern individuals’ trading appears destined to continue.
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Lecture by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, and Mr Vincent R Reinhart, Director, Division of Monetary Affairs of the Board of Governors of the US Federal Reserve System1, at the International Center for Monetary and Banking Studies, Geneva, 14 January 2004. Paper also presented at the meetings of the American Economic Association, San Diego, 3 January 2004.
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Ben S Bernanke: Conducting monetary policy at very low short-term interest rates Lecture by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, and Mr Vincent R Reinhart, Director, Division of Monetary Affairs of the Board of Governors of the US Federal Reserve System1, at the International Center for Monetary and Banking Studies, Geneva, 14 January 2004. Paper also presented at the meetings of the American Economic Association, San Diego, 3 January 2004. The references for the speech can be found on the Board of Governors of the Federal Reserve System’s website. * * * Can monetary policy committees, accustomed to describing their plans and actions in terms of the level of a short-term nominal interest rate, find effective means of conducting and communicating their policies when that rate is zero or close to zero? The very low levels of interest rates in Japan, Switzerland, and the United States in recent years have stimulated much interesting research on this question, and some has been applied in the field. Moreover, their minds concentrated by the possibility of having the policy rate pinned at zero, central bankers have responded flexibly, making changes in their operating procedures and communications strategies. Our purpose in this paper is to give a brief progress report and overview of current thinking on the conduct of monetary policy when short-term interest rates are very low or even zero.2 Monetary policy works for the most part through financial markets. Central bank actions are designed in the first instance to influence asset prices and yields, which in turn affect economic decisions and thus the evolution of the economy. When the short-term policy rate is at or near zero, the conventional means of effecting monetary ease--lowering the target for the policy rate--is no longer feasible, but monetary policy is not impotent. In this paper we will discuss three alternative (but potentially complementary) monetary strategies for stimulating the economy that do not involve changing the current value of the policy rate. Specifically, these alternatives involve (1) providing assurance to financial investors that short rates will be lower in the future than they currently expect, (2) changing the relative supplies of securities (such as Treasury notes and bonds) in the marketplace by shifting the composition of the central bank’s balance sheet, and (3) increasing the size of the central bank’s balance sheet beyond the level needed to set the short-term policy rate at zero (“quantitative easing”). In the final section, we briefly discuss the macroeconomic costs and benefits of very low interest rates, an issue that bears on the question of whether the central bank should take the policy rate all the way to zero before undertaking some of the alternatives we describe. I. Shaping Interest-Rate Expectations The pricing of long-lived assets, such as long-term bonds and equities, depends on the entire expected future path of short-term interest rates as well as on the current short-term rate. Prices and yields of long-lived assets are important determinants of economic behavior because they affect incentives to spend, save, and invest. Thus, a central bank may hope to affect financial markets and economic activity by influencing financial market participants’ expectations of future short-term rates. Important recent research has examined this potential channel of influence in fully articulated models based on optimizing behavior; see Michael Woodford (2003, chapter 6), Lars Svensson (2001), and Gauti Eggertson and Woodford (2003). This literature suggests that, even with the overnight nominal interest rate at zero, a central bank can impart additional stimulus by offering some form of commitment to the public to keep the short rate low for a longer period than previously expected. This commitment, if credible, should lower yields throughout the term structure and support other asset prices. We have benefited from the research of, and many discussions with, numerous colleagues. However, the views expressed here are our own and not necessarily shared by anyone else in the Federal Reserve System. See Bernanke (2002) and Clouse et al. (2003) for earlier discussions of these issues. In principle, the central bank’s policy commitment could take either of two forms: unconditional and conditional. An unconditional commitment is a pledge by the central bank to hold short-term rates at a low level for a fixed period of calendar time. In this case, additional easing would take the form of lengthening the period of policy commitment. However, given the many shocks that the economy is heir to, as well as other imponderables that affect the outlook, a policymaking committee might understandably be reluctant to tie its hands by making an unconditional promise, no matter how nuanced, about policy actions far into the future. An alternative strategy is to make a conditional policy commitment, one that links the duration of promised policies not to the calendar but to the evolution of economic conditions. For example, policy ease could be promised until the committee observes sustained economic growth, substantial progress in trimming economic slack, or a period of inflation above a specified floor. In practice, central banks appear to appreciate the importance of influencing market expectations about future policy. For example, in May 2001, with its policy rate virtually at zero, the Bank of Japan promised that it would keep its policy rate at zero for as long as the economy experienced deflation--a conditional policy commitment. More recently, the Bank of Japan has been more explicit about the conditions under which it would begin to raise rates; for example, it has been specified that a change from deflation to inflation that is perceived to be temporary will not provoke a tightening.3 In the United States, the August 2003 statement of the Federal Open Market Committee that “policy accommodation can be maintained for a considerable period” is another example of commitment. The close association of this statement with the Committee’s expressed concerns about “unwelcome disinflation” implied that this commitment was conditioned on the assessment of the economy. The conditional nature of the commitment was sharpened in the Committee’s December statement, which explicitly linked continuing policy accommodation to the low level of inflation and the slack in resource use.4 More generally, in recent years central banks have devoted enormous effort to improving their communications and transparency; a major benefit of such efforts should be a greater ability to align market expectations of policy with the policymaking committee’s own intentions. Of course, policy commitments can influence future expectations only to the extent that they are credible. Various devices might be employed to enhance credibility; for example, the central bank can make securities purchases or issue financial options that make it quite costly, in financial terms, to renege on its commitments (Clouse et al., 2003). An objection to this strategy is that it is not entirely clear why a central bank, which has the power to print money, should be overly concerned about its financial gains and losses. Eggertsson and Woodford (2003) point out that a government can more credibly promise to carry out policies that raise prices when (1) the government debt is large and not indexed to inflation and (2) the central bank values the reduction in fiscal burden that reflationary policies will bring (for example, because it may reduce the future level of distortionary taxation). Ultimately, however, the central bank’s best strategy for building credibility is to ensure that its deeds match its words, thereby building trust in its pronouncements. The requirement that deeds match words has the consequence that the shaping of market expectations is not an independent instrument of policy in the long run. II. Altering the Composition of the Central Bank’s Balance Sheet Central banks typically hold a variety of assets, and the composition of assets on the central bank’s balance sheet offers another potential lever for monetary policy. For example, the Federal Reserve participates in all segments of the Treasury market, with most of its current asset holdings of about $670 billion distributed among Treasury securities with maturities ranging from four weeks to thirty years. Over the past fifty years, the average maturity of the Federal Reserve System’s holdings of Treasury debt has varied considerably within a range from one to four years. As an important participant in the Treasury market, the Federal Reserve might be able to influence term premiums, and thus overall yields, by shifting the composition of its holdings, say from shorter- to longer-dated securities. In simple terms, if the liquidity or risk characteristics of securities differ, so that investors do not treat all securities as perfect substitutes, then changes in relative demands by a large purchaser have the potential to alter relative security prices. (The same logic might lead the central bank to consider purchasing assets other than Treasury securities, such as corporate bonds or stocks or For a recent appraisal of monetary policy options in Japan, see Bernanke (2003). 2003 FOMC statements and minutes. foreign government bonds. The Federal Reserve is currently authorized to purchase some foreign government bonds but not most private-sector assets, such as corporate bonds or stocks.) Perhaps the most extreme example of a policy keyed to the composition of the central bank’s balance sheet is an announced ceiling on some longer-term yield below the prevailing rate. This policy entails (in principle) an unlimited commitment to purchase the targeted security at the announced price. (To keep the overall size of its balance sheet unchanged, the central bank would have to sell other securities in an amount equal to the purchases of the targeted security.) Obviously, such a policy would signal strong dissatisfaction on the part of the policymaking committee with current market expectations of future policy rates. Whether policies based on manipulating the composition of the central bank balance sheet can be effective is a contentious issue. The limited empirical evidence generally suggests that the degree of imperfect substitutability within broad asset classes, such as Treasury securities, is not great, so that changes in relative supplies within the range of U.S. experience are unlikely to have a major impact on risk premiums or term premiums (Reinhart and Sack, 2001). If this view is correct, then attempts to enforce a floor on the prices of long-dated Treasury securities (for example) could be effective only if the target prices were broadly consistent with investor expectations of future values of the policy rate. If investors doubted that rates would be kept low, the central bank would end up owning all or most of those securities. Moreover, even if large purchases of, say, a long-dated Treasury security were able to affect the yield on that security, the policy may not have significant economic effects if the targeted security became “disconnected” from the rest of the term structure and from private rates, such as mortgage rates. Yet another complication affecting this type of policy is that the central bank’s actions would have to be coordinated with the central government’s finance department to ensure that changes in debtmanagement policies do not offset the attempts of the central bank to affect the relative supplies of securities. According to James Tobin, the Federal Reserve’s failure to coordinate adequately with the Treasury was the undoing of “Operation Twist” in 1963 (Tobin, 1973, pp. 32-33). Despite these objections, we should not fail to note that policies based on changing the composition of the central bank’s balance sheet have been tried in the United States. From 1942 to 1951, the Federal Reserve enforced rate ceilings at two and sometimes three points on the Treasury yield curve. This objective was accomplished with only moderate increases in the Federal Reserve’s overall holdings of Treasury securities, relative to net debt outstanding; moreover, there is little evidence that the targeted yields became “disconnected” from other public or private yields. The episode is an intriguing one, but unfortunately the implications for current policy are not entirely straightforward. We know that, by 1946, the Federal Reserve System owned almost nine-tenths of the (relatively small) stock of Treasury bills, suggesting that at the short end, the ceiling on the bill rate was a binding constraint. In contrast, the Federal Reserve’s relative holdings of longer-dated Treasury notes and bonds fell over the period, although the rate ceilings at these longer maturities were not breached until inflation pressures led to the Fed-Treasury Accord and the abandonment of the pegging policy in 1951. The conventional interpretation is that long-run policy expectations must have been consistent with the ceilings at the more distant points on the yield curve. Less clear is the extent to which the pegging policy itself influenced those policy expectations. Probably the safest conclusion about policies based on changing the composition of the central bank’s balance sheet is that they should be used only to supplement other policies, such as an attempt (for example, through a policy commitment) to influence expectations of future short rates. This combined approach allows the central bank to enjoy whatever benefits arise from changing the relative supplies of outstanding securities without risking the problems that may arise if the yields desired by the central bank are inconsistent with market expectations. III. Expanding the Size of the Central Bank’s Balance Sheet Besides changing the composition of its balance sheet, the central bank can also alter policy by changing the size of its balance sheet; that is, by buying or selling securities to affect the overall supply of reserves and the money stock. Of course, this strategy represents the conventional means of conducting monetary policy, as described in many textbooks. These days, most central banks choose to calibrate the degree of policy ease or tightness by targeting the price of reserves--in the case of the Federal Reserve, the overnight federal funds rate. However, nothing prevents a central bank from switching its focus from the price of reserves to the quantity or growth of reserves. When stated in terms of quantities, it becomes apparent that even if the price of reserves (the federal funds rate) becomes pinned at zero, the central bank can still expand the quantity of reserves. That is, reserves can be increased beyond the level required to hold the overnight rate at zero--a policy sometimes referred to as “quantitative easing.” Some evidence exists that quantitative easing can stimulate the economy even when interest rates are near zero; see, for example, Christina Romer’s (1992) discussion of the effects of increases in the money supply during the Great Depression in the United States. Quantitative easing may affect the economy through several possible channels. One potential channel is based on the premise that money is an imperfect substitute for other financial assets (in contrast to the view discussed in the previous section that emphasizes the imperfect substitutability of various nonmoney assets). If this premise holds, then large increases in the money supply will lead investors to seek to rebalance their portfolios, raising prices and reducing yields on alternative, non-money assets. Lower yields on long-term assets will in turn stimulate economic activity. The possibility that monetary policy works through portfolio substitution effects, even in normal times, has a long intellectual history, having been espoused by both Keynesians (Tobin, 1969) and monetarists (Brunner and Meltzer, 1973). Recently, Javier Andres, J. David Lopez-Salido, and Edward Nelson (2003) have shown how these effects might work in a general equilibrium model with optimizing agents. The practical importance of these effects remains an open question, however. Quantitative easing may also work by altering expectations of the future path of policy rates. For example, suppose that the central bank commits itself to keeping reserves at a high level, well above that needed to ensure a zero short-term interest rate, until certain economic conditions obtain. Theoretically, this action is equivalent to a commitment to keep interest rates at zero until the economic conditions are met, a type of policy we have already discussed. However, the act of setting and meeting a high reserves target is more visible, and hence may be more credible, than a purely verbal promise about future short-term interest rates. Moreover, this means of committing to a zero interest rate will also achieve any benefits of quantitative easing that may be felt through nonexpectational channels. Lastly, quantitative easing that is sufficiently aggressive and that is perceived to be long-lived may have expansionary fiscal effects. So long as market participants expect a positive short-term interest rate at some date in the future, the existence of government debt implies a current or future tax liability for the public. In expanding its balance sheet by open-market purchases, the central bank replaces public holdings of interest-bearing government debt with non-interest-bearing currency or reserves. If the open-market operation is not expected to be reversed too quickly, this exchange reduces the present and future interest costs of the government and the tax burden on the public. (Effectively, this process replaces a direct tax, say on labor, with the inflation tax.) Auerbach and Obstfeld (2003) have analyzed the fiscal and expectational effects of a permanent increase in the money supply along these lines. Note that the expectational and fiscal channels of quantitative easing, though not the portfolio substitution channel, require the central bank to make a credible commitment to not reverse its openmarket operations, at least until certain conditions are met. Thus, this approach also poses communication challenges for monetary policy makers. Japan once again provides the most recent case study. In the past two years, current account balances held by commercial banks at the Bank of Japan have increased about five-fold, and the monetary base has risen to almost 30 percent of nominal GDP. While deflation appears to have eased in Japan recently, it is difficult to know how much of the improvement is due to monetary policy, and, of the part due to monetary policy, how much is due to the zero-interest-rate policy and how much to quantitative easing. The experience of the United States with quantitative policies is limited to the period 1979 to 1982, when the Federal Reserve targeted nonborrowed reserves. Of course, nominal interest rates were not close to zero at that time. The U.S. experience does suggest, however, that the demand for reserves may be sufficiently erratic that the effects of quantitative policies may be intrinsically hard to calibrate. IV. Sequencing and the “Costs” of Low Interest Rates The forms of monetary stimulus described above can be used once the overnight rate has already been driven to zero or as a way of driving the overnight rate to zero. However, a central bank might choose to rely on these alternative policies while maintaining the overnight rate somewhat above zero. For example, monetary policy makers might attempt to influence market expectations of future short rates as an alternative to changing the current setting of the overnight rate. Another possibility is to try to affect term premiums, expectations of future rates, or both, by changing the composition of securities held by the central bank. (Unlimited expansion of the total volume of securities held by the central bank is not compatible, of course, with a positive overnight rate.) The appropriate sequencing of policy actions depends on the perceived costs associated with very low or zero overnight interest rates, as well as on operational considerations and estimates of the likely effects of alternative combinations of policies on the economy. What costs are imposed on society by very low short-term interest rates? Observers have pointed out that rates on financial instruments typically priced below the overnight rate, such as liquid deposits, shares in money market mutual funds, and collateralized borrowings in the “repo” market, would be squeezed toward zero as the policy rate fell, prompting investors to seek alternatives. Short-term dislocations might result, for example, if funds flowed in large amounts from money market mutual funds into bank deposits. In that case, some commercial paper issuers who have traditionally relied on money market mutual funds for financing would have to seek out new sources, while banks would need to find productive uses for the deposit inflows and perhaps face changes in regulatory capital requirements. In addition, liquidity in some markets might be affected; for example, the incentive for reserve managers to trade federal funds diminishes as the overnight rate falls, probably thinning brokering in that market. In thinking about the costs associated with a low overnight rate, one should bear in mind the message of Milton Friedman’s classic essay on the optimal quantity of money (Friedman, 1969). Friedman argued that an overnight interest rate of zero is optimal, because a zero opportunity cost of liquidity eliminates the socially wasteful use of resources to economize on money balances. From this perspective, the costs of low short-term interest rates can be seen largely as adjustment costs, arising from the unwinding of schemes designed to make holding transactions balances less burdensome. These costs are real but are also largely transitory and have limited sectoral impact. Moreover, to the extent that the affected institutions have economic functions other than helping clients economize on money balances (for example, if some money market mutual funds have a comparative advantage in lending to commercial paper issuers), there is scope for repricing that will allow these services to continue to be offered. Thus there seems to be little reason for central banks to avoid bringing the policy rate close to zero if the economic situation warranted. A quite different argument for engaging in alternative monetary policies before lowering the overnight rate all the way to zero is that the public might interpret a zero instrument rate as evidence that the central bank has “run out of ammunition.” That is, low rates risk fostering the misimpression that monetary policy is ineffective. As we have stressed, that would indeed be a misimpression, as the central bank has means of providing monetary stimulus other than the conventional measure of lowering the overnight nominal interest rate. However, it is also true that the considerable uncertainty that surrounds the use of these alternative measures does make the calibration of policy actions more difficult. Moreover, given the important role for expectations in making many of these policies work, the communications challenges would be considerable. Given these risks, policymakers are well advised to act preemptively and aggressively to avoid facing the complications raised by the zero lower bound.
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the HM Treasury Enterprise Conference, London, England, (via satellite), 26 January 2004.
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Alan Greenspan: Economic flexibility Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the HM Treasury Enterprise Conference, London, England, (via satellite), 26 January 2004. * * * As the Great Depression of the 1930s deepened, John Maynard Keynes offered an explanation for the then-bewildering series of events that was to engage economists for generations to come. Market systems, he argued, contrary to the conventional wisdom, did not at all times converge to full employment. They often, in economists’ jargon, found equilibrium with significant segments of the workforce unable to find jobs. His insight rested largely on certain perceived rigidities in labor and product markets. The notion prevalent in the 1920s and earlier - that economies, when confronted with unanticipated shocks, would quickly return to full employment - fell into disrepute as the depression festered. In its place arose the view that government action was required to restore full employment. More broadly, government intervention was increasingly seen as necessary to correct the failures and deficiencies viewed as inherent in market economies. Laissez-faire was rapidly abandoned and a tidal wave of regulation swept over much of the world’s business community. In the United States, labor practices, securities issuance, banking, agricultural pricing, and many other segments of the American economy, fell under the oversight of government. With the onset of World War II, both the U.S. and the U.K. economies went on a regimented war footing. Military production ramped up rapidly and output reached impressive levels. Central planning, in one sense, had its finest hour. The pattern of production and distribution depended on plans devised by a small, elite group rather than responding to the myriad choices of consumers that rule a market economy. The ostensible success of wartime economies operating at full employment, in contrast to the earlier frightening developments of the depression years, thwarted a full dismantlement of wartime regimens when hostilities came to an end. Wage and price controls, coupled with rationing, lingered in many economies well into the first postwar decade. Because full employment was no longer perceived as ensured by the marketplace, government initiatives promoting job growth dominated the postwar economic policy framework of the Western democracies. In the United States, the Congress passed, and the President signed, the “Employment Act of 1946.” However, cracks in the facade of government economic management emerged early in the postwar years, and those cracks were to continue widening as time passed. Britain’s heavily controlled economy was under persistent stress as it vaulted from one crisis to another in the early postwar decades. In the United States, unbalanced macroeconomic policies led to a gradual uptrend in the rate of inflation in the 1960s. The imposition of wage and price controls in the 1970s to deal with the problem of inflation proved unworkable and ineffective. The notion that the centrally planned Soviet economy was catching up with the West was, by the early 1980s, increasingly viewed as dubious, though it was not fully discarded until the collapse of the Berlin Wall in 1989 exposing the economic ruin behind the iron curtain. The East-West divisions following World War II engendered an unintended four-decades-long experiment in comparative economic systems, which led, in the end, to a judgment by the vast majority of policymakers that market economies were unequivocally superior to those managed by central planning. Many developing nations abandoned their Soviet-type economic systems for more market-based regimes. But even earlier in the developed world, distortions induced by regulation were more and more disturbing. In response, starting in the 1970s, American Presidents, supported by bipartisan majorities in the Congress, deregulated large segments of the transportation, communications, energy, and financial services industries. The stated purpose was to enhance competition, which was increasingly seen as a significant spur to productivity growth and elevated standards of living. Assisting in the dismantling of economic rigidities was the seemingly glacial, but persistent, lowering of barriers to cross-border trade and finance. As a consequence, the United States, then widely seen as a once great economic power that had lost its way, gradually moved back to the forefront of what Joseph Schumpeter, the renowned Harvard professor, called “creative destruction,” the continuous scrapping of old technologies to make way for the innovative. In that paradigm, standards of living rise because depreciation and other cash flows of industries employing older, increasingly obsolescent, technologies are marshaled, along with new savings, to finance the production of capital assets that almost always embody cutting-edge technologies. Workers, of necessity, migrate with the capital. Through this process, wealth is created, incremental step by incremental step, as high levels of productivity associated with innovative technologies displace lesser productive capabilities. The model presupposes the continuous churning of a flexible competitive economy in which the new displaces the old. The success of that strategy in the United States confirmed, by the 1980s, the earlier views that a loosening of regulatory restraint on business would improve the flexibility of our economy. Flexibility implies a faster response to shocks and a correspondingly greater ability to absorb their downside consequences and to recover from their aftermath. No specific program encompassed and coordinated initiatives to enhance flexibility, but there was a growing recognition, both in the United States and among many of our trading partners, that a market economy could best withstand and recover from shocks when provided maximum flexibility. Developments that enhanced flexibility ranged far beyond regulatory or statutory change. For example, employers have long been able to legally discharge employees at modest cost. But in the early postwar years, profitable large corporations were dissuaded from wholesale job reduction. Contractual inhibitions, to be sure, were then decidedly more prevalent than today, but of far greater importance, our culture in the aftermath of depression frowned on such action. Only when bankruptcy threatened was it perceived to be acceptable. But as the depression receded into history, attitudes toward job security and tenure changed. The change was first evidenced by the eventual acceptance by the American public of President Reagan’s discharge of federally employed air traffic controllers in 1981 when they engaged in an illegal strike. Job security, not a major concern of the average worker in earlier years, became a significant issue especially in labor negotiations. By the early 1990s, the climate had so changed that laying off workers to facilitate cost reduction had become a prevalent practice. Whether this seeming greater capacity to discharge workers would increase or decrease the level of structural unemployment was uncertain, however. In the event, structural unemployment decreased because the broadened freedom to discharge workers rendered hiring them less of a potentially costly long-term commitment. The increased flexibility of our labor market is now judged an important contributor to economic resilience and growth. American workers, to a large extent, see this connection and, despite the evident tradeoff between flexibility and job security, have not opposed innovation. An appreciation of the benefits of flexibility also has been growing elsewhere. Germany recently passed labor reforms, as have other continental European nations. U.K. labor markets, of course, have also experienced significant increases in flexibility in recent years. Beyond deregulation and culture change, innovative technologies, especially information technology, have been major contributors to enhanced flexibility. A quarter-century ago, companies often required weeks to unearth a possible inventory imbalance, allowing production to continue to exacerbate the excess. Excessive inventories, in turn, necessitated a deeper decline in output for a time than would have been necessary had the knowledge of their status been fully current. The advent of innovative information technologies has significantly foreshortened the reporting lag, enabling flexible real-time responses to emerging imbalances. Deregulation and the newer information technologies have joined, in the United States and elsewhere, to advance financial flexibility, which in the end may be the most important contributor to the evident significant gains in economic stability over the past two decades. Historically, banks have been at the forefront of financial intermediation, in part because their ability to leverage offered an efficient source of funding. But too often in periods of severe financial stress, such leverage brought down numerous, previously vaunted banking institutions, and precipitated a financial crisis that led to recession or worse. But recent regulatory reform coupled with innovative technologies has spawned rapidly growing markets for, among many other products, asset-backed securities, collateral loan obligations, and credit derivative default swaps. Financial derivatives, more generally, have grown throughout the world at a phenomenal rate of 17 percent per year over the past decade. Conceptual advances in pricing options and other complex financial products, along with improvements in computer and telecommunications technologies, have significantly lowered the costs of, and expanded the opportunities for, hedging risks that were not readily deflected in earlier decades. The new instruments of risk dispersion have enabled the largest and most sophisticated banks in their credit-granting role to divest themselves of much credit risk by passing it to institutions with far less leverage. Insurance companies, especially those in reinsurance, pension funds, and hedge funds continue to be willing, at a price, to supply this credit protection, despite the significant losses on such products that some of these investors experienced during the past three years. These increasingly complex financial instruments have contributed, especially over the recent stressful period, to the development of a far more flexible, efficient, and hence resilient financial system than existed just a quarter-century ago. One prominent example was the response of financial markets to a burgeoning and then deflating telecommunications sector. Worldwide borrowing by telecommunications firms in all currencies amounted to more than the equivalent of one trillion U.S. dollars during the years 1998 to 2001. The financing of the massive expansion of fiber-optic networks and heavy investments in third-generation mobile-phone licenses by European firms strained debt markets. At the time, the financing of these investments was widely seen as prudent because the telecommunications borrowers had very high valuations in equity markets, which could facilitate a stock issuance, if needed, to pay down bank loans and other debt. In the event, of course, prices of telecommunications stocks collapsed, and many firms went bankrupt. Write-downs were heavy, especially in continental Europe, but unlike in previous periods of large financial distress, no major financial institution defaulted, and the world economy was not threatened. Thus, in stark contrast to many previous episodes, the global financial system exhibited a remarkable ability to absorb and recover from shocks. *** The most significant lesson to be learned from recent economic history is arguably the importance of structural flexibility and the resilience to economic shocks that it imparts. The more flexible an economy, the greater its ability to self-correct in response to inevitable, often unanticipated, disturbances and thus to contain the size and consequences of cyclical imbalances. Enhanced flexibility has the advantage of being able to adjust automatically and not having to rest on policymakers’ initiatives, which often come too late or are misguided. I do not claim to be able to judge the relative importance of conventional stimulus and increased economic flexibility to our ability to weather the shocks of the past few years. But it is difficult to dismiss improved flexibility as having played a key role in the U.S. economy’s recent relative stability. In fact, the past two recessions in the United States were the mildest in the postwar period. The experience of Britain and many others during this period of time have been similar. *** I do not doubt that the vast majority of us would prefer to work in an environment that was less stressful and less competitive than the one with which we currently engage. The cries of distress amply demonstrate that flexibility and its consequence, rigorous competition, are not universally embraced. Flexibility in labor policies, for example, appears in some contexts to be the antithesis of job security. Yet, in our roles as consumers, we seem to insist on the low product prices and high quality that are the most prominent features of our current frenetic economic structure. If a producer can offer quality at a lower price than the competition, retailers are pressed to respond because the consumer will otherwise choose a shopkeeper who does. Retailers are afforded little leeway in product sourcing and will seek out low-cost producers, whether they are located in Guangdong province in China or northern England. If consumers are stern taskmasters of their marketplace, business purchasers of capital equipment and production materials inputs have taken the competitive paradigm a step further and applied it on a global scale. From an economic perspective, the globe has indeed shrunk. Not only have the costs of transporting goods and services, relative to the total value of trade, declined over most of the postwar period, but international travel costs, relative to incomes, are down, and cross-border communications capabilities have risen dramatically with the introduction of the Internet and the use of satellites. National boundaries are less and less a barrier to trade as companies more and more manufacture in many countries and move parts and components across national boundaries with the same ease of movement exhibited a half century ago within national economies. A consequence, in the eyes of many, if not most, economists, world per capita real GDP over the past three decades has risen almost 1-1/2 percent annually, and the proportion of the developing world’s population that live on less than one dollar per day has markedly declined. Yet globalization is by no means universally admired. The frenetic pace of the competition that has characterized markets’ extended global reach has engendered major churnings in labor and product markets. The sensitivity of the U.S. economy and many of our trading partners to foreign competition appears to have intensified recently as technological obsolescence has continued to foreshorten the expected profitable life of each nation’s capital stock. The more rapid turnover of our equipment and plant, as one might expect, is mirrored in an increased turnover of jobs. A million American workers, for example, currently leave their jobs every week, two-fifths involuntarily, often in association with facilities that have been displaced or abandoned. A million, more or less, are also newly hired or returned from layoffs every week, in part as new facilities come on stream. Related to this process, jobs in the United States have been perceived as migrating abroad over the years, to low-wage Japan in the 1950s and 1960s, to low-wage Mexico in the 1990s, and most recently to low-wage China. Japan, of course, is no longer characterized by a low-wage workforce, and many in Mexico are now complaining of job losses to low-wage China. In developed countries, conceptual jobs, fostered by cutting-edge technologies, are occupying an ever-increasing share of the workforce and are gradually replacing work that requires manual skills. Those industries in which labor costs are a significant part of overall costs have been under greater competition from foreign producers with lower labor costs, adjusted for productivity. This process is not new. For generations human ingenuity has been creating industries and jobs that never before existed, from vehicle assembling to computer software engineering. With those jobs come new opportunities for workers with the necessary skills. In recent years, competition from abroad has risen to a point at which developed countries’ lowest skilled workers are being priced out of the global labor market. This diminishing of opportunities for such workers is why retraining for new job skills that meet the evolving opportunities created by our economies has become so urgent a priority. A major source of such retraining in the United States has been our community colleges, which have proliferated over the past two decades. We can usually identify somewhat in advance which tasks are most vulnerable to being displaced by foreign or domestic competition. But in economies at the forefront of technology, most new jobs are the consequence of innovation, which by its nature is not easily predictable. What we in the United States do know is that, over the years, more than 94 percent of our workforce, on average, has been employed as markets matched idled workers seeking employment to new jobs. We can thus be confident that new jobs will displace old ones as they always have, but not without a high degree of pain for those caught in the job-losing segment of America’s massive job-turnover process. *** The onset of far greater flexibility in recent years in the labor and product markets of the United States and the United Kingdom, to name just two economies, raises the possibility of the resurrection of confidence in the automatic rebalancing ability of markets, so prevalent in the period before Keynes. In its modern incarnation, the reliance on markets acknowledges limited roles for both countercyclical macroeconomic policies and market-sensitive regulatory frameworks. The central burden of adjustment, however, is left to economic agents operating freely and in their own self-interest in dynamic and interrelated markets. The benefits of having moved in this direction over the past couple of decades are increasingly apparent. The United States has experienced quarterly declines in real GDP exceeding 1 percent at an annual rate on only three occasions over the past twenty years. Britain has gone forty-six quarters without a downturn. Nonetheless, so long as markets are free and human beings exhibit swings of euphoria and distress, the business cycle will continue to plague us. But even granting human imperfections, flexible economic institutions appear to significantly ameliorate the amplitude and duration of the business cycle. The benefits seem sufficiently large that special emphasis should be placed on searching for policies that will foster still greater economic flexibility while seeking opportunities to dismantle policies that contribute to unnecessary rigidity. Let me raise one final caution in this otherwise decidedly promising scenario. Disoriented by the quickened pace of today’s competition, some in the United States look back with nostalgia to the seemingly more tranquil years of the early post-World War II period, when tariff walls were perceived as providing job security from imports. Were we to yield to such selective nostalgia and shut out a large part, or all, of imports of manufactured goods and produce those goods ourselves, our overall standards of living would fall. In today’s flexible markets, our large, but finite, capital and labor resources are generally employed most effectively. Any diversion of resources from the market-guided activities would, of necessity, engender a less-productive mix. For the most part, we in the United States have not engaged in significant and widespread protectionism for more than five decades. The consequences of moving in that direction in today’s far more globalized financial world could be unexpectedly destabilizing. I remain optimistic that we and our global trading partners will shun that path. The evidence is simply too compelling that our mutual interests are best served by promoting the free flow of goods and services among our increasingly flexible and dynamic market economies.
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board of governors of the federal reserve system
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Speech by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the Bond Market Association's Legal and Compliance Conference, New York, 4 February 2004.
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Susan Schmidt Bies: Enterprise-wide compliance programs Speech by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the Bond Market Association’s Legal and Compliance Conference, New York, 4 February 2004. * * * Introduction I want to thank the Bond Market Association for the opportunity to speak to you this afternoon. Given the evolution of the financial markets and financial services industry and the unfortunate events that some firms have recently encountered, comprehensive and robust management of legal and reputational risks is becoming more essential. The agenda for this conference reflects many of the concerns that have been raised over the past two years regarding legal and reputational risks in general, and conflicts of interest, the adequacy of public disclosures, and the transparency of accounting in particular. I know that we all hoped that with the new year we could put behind us the corporate governance shortcomings and financial restatements of the past several quarters. Unfortunately, the news about Parmalat demonstrates that we are not yet out of the woods and that corporate governance problems are not limited to the United States, but are a global issue. Financial firms are facing losses and possible legal and reputational risks in connection with their dealings with this company. The industry still has a lot of work to do in managing risks, and this conference is an excellent step toward addressing important risk-management issues in the context of the compliance function. In addition to sponsoring this timely conference, the Bond Market Association has been at the forefront of myriad initiatives relating to risk management and compliance. One especially important initiative has been the association’s participation with other industry groups in establishing the Joint Market Practices Forum. The forum’s first initiative has been to articulate a statement of principles regarding the handling and use of material, nonpublic information by credit market participants. The statement of principles fulfills a number of objectives. The most critical, in my view, is the promotion of fair and competitive markets in which inappropriate use of material, nonpublic information is not tolerated. At the same time, the statement allows lenders to effectively manage credit-portfolio activities to facilitate borrower access to more-liquid and more-efficient sources of credit. This recognizes that the liquidity and efficiency of our financial markets are related directly to the integrity of, and public confidence in, those markets. The forum’s statement of principles also provides a number of meaningful recommendations, some of which have already been adopted by the major participants in the credit derivatives market. The statement and recommendations have sparked much-needed discussion and helped identify issues, such as conflicts of interest and insider trading, that may arise in connection with credit portfolio management. These are important steps toward improving the risk-management environment, and I commend you for voluntarily taking the initiative. One aspect of the forum’s statement that I would particularly like to applaud is its focus on controls and compliance across the consolidated organization, because that focus ties directly to my remarks today. Specifically, I would like to discuss the need for financial services firms to develop enterprisewide compliance programs for legal and reputational risk management. As financial firms continue to grow more complex and add new products, services, and activities - all of which are natural and positive market developments - they need to have a process to facilitate the evolution of the culture of compliance across the organization. I am first going to discuss the importance of an enterprise-wide approach to risk management and identify some particular areas in which an integrated approach can improve internal controls. Then I will talk about how compliance and internal audit can foster effective risk management. Enterprise-wide risk-management framework What do I mean by an enterprise-wide compliance program? I would define it as an integral part of an overall risk-management framework that is adopted by an entity’s board of directors and senior management and is applied in setting a strategy throughout a firm. As you may know, the Committee of Sponsoring Organizations of the Treadway Commission, or COSO, is in the process of finalizing an enterprise-wide risk-management framework that is expected to be published later this year. The principles the new COSO document espouses transcend functional areas, and I expect that it will be an important contribution to the ongoing discussion of how risk management can be strengthened across different types of organizations and functional areas. For those of you not familiar with the COSO framework, let me briefly explain that an enterprise-wide risk-management framework identifies potential events that may affect the entity and establishes how the organization will manage its risk given the firm’s risk appetite and strategic direction. In an enterprise-wide risk-management framework, managers are expected to evaluate at least annually the risks and controls within their scope of authority and to report the results of this process to the chief risk officer and the audit committee of the board of directors. In evaluating risks, managers need to consider both current and planned or anticipated operational and market changes and identify the risks arising from those changes. Once risks have been identified comprehensively, assessed, and evaluated as to their potential impact on the organization, management must determine the effectiveness of existing controls and develop and implement additional appropriate mitigating controls where needed. The robustness and effectiveness of these controls must be evaluated independently, soon after the control structure is established, so that any shortcomings can be identified promptly and corrected. Risk assessments initiated early in the planning process can give the firm time to implement mitigating controls and conduct a validation of the quality of those controls before launching the product. Strong internal controls and governance require that these assessments be done by an independent group. One of the weaknesses that we have seen is that management delegates both the development and the assessment of the internal control structure to the same risk-management, internal audit, compliance, or legal division. Instead, it is important to emphasize that line management has the responsibility for identifying risks and ensuring that the mitigating controls are effective, and that the assessments should be done by a group independent of that line organization. An enterprise-wide approach also can integrate the risk assessment of functions that have traditionally been managed in “silos”. Conflicts can arise in many different areas and functions of the firm, including sales and research. Conflicts can also occur when compensation structures create incentives inconsistent with prudent risk management or when the bottom line for the current quarter is unduly emphasized without adequate consideration of the risk being taken to accomplish those results. The potential for these conflicts to arise must be addressed squarely by senior management, and appropriate controls must be in place to manage and mitigate conflicts. A culture of compliance should establish - from the top of the organization - the proper ethical tone that will govern the conduct of business. In many instances, senior management must move from thinking about compliance chiefly as a cost center to considering the benefits of compliance in protecting against legal and reputational risks that can have an impact on the bottom line. It is important to note that the board of directors and senior management of financial firms are responsible for setting the “tone at the top” and developing the compliance culture that has been discussed at this conference. The board and senior management are obligated to deliver a strong message to others in the firm about the importance of integrity, compliance with the law, and overall good business ethics. They also need to demonstrate their commitment through their individual conduct and their response to control failures. The message and corresponding conduct should empower line staff to elevate ethical or reputational concerns to appropriate levels of management without fear of retribution. Reputational and legal risks pose major threats to financial services firms because the nature of their business requires maintaining the confidence of customers, creditors, and the general marketplace. Importantly, legal and reputational risk can negatively affect the profitability, and ultimately the viability, of a financial firm. Enterprise-wide compliance program A strong compliance program is an integral part of the risk-management function. For the reasons I will discuss, the best practice in complex financial firms is to conduct risk management on an enterprisewide basis. As a result, compliance activities should be managed on an enterprise-wide basis as well. Traditional risk management has focused on quantifiable risks, such as credit and market risks. Recent events have demonstrated the need for greater focus on the risks that are harder to quantify - that is, operational, legal, and reputational risks. Indeed, legal and reputational risks are significant risks facing some financial firms today. The compliance area is critically important in identifying, evaluating, and addressing legal and reputational risks. Given the significance of these risks, a strong enterprise-wide compliance program is a necessity for complex financial firms. A well-executed compliance program can also highlight operational problems. As an integral part of an enterprise-wide risk management, an enterprise-wide compliance program looks at and across business lines and activities of the organization as a whole to consider how activities in one area of the firm may affect the legal and reputational risks of other business lines and the enterprise as a whole. It considers how compliance with laws, regulations, and internal policies, procedures, and controls should be enhanced or changed in response. This approach is in marked contrast to the silo approach to compliance, which considers the legal and reputational risks of activities or business lines in isolation without considering how those risks interrelate and affect other business lines. The silo approach to compliance has prevailed for far too long in financial firms. We are overdue for a paradigm shift to an enterprise-wide compliance structure as we also shift to enterprise-wide risk management. Why is an enterprise-wide compliance program so important? Recently, in an interview with The Wall Street Journal, the independent board chairman of a prominent mutual fund company involved in the market-timing scandal identified as one of the firm’s compliance breakdowns the bifurcation of compliance responsibilities within the firm. That is, no one had the 25,000-foot view of what was happening across the organization, and this led to internal control shortcomings that were not identified and to opportunities for employees to take unfair advantage of other market participants. Moreover, the compliance function did not have the status and perceived importance it should have had. The company’s board reportedly has installed a board-level compliance officer in response to a review of the circumstances surrounding the control deficiencies. This addition helps to ensure that the board, the group that is ultimately responsible for risk management, can assess the quality and robustness of compliance across the organization. Enterprise-wide compliance programs incorporate controls that include transaction approval and monitoring procedures in all relevant functional areas. They also provide all decisionmakers with complete and comprehensive information about the proposed transaction. Involving all relevant functional areas and decisionmakers allows for an enhanced review of a transaction, one that considers the impact of the transaction across the consolidated organization. As a result, compliance is conducted on a comprehensive, holistic basis and not in silos. Involving all functional areas and decisionmakers also focuses attention on all the relationships a client may have across the organization, allowing identification of conflicts of interest or other sources of legal and reputational risks. Viewing compliance across the organization’s different functions minimizes the potential for legal and reputational risks to be overlooked. As a result, compliance policies, procedures, and controls are less likely to be inadequate. For example, conflict-of-interest policies and controls may be inadequate if risk management in the traditional credit function does not also consider the activities being conducted in the trading and sales areas. An enterprise-wide compliance program helps management and the board understand where the legal and reputational risks in the organization are concentrated, provides comparisons of the level and changing nature of risks, and identifies those control processes that most need enhancement. This process, in turn, can facilitate analysis of whether the legal and reputational risks taken in a particular part of the organization are appropriate. Of course, the ability to assess legal and reputational risks across the enterprise depends heavily on the quality and timeliness of information. The compliance function must ensure that controls and procedures capture the appropriate information to allow senior management and the board to better perform their risk management functions. The enterprise-wide compliance function should look at what is being reported to the board, the audit committee, and senior management regarding new or changed processes, procedures, and controls. Is there an effective mechanism for reporting control failures or limit exceptions? How are these exceptions pursued for follow-up action, and how are corrective actions communicated back to the board or management? Importantly, the compliance function should have a direct line to the general counsel through which it can report concerns and needed improvements to processes and controls. The focus on an enterprise-wide approach to compliance does not mean that the organization cannot leverage off of specific business-line compliance functions. Indeed, it is very important to retain business-line compliance functions because they are staffed by individuals who understand the activities being conducted and know where control breakdowns have occurred in the past. For example, the compliance function for a trading operation requires staff with detailed understanding of the back office, the middle office, and the front office. The enterprise-wide compliance approach supplements this business-line-specific view of compliance with a big-picture approach at the corporate level that encompasses and has access to all lines of business and operational areas. It incorporates the various business-line compliance reviews in assessing the robustness and adequacy of enterprise-wide legal and reputational risk management, and it ensures that significant issues are brought to the attention of senior global compliance officers as appropriate. The enterprise-wide view is particularly important when functions cross business lines and management lines of responsibility. When business lines or managers share responsibility for compliance, specific duties and chains of accountability need to be established at the linemanagement level and overseen by the person ultimately responsible for compliance across the organization. An enterprise-wide compliance program is also dynamic, constantly assessing new legal and reputational risks when new business lines or activities are added or existing activities are altered. Constant reassessment of risks and controls and communication with the business lines is necessary to avoid a compliance program that is operating on autopilot and does not proactively respond to change in the organization. The role of the new-product approval process The compliance program is an important participant in the new-product approval process, along with other relevant parties, including credit risk, market risk, operations, accounting, legal, audit, and senior line management. Compliance personnel should have an active voice in determining whether a particular activity or product constitutes a new product requiring review and approval. New products include products or services being offered to, or activities being conducted for the first time in, a new market or to a new category of customers or counterparties. For example, a product traditionally marketed to institutional customers that is being rolled out to retail customers (hedge funds, for instance) generally should be reviewed as a new product. In addition, significant modifications to products, services, and activities or their pricing warrant review as a new product. Even small changes in the terms of products or the scope of services or activities can greatly alter their risk profiles and justify review as a new product. When in doubt about whether a product, service, or activity warrants review as a new product, financial firms should err on the side of conservatism and route the proposal through the new-product approval process. Cutting short a new-product review because of a rush to deliver a new product to market, or because of performance pressures, increases the potential for serious legal and reputational risk. The determination of whether a new or modified activity requires additional compliance processes, procedures, or controls is clearly the province of the compliance staff. It involves the interaction of business-line compliance staff with personnel responsible for enterprise-wide risk management. Once these processes, procedures, or controls are designed, compliance personnel should help ensure that those controls are implemented effectively and are a comprehensive response to the legal and reputational risks posed. The role of internal audit Just as the compliance area performs an independent review of the firm’s activities and business lines, the compliance program also needs to be reviewed independently. Internal audit has the responsibility to review the enterprise-wide compliance program to determine if it is accomplishing the firm’s stated objectives, and if it is adequately and appropriately staffed, in light of growth, changes in the firm’s business mix, new customers, strategic initiatives, reorganizations, and process changes. Internal audit should evaluate the firm’s adherence to its own compliance and control processes and assess the adequacy of those processes in light of the complexity and legal and reputational risk profile of the organization. It should be obvious that internal audit, like the compliance program, needs to be staffed with personnel who have the necessary skills and experience to report on compliance with financial institution policies and procedures. Internal audit should test transactions to validate that business lines are complying with the firm’s standards and report the results of that testing to the board or audit committee, as appropriate. Structured transactions There are “lessons learned” from the legal and reputational risks that some financial firms faced in structuring transactions for Enron and WorldCom, among others. Those legal and reputational risks require a focus on appropriateness assessments, the enforceability of netting and collateral agreements, undocumented customer assurances, insurance considerations, and potential IRS challenges. Assessments of the appropriateness of a transaction for a client traditionally have required firms to determine if the transaction is consistent with the financial sophistication, financial condition, and investment policies of the customer. Given recent events, it is appropriate to raise the bar on appropriateness assessments in the approval process for complex structured transactions by taking into account the business purpose and economic substance of the transaction. When firms provide advice on, arrange, or actively participate in a complex structured finance transaction, they may assume legal and reputational risks if the end-user enters into the transaction for improper purposes. Firms should have effective and consistent policies and procedures that require a thorough review of the business purposes and economic substance of the transaction by all relevant functional areas and an assessment of any legal or reputational risks posed by the transaction. In instances that present heightened legal or reputational risk, the policies and procedures should require a review, by appropriate senior management, of the customer’s business relationship with the firm. Of course, these policies and procedures need to be supported and enforced by a strong tone at the top and a firm-wide culture of compliance. Conclusion The evolution of the financial markets and the number of significant governance issues recently faced by complex financial firms clearly underscore the need to view risk management on an enterprise-wide basis. An integral part of a robust legal and reputational risk-management function is a strong compliance program. For such programs to be effective in complex financial institutions, compliance must be addressed on an enterprise-wide basis.
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board of governors of the federal reserve system
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Testimony of Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Committee on Financial Services, US House of Representatives, Washington, 11 February 2004.
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Alan Greenspan: Federal Reserve Board’s semiannual monetary policy report to the Congress Testimony of Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Committee on Financial Services, US House of Representatives, Washington, 11 February 2004. * * * Mr. Chairman and members of the Committee, I am pleased to be here today to present the Federal Reserve's Monetary Policy Report to the Congress. When I testified before this committee in July, I reported that conditions had become a good deal more supportive of economic expansion over the previous few months. A notable reduction in geopolitical concerns, strengthening confidence in economic prospects, and an improvement in financial conditions boded well for spending and production over the second half of the year. Still, convincing signs of a sustained acceleration in activity were not yet in evidence. Since then, the picture has brightened. The gross domestic product expanded vigorously over the second half of 2003 while productivity surged, prices remained stable, and financial conditions improved further. Overall, the economy has made impressive gains in output and real incomes; however, progress in creating jobs has been limited. Looking forward, the prospects are good for sustained expansion of the U.S. economy. The household sector's financial condition is stronger, and the business sector has made substantial strides in bolstering balance sheets. Narrowing credit risk spreads and a considerable rally in equity prices have reduced financing costs and increased household wealth, which should provide substantial support for spending by businesses and households. With short-term real interest rates close to zero, monetary policy remains highly accommodative. And it appears that the impetus from fiscal policy will stay expansionary, on net, through this year. These circumstances all should spur the expansion of aggregate demand in 2004. At the same time, increases in efficiency and a significant level of underutilized resources should help keep a lid on inflation. In retrospect, last year appears to have marked a transition from an extended period of subpar economic performance to one of more vigorous expansion. Once again, household spending was the mainstay, with real personal consumption spending increasing nearly 4 percent and real outlays on residential structures rising about 10 percent. Last year's reductions in personal income tax rates and the advance of rebates to those households that were eligible for the expanded child tax credit boosted the growth of real disposable personal income. The very low level of interest rates also encouraged household spending through a variety of channels. Automakers took advantage of low interest rates to offer attractive incentive deals, buoying the purchase of new vehicles. The lowest home mortgage rates in decades were a major contributor to record sales of existing residences, engendering a large extraction of cash from home equity. A significant part of that cash supported personal consumption expenditures and home improvement. In addition, many households took out cash in the process of refinancing, often using the proceeds to substitute for higher-cost consumer debt. That refinancing also permitted some households to lower the monthly carrying costs for their homes and thus freed up funds for other expenditures. Not least, the low mortgage rates spurred sales and starts of new homes to very high levels. These developments were reflected in household financing patterns. Home mortgage debt increased about 13 percent last year, while consumer credit expanded much more slowly. Even though the ratio of overall household debt to income continued to increase, as it has for more than a half-century, the rise in home and equity prices enabled the ratio of household net worth to disposable income to recover to a little above its long-term average. The low level of interest rates and large volume of mortgage refinancing activity helped reduce households' debt-service and financial-obligation ratios a bit. And many measures of consumer credit quality improved over the year, with delinquency rates on consumer loans and home mortgages declining. A strengthening in capital spending over 2003 contributed importantly to the acceleration of real output. In the first quarter of the year, business fixed investment extended the downtrend that began in early 2001. Capital spending, however, ramped up considerably over the final three quarters of 2003, reflecting a pickup in expenditures for equipment and software. Outlays for high-tech equipment showed particular vigor last year. Even spending on communications equipment, which had been quite soft in the previous two years, accelerated. A growing confidence of business executives in the durability of the expansion, strong final sales, the desire to renew capital stocks after replacements had been postponed, and favorable financial conditions all contributed to the turnaround in equipment spending. By contrast, expenditures on nonresidential structures continued to contract on balance, albeit less rapidly than in 2001 and 2002. High vacancy rates for office buildings and low rates of capacity utilization in manufacturing evidently limited the demand for new structures. Inventory investment likewise failed to pick up much momentum over the year, as managers remained cautious. Firms finished 2003 with lean inventories relative to sales, an encouraging sign for the expansion of production going forward. To a considerable degree, the gathering strength of capital spending reflects a substantial improvement in the financial condition of businesses over the past few years. Firms' profits rose steeply during 2003 following smaller gains in the previous two years. The significantly stronger cash flow generated by profits and depreciation allowances was more than adequate to cover rising capital expenditures in the aggregate. As a result, businesses had little need to borrow during 2003. For the nonfinancial business sector as a whole, debt is estimated to have grown just 3-1/2 percent. Firms encountered very receptive conditions in longer-term credit markets in 2003. Interest rate spreads on both investment-grade and speculative-grade bond issues narrowed substantially over the year, as investors apparently became more confident about the economic expansion and saw less risk of adverse shocks from accounting and other corporate scandals. Corporate treasurers took advantage of the attractive market conditions by issuing long-term debt to lengthen the maturities of corporate liabilities. As a consequence, net short-term financing was extremely weak. The stock of business loans extended by banks and commercial paper issued by nonfinancial firms declined more than $100 billion over the year, apparently owing to slack demand for short-term credit rather than to a constriction in supply. Interest-rate spreads on commercial paper, like those on corporate bonds, were quite narrow. And although a Federal Reserve survey indicates that banks had continued to tighten lending conditions early in the year, by the second half, terms and standards were being eased noticeably. Moreover, responses to that survey pointed to a lack of demand for business loans until late in the year. Partly as a result of the balance-sheet restructuring, business credit quality appears to have recuperated considerably over the past few years. Last year, the default rate on bonds fell sharply, recovery rates on defaulted issues rose, the number of rating downgrades moderated substantially, and delinquencies on business loans continued to decline. The improved balance sheets and strong profits of business firms, together with attractive terms for financing in open markets and from banks, suggest that financial conditions remain quite supportive of further gains in capital spending in coming quarters. The profitability of the business sector was again propelled by stunning increases in productivity. The advance in output per hour in the nonfarm business sector picked up to 5-1/4 percent in 2003 after unusually brisk gains in the previous two years. The productivity performance of the past few years has been particularly striking in that these increases occurred in a period of relatively sluggish output growth. The vigorous advance in efficiency represents a notable extension of the pickup that started around the mid-1990s. Apparently, businesses are still reaping the benefits of the marked acceleration in technology. The strong gains in productivity, however, have obviated robust increases in business payrolls. To date, the expansion of employment has significantly lagged increases in output. Gross separations from employment, two-fifths of which have been involuntary, are about what would be expected from past cyclical experience, given the current pace of output growth. New hires and recalls from layoffs, however, are far below what historical experience indicates. To a surprising degree, firms seem able to continue identifying and implementing new efficiencies in their production processes and thus have found it possible so far to meet increasing orders without stepping up hiring. In all likelihood, employment will begin to grow more quickly before long as output continues to expand. Productivity over the past few years has probably received a boost from the efforts of businesses to work off the stock of inefficiencies that had accumulated in the boom years. As those opportunities to enhance efficiency become scarcer and as managers become more confident in the durability of the expansion, firms will surely once again add to their payrolls. A consequence of the rapid gains in productivity and slack in our labor and product markets has been sustained downward pressure on inflation. As measured by the chain-weighted price index for personal consumption expenditures excluding food and energy, prices rose less than 1 percent in 2003. Given the biases in such indexes, this performance puts measured inflation in a range consistent with price stability--a statutory objective of the Federal Reserve and a key goal of all central banks because it is perceived as a prerequisite for maximum sustainable economic growth. The recent performance of inflation has been especially notable in view of the substantial depreciation of the dollar in 2003. Against a broad basket of currencies of our trading partners, the foreign exchange value of the U.S. dollar has declined about 13 percent from its peak in early 2002. Ordinarily, currency depreciation is accompanied by a rise in dollar prices of imported goods and services, because foreign exporters endeavor to avoid experiencing price declines in their own currencies, which would otherwise result from the fall in the foreign exchange value of the dollar. Reflecting the swing from dollar appreciation to dollar depreciation, the dollar prices of goods and services imported into the United States have begun to rise after declining on balance for several years, but the turnaround to date has been mild. Apparently, foreign exporters have been willing to absorb some of the price decline measured in their own currencies and the consequent squeeze on profit margins it entails. Part of exporters' losses, however, have apparently been offset by short forward positions against the dollar in foreign exchange markets. A marked increase in foreign exchange derivative trading, especially in dollar-euro, is consistent with significant hedging of exports to the United States and to other markets that use currencies tied to the U.S. dollar. However, most contracts are short-term because long-term hedging is expensive. Thus, although hedging may delay the adjustment, it cannot eliminate the consequences of exchange rate change. Accordingly, the currency depreciation that we have experienced of late should eventually help to contain our current account deficit as foreign producers export less to the United States. On the other side of the ledger, the current account should improve as U.S. firms find the export market more receptive. *** Although the prospects for the U.S. economy look quite favorable, we need to remind ourselves that all forecasts are projections into an uncertain future. The fact that most professional forecasters perceive much the same benign short-term outlook that is our most likely expectation provides scant comfort. When the future surprises, history tells us, it often surprises us all. We must, as a consequence, remain alert to risks that could threaten the sustainability of the expansion. Besides the chronic concern about a sharp spike in oil or natural gas prices, a number of risks can be identified. Of particular importance to monetary policy makers is the possibility that our stance could become improperly calibrated to evolving economic developments. To be sure, the Federal Open Market Committee's current judgment is that its accommodative posture is appropriate to foster sustainable expansion of economic activity. But the evidence indicates clearly that such a policy stance will not be compatible indefinitely with price stability and sustainable growth; the real federal funds rate will eventually need to rise toward a more neutral level. However, with inflation very low and substantial slack in the economy, the Federal Reserve can be patient in removing its current policy accommodation. In the process of assessing risk, we monitor a broad range of economic and financial indicators. Included in this group are a number of measures of liquidity and credit creation in the economy. By most standard measures, aggregate liquidity does not appear excessive. The monetary aggregate M2 expanded only 5-1/4 percent during 2003, somewhat less than nominal GDP, and actually contracted during the fourth quarter. The growth of nonfederal debt, at 7-3/4 percent, was relatively brisk in 2003. However, a significant portion of that growth was associated with the record turnover of existing homes and the high level of cash-out refinancing, which are not expected to continue at their recent pace. A narrower measure, that of credit held by banks, also grew only moderately in 2003. All told, our accommodative monetary policy stance to date does not seem to have generated excessive volumes of liquidity or credit. That said, as we evaluate the risks to the economy, we also assess developments in financial markets. Broad measures of equity prices rose 25 percent in 2003, and technology stocks increased twice as quickly. The rally has extended into this year. And as I noted previously, credit spreads on corporate bonds have narrowed considerably, particularly for speculative-grade issues. This performance of financial markets importantly reflects investors' response to robust earnings growth and the repair of business balance sheets over the past few years. However, history shows that pricing financial assets appropriately in real time can be extremely difficult and that, even in a seemingly benign economic environment, risks remain. The outlook for the federal budget deficit is another critical issue for policymakers in assessing our intermediate- and long-run growth prospects and the risks to those prospects. As you are well aware, after a brief period of unified budget surpluses around the beginning of this decade, the federal budget has reverted to deficits. The unified deficit swelled to $375 billion in fiscal 2003 and appears to be widening considerably further in the current fiscal year. In part, these deficits are a result of the economic downturn and the period of slower growth that we recently experienced, as well as the earlier decline in equity prices. The deficits also reflect fiscal actions specifically intended to provide stimulus to the economy, a significant step-up in spending for national security, and a tendency toward diminished restraint on discretionary spending. Of course, as economic activity continues to expand, tax revenues should strengthen and the deficit will tend to narrow, all else being equal. But even budget projections that attempt to take such business-cycle influences into account, such as those from the Congressional Budget Office and the Office of Management and Budget, indicate that very sizable deficits are in prospect in the years to come. As I have noted before, the debate over budget priorities appears to be between those advocating additional tax cuts and those advocating increased spending. Although some stirrings in recent weeks in the Congress and elsewhere have been directed at actions that would lower forthcoming deficits, to date no effective constituency has offered programs to balance the budget. One critical element - present in the 1990s but now absent - is a framework of procedural rules to help fiscal policy makers make the difficult decisions that are required to forge a better fiscal balance. The imbalance in the federal budgetary situation, unless addressed soon, will pose serious longerterm fiscal difficulties. Our demographics - especially the retirement of the baby-boom generation beginning in just a few years - mean that the ratio of workers to retirees will fall substantially. Without corrective action, this development will put substantial pressure on our ability in coming years to provide even minimal government services while maintaining entitlement benefits at their current level, without debilitating increases in tax rates. The longer we wait before addressing these imbalances, the more wrenching the fiscal adjustment ultimately will be. The fiscal issues that we face pose long-term challenges, but federal budget deficits could cause difficulties even in the relatively near term. Long-term interest rates reflect not only the balance between the current demand for, and current supply of, credit, they also incorporate markets' expectations of those balances in the future. As a consequence, should investors become significantly more doubtful that the Congress will take the necessary fiscal measures, an appreciable backup in long-term interest rates is possible as prospects for outsized federal demands on national saving become more apparent. Such a development could constrain investment and other interest-sensitive spending and thus undermine the private capital formation that is a key element in our economy's growth prospects. Addressing the federal budget deficit is even more important in view of the widening U.S. current account deficit. In 2003, the current account deficit reached $550 billion - about 5 percent of nominal GDP. The current account deficit and the federal budget deficit are related because the large federal dissaving represented by the budget deficit, together with relatively low rates of U.S. private saving, implies a need to attract saving from abroad to finance domestic private investment spending. To date, the U.S. current account deficit has been financed with little difficulty. Although the foreign exchange value of the dollar has fallen over the past year, the decline generally has been gradual, and no material adverse side effects have been visible in U.S. capital markets. While demands for dollardenominated assets by foreign private investors are off their record pace of mid-2003, such investors evidently continue to perceive the United States as an excellent place to invest, no doubt owing, in large part, to our vibrant market system and our economy's very strong productivity performance. Moreover, some governments have accumulated large amounts of dollar-denominated debt as a byproduct of resisting upward exchange rate adjustment. Nonetheless, given the already-substantial accumulation of dollar-denominated debt, foreign investors, both private and official, may become less willing to absorb ever-growing claims on U.S. residents. Taking steps to increase our national saving through fiscal action to lower federal budget deficits would help diminish the risks that a further reduction in the rate of purchase of dollar assets by foreign investors could severely crimp the business investment that is crucial for our long-term growth. The large current account deficits and the associated substantial trade deficits pose another imperative - the need to maintain the degree of flexibility that has been so prominent a force for U.S. economic stability in recent years. The greatest current threat to that flexibility is protectionism, a danger that has become increasingly visible on today's landscape. Over the years, protected interests have often endeavored to stop in its tracks the process of unsettling economic change. Pitted against the powerful forces of market competition, virtually all such efforts have failed. The costs of any new protectionist initiatives, in the context of wide current account imbalances, could significantly erode the flexibility of the global economy. Consequently, creeping protectionism must be thwarted and reversed. *** In summary, in recent years the U.S. economy has demonstrated considerable resilience to adversity. It has overcome significant shocks that, in the past, could have hobbled growth for a much longer period than they have in the current cycle. As I have noted previously, the U.S. economy has become far more flexible over the past two decades, and associated improvements have played a key role in lessening the effects of the recent adverse developments on our economy. Looking forward, the odds of sustained robust growth are good, although, as always, risks remain. The Congress can help foster sustainable expansion by taking steps to reduce federal budget deficits and thus contribute to national saving and by continuing to pursue opportunities to open markets and promote trade. For our part, the Federal Reserve intends to use its monetary tools to promote our goals of economic growth and maximum employment of our resources in an environment of effective price stability.
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the Greater Omaha Chamber of Commerce 2004 Annual Meeting, Omaha, 20 February 2004.
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Alan Greenspan: The critical role of education in the nation’s economy Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the Greater Omaha Chamber of Commerce 2004 Annual Meeting, Omaha, 20 February 2004. * * * The United States economy has long been characterized by a strong tradition of entrepreneurial spirit among our business people, a high level of skill among our workers, and an openness by firms and workers alike to intense competition within and beyond our borders. Those attributes have given us a standard of living unparalleled for so large a population - and one that has risen steadily over the history of our nation. But with that bounty has also come the inevitable stresses and anxieties that accompany economic advance. One concern that has persisted for some time is the fear that we are irreversibly losing manufacturing jobs because of businesses’ efforts to extract rapid gains in production efficiencies and to cut labor costs by tapping the lower-wage economies of Asia and Latin America. More recently, similar concerns have arisen about the possibility that an increasing number of our better-paying white-collar jobs will be lost to outsourcing, especially to India and China. Many of these jobs are in the service sector, and they were previously perceived as secure and largely free from the international competition long faced in the manufacturing sector. There is a palpable unease that businesses and jobs are being drained from the United States, with potentially adverse long-run implications for unemployment and the standard of living of the average American. The issue is both important and sensitive, dealing as it does with the longer-term wealth of our nation and with the immediate welfare of so many individuals and communities. In the debate that has ensued, a large gulf is often perceived between the arguments of economists, who almost always point to the considerable benefits offered over the long term by exposure to free and open trade, and the obvious stress felt by those caught on the downside of turbulence created by that exposure. It is crucial that this gulf be bridged. As history clearly shows, our economy is best served by full and vigorous engagement in the global economy. Consequently, we need to increase our efforts to ensure that as many of our citizens as possible have the opportunity to capture the benefits that flow from that engagement. For reasons that I shall elucidate shortly, one critical element in creating those opportunities is to provide rigorous education and ongoing training to all members of our society. This proposal is not novel; it is, in fact, the strategy that we have followed successfully for most of the past century and a strategy that we now should embrace with renewed commitment. Over the long sweep of American generations and waves of economic change, we simply have not experienced a net drain of jobs to advancing technology or to other nations. Since the end of World War II, the unemployment rate in the United States has averaged less than 6 percent with no apparent trend; and as recently as 2000, it dipped below 4 percent. Moreover, real earnings of the average worker have continued to rise. Over the past century, per capita real income has risen at an average rate of more than 2 percent per year, declining notably only during the Great Depression of the 1930s and immediately following World War II. Incomes trended higher whether we had a trade deficit or a trade surplus and whether international outsourcing was large or small. The reason for this positive long-run trend in living standards appears to be that more fundamental economic forces are determining real incomes, irrespective of the specific jobs in which they are earned and irrespective of the proportion of domestic consumption met by imports. Intensive research in recent years into the sources of economic growth among both developing and developed nations generally point to a number of important factors: the state of knowledge and skill of a population; the degree of control over indigenous natural resources; the quality of a country’s legal system, particularly a strong commitment to a rule of law and protection of property rights; and yes, the extent of a country’s openness to trade with the rest of the world. For the United States, arguably the most important factor is the type of rule of law under which economic activity takes place. When asked abroad why the United States has become the most prosperous large economy in the world, I respond, with only mild exaggeration, that our forefathers wrote a constitution and set in motion a system of laws that protects individual rights, especially the right to own property. Nonetheless, the degree of state protection is sometimes in dispute. But by and large, secure property rights are almost universally accepted by Americans as a critical pillar of our economy. While the right of property in the abstract is generally uncontested in all societies embracing democratic market capitalism, different degrees of property protection do apparently foster different economic incentives and outcomes. Someone who owns a piece of land, but is restricted to a specific use, does not have unequivocal ownership and will act accordingly. Indeed, economic regulation, by its nature, impinges on the exercise of a property right. Continuous changes in regulations and, hence, in the consistency of property protection create a less certain environment, which undermines incentives to long-term investment and prevents the most productive use of our resources. The high level of protection for property rights and, for the most part, our reliance on regulation that is marketsensitive are significant factors in the overall attractiveness both to Americans and to foreigners of investing in the United States. The second critical aspect of wealth creation in the United States, and doubtless globally, is the level of knowledge and skill of the population. Today, the knowledge required to run the economy, which is far more complex than in our past, is both deeper and broader than ever before. We need to ensure that education in the United States, formal or otherwise, is supplying skills adequate for the effective functioning of our economy. The recent exceptional trends in U.S. productivity suggest that we are coping, but this observation should not lead to complacency. *** Productivity in the United States has increased generation after generation, creating ever-rising standards of living. This trend has persisted whether our competitive advantage came from the development of more efficient technologies in agriculture, textiles, and steel, or, more recently, from the design and fabrication of microprocessors and the harnessing of the human genome. Our knowledge-based skills in a business environment, supported by a rule of law, have enabled our workforce to create ever-greater value added - irrespective of what goods and services we have chosen to produce at home and what and how much we have chosen to import. Only when property rights are adequately protected will the entrepreneurs willingly work a heroic eighteen hours a day in their garages or at their computer terminals, secure in the knowledge that they will own what they create. In addition, those workers who are fortunate to work in a nation that protects the property rights of investors, both foreign and domestic, will benefit from the low cost of capital associated with secure property rights. That protection has fostered a thriving venture capital industry to finance the nascent ideas of budding entrepreneurs and has motivated existing businesses to invest some of their profits in research development. The real income earned by a worker depends importantly on his or her intelligence and skill. The capacity of workers, after being displaced, to find a new job that will eventually provide nearly comparable pay most often depends on the general knowledge of the worker and the ability of that individual to learn new skills. Even in the best of circumstances, discharged workers experience some loss of income in a transition to a new job and the associated new skills. Indeed, finding a new job takes time, and typically results in at least a temporary drop in pay. That loss, especially in a soft labor market, is not only a short-term drag on aggregate incomes but also a source of stress on the affected individuals. Generic capabilities in mathematics, writing, and verbal skills are key to the ability to learn and to apply new skills and thus to earn higher real wages over time. The avenues to acquiring those skills are many, and one effective tool that we have developed to facilitate the transition to a new job or profession has been our community colleges. These two-year institutions have been in the forefront of teaching the types of skills that build on workers’ previous experiences to create new job skills. Currently almost one in three of their enrollees are aged thirty or older, a statistic that suggests that these individuals have previous job experience. The impressive expansion of these learning centers attests to their success in imparting both general and practical job-related learning. A rising proportion of the population is also taking advantage of both general adult education and work-related instruction. The fact that, over the years, more than 94 percent of the workforce has been employed, on average, indicates that U.S. workers apparently have been sufficiently skilled and motivated to learn the new tasks that enable them to earn, on average, an ever-rising real wage. The never-ending necessity to learn new skills is due to the gradually but inexorably changing nature of our economy. The innovations that have so accelerated productivity in recent years are an extension of a longer-term, ever-growing conceptualization of economic output. The value added to our GDP from physical material input and manual labor has grown very slowly over the decades.1 By far, the greatest contribution during the past half century to our average annual real GDP increase of 3-1/4 percent has been the ideas embodied in both our human and physical capital. Technological advance is continually altering the shape, nature, and complexity of our economic processes. This rising complexity has required the labor force to be more and more technically oriented. Years of schooling, a rough proxy for skills, averaged nine and one-quarter years in 1950. A half century later schooling averaged more than twelve years. But technology and, more recently, competition from abroad have risen to a point at which demand for the lowest skilled workers in developed countries is diminishing, placing pressure on their wages. These workers will need to be equipped with the skills to compete effectively for the new jobs that our economy will create. But where will these jobs come from? For generations, human ingenuity has been creating products, industries, and jobs that never before existed, from vehicle assembling to computer software engineering, and with them have come new opportunities for workers with the necessary skills. Judged by rates of return and productivity gains, our workforce has appeared sufficiently skilled, through these generations to manage our increasingly complex capital stock. But in the past two decades, our system has had obvious strains, apparently reflecting an inability of our workforce to fully meet the ever-increasing skill requirements of an economy whose GDP is becoming more conceptual. At the risk of some oversimplification, if the skill composition of our workforce meshed fully with the needs of our increasingly complex capital stock, wage-skill differentials would be stable, and percentage changes in wage rates would be the same for all job grades. But for the past twenty years the real incomes of skilled, especially highly skilled, workers have risen more than the average of all workers, whereas real wage rate increases for lesser-skilled workers were below average, indeed flat. This situation suggests that, broadly speaking, we have been facing a shortage of highly skilled workers and a surplus of lesser-skilled workers relative to the optimum needs of our capital stock. Through the 1960s, the addition of skilled college graduates to the labor force, in part the result of schooling financed by the GI Bill, was sufficient to hold wage increases among the highly skilled to average gains. Real wages of the lesser skilled also rose significantly, in part, the result of effective high-school educations and the many skills learned during the war. Although in recent years the proportion of our labor force made up of those with at least some college has continued to grow, we appear, nonetheless, to be graduating too few skilled workers to address the apparent imbalance between the supply of such workers and the burgeoning demand for them. Perhaps the accelerated pace of high-tech equipment installations associated with the large increases in productivity growth in recent years is placing unachievable demands for skilled graduates over the short run. If the apparent acceleration in the demand for skilled workers to staff our high-tech capital stock is temporary as many presume, the pressure on our schools would ease as would the upward pressure on high-skilled wages. More broadly, in considering the issue of expanding our skilled workforce, many have a gnawing sense that our problems may be more than temporary and that the roots of the problem may extend back through our education system. Many of our students languish at too low a level of skill, and the result is an apparent excess of supply relative to a declining demand. These changing balances are most evident in the failure of real wages at the lower end of our income distribution to rise during the past quarter century. The hypothesis that we should be able to advance the knowledge that our students acquire as they move from kindergarten to twelfth grade, gets some support from international comparisons. A study conducted in 1995 revealed that, although our fourth-grade students were above average in both math “Technology and Trade.” Remarks by Alan Greenspan before the Dallas Ambassadors Forum, Dallas, Texas, April 16, 1999. and science, by the time they reached the eighth grade, they had dropped closer to the average.2 By the time they were in their last year of high school, they had fallen well below the international average. Accordingly, we apparently have quite a distance to go before we catch up. In short, our secondary school system needs to serve the requirements of a changing economy in the same way that the expansion of high schools with a broad curriculum served us so well in the first half of the twentieth century. Early last century, technological advance required workers with a higher level of cognitive skills - for instance the ability to read manuals, to interpret blueprints, or to understand formulas. Our educational system responded: In the 1920s and 1930s, high school enrollment in this country expanded rapidly, pulling youth from rural areas, where opportunities were limited, into moreproductive occupations in business and broadening the skills of students to meet the needs of an advancing manufacturing sector. It became the job of these institutions to prepare students for work life. In the context of the demands of the economy at that time, a high-school diploma represented the training needed to be successful in most aspects of American enterprise. The economic returns for having a high-school diploma rose and, as a result, high-school enrollment rates climbed. By the time that the United States entered World War II, the median seventeen-year-old was a highschool graduate - an accomplishment that set us apart from other countries. I cannot dismiss the notion that we can learn something from that period and perhaps from other countries. Still, I realize that the world was different from today in many ways. Societal changes have been numerous and profound, and our schools are being asked to do a great deal more than they have in the past. We need to be forward looking in order to adapt our educational system to the evolving needs of the economy and the realities of our changing society. Those efforts will require the collaboration of policymakers, education experts, and - importantly - our citizens. It is an effort that should not be postponed. *** We have seen encouraging signs of late that the labor market is improving. In all likelihood, employment will begin to increase more quickly before long as output continues to expand. But fears about job security are understandably significant when nearly two million of our workforce have been unemployed for more than a year. We have reason to be confident that new jobs will displace old ones as they always have, but America’s job-turnover process is never without pain for those caught in the job-losing portion. Those who have lost jobs, I know, are not readily consoled by the fact that current job insecurity concerns are not new. But keeping the current period in context is instructive. Jobs in the United States were perceived as migrating to low-wage Japan in the 1950s and 1960s, to low-wage Mexico in the 1990s, and most recently to low-wage China. Japan, of course, is no longer characterized by a low-wage workforce, and many in Mexico are now complaining of job losses to low-wage China. To be sure, many of our fellow citizens have experienced real hardships in our economic environment, which is becoming ever more internationally competitive. But the protectionist cures being advanced to address these hardships will make matters worse rather than better. The loss of jobs over the past three years is attributable largely to rapid declines in the demand for industrial goods and to outsized gains in productivity that have caused effective supply to outstrip demand. Protectionism will do little to create jobs; and if foreigners retaliate, we will surely lose jobs. We need instead to discover the means to enhance the skills of our workforce and to further open markets here and abroad to allow our workers to compete effectively in the global marketplace. In closing, I have stressed the importance of redressing the apparent imbalances between the supply and demand for labor across the spectrum of skills. Those imbalances have the potential to hamper the adjustment flexibility of our economy overall. But these growing imbalances are also aggravating the inequality of incomes in this country. The single central action necessary to ameliorate these imbalances and their accompanying consequences for income inequality is to boost the skills, and thus earning potential, of those workers lower on the skill ladder. The Third International Math and Science Study is a project of the International Study Center, Lynch School of Education, Boston College. A complete set of TIMMS publications is available on the center’s web site, http://timms.bc.edu/timms1995.html. To be sure, Americans have not been obsessed with the distribution of income but have instead placed much greater emphasis on the need to provide equality of opportunity. But equal opportunity requires equal access to knowledge. We cannot expect everyone to be equally skilled. But we need to pursue equality of opportunity to ensure that our economic system works at maximum efficiency and is perceived as just in its distribution of rewards.
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the Credit Union National Association 2004 Governmental Affairs Conference, Washington DC, 23 February 2004.
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Alan Greenspan: Understanding household debt obligations Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the Credit Union National Association 2004 Governmental Affairs Conference, Washington DC, 23 February 2004. * * * Introduction: credit unions and consumer lending Credit unions have long focused on the needs of their members. Traditionally, the industry has specialized in personal and automobile loans, and the bulk of lending at many credit unions remains concentrated on these types of loans. In the past decade, however, many of you have become more involved in first- and second-lien mortgage loans. With lending efforts focused on consumer and residential mortgage loans, credit unions have a natural interest in the financial health of America’s households. We have a similar interest at the Federal Reserve. Consumer spending accounts for more than two-thirds of gross domestic product, and residential investment - the construction of new homes makes up another 4 percent or so of GDP. In addition, households own more than $14 trillion in real estate assets, almost twice the amount they own in mutual funds and directly hold in stocks. Over the past two years, significant increases in the value of real estate assets have, for some households, mitigated stock market losses and supported consumption. Measuring the financial health of households One concern of many lending institutions has been the increase in bankruptcy rates during the past several years to an unusually high level. Elevated bankruptcy rates are troubling because they highlight the difficulties some households experience during economic slowdowns. But bankruptcy rates are not a reliable measure of the overall health of the household sector because they do not tend to forecast general economic conditions, and they can be significantly influenced over time by changes in laws and lender practices. In contrast to bankruptcy rates, delinquency rates may be a bit better measure of the overall health of the household sector. The recent experience with some delinquency rates has been encouraging, with rates falling for several measures of credit card and automobile debt. But, like bankruptcy rates, delinquency rates can reflect changes in underwriting and collection practices, and they may measure the financial health of a relatively narrow set of households. A primary measure used by the Federal Reserve to assess the extent of American household indebtedness and to provide a view of the financial health of the overall consumer sector is the quarterly debt service ratio. The debt service ratio measures the share of income committed by households for paying interest and principal on their debt. When the debt service ratio is high, households have less money available to purchase goods or services. In addition, households with a high debt service ratio are more likely to default on their obligations when they suffer adversity, such as job loss or illness. Of course, debt payments are not the only financial obligations of households and thus the Federal Reserve also calculates a more general financial obligations ratio. This measure incorporates households’ other recurring expenses, such as rents, auto leases, homeowners’ insurance and property taxes, that might be subtracting from the uncommitted income available to households. The Federal Reserve splits the aggregate financial obligations ratio into separate measures for homeowners and renters, measures that I will discuss in detail below. Changes in the debt service and financial obligation ratios over time Both the debt service ratio and the financial obligations ratio rose modestly over the 1990s. During the past two years, however, both ratios have been essentially flat. The debt service ratio has remained a touch above 13 percent, whereas the financial obligations ratio has hovered a bit above 18 percent. These ratios move slowly because both the stock of debt and the interest rates associated with the stock change slowly. Another reason is the stability in the ratio for homeowners, who hold the bulk of all household debt. Despite annual mortgage debt growth that exceeded 12 percent a year over the past two years, the financial obligations of homeowners have stayed about constant because mortgage rates have remained at historically low levels. The homeowners’ financial obligations ratio has also remained relatively constant despite this very rapid growth in mortgage debt, partly as a result of an enormous wave of refinancing of existing mortgages, which ended only in the fall of 2003. Refinancing has allowed homeowners both to take advantage of lower rates to reduce their monthly payments and, in many cases, to extract some of the built-up equity in their homes. These two effects seem to have roughly offset each other, suggesting that homeowners might set a target for their mortgage payments as a proportion of income and adjust their borrowing accordingly. Indeed, the surge in mortgage refinancings likely improved rather than worsened the financial condition of the average homeowner. Some of the equity extracted through mortgage refinancing was used to pay down more expensive, non-tax-deductible consumer debt or used to make purchases that would otherwise have been financed by more expensive and less tax-favored credit. Indeed, the refinancing phenomenon has very likely been a supportive factor for the general economy. The precise effect is difficult to identify because it is hard to know how much of the spending financed by home equity extraction might have taken place anyway. Nonetheless, we know that increases in home values and the borrowing against home equity likely helped cushion the effects of a declining stock market during 2001 and 2002. Rising credit card debts for homeowners and renters The rise in homeowners’ debt service burdens over the 1990s, albeit small, is associated with increases in their nonmortgage debt and, in particular, with rising levels of credit card debt. The financial obligation associated with credit card debt is difficult to measure. On the one hand, households are obligated to pay only a minimum amount and thus, in times of financial stress, a household can forgo making more than this minimum payment. On the other hand, we know that many households make more than the minimum payment and indeed likely would be quite uncomfortable paying only the minimum amount. During financial difficulties, these households might even consume less to pay more than the minimum. Defining the point at which households feel they should pay down their credit card debt is difficult, and thus our measure of debt service relies on estimates of minimum payments required by credit card lenders. There are several reasons that homeowners might carry more credit card debt than they did a decade ago, but these reasons generally do not indicate financial weakness among homeowning households. Indeed, as noted, delinquency rates on credit card payments have been falling during the past year, despite households’ relatively larger holding of credit card debt. One possible reason for the secular increase in credit card debt is rising U.S. homeownership rates. According to the Bureau of the Census, the share of U.S. households that own homes rose from about 64 percent in 1990 to almost 68 percent in 2003 even as the population grew substantially. Because of rising incomes, lower interest rates, and increased rates of household formation, more people have chosen to buy homes rather than to rent, increasing the value of mortgages outstanding. Although it does not show the relationship conclusively, the Federal Reserve’s Survey of Consumer Finances suggests that these newer homeowners who make smaller down payments tend to bring with them higher levels of nonmortgage debt and, in particular, credit card debt. The ability of lending institutions to manage the risks associated with mortgages that have high loan-to-value ratios seems to have improved markedly over the past decade, and thus the movement of renters into homeownership is generally to be applauded, even if it causes our measures of debt service of homeowners to rise somewhat. Another possible reason for rising credit card debt ratios is the use of credit cards for a variety of new purposes. The rise in credit card debt in the latter half of the 1990s is mirrored by a fall in unsecured personal loans. Reflecting this general trend, the proportion of personal loans in credit union portfolios has been declining as well. The wider availability of credit cards and their ease of use have encouraged this substitution. The convenience of credit cards also has caused homeowners to shift the payment for a variety of expenditures to credit cards. In sum, credit card debt service ratios have risen to some extent because households prefer credit cards as a method of payment. *** In contrast to the increase for homeowners, the rise in debt service ratios was steep for renters in the latter half of the 1990s. The rise for renters, as for homeowners, is concentrated in credit card lending and thus may reflect some of the same factors that have influenced homeowner debt service ratios. But unlike homeowners, renters in recent years have been using a higher fraction of their incomes for payments on student loans and used-car debt. Renters tend to be younger and have lower incomes than homeowners, so the fact that student loans and used-car payments are a larger share of their income is not surprising, although this trend might be worrisome if it indicates greater difficulties in becoming financially established. In addition, some of the rise in the debt service ratios of renters, unlike that of homeowners, occurred during the most recent recession, a difference highlighting the fact that incomes of renters are generally more at risk during economic downturns. Renters’ debt service ratios have stabilized during the past two years, a hopeful sign that is likely correlated with the overall improvement in the economy. However, the rise in the renter debt service ratio might indicate some trends among these households that may be of concern and that need to be investigated further. Mitigating homeowner payment shocks Rising debt service ratios are a concern if they reflect household financial stress and presage a drop in consumption or a rise in losses by lenders. Most homeowners and renters are aware of the possible difficulties should they lock themselves into a high level of debt payment obligations. Financial institutions might be able to help some households in this regard by looking for ways that households both renters and homeowners - can shield themselves from unexpected payment shocks. One way homeowners attempt to manage their payment risk is to use fixed-rate mortgages, which typically allow homeowners to prepay their debt when interest rates fall but do not involve an increase in payments when interest rates rise. Homeowners pay a lot of money for the right to refinance and for the insurance against increasing mortgage payments. Calculations by market analysts of the “option adjusted spread” on mortgages suggest that the cost of these benefits conferred by fixed-rate mortgages can range from 0.5 percent to 1.2 percent, raising homeowners’ annual after-tax mortgage payments by several thousand dollars. Indeed, recent research within the Federal Reserve suggests that many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade, though this would not have been the case, of course, had interest rates trended sharply upward. American homeowners clearly like the certainty of fixed mortgage payments. This preference is in striking contrast to the situation in some other countries, where adjustable-rate mortgages are far more common and where efforts to introduce American-type fixed-rate mortgages generally have not been successful. Fixed-rate mortgages seem unduly expensive to households in other countries. One possible reason is that these mortgages effectively charge homeowners high fees for protection against rising interest rates and for the right to refinance. American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage. To the degree that households are driven by fears of payment shocks but are willing to manage their own interest rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home. Conclusion In evaluating household debt burdens, one must remember that debt-to-income ratios have been rising for at least a half century. With household assets rising as well, the ratio of net worth to income is currently somewhat higher than its long-run average. So long as financial intermediation continues to expand, both household debt and assets are likely to rise faster than income. Without an examination of what is happening to both assets and liabilities, it is difficult to ascertain the true burden of debt service. Overall, the household sector seems to be in good shape, and much of the apparent increase in the household sector’s debt ratios over the past decade reflects factors that do not suggest increasing household financial stress. And, in fact, during the past two years, debt service ratios have been stable.
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Testimony of Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, 24 February 2004.
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Alan Greenspan: Government-sponsored enterprises Testimony of Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, 24 February 2004. * * * Mr. Chairman, Senator Sarbanes, and Members of the Committee: Thank you for inviting me to discuss the role of housing-related government-sponsored enterprises (GSEs) in our economy. These GSEs - the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and the Federal Home Loan Banks (FHLBs) - collectively dominate the financing of residential housing in the United States. Indeed, these entities have grown to be among the largest financial institutions in the United States, and they now stand behind more than $4 trillion of mortgages - or more than three-quarters of the single-family mortgages in the United States - either by holding the mortgage-related assets directly or assuming their credit risk.1 Given their ties to the government and the consequent private market subsidized debt that they issue, it is little wonder that these GSEs have come under increased scrutiny as their competitive presence in the marketplace has increased. In my remarks, I will not focus on the Federal Home Loan Banks, although much of this analysis applies to them as well. In fact, because the Home Loan Banks can design their advances to encompass almost any type of risk, they are more complex to analyze than other GSEs and, hence, raise additional issues. *** During the 1980s and early 1990s, Fannie Mae and Freddie Mac (hereafter Fannie and Freddie) contributed importantly to the development of the secondary mortgage markets for home loans and to the diversification of funding sources for depository institutions and other mortgage originators. Although the risk that a home mortgage borrower may default is small for any individual mortgage, risks can be substantial for a financial institution holding a large volume of mortgages for homes concentrated in one area or a few areas of the country. The possible consequences of such concentration of risk were vividly illustrated by the events of the 1980s, when oil prices fell and the subsequent economic distress led to numerous mortgage defaults in Texas and surrounding states. The secondary markets pioneered by Fannie and Freddie permit mortgage lenders to diversify these risks geographically and thus to extend more safely a greater amount of residential mortgage credit than might otherwise be prudent. The key to developing secondary markets was securitization, and Fannie and Freddie played a critical role in developing and promoting mortgage securitization, the process whereby mortgages are bundled together into pools and then turned into securities that can be bought and sold alongside other debt securities. Securitization by Fannie and Freddie allows mortgage originators to separate themselves from almost all aspects of risk associated with mortgage lending: Once the originator sells Fannie Mae and Freddie Mac stand behind mortgages in two ways: The first method is to purchase mortgages, bundle them together, and then sell claims on the cash flows to be generated by these bundles. These claims are known as mortgagebacked securities (MBS). The second method involves Fannie’s and Freddie’s purchasing mortgages or their own mortgage-backed securities outright and financing those purchases by selling debt directly in the name of the GSE. Both methods create publicly traded securities and thus permit a wide variety and large number of purely private investors to fund mortgages. Using the first method, Fannie and Freddie are relieved of interest-rate risk but are still exposed to credit risk because they guarantee MBS investors against the risk that some homeowners will default on the underlying mortgages. The second method of funding mortgages increases Fannie’s and Freddie’s debt outstanding and expands their balance sheets. In this case, Fannie Mae and Freddie Mac must manage the interest rate, prepayment, and credit risks associated with the mortgages they purchase. In the conforming mortgage market, Fannie Mae and Freddie Mac, using these two methods, play dominant roles in funding and managing the credit risk of the mortgages, but they do not participate directly in the origination of mortgage credit. Depository institutions, mortgage bankers, and their affiliates originate most mortgages. However, the underwriting standards of Fannie Mae and Freddie Mac substantially influence which borrowers receive mortgage credit. As discussed below, because of Fannie Mae’s and Freddie Mac’s government-sponsored advantages, there currently is no secondary market for conforming mortgages other than that provided by Fannie Mae and Freddie Mac. If a bank chooses not to sell the mortgage that it originates, it must fund that mortgage and manage the associated credit and interest rate risks itself. the loan into the secondary market, he or she may play no further role in the contract. This development was particularly important before the emergence of truly nationwide banking institutions because it provided a dramatically improved method for diversifying mortgage credit risk. Fannie and Freddie demonstrated that, by facilitating the diversification of mortgage portfolios and insisting on the application of sound loan underwriting standards, the credit risk associated with holding conforming mortgages could be reduced to very low levels and could be distributed across a wide variety and large number of investors. This innovation in the mortgage market led to the securitization of many other assets and to the creation of many other types of securities. During the 1980s, the GSEs led the private sector in this innovation, and their contribution enhanced the stability of our financial markets. Mortgage securitization continues to perform this crucial function, and its techniques have now been applied by the private sector in many markets, including markets for automobile loans, credit card loans, nonconforming mortgages, and commercial mortgages. Asset-backed securities and the secondary markets in which they trade generally provide both households and businesses with excellent access to credit at an appropriate risk-adjusted interest rate. Moreover, credit supply is far more stable today than it was because it is now founded on a much broader base of potential sources of funds. The aspiring homeowner no longer depends on the willingness of the local commercial bank or savings and loan association to hold his or her mortgage. Similarly, the sources of credit available to purchasers of cars and users of credit cards have expanded widely beyond local credit institutions. Unbeknownst to such borrowers, their loans may ultimately be held by a pension fund, an insurance company, a university endowment, or another investor far removed from the local area. This development has facilitated the substantial growth of nonmortgage consumer credit. Indeed, in the United States, more than $2 trillion of securitized assets currently exists with no government guarantee, either explicit or implicit. *** Given their history of innovation in mortgage-backed securities, why do Fannie and Freddie now generate such substantial concern? The unease relates mainly to the scale and growth of the mortgage-related asset portfolios held on their balance sheets. That growth has been facilitated, as least in part, by a perceived special advantage of these institutions that keeps normal market restraints from being fully effective. The GSEs’ special advantage arises because, despite the explicit statement on the prospectus to GSE debentures that they are not backed by the full faith and credit of the U.S. government, most investors have apparently concluded that during a crisis the federal government will prevent the GSEs from defaulting on their debt. An implicit guarantee is thus created not by the Congress but by the willingness of investors to accept a lower rate of interest on GSE debt than they would otherwise require in the absence of federal sponsorship. Because Fannie and Freddie can borrow at a subsidized rate, they have been able to pay higher prices to originators for their mortgages than can potential competitors and to gradually but inexorably take over the market for conforming mortgages.2 This process has provided Fannie and Freddie with a powerful vehicle and incentive for achieving extremely rapid growth of their balance sheets. The resultant scale gives Fannie and Freddie additional advantages that potential private-sector competitors cannot overcome. Importantly, the scale itself has reinforced investors’ perceptions that, in the event of a crisis involving Fannie and Freddie, policymakers would have little alternative than to have the taxpayers explicitly stand behind the GSE debt. This view is widespread in the marketplace despite the privatization of Fannie and Freddie and their control by private shareholders, because these institutions continue to have government missions, a line of credit with the Treasury, and other government benefits, which confer upon them a special status in the eyes of many investors. The part of Fannie’s and Freddie’s purchases from mortgage originators that they do not fund themselves, but instead securitize, guarantee, and sell into the market, is a somewhat different business. The value of the guarantee is a function of the expectation that Fannie and Freddie will not Conforming mortgages are mortgages that are eligible for purchase by Fannie and Freddie. Fannie and Freddie can purchase mortgages only below the conforming loan limit (currently $333,700) and will purchase only those mortgages that meet their underwriting standards, including, for many mortgages, the standard that the mortgage is equivalent in risk to a mortgage with an 80 percent loan-to-value ratio. This latter requirement makes it difficult to know the extent of the market, but market participants generally believe that Fannie and Freddie purchase a large share of the truly conforming mortgages. be allowed to fail. While the rate of return reflects the implicit subsidy, a smaller amount of Fannie’s and Freddie’s overall profit comes from securitizing and selling mortgage-backed securities (MBS). *** Fannie’s and Freddie’s persistently higher rates of return for bearing the relatively low credit risks associated with conforming mortgages is evidence of a significant implicit subsidy. A recent study by a Federal Reserve economist, Wayne Passmore, attempts to quantify the value of that implicit subsidy to the private shareholders of Fannie and Freddie. His research indicates that it may account for more than half of the stock market capitalization of these institutions. The study also suggests that these institutions pass little of the benefit of their government-sponsored status to homeowners in the form of lower mortgage rates. Passmore’s analysis suggests that Fannie and Freddie likely lower mortgage rates less than 16 basis points, with a best estimate centering on about 7 basis points. If the estimated 7 basis points is correct, the associated present value of homeowner savings is only about half the after-tax subsidy that shareholders of these GSEs are estimated to receive. Congressional Budget Office and other estimates differ, but they come to the essentially same conclusion: A substantial portion of these GSEs’ implicit subsidy accrues to GSE shareholders in the form of increased dividends and stock market value. Fannie and Freddie, as you know, have disputed the conclusions of many of these studies. As noted by the General Accounting Office, the task of assessing the costs and benefits associated with the GSEs is difficult. One possible way to advance the technical discussion would be for the Congress to request disinterested parties to convene groups of technical experts in an effort to better understand and measure these costs and benefits. *** The Federal Reserve is concerned about the growth and the scale of the GSEs’ mortgage portfolios, which concentrate interest rate and prepayment risks at these two institutions. Unlike many wellcapitalized savings and loans and commercial banks, Fannie and Freddie have chosen not to manage that risk by holding greater capital. Instead, they have chosen heightened leverage, which raises interest rate risk but enables them to multiply the profitability of subsidized debt in direct proportion to their degree of leverage. Without the expectation of government support in a crisis, such leverage would not be possible without a significantly higher cost of debt. Interest rate risk associated with fixed-rate mortgages, unless supported by substantial capital, however, can be of even greater concern than the credit risk. Interest rate volatility combined with the ability of homeowners to prepay their mortgages without penalty means that the cash flows associated with the holding of mortgage debt directly or through mortgage-backed securities are highly uncertain, even if the probability of default is low. In general, interest rate risk is readily handled by adjusting maturities of assets and liabilities. But hedging prepayment risk is more complex. To manage this risk with little capital requires a conceptually sophisticated hedging framework. In essence, the current system depends on the risk managers at Fannie and Freddie to do everything just right, rather than depending on a market-based system supported by the risk assessments and management capabilities of many participants with different views and different strategies for hedging risks. Our financial system would be more robust if we relied on a market-based system that spreads interest rate risks, rather than on the current system, which concentrates such risk with the GSEs. *** As always, concerns about systemic risk are appropriately focused on large, highly leveraged financial institutions such as the GSEs that play substantial roles in the functioning of financial markets. I should emphasize that Fannie and Freddie, to date, appear to have managed these risks well and that we see nothing on the immediate horizon that is likely to create a systemic problem. But to fend off possible future systemic difficulties, which we assess as likely if GSE expansion continues unabated, preventive actions are required sooner rather than later. As a general matter, we rely in a market economy upon market discipline to constrain the leverage of firms, including financial institutions. However, the existence, or even the perception, of government backing undermines the effectiveness of market discipline. A market system relies on the vigilance of lenders and investors in market transactions to assure themselves of their counterparties’ strength. However, many counterparties in GSE transactions, when assessing their risk, clearly rely instead on the GSEs’ perceived special relationship to the government. Thus, with housing-related GSEs, regulators cannot rely significantly on market discipline. Indeed, they must assess whether these institutions hold appropriate amounts of capital relative to the risks that they assume and the costs that they might impose on others, including taxpayers, in the event of a financial-market meltdown. The issues are similar to those that arise in the context of commercial banking and deposit insurance indeed, they are the reason that commercial banks are regulated and subject to stringent regulatory capital standards. Traditionally, questions of capital adequacy for financial institutions have been evaluated with regard to credit and interest rate risks. However, in the case of the GSEs and other large regulated financial institutions with significant roles in market functioning, liquidity and operation risks also need to be considered. Determining the suitable amount of capital for Fannie and Freddie is a difficult and technical process, and in the Federal Reserve’s judgment, a regulator should have a free hand in determining the minimum and risk-based capital standards for these institutions. The size of Fannie and Freddie, the complexity of their financial operations, and the general indifference of many investors to the financial condition of the GSEs because of their perceived special relationship to the government suggest that the GSE regulator must have authority similar to that of the banking regulators. In addressing the role of a new GSE regulator, the Congress needs to clarify the circumstances under which a GSE can become insolvent and, in particular, the resultant position both during and after insolvency - of the investors that hold GSE debt. This process must be clear before it is needed; otherwise, should these institutions experience significant financial difficulty, the hands of any regulator, and of public authorities generally, would be constrained by uncertainties about the process. Left unresolved, such uncertainties would only heighten the prospect that a crisis would result in an explicit guaranteeing of GSE debt. *** World-class regulation, by itself, may not be sufficient and indeed, as suggested by Treasury Secretary Snow, may even worsen the situation if market participants infer from such regulation that the government is all the more likely to back GSE debt. This is the heart of a dilemma in designing regulation for the GSEs. On the one hand, if the regulation of the GSEs is strengthened, the market may view them even more as extensions of the government and view their debt as government debt. The result, short of a marked increase in capital, would be to expand the implicit subsidy and allow the GSEs to play an even larger unconstrained role in the financial markets. On the other hand, if we fail to strengthen GSE regulation, the possibility of an actual crisis or insolvency is increased. Some observers have argued that Fannie and Freddie are simple institutions with a function that is clear to all. The evidence suggests that this is far from the case. The difficulties of creating transparent accounting standards to reflect the gains and losses associated with hedging mortgage-prepayment risk highlight that the business of taking on interest rate and prepayment risk is far from simple and is difficult to communicate to outside investors. Most of the concerns associated with systemic risks flow from the size of the balance sheets that these GSEs maintain. One way the Congress could constrain the size of these balance sheets is to alter the composition of Fannie’s and Freddie’s mortgage financing by limiting the dollar amount of their debt relative to the dollar amount of mortgages securitized and held by other investors. Although it is difficult to know how best to set such a rule, this approach would continue to expand the depth and liquidity of mortgage markets through mortgage securitization but would remove most of the potential systemic risks associated with these GSEs. Ideally such a ratio would focus the business operations of Fannie and Freddie on the enhancement of secondary markets and not on the capture of the implicit subsidy.3 Limiting the debt of Fannie and Freddie and expanding their role in mortgage securitization would be consistent with the original congressional intent that these institutions provide stability in the market for residential mortgages and provide liquidity for mortgage investors. Deep and liquid markets for mortgages are made using mortgage-backed securities that are held by non-GSE private investors. Fannie’s and Freddie’s purchases of their own or each other’s securities with their debt do not appear needed to supply mortgage market liquidity or to enhance capital markets in the United States. Likewise, the ability of Federal Home Loan Banks to hold mortgages and mortgage-backed securities directly could also be limited, so that mortgage-related interest rate risks are managed by a variety of purely private investors. The expansion of homeownership is a widely supported goal in this country. A sense of ownership and commitment to our communities imparts a degree of stability that is particularly valuable to society. But there are many ways to enhance the attractiveness of homeownership at significantly less potential cost to taxpayers than through the opaque and circuitous GSE paradigm currently in place. Even with a constraint on debt issuance, Fannie and Freddie would remain among the largest financial institutions in the United States and would be able to grow with the size of the mortgage markets. These are important organizations that, because of their implicit subsidy, are expanding at a pace beyond that consistent with systematic safety. They have made, and should - with less reliance on subsidies - continue to make, major contributions to the financial system of the United States. *** In sum, the Congress needs to create a GSE regulator with authority on a par with that of banking regulators, with a free hand to set appropriate capital standards, and with a clear process sanctioned by the Congress for placing a GSE in receivership. However, if the Congress takes only these actions, it runs the risk of solidifying investors’ perceptions that the GSEs are instruments of the government and that their debt is equivalent to government debt. The GSEs will have increased incentives to continue to grow faster than the overall home mortgage market. Because they already purchase most conforming mortgages, they, like all effective profit-maximizing organizations, will be seeking new avenues to expand the scope of their operations, assisted by a subsidy that their existing or potential competitors do not enjoy. Thus, GSEs need to be limited in the issuance of GSE debt and in the purchase of assets, both mortgages and nonmortgages, that they hold. Fannie and Freddie should be encouraged to continue to expand mortgage securitization, keeping mortgage markets deep and liquid while limiting the size of their portfolios. This action will allow the mortgage markets to support homeownership and homebuilding in a manner consistent with preserving the safe and sound financial markets of the United States.
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Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the meetings of the Eastern Economic Association, Washington DC, 20 February 2004.
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Ben S Bernanke: The great moderation Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the meetings of the Eastern Economic Association, Washington DC, 20 February 2004. The references for the speech can be found on the Board of Governors of the Federal Reserve System’s website. * * * One of the most striking features of the economic landscape over the past twenty years or so has been a substantial decline in macroeconomic volatility. In a recent article, Olivier Blanchard and John Simon (2001) documented that the variability of quarterly growth in real output (as measured by its standard deviation) has declined by half since the mid-1980s, while the variability of quarterly inflation has declined by about two thirds.1 Several writers on the topic have dubbed this remarkable decline in the variability of both output and inflation “the Great Moderation”. Similar declines in the volatility of output and inflation occurred at about the same time in other major industrial countries, with the recent exception of Japan, a country that has faced a distinctive set of economic problems in the past decade. Reduced macroeconomic volatility has numerous benefits. Lower volatility of inflation improves market functioning, makes economic planning easier, and reduces the resources devoted to hedging inflation risks. Lower volatility of output tends to imply more stable employment and a reduction in the extent of economic uncertainty confronting households and firms. The reduction in the volatility of output is also closely associated with the fact that recessions have become less frequent and less severe.2 Why has macroeconomic volatility declined? Three types of explanations have been suggested for this dramatic change; for brevity, I will refer to these classes of explanations as structural change, improved macroeconomic policies, and good luck. Explanations focusing on structural change suggest that changes in economic institutions, technology, business practices, or other structural features of the economy have improved the ability of the economy to absorb shocks. Some economists have argued, for example, that improved management of business inventories, made possible by advances in computation and communication, has reduced the amplitude of fluctuations in inventory stocks, which in earlier decades played an important role in cyclical fluctuations.3 The increased depth and sophistication of financial markets, deregulation in many industries, the shift away from manufacturing toward services, and increased openness to trade and international capital flows are other examples of structural changes that may have increased macroeconomic flexibility and stability. The second class of explanations focuses on the arguably improved performance of macroeconomic policies, particularly monetary policy. The historical pattern of changes in the volatilities of output growth and inflation gives some credence to the idea that better monetary policy may have been a major contributor to increased economic stability. As Blanchard and Simon (2001) show, output volatility and inflation volatility have had a strong tendency to move together, both in the United States and other industrial countries. In particular, output volatility in the United States, at a high level in the immediate postwar era, declined significantly between 1955 and 1970, a period in which inflation volatility was low. Both output volatility and inflation volatility rose significantly in the 1970s and early 1980s and, as I have noted, both fell sharply after about 1984. Economists generally agree that the 1970s, the period of highest volatility in both output and inflation, was also a period in which monetary Kim and Nelson (1999) and McConnell and Perez-Quiros (2000) were among the first to note the reduction in the volatility of output. Kim, Nelson, and Piger (2003) show that the reduction in the volatility of output is quite broad based, affecting many sectors and aspects of the economy. Warnock and Warnock (2000) find a parallel decline in the volatility of employment, especially in goods-producing sectors. The United States has experienced only two relatively mild recessions since 1984, compared with four recessions - two of them quite deep - in the fifteen years before 1984. Indeed, according to the National Bureau of Economic Research’s monthly business cycle chronology, which covers the period since the Civil War, the 120-month expansion of the 1990s was the longest recession-free period the United States has enjoyed, and the 92-month expansion of the 1980s was the third longest such period. McConnell and Perez-Quiros (2000) and Kahn, McConnell, and Perez-Quiros (2002) make this argument. McCarthy and Zakrajsek (2003) provide an overview and evaluation of this literature; they conclude that better inventory management has reinforced the trend toward lower volatility but is not the ultimate cause. Willis (2003) discusses structural changes that may have contributed to reduced variability of inflation. policy performed quite poorly, relative to both earlier and later periods (Romer and Romer, 2002).4 Few disagree that monetary policy has played a large part in stabilizing inflation, and so the fact that output volatility has declined in parallel with inflation volatility, both in the United States and abroad, suggests that monetary policy may have helped moderate the variability of output as well. The third class of explanations suggests that the Great Moderation did not result primarily from changes in the structure of the economy or improvements in policymaking but occurred because the shocks hitting the economy became smaller and more infrequent. In other words, the reduction in macroeconomic volatility we have lately enjoyed is largely the result of good luck, not an intrinsically more stable economy or better policies. Several prominent studies using distinct empirical approaches have provided support for the good-luck hypothesis (Ahmed, Levin, and Wilson, 2002; Stock and Watson, 2003). Explanations of complicated phenomena are rarely clear cut and simple, and each of the three classes of explanations I have described probably contains elements of truth. Nevertheless, sorting out the relative importance of these explanations is of more than purely historical interest. Notably, if the Great Moderation was largely the result of good luck rather than a more stable economy or better policies, then we have no particular reason to expect the relatively benign economic environment of the past twenty years to continue. Indeed, if the good-luck hypothesis is true, it is entirely possible that the variability of output growth and inflation in the United States may, at some point, return to the levels of the 1970s. If instead the Great Moderation was the result of structural change or improved policymaking, then the increase in stability should be more likely to persist, assuming of course that policymakers do not forget the lessons of history. My view is that improvements in monetary policy, though certainly not the only factor, have probably been an important source of the Great Moderation. In particular, I am not convinced that the decline in macroeconomic volatility of the past two decades was primarily the result of good luck, as some have argued, though I am sure good luck had its part to play as well. In the remainder of my remarks, I will provide some support for the “improved-monetary-policy” explanation for the Great Moderation. I will not spend much time on the other two classes of explanations, not because they are uninteresting or unimportant, but because my time is limited and the structural change and good-luck hypotheses have been extensively discussed elsewhere.5 Before proceeding, I should note that my views are not necessarily those of my colleagues on the Board of Governors or the Federal Open Market Committee. The Taylor curve and the variability tradeoff Let us begin by asking what economic theory has to say about the relationship of output volatility and inflation volatility. To keep matters simple, I will make the strong (but only temporary!) assumption that monetary policymakers have an accurate understanding of the economy and that they choose policies to promote the best economic performance possible, given their economic objectives. I also assume for the moment that the structure of the economy and the distribution of economic shocks are stable and unchanging. Under these baseline assumptions, macroeconomists have obtained an interesting and important result. Specifically, standard economic models imply that, in the long run, monetary policymakers can reduce the volatility of inflation only by allowing greater volatility in output growth, and vice versa. In other words, if monetary policies are chosen optimally and the economic structure is held constant, there exists a long-run tradeoff between volatility in output and volatility in inflation. The ultimate source of this long-run tradeoff is the existence of shocks to aggregate supply. Consider the canonical example of an aggregate supply shock, a sharp rise in oil prices caused by disruptions to foreign sources of supply. According to conventional analysis, an increase in the price of oil raises the overall price level (a temporary burst in inflation) while depressing output and employment. Monetary policymakers are therefore faced with a difficult choice. If they choose to tighten policy (raise the short-term interest rate) in order to offset the effects of the oil price shock on the general price level, they may well succeed - but only at the cost of making the decline in output more severe. Likewise, if monetary policymakers choose to ease in order to mitigate the effects of the oil price shock Using more formal econometric methods, Kim, Nelson, and Piger (2003) also found that structural breaks in the volatility and persistence of inflation occurred about the same times as the changes in output volatility. Stock and Watson (2003) provide a recent overview of the debate. on output, their action will exacerbate the inflationary impact. Hence, in the standard framework, the periodic occurrence of shocks to aggregate supply (such as oil price shocks) forces policymakers to choose between stabilizing output and stabilizing inflation.6 Note that shocks to aggregate demand do not create the same tradeoff, as offsetting an aggregate demand shock stabilizes both output and inflation. This apparent tradeoff between output variability and inflation variability faced by policymakers gives rise to what has been dubbed the Taylor curve, reflecting early work by the Stanford economist and current Undersecretary of the Treasury John B. Taylor.7 (Taylor also originated the eponymous Taylor rule, to which I will refer later.) Graphically, the Taylor curve depicts the menu of possible combinations of output volatility and inflation volatility from which monetary policymakers can choose in the long run. Figure 1 shows two examples of Taylor curves, marked TC1 and TC2. In Figure 1, volatility in output is measured on the vertical axis and volatility in inflation is measured on the horizontal axis. As shown in the figure, Taylor curves slope downward, reflecting the theoretical conclusion that an optimizing policymaker can choose less of one type of volatility in the long run only by accepting more of the other.8 A direct implication of the Taylor curve framework is that a change in the preferences or objectives of the central bank alone - a decision to be tougher on inflation, for example - cannot explain the Great Moderation. Indeed, in this framework, a conscious attempt by policymakers to try to moderate the variability of inflation should lead to higher, not lower, variability of output. How, then, can the Great Moderation be explained? Figure 1 suggests two possibilities. First, suppose it were the case, contrary to what we assumed in deriving the Taylor curve, that monetary policies during the period of high macroeconomic volatility were not optimal, perhaps because policymakers did not have an accurate understanding of the structure of the economy or of the impact of their policy actions. If monetary policies during the late 1960s and the 1970s were sufficiently far from optimal, the result could be a combination of output volatility and inflation volatility lying well above the efficient frontier defined by the Taylor curve. Graphically, suppose that the true Taylor curve is the solid curve shown in Figure 1, labeled TC2. Then, in principle, sufficiently well executed policies could achieve a combination of output volatility and inflation volatility such as that represented by point B, which lies on that curve. However, less effective policies could lead to the economic outcome represented by point A in Figure 1, at which both output volatility and inflation volatility are higher than at point B. We can see now how improvements in monetary policy might account for the Great Moderation, even in the absence of any change in the structure of the economy or in the underlying shocks. Improvements in the policy framework, in policy implementation, or in the policymakers’ understanding of the economy could allow the economy to move from the inefficient point A to the efficient point B, where the volatility of both inflation and output are more moderate. Figure 1 can also be used to depict a second possible explanation for the Great Moderation, which is that, rather than monetary policy having improved, the underlying economic environment may have become more stable. Changes in the structure of the economy that increased its resilience to shocks or reductions in the variance of the shocks themselves would improve the volatility tradeoff faced by policymakers. In Figure 1, we can imagine now that the true Taylor curve in the 1970s is given by the dashed curve, TC1, and the actual economic outcome chosen by policymakers is point A, which lies on TC1. Improved economic stability in the 1980s and 1990s, whether arising from structural change or good luck, can be represented by a shift of the Taylor curve from TC1 to TC2, and the new economic outcome as determined by policy is point B. Relative to TC1, the Taylor curve TC2 represents economic outcomes with lower volatility in output for any given volatility of inflation, and vice versa. According to the “shifting Taylor curve” explanation, the Great Moderation resulted not from improved practice of monetary policy (which has always been as effective as possible, given the Strictly speaking, according to standard models, policymakers face a tradeoff between volatility of inflation and volatility of the output gap, the difference between potential output and actual output. If the economy’s potential output grows relatively smoothly, variability in the output gap will be closely related to variability in actual output. Chatterjee (2002) provides an overview of the Taylor curve and its implications. For an exposition by Taylor himself, see Taylor (1998). The policy tradeoff between the variability of inflation and the variability of output implied by the Taylor curve is reminiscent of an older proposition, that policymakers could achieve a permanently higher level of output (and thus a permanently lower level of unemployment) by accepting a permanently higher level of inflation. However, for both theoretical and empirical reasons, this older idea of a long-run tradeoff between the levels of inflation and output has been largely discredited, and the Taylor curve tradeoff is in some sense its natural successor. environment) but rather by favorable structural change or reduced variability of economic shocks. Of course, more complicated scenarios in which policy becomes more effective and the underlying economic environment becomes more stable are possible and indeed likely. With this bit of theory as background, I will focus on two key points. First, without claiming that monetary policy during the 1950s or in the period since 1984 has been ideal by any means, I will try to support my view that the policies of the late 1960s and 1970s were particularly inefficient, for reasons that I think we now understand. Thus, as in the first scenario just discussed (represented in Figure 1 as a movement from point A to point B), improvements in the execution of monetary policy can plausibly account for a significant part of the Great Moderation. Second, more subtly, I will argue that some of the benefits of improved monetary policy may easily be confused with changes in the underlying environment (that is, improvements in policy may be incorrectly identified as shifts in the Taylor curve), increasing the risk that standard statistical methods of analyzing this question could understate the contribution of monetary policy to the Great Moderation. Reaching the Taylor curve: improvements in the effectiveness of monetary policy Monetary policymakers face difficult challenges in their efforts to stabilize the economy. We are uncertain about many aspects of the workings of the economy, including the channels by which the effects of monetary policy are transmitted. We are even uncertain about the current economic situation as economic data are received with a lag, are typically subject to multiple revisions, and in any case can only roughly and partially depict the underlying economic reality. Thus, in practice, monetary policy will never achieve as much reduction in macroeconomic volatility as would be possible if our understanding were more complete. Nevertheless, a number of economists have argued that monetary policy during the late 1960s and the 1970s was unusually prone to creating volatility, relative to both earlier and later periods (DeLong, 1997; Mayer, 1998; Romer and Romer, 2002). Economic historians have suggested that the relative inefficiency of policy during this period arose because monetary policymakers labored under some important misconceptions about policy and the economy. First, during this period, central bankers seemed to have been excessively optimistic about the ability of activist monetary policies to offset shocks to output and to deliver permanently low levels of unemployment. Second, monetary policymakers appeared to underestimate their own contributions to the inflationary problems of the time, believing instead that inflation was in large part the result of nonmonetary forces. One might say that, in terms of their ability to deliver good macroeconomic outcomes, policymakers suffered from excessive “output optimism” and “inflation pessimism.” The output optimism of the late 1960s and the 1970s had several aspects. First, at least during the early part of that period, many economists and policymakers held the view that policy could exploit a permanent tradeoff between inflation and unemployment, as described by a simple Phillips curve relationship. The idea of a permanent tradeoff opened up the beguiling possibility that, in return for accepting just a bit more inflation, policymakers could deliver a permanently low rate of unemployment. This view is now discredited, of course, on both theoretical and empirical grounds.9 Second, estimates of the rate of unemployment that could be sustained without igniting inflation were typically unrealistically low, with a long-term unemployment rate of 4 percent or less often being characterized as a modest and easily attainable objective.10 Third, economists of the time may have been unduly optimistic about the ability of fiscal and monetary policymakers to eliminate short-term fluctuations in output and employment, that is, to “fine-tune” the economy. What I have called inflation pessimism was the increasing conviction of policymakers in the 1960s and 1970s, as inflation rose and remained stubbornly high, that monetary policy was an ineffective tool for controlling inflation. As emphasized in recent work on the United States and the United Kingdom by Friedman (1968) provided a major theoretical critique of the idea of a permanent tradeoff. Scholars disagree about when and to what degree U.S. monetary policymakers absorbed the lessons of Friedman’s article. Orphanides (2003) has emphasized the importance of poor estimates of potential output and the closely associated concept of the natural rate of unemployment for explaining the inflationary policies of the 1970s. He notes the difficulty that policymakers of the time faced in distinguishing the productivity slowdown of the period from a cyclical decline in output. Analytical support for the view that confusion between the cyclical and secular aspects of the 1970s’ slowdown had inflationary consequences is provided by Lansing (2002) and Bullard and Eusepi (2003). Edward Nelson (2004), during this period policymakers became more and more inclined to blame inflation on so-called cost-push shocks rather than on monetary forces. Cost-push shocks, in the paradigm of the time, included diverse factors such as union wage pressures, price increases by oligopolistic firms, and increases in the prices of commodities such as oil and beef brought about by adverse changes in supply conditions. For the purpose of understanding the upward trend in inflation, however, the most salient attribute of cost-push shocks was that they were putatively out of the control of the monetary policymakers. The combination of output optimism and inflation pessimism during the latter part of the 1960s and the 1970s was a recipe for high volatility in output and inflation - that is, a set of outcomes well away from the efficient frontier represented by the economy’s Taylor curve. Notably, the belief in a long-run tradeoff between output and inflation, together with an unrealistically low assessment of the sustainable rate of unemployment, resulted in high inflation but did not deliver the expected payoff in terms of higher output and employment. Moreover, the Fed’s periodic attempts to rein in surging inflation led to a pattern of “go-stop” policies, in which swings in policy from ease to tightness contributed to a highly volatile real economy as well as a highly variable inflation rate. Wage-price controls, invoked in the belief that monetary policy was ineffective against cost-push forces, also ultimately proved destabilizing. Monetary policymakers bemoaned the high rate of inflation in the 1970s but did not fully appreciate their own role in its creation. Ironically, their errors in estimating the natural rate and in ascribing inflation to nonmonetary forces were mutually reinforcing. On the one hand, because unemployment remained well above their over-optimistic estimates of the sustainable rate, they were inclined to attribute inflation to outside forces (such as the actions of firms and unions) rather than to an overheated economy (Romer and Romer, 2002; Nelson, 2004). On the other hand, the view of policymakers that exogenous forces largely drove inflation made it more difficult for them to recognize that their estimate of the sustainable rate of unemployment was too low. Several years passed before policymakers were finally persuaded by the evidence that sustained anti-inflationary monetary policies would actually work (Primiceri, 2003). As you know, these policies were implemented successfully after 1979, beginning under Fed Chairman Volcker. Better known than even the Taylor curve is John Taylor’s famous Taylor rule, a simple equation that has proved remarkably useful as a rule-of-thumb description of monetary policy (Taylor, 1993). In its basic form, the Taylor rule relates the Federal Reserve’s policy instrument, the overnight federal funds interest rate, to the deviations of inflation and output from the central bank’s desired levels for those variables. Estimates of the Taylor rule for the late 1960s and the 1970s reflect the output optimism and inflation pessimism of the period, in that researchers tend to find a weaker response of the policy rate to inflation and (in some studies) a relatively stronger response to the output gap than in more recent periods.11 As I will shortly discuss further, an insufficiently strong response to inflation let inflation and inflation expectations get out of control and thus added volatility to the economy. At the same time, strong responses to what we understand in retrospect to have been over-optimistic estimates of the output gap created additional instability. As output optimism and inflation pessimism both waned under the force of the data, policy responses became more appropriate and the economy more stable. In this sense, improvements in policymakers’ understanding of the economy and the role of monetary policy allowed the economy to move closer to the Taylor curve (or, in terms of Figure 1, to move from point A to point B). Improved monetary policy or a shifting Taylor curve? Improvements in monetary policy that moved the economy closer to the efficient frontier described by the Taylor curve can account for part of the Great Moderation. However, several empirical studies have questioned the quantitative importance of this effect and emphasized instead shifts in the Taylor curve, brought about by structural change or good luck. For example, in a paper presented at the See, for example, Judd and Rudebusch (1998), Taylor (1999), Clarida, Gali, and Gertler (2000), Cogley and Sargent (2002), and Mehra (2002). Orphanides (2003) argues that, if one takes account of policymakers’ mis-estimates of the output gap in the 1970s, the same Taylor rule that describes policy after 1979 applies to the 1970s as well. The debate is an important one, but it may bear more on what policymakers actually thought they were doing - and thus on the history of ideas - then on the question of whether monetary policy was in fact inefficient or even destabilizing during the period. There seems to be little doubt that it was. Federal Reserve Bank of Kansas City’s annual Jackson Hole conference, James Stock and Mark Watson (2003) use several alternative macroeconomic models to simulate how the economy would have performed after 1984 if monetary policy had followed its pre-1979 pattern. Although inflation performance after 1984 would clearly have been worse if pre-1979 monetary policies had been used, Stock and Watson find that output volatility would have been little different. They conclude that improved monetary policy does not account for much of the reduction in output volatility since the mid-1980s. Instead, noting that the variance of the economic shocks implied by their models for the 1970s was much higher than the variance of shocks in the more recent period, they embrace the good-luck explanation of the Great Moderation. Interesting research by Timothy Cogley and Thomas Sargent (2002) and by Shaghil Ahmed, Andrew Levin, and Beth Anne Wilson (2002) likewise find a substantial reduction in the size and frequency of shocks in the more recent period, supporting the good-luck hypothesis. Both the structural change and good-luck explanations of the Great Moderation are intriguing and (to reiterate) both are no doubt part of the story. However, an unsatisfying aspect of both explanations is the difficulty of identifying changes in the economic environment large enough and persistent enough to explain the Great Moderation, both in the United States and abroad. In particular, it is not obvious that economic shocks have become significantly smaller or more infrequent, as required by the goodluck hypothesis. Tensions in the Middle East, often blamed for the oil price shocks of the 1970s, have hardly declined in recent years, and important developments in technology and productivity have continued to buffet the economy (albeit in a more positive direction than in the 1970s). Nor has the international economic environment become obviously more placid, as a series of financial crises struck various regions of the world during the 1990s and the powerful forces of globalization have proceeded apace. In contrast, following the adverse experience of the 1970s, changes in the practice of monetary policy occurred around the world in similar ways and during approximately the same period. Certainly, stability-enhancing changes in the economic environment have occurred in the past two decades. However, an intriguing possibility is that some of these changes, rather than being truly exogenous, may have been induced by improved monetary policies. That is, better monetary policies may have resulted in what appear to be (but only appear to be) favorable shifts in the economy’s Taylor curve. Here are some examples of what I have in mind. First, monetary policies that brought down and stabilized inflation may have led to stabilizing changes in the structure of the economy as well, in line with the prediction of the famous Lucas (1976) critique that economic structure depends on the policy regime. High and unstable inflation increases the variability of relative prices and real interest rates, for example, distorting decisions regarding consumption, capital investment, and inventory investment, among others. Likewise, the high level, variability, and unpredictability of inflation profoundly affected decisions regarding financial investments and money holdings. Theories of “rational inattention” (Sims, 2003), according to which people vary the frequency with which they re-examine economic decisions according to the underlying economic environment, imply that the dynamic behavior of the economy would change - probably in the direction of greater stability and persistence - in a more stable pricing environment, in which people reconsider their economic decisions less frequently. Second, changes in monetary policy could conceivably affect the size and frequency of shocks hitting the economy, at least as an econometrician would measure those shocks. This assertion seems odd at first, as we are used to thinking of shocks as exogenous events, arising from “outside the model,” so to speak. However, econometricians typically do not measure shocks directly but instead infer them from movements in macroeconomic variables that they cannot otherwise explain. Shocks in this sense may certainly reflect the monetary regime. For example, consider the cost-push shocks that played such an important role in 1970s’ thinking about inflation. Seemingly unexplained or autonomous movements in wages and prices during this period, which analysts would have interpreted as shocks to wage and price equations, may in fact have been the result of earlier monetary policy actions, or (more subtly) of monetary policy actions expected by wage- and price-setters to take place in the future. In an influential paper, Robert Barsky and Lutz Kilian (2001) analyze the oil price shocks of the 1970s in this spirit. Barsky and Kilian provide evidence that the extraordinary increases in nominal oil prices during the 1970s were made feasible primarily by earlier expansionary monetary policies rather than by truly exogenous political or economic events. Third, monetary policy can also affect the distribution of measured shocks by changing the sensitivity of pricing and other economic decisions to exogenous outside events. For example, significant movements in the price of oil and other commodities continued to occur after 1984. However, in a low-inflation environment, with stable inflation expectations and a general perception that firms do not have pricing power, commodity price shocks are not passed into final goods prices to nearly the same degree as in a looser monetary environment. As a result, a change in commodity prices of a given size shows up as a smaller shock to output and consumer prices today than it would have in the earlier period. Likewise, there is evidence that fluctuations in exchange rates have smaller effects on domestic prices and economic activity when inflation is less volatile and inflation expectations are stabilized (Gagnon and Ihrig, 2002; Devereux, Engel, and Storgaard, 2003). Fourth, changes in inflation expectations, which are ultimately the product of the monetary policy regime, can also be confused with truly exogenous shocks in conventional econometric analyses. Marvin Goodfriend (1993) has suggested, for example, that insufficiently anchored inflation expectations have led to periodic “inflation scares”, in which inflation expectations have risen in an apparently autonomous manner. Increases in inflation expectations have the flavor of adverse aggregate supply shocks in that they tend to increase the volatility of both inflation and output, in a combination that depends on how strongly the monetary policymakers act to offset these changes in expectations. Theoretical and empirical support for the idea that inflation expectations may become an independent source of instability has grown in recent years.12 As I mentioned earlier, a number of researchers have found that the reaction of monetary policymakers to inflation has strengthened, in that the estimated coefficient on inflation in the Taylor rule has risen from something less than 1 before 1979 to a value significantly greater than 1 in the more recent period. If the policy interest rate responds to increases in inflation by less than one-for-one (so that the real policy rate does not rise in the face of higher inflation), economic theory tells us that inflation expectations and the economy in general can become unstable. The problem arises from the fact that, if policymakers do not react sufficiently aggressively to increases in inflation, spontaneously arising expectations of increased inflation can ultimately be selfconfirming and even self-reinforcing. Incidentally, the stability requirement that the policy rate respond to inflation by more than one-for-one is called the Taylor principle (Taylor, 1993, 1999) - the third concept named after John Taylor that has played a role in this talk. The finding that monetary policymakers violated the Taylor principle during the 1970s but satisfied the principle in the past two decades would be consistent with a reduced incidence of destabilizing expectational shocks.13 Support for the view that inflation expectations can be an independent source of economic volatility has also emerged from the extensive recent literature on learning and macroeconomics (Evans and Honkopohja, 2001). For example, Athanasios Orphanides and John C. Williams (2003a, 2003b) have studied models in which the public must learn the central bank’s underlying preferences regarding inflation by observing the actual inflation process.14 With learning, inflation expectations take on a more adaptive character; in particular, high and unstable inflation will beget similar characteristics in the pattern of inflation expectations. As Orphanides and Williams show, when inflation expectations are poorly anchored, so that the public is highly uncertain about the long-run rate of inflation that the central bank hopes to achieve, they can become an additional source of volatility in the economy. An analysis that did not properly control for the expectational effects of changes in monetary policy might incorrectly conclude that the Taylor curve had shifted in an adverse direction. Conclusion The Great Moderation, the substantial decline in macroeconomic volatility over the past twenty years, is a striking economic development. Whether the dominant cause of the Great Moderation is structural change, improved monetary policy, or simply good luck is an important question about which no consensus has yet formed. I have argued today that improved monetary policy has likely made an important contribution not only to the reduced volatility of inflation (which is not particularly controversial) but to the reduced volatility of output as well. Moreover, because a change in the monetary policy regime has pervasive effects, I have suggested that some of the effects of improved See Bernanke (2003, 2004) for more extensive discussions. In a similar spirit, Stefania Albanesi, V.V. Chari, and Lawrence Christiano (2003) have shown that when the central bank’s commitment to fighting inflation is perceived to be weak, as may have been the case during the 1970s, self-confirming increases in expected inflation are possible and will tend to destabilize the economy. See Bernanke (2004) for additional discussion. monetary policies may have been misidentified as exogenous changes in economic structure or in the distribution of economic shocks. This conclusion on my part makes me optimistic for the future, because I am confident that monetary policymakers will not forget the lessons of the 1970s. I have put my case for better monetary policy rather forcefully today, because I think it likely that the policy explanation for the Great Moderation deserves more credit than it has received in the literature. However, let me close by emphasizing that the debate remains very much open. Although I have focused on its strengths, the monetary policy hypothesis has potential deficiencies as well. For example, although I pointed out the difficulty that the structural change and good-luck explanations have in accounting for the rather sharp decline in volatility after 1984, one might also question whether the change in monetary policy regime was sufficiently sharp to have had the effects I have attributed to it.15 The consistency of the monetary policy explanation with the experience of the 1950s, a period of stable inflation during which output volatility declined but was high in absolute terms, deserves further investigation. Moreover, several of the channels by which monetary policy may have affected volatility that I have mentioned today remain largely theoretical possibilities and have not received much in the way of rigorous empirical testing. One of my goals today was to stimulate further research on this question. Clearly, the sources of the Great Moderation will continue to be an area for fruitful analysis and debate. Figure 1 Monetary policy and the variability of output and inflation Stock and Watson (2003) make this point. Supporting their argument, in Bernanke (2004) I present evidence that even today inflation expectations may not be anchored as well as we would like.
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board of governors of the federal reserve system
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Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the Economic Club of Memphis dinner, Memphis, 19 February 2004.
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Susan Schmidt Bies: Financial markets and corporate governance Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the Economic Club of Memphis dinner, Memphis, 19 February 2004. * * * I am so pleased to be back in Memphis tonight and to speak to the Economic Club of Memphis, an organization that I once had the honor to chair. Some of you have asked about my experience as a member of the Board of Governors of the Federal Reserve System, and I find that I am dealing with familiar issues that I have frequently addressed in my business career, but from a different perspective. Tonight, I want to touch on one of those areas, corporate governance, but I also want to focus on the way a central banker considers corporate governance issues, particularly how these issues affect the performance of financial markets and the functioning of the economic system. The governance problems that have come to light over the past couple of years have focused attention on the quality of accounting standards, the professionalism of auditors, and the governance practices of major companies and, most recently, of mutual funds. These scandals have been the topic of much debate and have triggered a spate of regulatory reforms. However, rather than review the litany of scandals and regulatory responses, I would like to step back and discuss some broader, longer-term issues that affect accounting and corporate governance. Looking beyond the isolated cases of outright fraud, I believe a fundamental problem is this: as organizations have grown in size and scope, innovative financing techniques have made it more difficult for outside investors to understand a particular firm’s risk profile and the performance of its various lines of business. Traditional accounting standards have not kept pace with the riskmanagement tools employed by sophisticated corporations. Thus, more meaningful disclosure of firms’ risk-management positions and strategies is crucial for improving corporate transparency for market participants. The second issue I want to explore is how corporate governance in the United States is shaped by the increasing importance of institutional investors, such as mutual funds and pension funds, as major holders of corporate equity. Two themes will emerge. The first is that institutional investors may play a role as delegated monitors in helping to promote efficient governance. The second is that delegated monitors are subject to their own governance challenges. Unfortunately, this last point is illustrated all too well by the governance problems that have recently surfaced in the U.S. mutual fund industry. Financial innovations and disclosure Over the past few decades, firms have acquired effective new tools with which to manage financial risk. For example, securitization helps a firm manage the risk of a concentrated exposure by transferring some of that exposure outside the firm. By pooling assets and issuing marketable securities, firms obtain liquidity and reduce funding costs. Of course, moving assets off the balance sheet and into special purpose entities, with the attendant creation of servicing rights and high risk residual interests retained by firms, generates its own risks and reduces transparency unless the firm takes additional steps to enhance disclosure. Several types of securitization have grown rapidly over the past decade. One of the fastest growing has been asset-backed commercial paper, which soared from only $16 billion outstanding at the end of 1989 to about $690 billion as of year-end 2003. Commercial mortgage securitizations have also proliferated noticeably since the early 1990s. The dollar amount of outstanding securities backed by commercial and multifamily mortgages has risen from $36 billion at the end of 1989 to just under $450 billion as of this past September. In addition, commercial banks and finance companies have moved business loans off their books through the development of collateralized debt obligations. Securitized business loans amounted to $100 billion in the third quarter of 2003, up from a relatively miniscule $2 billion in 1989. Firms also use derivatives to manage their risk exposures to price fluctuations in currency, commodity, energy, and interest rate markets. More recently, firms have used credit derivatives, a relatively new type of derivative that allows them to purchase protection against the risk of loss from the default of a given entity. By purchasing such protection, financial and nonfinancial firms alike can reduce their exposures to particular borrowers or counterparties. Credit derivatives also allow financial firms to achieve a more diversified credit portfolio by acquiring credit exposure to borrowers with which they do not have a lending relationship. For example, European insurance companies reportedly have used credit derivatives to acquire exposure to European corporations that, because they rely primarily on bank lending, have little publicly traded debt outstanding. The improvements in technology, the quick pace of financial innovation, and the evolving riskmanagement techniques almost ensure that businesses will increasingly use almost limitless configurations of products and services and sophisticated financial structures. Accordingly, outsiders will have ever more difficulty understanding the risk positions of many large, complex organizations. These developments represent significant challenges to standard setters and to firms. For market discipline to be effective, accounting standards must evolve to accurately capture these developments. Company managers must also do their part, by ensuring that public disclosures clearly identify all significant risk exposures - whether on or off the balance sheet - and their effects on the firm’s financial condition and performance, cash flow, and earnings potential. With regard to securitizations, derivatives, and other innovative risk transfer instruments, accounting measurement of a company’s balance sheet at a point in time is insufficient to convey the full effect of a company’s financial risk profile. Therefore, disclosures about how risks are being managed and the underlying basis for values and other estimates must be included in financial reports. Unlike typical accounting reports, information generated by risk management tends to be oriented less to a particular time and more to a description of the risks. To take an example from the world of banking, in which the discipline of risk management is relatively well developed, a fair value report might say that the value of a loan portfolio is $300 million and has dropped $10 million from the previous report. However, the bank’s internal risk report would show much more extensive information, such as the interest rates on the loans, the credit quality of the underlying assets, and the range of values the portfolio would take under alternative future scenarios. Thus, unlike a user of the fair value report, the user of a risk-management report could determine whether the fall in value was due to declining credit quality, rising interest rates, or sales or payoffs of loans. Corporate risk officers have developed other types of reports that provide information on the extent to which the total return in a particular line of business compensates for the line’s comprehensive risk. A reader of such a report can determine whether the growing lines of business have risk exposures that tend to offset those in other business lines - thereby resulting in lower volatility for the earnings of the corporation as a whole. I particularly want to emphasize that disclosure need not be in a standard framework nor exactly the same for all organizations. Rather, we should all be insisting that each entity disclose the information that its investors need in order to evaluate the entity’s risk profile in the most convenient and useful way. And we should keep in mind that disclosure without context may not be meaningful. Transparency means that the information presented provides an accurate understanding of the entity’s transactions. To achieve greater transparency, organizations should continue to improve their risk management and reporting functions. When they are comfortable with the reliability and consistency of the information in these reports, they should begin disclosing this information to the market, perhaps in summary form, paying due attention to the need for keeping proprietary business data confidential. Disclosures would not only provide more qualitative and quantitative information about the firm’s current risk exposure to the market but also help the market assess the quality of the risk oversight and risk appetite of the organization. Less than fully transparent disclosures are not limited to “complex” off-balance-sheet transactions. One glaring example is the treatment of expenses associated with defined-benefit pension plans. In recent years we have seen how the accounting rules for these plans can produce, quite frankly, some very misleading measures of corporate earnings and balance sheets. In effect, firms use expectations of the long-term return on assets in defined-benefit plans to calculate current-period pension costs (income) while disguising the volatility actually occurring in the portfolio. At the same time, they use a spot rate to discount the future liabilities. This accounting is reconciled with economic reality by gradual amortization of the discrepancies between the assumed and the actual returns experienced on pension assets. As many of you are aware, this smoothing feature can create very large distortions between economic reality and the pension-financing cost accruals embedded in the income statement. Moreover, a recent study by Federal Reserve staff indicates that “full disclosure” of the underlying details, by itself, does not appear to be a panacea.1 The study adopts the premise that most of what investors need to know about the true pension-financing costs, not the mixed attribute accounting costs, can be reflected in two numbers disclosed in the pension footnote. These two numbers are the fair market value of pension assets and the present value of outstanding pension liabilities. The study finds that these direct measures of pension assets and liabilities tend to be ignored by investors in favor of the potentially misleading accounting measures, and as a result, the average firm with a defined-benefit plan in 2001 may have been 5 percent to 10 percent overvalued relative to an otherwise similar firm without a defined-benefit plan. In general, the test for useful disclosure should be the following questions: Are the firm and its accountants providing investors with what is needed to accurately evaluate the financial position of the firm and the risks that it faces? And is the information provided in a manner that facilitates accurate assessments by investors? Ultimately, improved transparency would benefit corporations by reducing uncertainty about the value of their securities, which would lower the cost of, and increase access to, market funding. In the past few years, capital markets have shown themselves to be a powerful force in disciplining and rewarding firms. In the summer of 2002, after corporate bond investors had been badly burned by over-leveraged telecommunication firms and a wave of corporate accounting scandals, risk spreads on corporate bonds ballooned toward record levels. However, substantial declines in risk spreads of corporate bonds over the past year reflect the increased emphasis on corporate governance and audit quality and stronger corporate balance sheets accomplished through lengthening the average maturity of liabilities and de-leveraging. These narrower debt spreads have significantly reduced the cost of capital to firms, particularly at the lower end of the credit quality spectrum, where the average risk spread on junk-rated corporate bonds has fallen about 700 basis points, to its lowest level since mid-1998. Financing patterns and corporate governance Besides the changes in transparency to which I have already alluded, another key development affecting corporate governance has been the increasing portion of public equity held by institutional investors on behalf of households. According to the Flow of Funds accounts published by the Federal Reserve, the combined share of corporate equity managed by mutual funds, pension funds, and life insurance companies grew from only 3 percent in 1952 to 48 percent by the third quarter of 2003, the latest period for which data are now available. As of that date, pension funds held 21 percent of corporate equity in the United States. Mutual funds held another 21 percent, and life insurance companies held 6 percent, mainly through separate accounts that, in effect, were mutual funds with insurance wrappers. These changes are indeed dramatic, but it is not obvious whether we should be comforted or concerned that an increasing share of corporate equity is in the hands of institutional investors. A primary issue is whether institutional investors are more “active shareholders” than individual investors. That is, compared with individual investors - especially those with large holdings - are institutional investors more likely to actively monitor and influence both management actions and corporate governance mechanisms at the firms in which they invest? Shareholder activism may provide market discipline directly by preventing management from pursuing its own interests at the expense of shareholders. Shareholder activism may also pave the way for other forms of market discipline - such as corporate takeovers and changes in share prices and funding costs - by eliminating management-takeover protections and by inducing greater transparency. Unfortunately, whether institutional investors have more or less incentive to be activist shareholders than individual investors is not clear. On the one hand, because institutional investors make large investments in companies, they will have more bargaining power with company management than individual investors have, and they will derive more benefits from mitigating corporate malfeasance than individual investors will. Among institutional investors, pension funds and insurance companies Julia Coronado and Steve Sharpe, “Did Pension Accounting Contribute to a Stock Market Bubble?” Brookings Papers on Economic Activity, July 2003. are thought to benefit the most from shareholder activism because they tend to have relatively longterm investment horizons. On the other hand, managers of index mutual funds may have little interest in shareholder activism since they merely adjust their holdings when the mix of the index changes and want only to follow the index, not influence it. In addition, mutual funds and pension funds may have conflicts of interest that encourage passivity. Activism by a mutual fund complex or a pension fund manager could strain its relationships with corporate clients. For example, a fund manager bidding for the management of a firm’s 401(k) plan may be reluctant to vote against the board of directors’ proxy recommendations. In practice, institutional investors appear to have been relatively passive shareholders, in the sense that they have tended to initiate relatively few reform proposals. Before the past twenty years, most reform proposals were submitted by a handful of individuals and religious groups. Since the mid-1980s, some institutional investors - mainly large public pension funds and a few union funds have stepped up to the plate and offered their own proposals, but corporate pension funds, mutual funds, and insurance companies have remained on the sidelines. Appearances can be misleading, however. Some institutional investors are active behind the scenes, preferring direct contact with the management of the firms in their portfolios to indirect action through reform proposals. Moreover, passive institutional investors may still benefit shareholders as a whole by facilitating the building of shareholder coalitions that are initiated by others or by posing a possible threat to managers who might fail to act in the interest of shareholders. In addition, there have been reports that institutional shareholders are picking up the pace of their activism. For instance, according to the Investor Responsibility Research Center, labor union funds initiated a record number of shareholder proposals in 2003. And institutional shareholder activism may soon receive a boost from a rule that the Securities and Exchange Commission (SEC) has proposed to increase the power of institutional investors. The rule specifies circumstances under which shareholders with at least 5 percent of outstanding shares, held for at least two years, must be allowed by management to publish nominations for board members on the company’s proxy statement. However, increasing shareholder access to the proxy statement may not be without costs. Some have argued that the democratization of the nomination process may pave the way for special interests to undermine the goal of maximizing shareholder value. Ultimately, the question of whether institutional investors mitigate corporate governance problems is an empirical one. Academic work in this area has not convincingly linked institutional holdings to firm performance. But some studies have shown that institutional shareholder activism does appear to be motivated by efforts to increase shareholder value, and other studies have confirmed that institutional activism is associated with a greater incidence of corporate governance events, such as shareholder lawsuits and corporate takeovers. Based on these findings, it would be premature to conclude that the rising share of corporate equity held by institutional investors is clearly good in terms of sound corporate governance. That said, believing that institutional shareholder activism has benefits and that these benefits may help pave the way for market discipline in a broader sense does seem reasonable. Corporate governance at mutual funds Perhaps another reason for being cautious about the benefits of institutional ownership is that institutional investors have their own governance problems. As you are no doubt aware, such problems at mutual funds have been manifest in headlines over the past year. I would now like to discuss both the conflicts of interest that lie at the heart of many of the recent mutual fund scandals and the responses by investors and regulators. Arguably the most fundamental conflict of interest at mutual funds occurs because the compensation of mutual fund managers and management companies is generally tied to the value of the assets they manage. As a result, managers have an incentive to attract cash, and they may do so by methods which impose costs on long-term shareholders. For example, as was heralded in the press, a few mutual fund firms allowed late traders to exploit stale share prices by rapidly trading mutual fund shares. Long-term shareholders suffered reduced investment returns, but management companies collected extra fees on the “hot money” while it was in their funds. Importantly, long-term investors were not informed of these deals. Another method for attracting cash is to compensate mutual fund brokers for bringing in new money. So-called “directed brokerage”, for example, is a means of rewarding a broker who sells mutual fund shares by giving the broker a slice of the fund’s securities trading business. Such compensation arrangements clearly give brokers an incentive to sell these mutual funds regardless of whether the funds are appropriate for their clients. What is particularly troubling about these “kick-backed” commissions is that most shareholders never learn about them, since portfolio securities trading costs are not included in the expense ratios and fee summaries that mutual funds publish in their prospectuses and annual reports. A related problem is “soft dollars”, which allow mutual fund portfolio managers to pay brokers for a bundled combination of trade execution and “research” services. Like directed brokerage costs, soft dollars are lumped into the costs of trading portfolio securities and are not disclosed up front in mutual fund fee summaries, so they are virtually invisible to most investors. The definition of soft-dollar research is quite broad, so an investment adviser can purchase Wall Street Journal subscriptions and Bloomberg accounts with soft dollars, without reporting these costs to shareholders. In short, softdollar arrangements are ripe for abuse, and the SEC is now considering whether to impose new restrictions on their use and to require more meaningful disclosure of their cost to investors. Of course, mutual fund managers are not the only ones to blame for the mutual fund scandals. Late trading, which illegally diluted the returns of long-term investors in mutual funds, was accomplished primarily with the help of brokers and intermediaries. So we must keep in mind that the problems and their solutions involve more than just the firms that operate mutual funds. Not surprisingly, the breadth of the scandal and the cost to investors has led many to reassess the benefits of owning mutual funds. One-third of respondents to a recent Gallup survey indicated that the scandal had made them less likely to invest in mutual funds, and three-quarters said they would pull assets out of a mutual fund complex that admitted to wrongdoing. The scandal has also affected institutional investors, such as pension-fund sponsors, whose fiduciary duties require them to assess whether a particular investment is prudent and in the interest of plan participants and beneficiaries. Both retail and institutional investors have pulled back sharply from some investment management companies where abuses occurred. Yet, mutual fund investors have shown little, if any, aggregate net reaction, perhaps because investors pulled cash out of funds with problems and reinvested it in other mutual funds. In the three months before September, when the New York Attorney General first publicly described the trading abuses, $56 billion on net was invested in long-term mutual funds. Net investment actually increased in the next three months, to $59 billion. Why didn’t the scandal cause a large pullback from the mutual fund industry? The recent strength of the stock market is part of the explanation. And to be sure, many mutual funds have remained untainted by the scandal, and some of them received a disproportionate share of the new cash invested in mutual funds in recent months. But mutual funds have maintained their position in U.S. families’ portfolios primarily because they continue to offer low-cost access to highly liquid, diversified portfolios. The lasting importance of mutual funds for so many U.S. households makes it all the more pressing that the problems arising from these conflicts of interest be addressed. Addressing these problems, however, is proving to be a difficult task. Each month the scope of the scandal seems to grow. The Wall Street Journal’s “Mutual Fund Scandal Scorecard” now lists sixteen mutual fund complexes, nine brokerage firms, three hedge funds, and a bank. As the roster has expanded and new forms of malfeasance have come to light, the list of suggested reforms has itself become rather lengthy. Consider first the reforms that are intended to combat market timing of mutual funds. Ironically, the scandal headlines have publicized the profitability of market timing, so rule changes are urgently needed to prevent additional dilution. One interesting proposal would be to allow mutual funds to adopt, voluntarily, a delayed-pricing rule, under which transactions today would receive tomorrow’s market-close prices. Long-term investors who wish to avoid market-timing dilution could purchase shares of delayed-pricing funds, and investors who want same-day pricing could purchase shares of funds that price by current rules. Other reforms are aimed at strengthening governance structures. The SEC recently adopted new rules requiring each mutual fund to adopt formal compliance procedures and to have a chief compliance officer who reports directly to the fund’s independent directors. By centralizing the responsibility for compliance in one officer’s hands, the rules should improve mutual funds’ internal controls and give shareholders’ interests an authoritative voice within the management company. I hope that measures like this will end some of the more egregious breakdowns of internal controls at mutual funds, such as the situations in which marketing departments overruled portfolio managers in allowing late trades of mutual funds. Proposed rules mandating greater strength and independence for mutual fund boards might also give greater weight to shareholders’ interests in mutual fund decision-making. But it is worth noting that governance reforms alone may not accomplish much. One mutual fund family, for example, has an independent chairman and a board that is 80 percent independent. Yet this firm is alleged to have tolerated some of the industry’s worst abuses. The transparency of mutual funds is also being addressed. Recent SEC and congressional proposals would require mutual funds to disclose their fees in dollars, explain in writing why fees are reasonable, report the costs incurred to trade portfolio securities, and disclose policies on handling market timers. And a recent reform proposal published by the SEC only a few weeks ago would mandate the type and format of disclosures to clients that a broker would need to make about the compensation he or she would receive for selling a particular mutual fund. Although I applaud these moves toward enhanced disclosure and increased transparency, I have concerns similar to those expressed earlier about the difficulties of rules-based accounting. In particular, the relationship between mutual funds and brokers has become extraordinarily complex and lucrative. Further, as financial innovation continues, conflicts of interest will continue to arise. Enterprise-wide risk management One of the challenges the Federal Reserve System has as the umbrella supervisor of financial holding companies is to encourage the evolution of corporate governance within organizations that keeps pace with changing business strategies. Earlier in my remarks I referred to the challenges to investors, managers, and boards of directors in understanding complex organizations. As supervisors, we have similar challenges in monitoring and evaluating the effectiveness of corporate governance, compliance, and internal controls in financial institutions. Further, as risk exposures change, we need to modify the capital rules for banking organizations to better reflect the diversity of their risk exposures. One common theme that has recurred in the scandals of the past two years - whether it is Enron, Arthur Anderson, Tyco, stock research, mutual fund trading, or Parmalat - is that the interest of individual officers can easily conflict with that of the firm as a whole. Many times the problem results from the failure to identify conflicts of interest among various lines of business. Too often firms are governed through silos by individual lines of business without a comprehensive risk review by executive officers and the appropriate committee of the board of directors. Financial institutions are being encouraged to establish enterprise-wide risk management functions to ensure that risks of all types, including conflicts of interest, are identified; risk appetites are defined; appropriate mitigating controls are effective; and exceptions are rigorously reviewed at a high level within the organization. Enterprise-wide risk management is also rapidly developing at nonfinancial firms. Later this year, the Committee of Sponsoring Organizations of the Treadway Commission will issue a framework for effective risk management that is versatile enough for all types and sizes of firms to use. Risk management and good corporate governance should be thought of as more than expense centers. If these functions are effectively managed, they can mitigate losses and reduce surprises to the market that can disrupt customer relationships, increase the cost of capital, and tarnish the reputation of the firm. Further, as in any corporate function, focusing on the risks in what is done day-to-day can help identify opportunities to improve operations. Conclusion Enterprise-wide risk-management and stronger internal governance structures are needed. However, the mutual fund scandal reminds us that monitors, even boards of directors, may have their own governance problems. Full and meaningful disclosure will always be crucial for limiting the ability of companies to pursue their own interest at the expense of investors. Indeed, many of the problems uncovered at mutual funds and in the corporate world can be traced to relationships or transactions that were hidden from view. I am confident that greater transparency will provide the foundation for more effective corporate governance in the future.
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board of governors of the federal reserve system
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Remarks by Mr Edward M Gramlich, Member of the Board of Governors of the US Federal Reserve System, at the Euromoney Bond Investors Congress, London, 25 February 2004.
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Edward M Gramlich: Budget and trade deficits - linked, both worrisome in the long run, but not twins Remarks by Mr Edward M Gramlich, Member of the Board of Governors of the US Federal Reserve System, at the Euromoney Bond Investors Congress, London, 25 February 2004. * * * Thank you for inviting me to speak today. While I know that most of you would welcome any insights I might have about current U.S. monetary policy - whether the Open Market Committee will be raising or lowering interest rates at our next meeting - I prefer to focus instead on some issues that could become serious over the longer run. These issues involve the persistent budget and trade deficits facing the American economy, issues that could eventually involve significant economic adjustments around the world.1 Large budget and trade deficits are not a new phenomenon. They also arose in the United States in the mid-1980s. At that time, the business press and many economists began referring to the situation as one of “twin deficits.” With the current re-emergence of both deficits, the phrase has come back into common usage - too common, in my view. To be sure, in theoretical models there is a scenario by which budget deficits can create trade deficits, and one by which trade deficits can create budget deficits. But there are also many scenarios by which either deficit can arise independently, or even by which budget and trade deficits can move in opposite directions, as they did in the 1990s. In general, while budget and trade deficits can be linked, there are important differences between the two, both in how they respond to economic forces and in their long-run consequences. I start by examining the relationship between budget and trade deficits - why they are linked but not twins. I discuss the sustainability conditions for budget and trade deficits; the conditions that must be fulfilled for the debts on both accounts to be stabilized in relation to the size of the U.S. economy. Then I discuss what happens if either debt violates this condition and rises in relation to the size of the economy. This discussion, in turn, raises further interesting distinctions between the two deficits. The link The link between budget and trade deficits can be seen most naturally through the national income accounting framework. Any saving the nation does finances either private domestic investment directly or the accumulation of claims on foreigners. This means that national saving - the sum of private and government saving - equals private domestic investment plus that period’s accumulation of claims on foreigners, or the trade surplus. The trade surplus can also be thought of as net foreign lending. All of these relationships are accounting identities - true at every moment in time apart from data inconsistencies captured by a statistical discrepancy. In equation form, we have NS = S – BD = I – TD On the left side of the equation NS refers to national saving, S refers to overall private saving, and BD refers to the government budget deficit. This part of the equation says merely that total national saving equals the sum of all saving done in the economy by the private sector and the government sector. A budget surplus would be treated as governmental saving and added to private saving; a budget deficit would be treated as governmental dissaving and subtracted. The right side of the equation repeats the familiar open economy identity that national saving equals private domestic investment, I, plus the accumulation of claims on foreigners or less that domestic investment financed by foreigners. As was noted earlier, borrowing from foreigners involves either a reduction of claims on them or an increase of claims on us by them. It is by definition equal to the As with all such talks, I am speaking for myself and not for other members of the Federal Reserve Board or the Federal Open Market Committee. trade deficit TD. In the equation, then, a trade surplus means that some national saving goes to building up claims on foreigners (national saving is greater than domestic investment) while a trade deficit means that some investment is financed by foreigners (national saving is less than domestic investment). This identity first demonstrates the all-important role of national saving in shaping long-run economic welfare. National saving is the only way a country can have its capital and own it too. Models of the economic growth process identify national saving as one of the key policy variables in influencing a nation’s living standards in the long run. The identity also makes clear that the budget deficit and the trade deficit can move together on a dollar-per-dollar basis, but only if the difference between private domestic investment and private saving is constant. Typically that difference will not be constant. For example, if there were to be an investment boom, interest rates might rise to induce some new private saving and some new lending by foreigners. The implied trade deficit might rise and, because of the rise in income, the budget deficit might fall. In this case, the trade deficit would increase while the budget deficit fell. Conversely, suppose that expansionary fiscal policy resulted in a rise in budget deficits. If this expansion were totally financed by borrowing from foreigners, domestic interest rates would not change much, and domestic investment and private saving might not either. In this scenario, there could be a simultaneous dollar-per-dollar change in budget and trade deficits - the classic twin-deficit scenario. Such a situation is most likely to occur in small economies fully open to international trade and capital flows, economies in which domestic interest rates are determined by world capital markets and are independent of domestic economic variables. But if domestic interest rates do change, as they likely would in either a closed economy or a large open economy, private investment and saving would also likely change, and any strict link between budget and trade deficits would be broken. One could spin any number of scenarios, but these are enough to make the basic point. Because of the underlying relationship between saving and investment, budget and trade deficits could be strictly linked. But in a large open economy like the United States, it is easy to imagine plenty of scenarios in which they are imperfectly linked, and even some scenarios in which they move in opposite directions. Budget and trade deficits should be viewed as linked, but not as twins. Stability conditions Although the economic implications and reactions of budget deficits and trade deficits differ, both are deficits. Another elementary accounting identity says that last period’s debt level plus the current deficit equals the current period’s debt level. This identity is true whether we are talking about budget deficits building up the stock of outstanding government debt (a liability of the government sector to the private sector), or trade deficits building up the stock of external debt (the net stock of accumulated foreign claims against the United States).2 Economists have worried for years about optimal stocks of government and external debt. For government debt, the optimal stock turns out to be related to the optimal level of national saving, which can be defined as the level that maximizes the nation’s long-term path of consumption per worker. The optimal stock of net external debt can be determined in the same framework from an open economy perspective. While these models can be instructive, today I am going to focus on a weaker standard. Whatever the long-term optimal level of government debt, and whatever the optimal level of external debt, one can separately ask whether either debt level is becoming a more, or less, important economic factor over time. For government debt, this weaker standard, or stability condition, determines merely whether the ratio of debt to gross domestic product (GDP) is stable. If it is, interest payments on the debt will, in equilibrium, also settle down to a stable proportion of GDP. For external debt, a stable debt-to-GDP ratio means that the net interest and dividend payments of the United States to foreign investors will also settle down to a constant ratio to GDP. The appendix derives this stability condition generically. It is that d (g – i)/(1 + g) = p, Both debt stocks would also include a valuation adjustment to deal with capital gains and losses. where d is the stable ratio of debt to GDP, g is the nominal growth rate of the economy, i is the nominal interest rate in the economy, and p is the ratio of the primary deficit to GDP. For budget accounts, the primary deficit is the national income accounts budget deficit, but excluding interest payments. For trade accounts, the primary trade deficit is the current account deficit, excluding net interest and dividend payments to foreigners.3 As a general rule, the economy’s growth rate and interest rate will be fairly close. The equation says that if they are equal, the primary deficit must be zero to stabilize the debt-to-GDP ratio. If the interest rate is slightly above the growth rate, as it would be in models without risk for economies that save less than the theoretical optimum, a nation with outstanding debt would have to run a slight primary surplus to stabilize its debt-to-GDP ratio. If the effective interest rate on debt is slightly below the growth rate, as it has generally been found to be in the past for both deficits, a nation with outstanding debt could run slight primary deficits and not see the debt ratio grow.4 On the foreign side, this condition has until now been especially forgiving. Even with a large net debt position, our net investment income from foreigners has exceeded that paid out to foreigners. Since the net interest rate has been less than the GDP growth rate, the ratio of external debt to GDP could have been stabilized with a moderate primary trade deficit.5 Magnitudes It is well known that the U.S. economy now suffers both budget and trade deficits. But how do these deficits compare with the stability conditions? Historically, there have not been significant instabilities in U.S. federal budget deficits.6 Overall deficits have averaged about 2 percent of GDP over the past four decades, but Figure 1 shows that when interest is deducted, primary budget deficits have averaged close to zero, the approximate level that stabilizes the debt-to-GDP ratio. Hence, the outstanding debt, while fluctuating in the range of 25 percent to 50 percent of GDP, has actually declined slightly as a share of GDP. It was 38 percent of GDP in the mid-1960s and is now only 37 percent of GDP. The ratio did rise as high as 50 percent in the high-deficit years of the early 1990s, but it dropped sharply thereafter with the primary budget surpluses of the late 1990s. Looking ahead, things might not be so favorable. As a result of recent fiscal changes, the budget has lately fallen into primary deficit again; this primary deficit is now more than 2 percent of GDP (1.5 percent after cyclical adjustment). The deterioration reflects the much-discussed recent rapid growth in expenditures, along with significant tax cuts. Perhaps more significant, in a few years the United States will face huge looming costs for retirement and health programs. It will take extraordinary fiscal discipline just to keep the present primary deficit near its current level of 1 to 2 percent of GDP over the short, medium, and long run. And even at that level, the stability condition is violated by at least 1 percent of GDP, suggesting that the debt-to-GDP ratio is likely to climb steadily upward.7 This primary trade deficit differs from the trade deficit component of GDP mentioned earlier because it includes foreign transfers and other small items. Laurence Ball, Douglas W. Elmendorf, and N. Gregory Mankiw, “The Deficit Gamble”, Journal of Money, Credit, and Banking, vol. 30, no. 4, (November 1998), pp. 699-720, show that interest rates on domestic government debt have generally been slightly less than the GDP growth rate in past decades. The rate-of-return puzzle is in turn a question about why foreign direct investment in the United States has such a low rate of return. See Raymond J. Mataloni, Jr., “An Examination of the Low Rates of Return of Foreign-Owned U.S. Companies”, Survey of Current Business, vol. 80 (March 2000), pp. 55-73. Even though the previous identity referred to the consumption budget for the entire government sector, in this section I switch over to the familiar concept of the total budget for the U.S. federal government. State and local governments more or less finance their current spending and do not have much outstanding debt apart from that backed by capital formation; and federal capital investment is very small. These statements are based on estimates of the Congressional Budget Office, The Budget and Economic Outlook, Fiscal Years 2005 to 2014 (January 2004). A further discussion of the long-run budget outlook can be found in Alan J. Auerbach, William G. Gale, Peter R. Orszag, and Samara R. Potter, “Budget Blues: The Fiscal Outlook and Options for Reform,” in Henry J. Aaron, James Lindsay, and Pietro Nivola (eds.), Agenda for the Nation (The Brookings Institution, 2003). See also the General Accounting Office, Truth and Transparency: The Federal Government’s Financial Condition and Fiscal Outlook On the trade side, Figure 2 shows that the trend is definitely more worrisome. While the budget debt has fluctuated between 25 percent and 50 percent of GDP over the past several decades, the net external debt has grown steadily. Until 1985, this external debt was not even positive; that is, until that time the United States had net claims on foreigners. But because the United States has run persistent and sizable primary trade deficits since 1990, the net external debt is now 25 percent of GDP and rising sharply. The primary trade deficit is now 5 percent of GDP, violating the stability condition by nearly this same amount. At this rate, the external debt ratio will climb very quickly. While the trade deficit does have equilibrating tendencies, as will be discussed later, there are also forces that tend to increase it. Econometric studies of the basic demand for imports and exports find that the U.S. income elasticity of demand for imports is higher than the foreign income elasticity of demand for U.S. exports. This means that even if the world economy grows at the same rate as the U.S. economy, our trade deficit is likely to widen, (apart from any changes in relative prices).8 Indeed, the U.S. primary trade deficit has widened steadily since 1990. Adjustments I have just argued that the U.S. is now in violation of the stability condition for both budget and trade deficits - recently and moderately on the budget side, persistently and significantly on the trade side. What are the implications? With each deficit there is probably a credibility range. By that, I mean a limited range within which a country may be able to violate its stability condition and have its debt-to-GDP ratio trend upward without further economic consequences. For budgets, there may be a range within which the debtto-GDP ratio can grow without significant changes in interest rates.9 As equation 1 indicates, economic performance in this range is by no means optimal, because the persistent deficits are subtracting funds that would otherwise be devoted to capital investment and future growth in living standards. But there may not be significant relative price effects. The same is true on the trade side; there could be a range in which foreign claims on the United States just build up without major impact on relative prices. Once the economy gets outside of the credibility range, more significant relative price adjustments become likely. On the trade side, for example, the continued accumulation of foreign claims on the U.S. economy will raise the issue of whether foreign investors will want to hold an ever-increasing share of their wealth in the form of U.S. assets. Or, as is the focus of the stability condition above, whether the U.S. economy can indefinitely pay out ever-higher shares of GDP in the form of interest and dividend payments. The conventional view is that at some point there should be a relative price adjustment - some combination of rising U.S. interest rates (to make U.S. assets more attractive), rising foreign prices (to make imports more expensive), moderating U.S. prices (to make U.S. exports more competitive), or a change in exchange rates. Each of these reactions is likely to occur naturally, and each moves in the direction of lowering the external imbalance. That is why foreign trade deficits are typically thought of as self-correcting. The main risk here is that the natural adjustments may not occur gradually, but so rapidly as to threaten various types of dislocations. There are complicating factors. One involves the currency denomination of the net debt. Countries with large trade deficits often have their external liabilities denominated in a foreign currency. Hence, when their own currency depreciates, the value and burden of foreign debt automatically increases. The United States does not have this problem because most of its debt is denominated in dollars say, foreign holdings of U.S. Treasury bills. If the dollar were to fall, the value of our debt in terms of foreign currencies would then automatically decline, inducing foreign wealth-holders to make further portfolio shifts, perhaps even including increasing their stock of dollar-denominated debt. This (September 17, 2003) and Rudolph G. Penner and C. Eugene Steuerle, Budget Crisis at the Door (The Urban Institute, October 2003). See, for example, Peter Hooper, Karen Johnson, and Jaime Marquez, “Trade Elasticities for G-7 Countries”, Princeton Studies in International Economics, vol. 87, (August 2000). Even this claim may be overoptimistic. See, for example, Thomas Laubach, “New Evidence on the Interest Rate Effects of Budget Deficits and Debt,” Finance and Economics Discussion Series working paper (April 2003). Among other things, Laubach has an interesting way to remove cyclical effects from his dependent variables, interest rates. denomination effect would not permanently prevent any relative price adjustment, but it could lengthen the process. Beyond that, for pragmatic reasons this conventional adjustment process could be extended or distorted even further. By way of illustration, Asian central banks have now accumulated more than a trillion dollars of international currency reserves - largely in dollar-denominated assets - equal to roughly half of the outstanding net debt of the United States. These central banks are not traditional wealth-holders motivated by expected risks and returns. Instead, they seem motivated more by the prospect of preserving low domestic currency values for their exporters.10 To pursue this objective, they can print money to buy U.S. securities. This monetary expansion could generate domestic inflation unless it is sterilized with other open market sales of securities - and the mere scale of present and expected future debt stocks may make continued sterilization impossible. But if these central banks continue behaving this way, the so-called credibility range could be extended significantly. While trade deficits should ultimately correct themselves, perhaps after a long trek through the credibility range, there are really no natural self-corrective mechanisms for budget deficits. Once the U.S. economy gets through the credibility range, interest rates on the increasing government debt will have to rise to induce people to hold the debt. This rise increases the interest burden and causes total deficits to rise further, all the time subtracting more and more funds from capital accumulation. Once this process begins, market psychology may hasten the adjustment.11 Hence, while natural forces lessen the basic external imbalance, they increase the basic budget imbalance. In the long run, the only way to correct budget deficits is for policymakers to correct them. Outside forces There are several outside forces - both natural and as a result of policy - that could influence budget and trade deficits. One generally helpful influence is productivity growth. Say the U.S. economy benefits from an exogenous positive shock to productivity growth, as it seemed to have in the late 1990s. This shock would raise the trend path of income, meaning that slightly higher primary budget and trade deficits could still be consistent with debt-to-GDP stability; in effect, a higher level of g can be plugged into equation 2 (at least as long as it is not offset by a higher i). Higher productivity could also help lengthen the credibility range, the range in which moderate changes in the debt ratio might not lead to adverse changes in relative prices. Among other things, higher productivity could raise the marginal product of capital and make investment in U.S. assets relatively attractive. But even with these favorable developments, the stability conditions discussed above still hold. If they are violated, the natural adjustment mechanisms will eventually take over for the trade deficit, and the primary budget deficit will eventually have to be reduced to stop a growing government debt ratio. One unhelpful measure is trade protectionism. While it might appear that trade protectionism would correct trade deficits, it probably will not. Over the medium and long run, the economy should be producing near its natural growth path, perhaps because of timely monetary and/or fiscal policy, perhaps because of natural equilibrating forces in the economy. In this event, trade protectionism would not stimulate added national production. Even if protectionist measures reduce imports, the added spending demands for import-competing industries will crowd out other types of production. Put another way, equation 1 shows that the trade deficit is ultimately determined by national saving and investment. Without a change in these, protectionism merely shifts the types of goods that are produced. It does not increase overall production and, short of cutting off trade altogether, does not even change the trade balance. Moreover, as is well known, over the long run, trade protection lowers a nation’s standard of living. Finally, suppose politicians actually do correct budget deficits, again assuming an economy near its medium-term growth path. As mentioned above, such a fiscal austerity policy is the only known way to This view is given in Michael Dooley, David Folkerts-Landau, and Peter Garber, “An Essay on the Revived Bretton Woods System”, NBER Working Paper 9971 (National Bureau of Economic Research, September 2003). An argument that market psychology will hasten the adjustment is given by Robert E. Rubin, Peter R. Orszag, and Allen Sinai in “Sustained Budget Deficits: Large Run US Economic Performance and the Risk of Financial and Fiscal Disarray,” paper presented at the meetings of the American Economic Association (San Diego, California, January 4, 2004). correct persistent budget deficits. The reduction in deficits should lower domestic interest rates and trigger changes in exchange rates that lower imports and raise exports. Hence, well-designed fiscal austerity measures could solve all the problems simultaneously. They correct budget deficits directly, they reduce trade deficits indirectly, and the implied higher level of national saving also permits more funds to flow into capital formation and long-term productivity enhancements. Fiscal austerity is the one tried and true approach to dealing with budget and trade deficits simultaneously. Conclusions There are obviously strong links between budget and trade deficits, and the deficit-debt dynamic relationships are very similar. At the same time, it is misleading simply to equate the two deficits, as is often done in the twin-deficit literature. Budget deficits typically involve a reduction in national saving and, if large, a steadily growing government debt-to-GDP ratio. They typically will not be corrected without explicit action. Trade deficits, on the other hand, typically involve an increase in foreign claims on the U.S. economy. As these claims grow in relation to national income, at least some natural forces are set in motion to correct the imbalance. From a policy standpoint, neither deficit may be terribly harmful in the short run, and at least the recent fiscal deficits have been useful in stabilizing movements in output. Moreover, there is likely to be a credibility range in which debt levels could rise relative to GDP without much change in relative prices. In the long run, however, both deficits could become much more worrisome. There are forces tending to increase both deficits: political and demographic for budget deficits, income elasticities for trade deficits. At some point, continued large-scale trade deficits could trigger equilibrating, and possibly dislocating, changes in prices, interest rates, and exchange rates. Continued budget deficits will steadily detract from the growth of the U.S. capital stock and may also trigger dislocating changes. Appendix: Derivation of the stability condition Let P denote the primary deficit (for either budget or trade), D the debt for either, and i the nation’s nominal riskless interest rate. Then apart from valuation adjustments D = D–1 (1 + i) + P (A1) Divide through by GDP (Y): D/ Y = (D–1 /Y–1 )* (1 + i)/(1 + g) + P/Y. (A2) Use lower case letters to refer to the ratio of a variable to GDP. This ratio is a measure of the proportionate importance of the variable. d = d –1 (1 + i)/(1 + g) + p. (A3) If there is stability in the debt-to-GDP ratio, d = d –1 = d. Then d (1 – (1 + i)/(1 + g)) = p (A4) and d (g – i)/(1 + g) = p (A5) This is equation 2 in the text. Note that if i = g, p must equal 0. If d is positive and i > g, p must be less than zero, a primary surplus. If d is positive and i < g, p can be greater than zero, a primary deficit.
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Testimony by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System before the Committee on the Budget, US House of Representatives, 25 February 2004.
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Alan Greenspan: Economic outlook and current fiscal issues Testimony by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System before the Committee on the Budget, US House of Representatives, 25 February 2004. * * * Mr. Chairman and members of the committee, I am pleased to be here today and to offer my views on the outlook for the economy and current fiscal issues. I want to emphasize that I speak for myself and not necessarily for the Federal Reserve. As you know, the U.S. economy appears to have made the transition from a period of subpar growth to one of more vigorous expansion. Real gross domestic product (GDP) rose briskly in the second half of last year, fueled by a sizable increase in household spending, a notable strengthening in business investment, and a sharp rebound in exports. Moreover, productivity surged, prices remained stable, and financial conditions improved further. Overall, the economy has lately made impressive gains in output and real incomes, although progress in creating jobs has been limited. The most recent indicators suggest that the economy is off to a strong start in 2004, and prospects for sustaining the expansion in the period ahead are good. The marked improvement in the financial situations of many households and businesses in recent years should bolster aggregate demand. And with short-term real interest rates close to zero, monetary policy remains highly accommodative. Also, the impetus from fiscal policy appears likely to stay expansionary through this year. At the same time, increases in efficiency and a significant level of underutilized resources should help keep a lid on inflation. This favorable short-term outlook for the U.S. economy, however, is playing out against a backdrop of growing concern about the prospects for the federal budget. As you are well aware, after having run surpluses for a brief period around the turn of the decade, the federal budget has reverted to deficit. The unified deficit swelled to $375 billion in fiscal 2003 and appears to be continuing to widen in the current fiscal year. According to the latest projections from the Administration and the Congressional Budget Office (CBO), if current policies remain in place, the budget will stay in deficit for some time. In part, the recent deficits have resulted from the economic downturn in 2001 and the period of slow growth that followed, as well as the sharp declines in equity prices. The deficits also reflect a significant step-up in spending on defense and higher outlays for homeland security and many other nondefense discretionary programs. Tax reductions - some of which were intended specifically to provide stimulus to the economy - also contributed to the deterioration of the fiscal balance. For a time, the fiscal stimulus associated with the larger deficits was helpful in shoring up a weak economy. During the next few years, these deficits will tend to narrow somewhat as the economic expansion proceeds and rising incomes generate increases in revenues. Moreover, the current ramp-up in defense spending will not continue indefinitely. Merely maintaining a given military commitment, rather than adding to it, will remove an important factor driving the deficit higher. But the ratio of federal debt held by the public to GDP has already stopped falling and has even edged up in the past couple of years - implying a worsening of the starting point from which policymakers will have to address the adverse budgetary implications of an aging population and rising health care costs. For about a decade, the rules laid out in the Budget Enforcement Act of 1990, and the later modifications and extensions of the act, provided a procedural framework that helped the Congress make the difficult decisions that were required to forge a better fiscal balance. However, the brief emergence of surpluses eroded the will to adhere to those rules, and many of the provisions that helped to restrain budgetary decisionmaking in the 1990s - in particular, the limits on discretionary spending and the PAYGO requirements - were violated more and more frequently and eventually allowed to expire. In recent years, budget debates have turned to choices offered by those advocating tax cuts and those advocating increased spending. To date, actions that would lower forthcoming deficits have received only narrow support, and many analysts are becoming increasingly concerned that, without a restoration of the budget enforcement mechanisms and the fundamental political will they signal, the inbuilt political bias in favor of red ink will once again become entrenched. In 2008 - just four years from now - the first cohort of the baby-boom generation will reach 62, the earliest age at which Social Security retirement benefits may be claimed and the age at which about half of prospective beneficiaries choose to retire; in 2011, these individuals will reach 65 and will thus be eligible for Medicare. At that time, under the intermediate assumptions of the OASDI trustees, there will still be more than three covered workers for each OASDI beneficiary; by 2025, this ratio is projected to be down to 2-1/4. This dramatic demographic change is certain to place enormous demands on our nation’s resources - demands we almost surely will be unable to meet unless action is taken. For a variety of reasons, that action is better taken as soon as possible. The budget scenarios considered by the CBO in its December assessment of the long-term budget outlook offer a vivid - and sobering - illustration of the challenges we face as we prepare for the retirement of the baby-boom generation. These scenarios suggest that, under a range of reasonably plausible assumptions about spending and taxes, we could be in a situation in the decades ahead in which rapid increases in the unified budget deficit set in motion a dynamic in which large deficits result in ever-growing interest payments that augment deficits in future years. The resulting rise in the federal debt could drain funds away from private capital formation and thus over time slow the growth of living standards. Favorable productivity developments, of course, can help to alleviate the impending budgetary strains, but no one should expect productivity growth to be sufficient to bail us out. Indeed, productivity would have to grow at a rate far above its historical average to fully resolve the long-term financing problems of Social Security and Medicare. Higher productivity, of course, buoys expected revenues to the system, but it also raises Social Security obligations.1 Moreover, although productivity has no direct link to Medicare spending, historical experience suggests that the demand for medical services increases with real income, which over time rises in line with productivity. Today, federal outlays under Social Security and Medicare amount to less than 7 percent of GDP. In December, the CBO projected that these outlays would increase to 12 percent of GDP by 2030 under current law, using assumptions about the growth of health-care costs similar to the intermediate assumptions of the Medicare trustees; when spending on Medicaid is added in, the rise in the ratio is even steeper. To be sure, the rise in these outlays relative to GDP could be financed by tax increases, but the CBO results suggest that, even if other non-interest spending is constrained fairly tightly, ensuring fiscal stability would require an overall federal tax burden well above its long-term average. Most experts believe that the best baseline for planning purposes is to assume that the demographic shift associated with the retirement of the baby-boom generation will be permanent - that is, it will not reverse when that cohort passes away. Indeed, so long as longevity continues to increase - and assuming no significant changes in immigration or fertility rates - the proportion of elderly in the population will only rise. If this fundamental change in the age distribution materializes, we will eventually have no choice but to make significant structural adjustments in the major retirement programs. One change the Congress could consider as it moves forward on this critical issue is to replace the current measure of the “cost of living” that is used for many purposes with respect to both revenues and outlays with a more appropriate price index. As you may be aware, in 2002, the Bureau of Labor Statistics introduced a new price index - the chained consumer price index (CPI). The new index is based on the same underlying individual prices as is the official CPI. But it combines those prices so as to remove some of the inadvertent bias in the official price index, and thus it better measures changes in the cost of living, the statutory intent of the indexing.2 All else being equal, had a chained CPI been used for indexing over the past decade, the cumulative unified budget deficit and thus the level of the federal debt would have been reduced about $200 billion; higher receipts and the reduction in debt service associated with those higher receipts account for roughly 60 percent of the saving, with the remainder attributable to lower outlays. Shifting to the chain-weighted measure would not address perhaps more fundamental shortcomings in the CPI - most notably the question of whether quality improvement is adequately captured - but it would be an important step toward better implementation of the intention of the Congress. Under current law, faster productivity growth would not affect individuals who are already retired because their benefits are indexed by the consumer price index (CPI). However, it would raise initial benefits for future retirees through its effect on real wages over time. In the end, productivity would have to rise about 3-1/2 percent per year, about 2 percentage points per year faster than the trustees’ current intermediate assumption, to eliminate the Social Security imbalance over seventy-five years; productivity growth would have to be even more rapid to achieve balance in perpetuity. In particular, the chained CPI captures more fully than does the official CPI the way that consumers alter the mix of their expenditures in response to changes in relative prices. Another possible adjustment relates to the age at which Social Security and Medicare benefits will be provided. Under current law, and even with the so-called normal retirement age for Social Security slated to move up to 67 over the next two decades, the ratio of the number of years that the typical worker will spend in retirement to the number of years he or she works will rise in the long term. A critical step forward would be to adjust the system so that this ratio stabilizes. A number of specific approaches have been proposed for implementing this indexation, but the principle behind all of them is to insulate the finances of the system, at least to a degree, from further changes in life expectancy. Sound private and public decisionmaking will be aided by determining ahead of the fact how one source of risk, namely demographic developments, will be dealt with. The degree of uncertainty about whether future resources will be adequate to meet our current statutory obligations to the coming generations of retirees is daunting. The concern is not so much about Social Security, where benefits are tied in a mechanical fashion to retirees’ wage histories and we have some useful tools for forecasting future outlays. The outlook for Medicare, however, is much more difficult to assess. Although forecasting the number of program beneficiaries is reasonably straightforward, we know very little about how rapidly medical technology will continue to advance and how those innovations will translate into future spending. To be sure, technological innovations can greatly improve the quality of medical care and can, in theory, reduce the costs of existing treatments. But because medical technology expands the range of treatment options, it also has the potential of adding to overall spending - in some cases, significantly. As a result, the range of possible outlays per recipient is extremely wide. This uncertainty is an important reason to be cautious - especially given that government programs, whether for spending or for tax preferences, are easy to initiate but can be extraordinarily difficult to shut down once constituencies for them develop. In view of this upward ratchet in government programs and the enormous uncertainty about the upper bounds of future demands for medical care, I believe that a thorough review of our spending commitments - and at least some adjustment in those commitments - is necessary for prudent policy. I also believe that we have an obligation to those in and near retirement to honor what has been promised to them. If changes need to be made, they should be made soon enough so that future retirees have time to adjust their plans for retirement spending and to make sure that their personal resources, along with what they expect to receive from the government, will be sufficient to meet their retirement needs. I certainly agree that the same scrutiny needs to be applied to taxes. However, tax rate increases of sufficient dimension to deal with our looming fiscal problems arguably pose significant risks to economic growth and the revenue base. The exact magnitude of such risks is very difficult to estimate, but they are of enough concern, in my judgment, to warrant aiming to close the fiscal gap primarily, if not wholly, from the outlay side. The dimension of the challenge is enormous. The one certainty is that the resolution of this situation will require difficult choices and that the future performance of the economy will depend on those choices. No changes will be easy, as they all will involve lowering claims on resources or raising financial obligations. It falls on the Congress to determine how best to address the competing claims. In doing so, you will need to consider not only the distributional effects of policy change but also the broader economic effects on labor supply, retirement behavior, and private saving. History has shown that, when faced with major challenges, elected officials have risen to the occasion. In particular, over the past twenty years or so, the prospect of large deficits has generally led to actions to narrow them. I trust that the recent deterioration in the budget outlook and the fastapproaching retirement of the baby-boom generation will be met with similar determination and effectiveness.
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Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the Institute for International Economics Conference, Washington, DC, 26 February 2004.
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Ben S Bernanke: Euro at five - ready for a global role? Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the Institute for International Economics Conference, Washington, DC, 26 February 2004. The references for the speech can be found on the Board of Governors of the Federal Reserve System’s website. * * * “What is the appropriate domain of a currency area? It might seem at first that the question is purely academic since it hardly appears within the realm of political feasibility that national currencies would ever be abandoned in favor of any other arrangement.” Robert A. Mundell (1961, p. 657) It is an honor for me to address such a distinguished group on the occasion of the euro’s fifth anniversary. I congratulate the Institute of International Economics for putting together such an excellent program. The successful introduction, five years ago, of an entirely new currency over a wide range of polities and economies was, at a minimum, a remarkable technical achievement. As a card-carrying member of the club of monetary economists, I like to think that our collective expertise was helpful in making that achievement possible. As both a policymaker and an economist, I welcome this opportunity to look back on the first five years of the euro to see what we can learn from the experience and to consider what this grand experiment implies for the future. I should say at the outset that, as usual, my remarks this evening reflect my own views and not necessarily those of my colleagues in the Federal Reserve System.1 The economic analysis of optimal currency areas began, of course, with Robert Mundell’s seminal 1961 paper, from which I have quoted above.2 As you know, Mundell argued that, ideally, economic similarity, not political boundaries, should define the geographic area spanned by a common currency. He was the first to state the classic tradeoff implied by the decision to adopt a common currency. According to Mundell, the principal advantage of a common currency is the reduction in transaction costs implied by the use of a common medium of exchange across a broad area. The disadvantage of a common currency is the loss of the shock-absorber properties of flexible exchange rates and independent monetary policies. Flexible exchange rates and independent monetary policies will be useful shock absorbers to the extent that macroeconomic shocks are imperfectly correlated across regions, wages and prices are sticky, and other macroeconomic adjustment mechanisms - such as factor mobility or fiscal transfers among regions - are weak or absent. Thus, from the Mundellian perspective, the case for a common currency within a broad area is stronger, the greater the actual or potential economic and financial integration within the area; the greater the correlation of macroeconomic shocks among regions within the area; and the more effective the non-monetary shock absorbers, such as factor mobility. Whether the nations that compose the European Monetary Union (EMU) form an optimal currency area in Mundell’s sense has been widely debated by researchers. For example, Barry Eichengreen argued early on (Eichengreen, 1992) that Europe was perhaps not well suited for a common currency on economic grounds (though he found the political motivations more compelling). According to Eichengreen, the factors reducing the desirability of a monetary union in Europe included the historical variability of real exchange rates among European nations, the low degree of labor mobility between countries, and a lower correlation of underlying shocks among European countries than among regions of the United States.3 Other critics of monetary unification, such as Martin Feldstein, have stressed the limited extent of fiscal transfers within the European Union. Differences across countries in the nature and strength of the monetary policy transmission mechanism are another factor that may reduce the attractiveness of a monetary union.4 However, some more recent assessments, which Karen Johnson and members of the Board’s International Finance Division provided helpful assistance and comments. McKinnon (1963) extended Mundell’s analysis. See also Bayoumi and Eichengreen (1992). The volume edited by Angeloni, Kashyap, and Mojon (2003) documents these differences in detail. have emphasized factors such as the high propensity of European countries to trade with each other and the increased coherence of national business cycles within Europe, have generally been more favorable (Alesina, Barro, and Tenreyro, 2002; Agresti and Mojon, 2001). Of course, analyses that look only at historical conditions ignore the important possibility that monetary union itself may induce endogenous changes in trade propensities, the pattern of macroeconomic shocks, and other components of the Mundellian analysis, a point that Eichengreen and many other authors have made. Rather than pursuing the question of whether Europe is in fact an optimal currency area in Mundell’s sense, I think it is useful simply to recognize that the European experiment in economic and monetary union has not been motivated primarily by Mundellian factors. (Mundell himself did not expect that such considerations would be sufficient to lead to monetary unions, as the quote with which I began suggests.) Political factors, rather than economic ones, have played the dominant role. The nations of Europe share a remarkable cultural heritage in philosophy, politics, science, religion, and the arts, and advanced thinkers have long recognized that this common heritage might serve as a basis for the formation of a cohesive European political entity. Such an entity presumably could influence world events and provide for a common defense more effectively than could a collection of nation-states. Indeed, political and economic integration within regions of Europe has occurred on a number of occasions - for example, in Germany and Italy. Another important motivation for political integration has been the desire to reduce the risk of intra-European conflict. From Napoleon to Bismarck to the Kaiser to Hitler, Franco-Prussian and then Franco-German conflicts were flash points for continentwide and worldwide wars. European economic and monetary union holds the promise of binding so closely the economic interests of these two powers, as well as those of other European nations, as to make future intra-European conflict unthinkable. Such arguments have been part of the debate over European integration at least since the 1957 Treaty of Rome. Indeed, the hope of policymakers is to create a virtuous circle, in which closer economic integration promotes greater political cooperation, which enhances opportunities for economic integration, and so on.5 The largely political origin of the union has several implications for the economic analysis of the common currency. First, from a purely economic point of view, the creation of the European economic and monetary union is at least partly an exogenous event. Thus, we have something of a natural experiment from which to learn about the effects of such institutional innovations. Second, we should keep in mind that our assessment of the success of the euro, indeed of the entire experiment in European integration, rests not only on economic criteria but also on the success of Europe as a political entity. If we think of the introduction of the euro as representing to some degree a natural experiment in monetary economics, what can we say about the costs and benefits, at least thus far, of this sweeping institutional change? We can look in a number of areas for effects of monetary unification, including the patterns of trade, developments in the financial sector, changes in macroeconomic stability, and the international role of the new currency. Many of these areas have already been examined today in much greater detail than I can do here. Rather than trying to be exhaustive, I will instead assert and briefly defend a hypothesis. The hypothesis is that the most significant effects of monetary unification have been felt, and will continue to be felt, in the development of European financial markets, and that the greatest economic benefits to Europe in the long run will accrue through the improved functioning of these markets. To defend this hypothesis, I need first to consider briefly the effects of monetary unification in some other key areas. Let us begin with trade. The debate about monetary unification was influenced to some extent by a tradition of empirical research that provided some basis for optimism about the effects of a common currency on trade. For example, the extensive literature on so-called border effects concluded that nations trade with each other far less than would be expected based on the extent of trade between regions within a country, opening up the possibility that differing national currencies are among the factors that inhibit trade. In a recent study, Reuven Glick and Andrew Rose (2001) provided some support for the idea that currency unions promote trade. Glick and Rose analyzed a panel data set of 217 countries for the period 1948 through 1997. They found that entering or leaving a currency union had large effects on trade flows; indeed, they estimated that a pair of countries that begins to use a common currency should see a doubling in bilateral trade. However, as Glick and Rose themselves note, many of the countries entering or leaving currency unions during The importance of political factors in the European economic union has also been illustrated by the importance of non-economic considerations in the debates about joining the union in nations such as Sweden and the United Kingdom. their sample period were small and poor, not rich and (in some cases) large like the nations of western Europe. Moreover, their analysis does not rule out either reverse causality (that is, that increasing trade may promote the adoption of a currency union, rather than vice versa) or the possibility that a third, unmeasured factor (such as political relationships) may have influenced both trade and currency policies. In contrast to the findings of Glick and Rose, evidence drawn directly from the recent European experience does not generally support the view that adoption of a common currency has a major effect on the magnitude or direction of trade.6 True, euro-area exports did surge after the adoption of the euro in January 1999. However, cyclical conditions and the early weakness of the new currency no doubt played a critical role in that increase, an inference confirmed by the substantial slowing in European export growth since the beginning of 2001. Also striking is the fact that the share of total euro-area exports destined for other members of the euro-zone did not increase with the introduction of the new currency, as would be likely if the common currency promoted trade. Indeed, at about 50 percent of total exports, the intra-euro-area export share today remains noticeably below the recent peak of about 57 percent reached in the early 1990s. The most decisive evidence on the trade question can be found by looking at microdata. In an important study, John Rogers (2003) of the Board staff analyzed annual data on the prices of 139 items, collected by the Economist Intelligence Unit for twenty-five European and thirteen U.S. cities. For his main results, Rogers divided the items into traded and non-traded categories, though he considered many other ways of slicing the data as well. He then analyzed the cross-city dispersion of prices in each year. Of course, the reduction of barriers to trade, the harmonization of tax policies, and the increased efficiency of cross-national markets should lead to reduced dispersion in the prices of goods, especially actively traded goods, as competition and arbitrage reduce local monopoly power and differences in prices. Rogers found a substantial decline in the dispersion of traded-goods prices across European cities over 1990-2001. Indeed, by the end of the period, the variability of traded goods prices across cities within EMU countries had declined by more than half, and it was not substantially different from the variability found among cities in the United States. This convergence of prices suggests a powerful, ongoing process of increased economic integration and elimination of barriers to trade among the members of the European Monetary Union. Crucially, however, Rogers found that the bulk of this convergence occurred between 1990 and 1994, the period of the “single market” initiative. Only a small part of the convergence in traded goods prices occurred after 1998, the period during which the euro was introduced and national currencies were withdrawn from circulation. Rogers’ evidence therefore suggests that the increased integration of product markets in Europe has been an ongoing process, which may have been assisted by the adoption of the euro but for which a common currency has hardly proved essential. A second question of interest is the degree to which adoption of the euro has affected macroeconomic stability in the euro zone. In Mundell’s taxonomy, adoption of a common currency is a strictly negative factor for stability because it eliminates the shock-absorbing features of flexible exchange rates and independent monetary policies. In fact, however, the effects of the common currency on macroeconomic stability in Europe have been positive as well as negative. Notably, the structure and mandate of the European Central Bank (ECB), as well as the perception of continuity with the policies of the pre-euro Bundesbank, have enhanced the ECB’s credibility and contributed to low and stable inflation in the euro-zone. Although Germany and several other countries in the union enjoyed low inflation before the adoption of the common currency, with some partial exceptions to be discussed in a moment, the ECB has been able to “export” that benefit to other members of the monetary union. The common currency has also eliminated periodic exchange-rate crises, which had plagued European monetary arrangements and generated real and financial disturbances at least since the days of the gold standard. On the other hand, the ECB has faced the challenge of making policy for Europe as a whole despite differing macroeconomic conditions in member countries, a dilemma that Mundell would have predicted. For example, since 1999 a few countries, such as Ireland, have had inflation rates consistently above the euro-zone average. Irish inflation peaked at 7 percent on a twelve-month basis Micco, Stein, and Ordonez (2003), using bilateral trade data from the early years of the monetary union, find modest tradeenhancing effects. in November 2000 and has since been in the 4 to 5 percent range. At the same time, other countries, such as Germany, have experienced low - perhaps uncomfortably low - rates of inflation.7 Patrick Honohan and Philip Lane (2003) investigated the sources of relatively high inflation in Ireland after the adoption of the euro. These authors found that the loss of exchange-rate flexibility and monetary autonomy played important roles in the Irish inflation. For example, a relatively large share of Ireland’s trade is with non-European partners, so that the early weakness of the euro stimulated Irish exports and economic activity disproportionately. Ireland was also unable to resort to monetary restraint to cool down an economy that, for a variety of reasons, was experiencing faster demand growth than most of the rest of Europe.8 Ireland’s relatively high inflation rate may in turn have had destabilizing effects, because, in combination with low pan-European nominal interest rates, it implied that the Irish economy faced a negative real rate of interest. One possible consequence of the low real rate is the boom in Irish property prices, which has fed back into higher domestic spending. Of course, at the other end of the spectrum, Germany has experienced weak growth and very low inflation in the past few years (Sinn, 2003). Without the ability to use stabilizing monetary policy, Germany has eased fiscal policy and thus has come into conflict with its obligations under the Stability and Growth Pact. In short, with respect to macroeconomic stability, the common currency appears to have had both positive and negative effects. More time will be needed before we can assess whether the common currency will ultimately be a stabilizing or a destabilizing influence at the macroeconomic level. Yet a third area in which potential benefits of the euro have often been cited is in respect to the common currency’s potential international role. The phrase “international role of the euro” covers a number of disparate possible functions of the currency. These functions include the use of eurodenominated assets as official reserves, the use of the euro as a vehicle currency in foreign-exchange transactions, the denomination in euros of financing instruments issued by borrowers not resident in the euro zone, the acceptance of euro-denominated or euro-linked assets in international investment portfolios, and the invoicing in euros of internationally traded goods and services. Of course, during the post-World War II period the U.S. dollar has been the dominant international currency with respect to each of these functions. It seems plausible that the euro, a low-inflation currency used by an economy comparable to that of the United States in size and sophistication, will, over time, increase its “market share” in each of these areas. However, the euro’s potential international role, and, more importantly, the benefits to euro-zone countries of an increased role for the euro differ significantly by function. A summary evaluation of the euro’s international position is that the common currency’s role has been increasing but that so far the euro has posed less of a challenge to the U.S. dollar as an international medium of exchange than some analysts expected. For example, in foreign exchange markets the U.S. dollar accounts for nearly 50 percent of transaction “sides,” compared with about 25 percent for the euro, implying that the overwhelming majority of foreign-exchange transactions involve the dollar (European Central Bank, 2003, p. 26; data are from Continuous Linked Settlement). Hence, the dollar appears to remain the international “vehicle currency,” serving as a temporary abode of value for foreign-exchange transactions involving third currencies, whereas the euro’s role in foreign-exchange markets is similar to that played in earlier times by the deutschemark (Solans, 2003). The dollar also remains the dominant invoicing currency for internationally traded raw materials, such as oil. The dollar is even dominant in U.S.-European trade, with more than 90 percent of U.S. exports to Europe and something more than 80 percent of European exports to the United States being invoiced in dollars as of September 2003 (European Central Bank, 2003, p. 33). With regard to the currency composition of official reserves, dollar-denominated assets accounted for 64.5 percent of world reserves at the end of 2002, down from 67.5 percent at the end of 2000. During the same period, the euro’s share of international reserves rose from 15.9 percent to 18.7 percent (European Central Bank, 2003, p. 45). Although economists and financial market participants will observe the developing role of the euro in international transactions with interest, the direct benefits to euro-zone economies of having the euro play an international medium-of-exchange role are relatively modest. Arguably, the more significant Some cross-country differences in inflation might simply reflect convergence in price levels, resulting from the BalassaSamuelson effect or from initial conversion factors from national currencies to the euro not precisely consistent with the law of one price for tradables. Rogers (2003) finds some evidence for the latter effect but not the former. Of course, fiscal policy remained available, though most economists agree that fiscal policy is less effective than monetary policy as a short-run stabilization tool. aspects of the euro’s international role arise from the strengthening and expansion of eurodenominated financial markets as these markets take on a greater international character. Internationalization of European financial markets increases investment opportunities, opportunities for diversification, and sources of funding and improves liquidity and market efficiency. On that note, let me turn finally to the effect of the common currency on European financial markets. As I have already suggested, the most important benefit of the currency union has been and will likely continue to be its strengthening of European financial markets. Traditionally, the efficiency and scope of these markets has been hampered by the costs and risks associated with the use of multiple currencies as well as by the fragmentation arising from international differences in legal structure, accounting rules, and other institutions. Given the rapidity and frequency of trade in financial markets, even small transaction costs can hamper the efficiency and liquidity of those markets. The common currency, with ongoing efforts to harmonize financial regulations and institutions, has significantly reduced those transaction costs. Together with lower country-specific macro risks arising from the adoption of the common currency, this reduction in transaction costs has greatly improved the breadth and efficiency of European financial markets. Importantly, the benefit of more efficient financial markets goes well beyond the benefits to financial investors and the financial industry itself. A growing academic literature suggests that financial development is a critical precursor to broader economic development (King and Levine, 1993). In this vein, a study for the European Commission estimated that financial development that brought the European financial system close to U.S. norms might add almost a percentage point to the growth of value added in manufacturing in the European Union (Giannetti et al., 2002). Whether one accepts this optimistic assessment or not, there are evidently significant potential benefits to financial deepening that go beyond the financial sector itself. How has the common currency improved financial efficiency? Perhaps the most dramatic effects of the monetary union in the financial sphere have been in fixed-income markets, both government and private. Government debt markets, because of their size, safety, and benchmark status, are central to a vibrant fixed-income market, and they have been particularly strengthened by the adoption of the euro. Notably, since the run-up to monetary union began, sovereign debt yields have converged to a remarkable extent. For example, between 1990 and 1996, spreads on Italian and Spanish government bonds, relative to German bonds of comparable maturity, averaged about 430 and 350 basis points, respectively. Today the spreads paid by these governments are quite small, in the vicinity of 15 basis points over the German equivalent for Italy and essentially zero for Spain.9 Clearly, these governments have benefited substantially by the reduction in inflation risk and exchange rate risk provided by the common currency.10 The addition of some sovereign default risk (now relevant because individual countries are no longer able to inflate away their debts) has evidently not offset these benefits, perhaps because of the effects of the Stability and Growth Pact. Beyond improving the fundamentals of government finances, the common currency has also increased the depth and breadth of government bond markets. In particular, the development of a large market in euro-denominated government debt and the resulting expansion in cross-border holdings of debt has improved market liquidity and opportunities for risk sharing. For example, in their excellent survey of developments in European financial markets since the introduction of the euro, Gabriele Galati and Kostas Tsatsaronis (2003, p. 174) note that nonresident holdings of French government bonds rose from about 15 percent at the end of 1997 to about 35 percent by 2002. Moreover, as of 2002, foreigners held three-quarters of Belgian government long-term bonds and 63 percent of Irish government debt. A broader investor clientele implies more potential bidders in primary markets and more transactions in secondary markets, improving liquidity. This broadening is the sense in which an international role for the euro, by which here I mean more internationalized European financial markets, seems to promise the greatest potential benefits. The European government bond market has been substantially strengthened by the adoption of the common currency, but it has not attained the liquidity of the U.S. Treasury market (and may never do so). Although aggregate issuance of euro-zone government debt is of the same order of magnitude as So-called “convergence plays” proved very profitable for financial investors who bet on the success of the European Monetary Union and its implication that government debt spreads would largely disappear. It is interesting, however, that even nonmembers such as Sweden and the United Kingdom have seen their bond yields converge to the German benchmark since about 1997 or 1998. U.S. Treasury issues, there remains the fundamental difference that euro-zone debt is the debt of twelve sovereign entities, rather than one as in the United States. Naturally, the Stability and Growth Pact notwithstanding, the European Union accepts no collective responsibility for the debts of individual governments. Moreover, so far coordination of issuance schedules, the structure of issues, and other technical details has been limited. However, opportunities for further strengthening of the euro-zone government bond market appear to remain. For example, if the technical details can be worked out, one can imagine the issuance of securities backed by the obligations of multiple European governments. These securities could be made uniform by fixing the country shares of the underlying debt, or by stripping off country-specific default risks through such instruments as credit default swaps. Such securities would provide a benchmark yield curve, among other advantages. The benefits of the euro for government bond markets have carried over to corporate bond markets as well. Issuance of euro-denominated bonds by corporations took off soon after the introduction of the new currency. Although much of the boom no doubt reflected general macroeconomic conditions and other factors, potential access to a much larger base of investors willing to hold bonds in the common currency and resulting improvements in pricing and liquidity also played a role. Underwriting costs have also fallen, the result of both greater competition and the reduced costs of bringing issues to market (Santos and Tsatsaronis, 2003). The rapid development of Europe’s corporate bond market, including a nascent high-yield market, should prove highly beneficial to European economic development. The benefits of the common currency for other types of securities markets have been more mixed thus far, but the potential is there. The European interbank market was strengthened substantially in tandem with the creation of the Eurosystem of central banks. In contrast, markets for securities lending (repo markets) remain somewhat fragmented, and commercial paper markets are underdeveloped. European stock markets, which in any case account for a smaller share of financing activity than in the United States, have not been successfully harmonized thus far, and cross-border equity investments may still involve high transaction costs (McAndrews and Stefanadis, 2002). However, it is widely observed that the perspectives and strategies of European equity analysts have changed, toward a de-emphasis on country-specific factors and greater attention to industry and company factors in the valuation of stocks (Adjaouté and Danthine, 2002). This change indicates that financial market participants see increased financial and economic integration in Europe as an irreversible trend. Efforts to adhere to the Lamfalussy Process, which aims to streamline the harmonization process for financial market legislation and regulation, should hasten the integration of European securities markets. European finance has traditionally been bank-centered. What will happen to banks in the new regime? Banks may lose some loan customers to the growing securities markets, but they will also benefit from increased access to finance, both in the interbank market and in the corporate bond market. Indeed, the banks were large players in the early boom in the issuance of euro-denominated corporate bonds, accounting for more than half the new issues thus far (Galati and Tsatsaronis, 2003, p. 181). On the lending side, banks’ local knowledge and specialized services should allow them to retain an important market share. In a study that illustrated the importance of banks’ knowledge of local conditions, Allen Berger and David Smith (2003) found that European affiliates of multinational corporations strongly prefer working with a bank in the country of their operation, rather than a bank from the country of the multinational’s corporate headquarters. Moreover, having chosen a bank in the country of operations, the affiliates were more likely to select a bank with local or regional operations than a bank with global reach. These results are consistent with the view that bankers’ competitive advantage relative to security markets is their knowledge of local firms, markets, and economic conditions and their ability to establish long-term relationships with local customers. Perhaps the European banking situation will begin to look more like that of the United States, where borrowing through securities issuance and banking co-exist, providing different services and meeting the needs of different clienteles. Moreover, the composition of banks may settle into the pattern of the United States, where very large banks with a global reach and the capacity to engineer highly complex transactions and community banks that specialize in lending to the local area have both found room to flourish. However banking may evolve in Europe, increased financial integration that makes local banking markets more “contestable” will likely improve the efficiency with which local banking services are delivered. My remarks this evening have only scratched the surface of a large topic, but it seems safe to conclude that the common currency has had and will continue to have large benefits for European finance. At a minimum, the single currency eliminates exchange-rate risks that exist when securities are denominated in different currencies. The single unit of account seems also likely to reduce transaction costs and eliminate a portion of the fixed costs involved in issuing similar securities in multiple currencies. These factors are already serving to moderate home bias in borrowing and lending, leading to larger, more-liquid, and more-diversified financial markets. Clearly, a great deal more work needs to be done, both by the government and by the private sector, to realize the full benefits of the common currency for European finance. Beyond the markets that I have mentioned as needing special attention, like equity markets, further harmonization is also required to coordinate national systems for payments, clearing, and settlement. A larger and more integrated financial system may carry greater systemic risks and raise new challenges for the system of financial oversight and supervision. Further challenges will arise as new countries, including those currently at a relatively low level of financial development, join the European monetary system. Their accession will greatly complicate the harmonization process, but given what we know about the role of finance in economic development, the benefits for both the new members and the current ones could be very large.
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board of governors of the federal reserve system
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Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the Global Association of Risk Professionals Fifth Annual Convention, New York, 25 February 2004.
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Susan Schmidt Bies: Qualitative aspects of effective risk management Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the Global Association of Risk Professionals Fifth Annual Convention, New York, 25 February 2004. * * * Good morning. I am delighted to be here for GARP’s 5th Annual Risk Management Convention and to support, to the extent that I can, the work of your organization. It’s gratifying to see the progress GARP has made in its short life toward promoting the visibility and quality of the risk management profession. I congratulate you on the progress you have made and wish you further success in the years ahead. I have spent much of my own career in the field of risk management, and certainly the Federal Reserve has a keen interest in the matter. For those of us who have spent more than a few years in the business, it is easy to see the recent progress in the quantitative or scientific aspects of risk management as a result of data base and other technological advances. These increased capabilities have helped push financial theory and have opened doors and minds to new ways of measuring and managing risk. These advances have also made possible the development of important new markets and products that have become widespread and essential to the risk management practices of both financial and nonfinancial firms. They have also made the practice of risk management far more sophisticated and complex. The application of mathematics and statistics, the collection and compilation of large amounts of data, and the analysis and characterization of the risks embedded in business activities today are much different - and in many ways more challenging - than they were not long ago. While the enhanced quantitative dimensions of risk measurement may be quite visible (at least to practitioners of the art), their implications for the qualitative aspects of risk management may be less apparent. In practice, though, these qualitative aspects are no less important to the successful operation of a business - as events continue to demonstrate. As risk measurement practices advance, the full range of risk management practices needs to keep pace. In my remarks today, I would like to highlight some of the advances in risk management that we have seen in recent years, particularly those related to the management and transfer of credit risk. These gains and the development of new and important markets have come about because of better riskmeasurement techniques and have the potential, I believe, to substantially improve the efficiency of U.S. and world financial markets. However, as an economist, I also know there is no free lunch; some of the implications of these developments on the more fundamental elements of risk management must be considered and adequately addressed if the quantitative aspects are to work well. For obvious reasons, I will focus on the practices of large commercial banks. Competitive and innovative markets I would like to draw on some observations gathered from the Federal Reserve’s role in banking supervision as we have worked to better understand recent practices by financial institutions to manage and transfer credit risk. I find the preliminary assessment to be informative, interesting, and at least somewhat reassuring; however, I also feel that it appropriately highlights vulnerabilities in market practices that must be carefully monitored and managed. Because much of the innovation in credit risk transfer involves credit derivatives, attention has been focused on transactions using these instruments and on credit default swaps (CDS), in particular. By way of note, the Federal Reserve also is participating in work commissioned last year by the Financial Stability Forum to gain a broader understanding of these issues. I look forward to the conclusions and assessment in this regard. As most of you know, credit default swaps involve the sale, or transfer, of credit risk associated with a specific reference entity for a fixed term in exchange for a fee from the other counterparty (the “protection buyer”). Related instruments - synthetic collateralized debt obligations (CDOs) - entail similar arrangements, but are based on portfolios of exposures and are “tranched” in a manner typically seen in securitizations. Consequently, through CDOs, parties gain even greater flexibility in tailoring and marketing financial transactions to match the risk appetites of ultimate investors, or risk takers. This market has grown rapidly in recent years, attracting increased attention among risk managers and leading to larger operations and higher staffing levels - particularly at dealer firms. The British Bankers Association, for example, reports that the notional value of credit derivatives has grown from less than $200 billion in 1997 to nearly $2 trillion in 2002. Our own bank Call Reports indicate that late last year U.S. commercial banks held credit derivatives with notional values of more than $800 billion, which may represent one-third of the global market. Trading of these instruments occurs mostly among some 1,200 large investment-grade “reference entities,” with more liquidity, of course, among the most active fifty names than among the next several hundred. Most liquidity for CDS contracts is with five-year maturities, although participants are trying to expand market depth at longer terms. There are also efforts to push demand beyond investment-grade corporate names, for example to high-yield and middle-market sectors. A key question - how much risk is being transferred? - has been difficult to answer due to the participation in the market of many types of regulated and unregulated investors and firms as well as the fact that participants simply reverse or close out one exposure by entering into an additional and offsetting one, as they do with other types of swaps. To be sure, notional amounts substantially overstate the level of risk transfer, but by most accounts, market participants seem to agree that the volume of risk transferred has been material. Anecdotally, some of the largest banks indicate they hedge about 15 percent of their investment-grade corporate credit. Standard and Poor’s estimates the banking system globally has used credit derivatives to transfer the risk associated with some $300 billion of exposures. But S&P acknowledges that this estimate likely overstates the true level of risk transferred because CDS are almost exclusively written on low-risk, investment-grade credits, and because banks issuing CDOs typically retain the riskier tranches. Even so, it seems to me that such risk management practices are important in governing credit risk in large banking organizations and, in many respects, reducing systemic risk, as well. Despite the common practice by banks that issue CDOs to retain much or all of the first-loss or “expected-loss” tranche, such banks have at least reduced their previous, full credit exposure. Moreover, the sale and purchase of CDS also allow banks to manage concentrations and to further diversify their portfolios. In the event of highly unexpected defaults among investment-grade firms, a hedged bank’s losses will be reduced. The experience with credit derivatives in the Enron, World Com, and Parmalat events, indicate that these new risk products can work effectively. One aspect that we, as bank supervisors, find encouraging about the growth of credit risk transfer activity is the diversification benefit it provides - and its potential for greater economic efficiency. Certainly, not all of the risk transferred by banks has left the banking sector. S&P estimates that roughly one-half of this risk remains in the banking sector. The insurance sector, including reinsurance firms, has been a major participant among nonbank firms. Among banks, the belief is that those in Europe and Asia have been net sellers of credit protection, particularly with respect to North American borrowers. Such credit flows, whether within or outside the banking system, should help enhance the geographic diversification of the protection-seller and add liquidity to the debt offerings of the reference firms. By distributing risks more broadly among the major players - banks, insurance companies, hedge funds, and private asset managers - these transactions would seem almost by definition to add to the diversity and strength of financial markets and reduce risk concentrations. By their design, derivative instruments segment risk for distribution to parties most willing to accept them. A key point, however, is that these parties are also able to do so by successfully absorbing and diffusing any subsequent loss. In any event, reducing or more evenly redistributing the risk within the banking system - where such credit risk has been traditionally concentrated - would seem to be a clear benefit. A second question that is certainly of interest to you as risk management professionals is whether participants recognize and understand the underlying risks. It is important to recognize that the market for credit default swaps is dominated by large institutions and private investors that have specialized expertise in credit analysis and significant historical performance records. Participants will always adjust their positions and move in and out of markets as they gain experience, and there will certainly be lessons to learn along the way. We will learn them, and hopefully we will deal with them well - as we have so far. But we have little evidence, to date, that suggests there are material weaknesses in the knowledge and understanding of the major market-making dealers. That said, I would offer one critical caveat regarding the potential for a large group of market participants to place an over-reliance on external ratings and key modeling assumptions. In particular, the pricing and risk management of the increasingly complex credit risk transfer instruments and trading strategies rely on credit risk models and supporting assumptions, including assumptions about the degree of default correlations between different reference entities. Although these future correlations cannot be measured, correlations during periods of normal conditions can change greatly during periods of stress. Time will tell how robust these models are and whether they will perform well. Market participants must consider whether there is a concentration of reliance on a small set of risk management frameworks or approaches in the Credit Risk Transfer (CRT) market. This issue arises in regard to the reported similarity of credit risk models and assumptions used by major market participants. Of course, there is nothing inherently wrong with convergence in risk management approaches. But in this case, given the widespread view that models are still in their relative infancy, the similarities are perhaps worth noting. This issue also arises in relation to the reliance on rating agency ratings and methodologies regarding CDO tranches and related structures. Ideally, all market participants that are investing substantial amounts in CDOs would have the capacity to undertake their own analysis of the risks, so that the rating agency ratings would function more as a supplement to these analyses. In practice, however, it is likely that substantial reliance will be placed on the rating agency’s rating. Consequently, the risk judgments of many market participants are concentrated in the hands of a small number of public rating agencies. In the context of commercial banking where past credit-related failures have had substantial and widespread effects, we also have close government supervision, that has focused primarily on risk management practices and controls relating to evolving market practices. I would not for a minute suggest that such oversight ensures that all will go well in the future. But it should help to reinforce effective risk management, and we are learning from the growing list of case studies. Qualitative aspects This discussion of the role of derivatives in transferring credit risk serves to illustrate many important and not always highly technical - aspects of risk management that cannot be overlooked. Some of these issues relate to the nascent features of that particular market, but they apply to other markets as well, and to the sheer complexity of measuring risk. Thoughts of legal risk, operational risk, reputational risk, counterparty credit risk, and model risk all come to mind. For their part, central bankers and bank supervisors must also consider the implications of new products, activities, and management innovations on financial markets, systemic risk, and their own prudential regulations. The combined implications of market innovations on all of these and other issues can be profound and challenging, but, I would submit, overall beneficial to market efficiency. We simply must manage the process well. In the legal arena, the financial industry has made, and continues to make, substantial progress, for example, standardizing netting agreements related to derivative instruments and reducing related misunderstandings and differences among institutions and legal jurisdictions. Understanding market practices, such as those related to settling transactions using “cheapest to deliver,” and knowing for certain the specific legal entities that are the reference parties on credit risk swaps are also crucial, low tech elements of a successful risk management process. Uncertainties will exist in any complicated operation. They are typically greater when associated with innovation and they grow as product structures become more complex. We all need to recognize this. Regarding models, aside from the technical parts, it’s important to consider the less quantitative. For instance, are the inputs sound? Are the model parameters based on sufficiently robust and accurate data? Are the assumptions reasonable? One needs to understand the business and risk management principles, but that does not require a “quant.” In modeling, “GIGO” - garbage in, garbage out - always rules. Data integrity is growing in importance in effective risk management. In today’s world of credit risk models, especially for centralized underwriting in areas such as consumer, mortgage, and small business credit, the responsibilities of data input may reside with the lending officer. To ensure effective underwriting, the culture and incentives for loan officers should support accountability for valid information going into a model. In the “old days” when individual loan officers made credit decisions, any weaknesses in underwriting were confined to that lender’s portfolio. It was the responsibility of loan reviewers to identify those weaknesses before losses became extensive. Today, the responsibility for effectively predicting defaults and loss given default resides with the senior credit officer responsible for the credit scoring model. When the underwriting results are then tested for reliability, it is critical to identify the root cause of errors due to model specifications and changes in customer behavior. The risk of centralized, model-based underwriting is that errors are no longer limited to the portfolio of a single loan officer. Rather, model errors can create significant systemic risks across that loan product portfolio. We are still trying to learn how to estimate these types of risks. In our current regulatory efforts to develop internal rating-based capital standards for credit risk, we find that simply identifying and describing “minimum” data requirements can be a challenge. What is adequate and robust for a given purpose and what is not? Each company’s practices are unique - as they should be. We do not wish to create the moral hazard and greater systemic risk associated with a highly specific, government-dictated procedure to measure risk. Rather, we want the discipline that can be gained from requiring that the input data and the parameters used for regulatory purposes are as much as possible - the same as those used for business purposes, so that they can be markettested. Differences among model results will occur, but both management and regulators must decide what is good enough for their respective purposes. Some answers are more judgmental than empirical. Experience, judgment, and a sound degree of prudence are all important. In the old days, banking was often a smaller and certainly less complex business. In this smaller scale, management could gain a more direct “feel” about their customers, their exposures, and the related risk. And the potential consequences of making mistakes were typically small as well. If the bank had a bad loan underwriter, it could dismiss the person and proceed to clean up the mess. As many banking organizations have grown into much larger and far more complex institutions, that personal feel often gets lost. Their managements need the more sophisticated and systematic processes that risk modeling can provide, but they also need to ensure that an incorrect or weak model does not bring down the house. I would offer that success in this area often requires grey hair and keen intuition as well as highly developed analytical skills. Beyond these points, accounting and disclosure practices must be considered as they relate to such matters as earnings volatility, customer suitability, and the incentives or disincentives they provide to risk managers. Fundamental elements of corporate governance must also be adequately addressed and they naturally become more challenging as activities become more complex. Nevertheless, they cannot be ignored, given the corporate scandals of recent years and the legislated remedies that followed. Recent failures of corporate governance - whether at Enron, Parmalat, or the New York Stock Exchange - have changed the landscape underlying many transactions conducted by financial institutions. The implications of the Sarbanes-Oxley legislation are now being felt throughout corporate America and are proving to be expensive to many firms. How much better, for all, had these few corporations behaved more responsibly all along! Responsible self-governance and sound corporate governance are much better and far less costly than rigid governmental-imposed rules. A greater awareness of business ethics and a reshaping of accounting practices and incentive packages should help. But risk managers must also play an active role in focusing on sound practices, and not just on expedience. Accounting, disclosure, and market discipline Revelations of significant corporate governance and accounting failures, with Parmalat being the latest example, demonstrate that strong accounting, effective internal and external auditing, and transparent disclosure practices are critical concerns worldwide, not just in one part of the world, such as the United States. Events at the international level have renewed attention to the need for companies worldwide to implement high-quality corporate governance practices and accounting and disclosure standards, and for their external auditors to employ rigorous and sound international auditing techniques. Long before coming to the Federal Reserve, I had a strong interest and became involved in accounting, auditing, and internal control matters. This led to my serving on the Financial Accounting Standard Board’s Emerging Issues Task Force and the Committee on Corporate Reporting of the Financial Executives Institute. I have continued to pursue this interest in my role as a Federal Reserve Board member and as chair of the Board’s Committee on Supervisory and Regulatory Affairs. I would like, now, to turn to some of the recent accounting issues surrounding complex instruments and the role of financial disclosure in promoting risk management. For starters, I am pleased to see movement in recognizing employee stock options grants as a business expense. At year-end 2003, thirty-five of the fifty largest U.S. bank holding companies that we closely monitor each quarter were taking this approach, a notable increase from the year before. Many nonbank firms are doing so as well, and we should expect to see many more companies do so in periods ahead. In my view, that is a useful step toward more accurately disclosing a company’s true results, and one that should help rebuild investor confidence in financial statements. The techniques for valuing financial derivatives - whether they be employee stock options, mortgage interest rate lock commitments, credit default swaps, or another type - are continuing to evolve. As these markets grow, fair-value estimates will only improve. In the process, firms of all types will face growing competitive pressures to manage risk more effectively and to make greater use of these and other products. Accounting rules and disclosure practices must keep pace. A frequently cited issue is the effect of current hedge accounting rules, which sometimes cause banks to recognize losses on credit hedges while ignoring, in earnings, the offsetting gains in the economic value of the asset hedged. This leads to greater earnings volatility and has understandably caused some banks to reassess, and in some cases scale back, their credit hedging activities. If market discipline is to function, accounting boards themselves must find better, more-innovative solutions that more accurately capture the underlying economics of transactions. Moreover, with regard to securitizations, derivatives, and other innovative instruments that can transfer risk, it is not at all clear that accounting measures of a company’s balance sheet at a given point in time are sufficient to reflect the company’s financial risk profile. As bank regulators, we recognize the need to strike the right balance in deciding what disclosure standards to promote. It is said that for every complex issue there is an answer that is simple, concise, and wrong. We would prefer to get it right. We need to identify the information that sufficiently informs investors of risk levels without being unduly burdensome and without revealing proprietary information. Much of the answer may involve disclosures about how risks are being managed and valued, drawing less on accounting information and more on information available in risk management reports. Disclosures need not be fully standardized; rather each firm should tell its own story. One area in which improved disclosures by banking organizations are needed involves credit risk and the allowance for loan losses. As you know, there is a high degree of management judgment in estimating the loan-loss allowance, and that estimate can have a significant impact on an institution’s balance sheet and earnings. Expanded disclosures in this area would improve market participants’ understanding of an institution’s risk profile and whether the firm has adequately provided for its estimated credit losses in a consistent, well-disciplined manner. Accordingly, I strongly encourage institutions to provide additional disclosures in this area. Examples include a breakdown of credit exposures by internal credit grade, the allowance estimates broken down by key components, morethorough discussions of why allowance components have changed from period to period, and enhanced discussions of the rationale behind changes in the more-subjective allowance estimates, including unallocated amounts. It is also important to note that the soon-to-be-released enterprise risk management (ERM) framework of the Committee of Sponsoring Organizations of the Treadway Commission, or COSO, should provide much needed guidance in the areas of risk management and internal controls and, thus, is of particular interest to bank regulators. The ERM framework, as proposed, requires an entity to identify the potential events that may affect its operations and requires the entity to systematically manage those risks with a particular emphasis on its risk appetite and strategic direction. The framework is predicated on the existence of sound controls and effective management. Successful application of the framework requires managers to consider both current and planned or anticipated operational and market changes and to identify the risks arising from those changes. Once these risks have been identified comprehensively, assessed, and evaluated as to their potential impact on the organization, management must determine the effectiveness of existing controls and develop and implement additional mitigating controls where needed. This is a critical step and if it is not performed properly, it may doom the entire process. One of the weaknesses that we have seen is the delegation by management of both the development and the assessment of the internal control structure to the same risk management, internal control, or compliance group. It is important to emphasize that line management has the responsibility for identifying risks and ensuring that the mitigating controls are effective - and to leave the assessments to a group that is independent of that line organization. Managers should be expected to evaluate the risks and controls within their scope of authority at least annually and to report the results of this process to the chief risk officer and the audit committee of the board of directors. An independent group, such as internal audit, should perform a separate assessment to confirm management’s assessment. Internal audit’s review should determine whether the firm is accomplishing its stated control objectives, in light of growth and changes in the firm’s business mix as well as in regard to new customers, strategic initiatives, reorganizations, and process changes. Internal audit should also evaluate the entity’s adherence to its control processes and assess the adequacy of those processes and its related disclosure practices in light of the complexity and legal and reputational risk profile of the organization. It is essential for internal audit to be staffed with personnel who have the necessary skills and experience to report on the degree of compliance with an entity’s policies and procedures. Internal audit should test transactions to validate that business lines are complying with the firm’s standards and should report the results of that testing to the board or the audit committee, as appropriate. Although I have referred to internal audit, the key point is that strong internal controls, sound corporate governance, and effective disclosure practices require that periodic assessments of overall effectiveness be performed by an independent group. Then, as corporate disclosure practices evolve, market analysts must do their part to understand the information, while recognizing both its value and its limitations. Analysts need to make sure they are correctly using all available information. This includes understanding that some accounting practices may not result in the best presentation of economic reality and that other sources of information may provide more-accurate insight into a company’s condition. For example, current accounting rules for defined-benefit pension plans permit firms to use expectations of the long-term return on assets to calculate current-period pension costs. A spot rate is used to discount future liabilities. The discrepancies between the assumed and the actual returns are reconciled by gradual amortization. This smoothing feature can create large distortions between economic reality and the pension-financing cost accrual embedded in the income statement. A recent study by Federal Reserve staff members indicates that “full disclosure” of the underlying details would not necessarily assist the analyst in reaching a “correct” judgment.1 The study adopts the premise that most of what investors need to know about true pension-financing costs can be reflected in two numbers disclosed in the pension footnote. These two numbers are the fair-market value of the pension assets and the present value of outstanding pension liabilities. The study finds that these two numbers tend to be ignored by investors in favor of the potentially misleading accounting measures. Investors and analysts need to ensure that the information they are using most accurately reflects the organization under consideration. Also, bank employees who use financial statements of potential borrowers to make credit-related decisions need to understand the documents they are using and be able to identify potential shortfalls. Too often, analysts have relied too heavily on projections and interpretations given to them by management. Recent events have injected more independence into the analysis process and should help wean many analysts from CFOs and investor relations departments. More-insightful and moreindependent analysis by them can help greatly in promoting market discipline and identifying a company’s true worth. That progress, in turn, strengthens the input data and the risk-measurement systems we all rely on. Throughout its supervisory and regulatory efforts, the Federal Reserve is, indeed, looking more to market signals. For example, information contained in subordinated debt spreads, credit default swap spreads, KMV EDFs, and equity prices provide useful indications of the market’s collective assessment of a company’s underlying risk. In banks, this information supports credit judgments and overall measures of the institution’s capital adequacy and credit risk. As regulators worldwide move to finalize new capital standards, the role of market information in risk management should grow further, particularly among the largest banks, as it will in our own oversight activities. Before closing, I would like to take off my central banker hat and speak to you only as an industry observer and a former bank CFO. I want to simply note the historically low level of interest rates which are not within the work experience of many investment and risk managers. The typical response is to try to increase nominal yields and widen spreads. Thus, some banks have acted to extend portfolio durations and accept risk, given the steep yield curve, because statistics will likely tell you that the odds of a rate increase are greater than a further decline. We are also seeing some investors attempt to increase nominal yields by investing in lower-rated bonds. But the skills that this association’s members practice, remind us that the goal should be appropriate “risk management,” that is, given an Julia Coronado and Steve Sharpe, “Did Pension Accounting Contribute to a Stock Market Bubble?” Brookings Papers on Economic Activity, July 2003. organization’s risk appetite, the attractiveness of higher yields must always be balanced against the increased level of risk in the transaction. And in times of turns in business and interest rate cycles, estimating these tradeoffs can be more difficult. That is not a prediction of near or future rate movements - just advice from an experienced manager of interest rate risk. Conclusion In my remarks this morning, I have sought to encourage you to continue your efforts to support the evolution of risk-management practices and heighten the degree of professionalism that every effective risk manager should demonstrate. I would like to leave by reminding all of you not to become so caught up in the latest technical development that you lose sight of the qualitative aspects of your responsibilities. Models alone do not guarantee an effective risk-management process. You should encourage continuous improvement in all aspects, including some I mentioned today - data integrity, legal clarity, transparent disclosures, and internal controls.
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board of governors of the federal reserve system
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Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, before the New York Forecasters Club, New York, 26 February 2004.
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Susan Schmidt Bies: The economic outlook and the state of household and business finances Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, before the New York Forecasters Club, New York, 26 February 2004. * * * It is a pleasure to be with you today. As a relative newcomer to the forecasting profession, I must say that speaking to such an esteemed group of professional prognosticators is a bit intimidating. But newcomers often bring new perspectives, and I hope my remarks will prove informative. I intend to talk briefly about my assessment of the economic outlook and then turn to a more detailed discussion of how the evolution of household and business balance sheets in recent years is affecting economic activity.1 The Economic outlook As you know, real gross domestic product grew at an annual rate of 6 percent in the second half of 2003, and the economic fundamentals seem to be in place for another sizable advance this year. Indeed, the GDP forecasts of Federal Open Market Committee members have a central tendency range of 4-1/2 to 5 percent. Yet despite the recent strong pace of economic activity, the labor market has improved only slowly. I am cautiously optimistic, however, that job growth will pick up - perhaps substantially - over the course of this year. My business contacts tell me that companies have indeed become more optimistic about economic prospects and that their plans include some increase in the size of their payrolls. The FOMC expects the unemployment rate to fall to between 5-1/4 and 5-1/2 percent by the end of this year. Although economic growth revived in the second half of 2003, core consumer price inflation continued to slow. Surveys suggest that inflation expectations remain stable, and extraordinary gains in labor productivity have continued to keep price pressures in check. Moreover, I expect these recent favorable price trends to continue, and I am very comfortable with the FOMC’s prediction of a 1 percent to 1-1/4 percent rise in the PCE price index this year - a shade less than the increase in 2003. Briefly putting on my hat as a monetary policy maker, I will say that the prospect of a strongly growing economy, falling unemployment, and low inflation seems to be close to a central banker’s ideal. Under these conditions, we can be patient before we must, inevitably, confront the need to diminish the substantial degree of monetary accommodation now in place. Given this broad-brush summary of the outlook, let me now take a closer look at the financial positions of U.S. households and businesses. As I will discuss, the favorable financial conditions in both sectors should support a solid increase in household and business expenditures. Household financial conditions Some commentators have expressed concern about the rapid growth in household debt in recent years. They fear that households have become overextended and will need to rein in their spending to keep their debt burdens under control. My view, however, is considerably more sanguine. Although there are pockets of financial stress among households, the sector as a whole appears to be in good shape. Certainly, households have taken on quite a bit of debt over the past several years. According to the latest available data, total household debt grew at an annual rate of 10 percent between the end of 1999 and the third quarter of 2003; in comparison, after-tax household income increased at a rate of The opinions that I will be expressing are my own and do not necessarily reflect those of my colleagues on the Board of Governors or Federal Open Market Committee. 6 percent. The rapid growth in household debt largely reflects a surge in mortgage borrowing, which has been fueled by historically low mortgage interest rates and strong growth in house prices. Despite the heavy borrowing, households have kept the repayment burden of their debt in check. Notably, many homeowners have taken advantage of low interest rates to refinance their mortgages, some having done so several times over the past couple of years. Survey data suggest that homeowners took out cash in more than one-third of these “refis,” often to pay down loans with higher interest rates. The resulting drop in the average interest rate on household debt, combined with the lengthening maturity of this debt, has tempered the repayment obligation from the growing stock of debt. The Federal Reserve publishes two series that quantify this repayment obligation. The first series, the debt service ratio, measures the required payments on mortgage and consumer debt as a share of after-tax personal income. The second series, the financial obligations ratio, is a broader version of the debt service ratio that includes required household payments on rent, auto leases, homeowners’ insurance, and property taxes. Both ratios rose during the 1990s, and both reached a peak in late 2001. Since then, however, they have receded slightly on net from their respective peaks, an indication that households, in the aggregate, have been keeping an eye on repayment burdens. Because the debt service ratio and the financial obligations ratio are calculated from aggregate data, they do not necessarily indicate whether the typical household is experiencing financial stress. Nonetheless, we have found that changes in either ratio help predict future changes in consumer loan delinquencies. Accordingly, the fact that these ratios have come off their recent peaks is a hopeful sign about household loan performance. Indeed, delinquency rates for a wide range of household loans turned down over the second half of 2003. Another often-cited indicator of household financial conditions is the personal bankruptcy rate. Movements in the bankruptcy rate, to be sure, partly reflect changes in the incidence of financial stress, but the rate has been trending up for more than two decades for a variety of other reasons. The Bankruptcy Reform Act of 1978 made bankruptcy a more attractive option for most households by increasing the amount of wealth that households could retain after bankruptcy. Other factors that have likely contributed to the upward trend are the decrease in the social stigma of filing for bankruptcy and the growing access to credit in the United States. As lenders have become more sophisticated in their ability to assess the riskiness of borrowers, they have extended loans to households that were previously denied credit. These households are more likely to default on their obligations than the typical borrower, but this increased risk is priced into loan terms. Although the bankruptcy rate remains elevated, it has edged down on balance in recent months, likely because of the pickup in economic growth in the United States since mid-2003. This relatively upbeat assessment of household credit quality seems to be shared by lenders and by investors in securities backed by consumer debt. According to the Federal Reserve’s survey of senior loan officers, banks have not materially changed their lending policies for consumer loans over the past couple of years. This behavior certainly does not point to much concern about household loan performance. Moreover, one gets an even more positive message from the credit spreads on securities backed by auto loans and credit card receivables. In recent months, the spreads between the yields on these securities and swap rates of comparable maturities have narrowed across the credit spectrum. Thus far, I have focused on the liability side of the household balance sheet, but there have been favorable developments on the asset side as well. Equity prices rallied strongly last year and have continued to rise this year, reversing a good chunk of the losses sustained over the previous three years. In addition, home prices appreciated sharply during each year from 1997 to 2002. Although the increases in home prices have slowed somewhat lately, the cumulative rise since the late 1990s has exceeded the growth in per capita income by a wide margin. All told, the ratio of household net worth to disposable income - a useful summary of the sector’s financial position - recovered last year to stand at a level slightly above its long-term average. Before I turn to the business sector, let me address two concerns that have been voiced about the prospects for households. The first of these regards the low level of the personal saving rate. During the past several years, the personal saving rate has been in the neighborhood of 2 percent, well below its earlier post-World War II average of nearly 8 percent. Such low personal savings rates raise concerns that households may not be saving enough to meet longer-run needs, such as for retirement or college education of their children. What might be behind this paucity of personal saving? As recently as the early 1990s, the saving rate was near its long-run average. One reason that the saving rate fell during the 1990s was the rising stock market. Higher equity prices led consumers to feel wealthier, which boosted spending relative to income and thus reduced the saving rate. In addition, the greater household wealth brought about by higher equity prices meant that any saving goals a family might have - such as for education or retirement - were closer to being fulfilled. Hence, households would need to save less to achieve those goals. By this logic, we might have expected to see some increase in the saving rate in the aftermath of the sharp declines in equity prices in 2000, 2001, and 2002. It is true, as I noted earlier, that rising house prices cushioned these losses. But, on net, household wealth took a hit during these years without any commensurate rise in the saving rate. A key factor that has likely boosted spending - and thus held down saving - has been the low level of interest rates. The low interest rates have worked directly by stimulating spending in interest-sensitive sectors such as consumer durable goods. In addition, they have facilitated the restructuring of the household sector’s balance sheet, with a positive indirect effect on expenditures. In particular, over the past few years, homeowners have extracted a large amount of home equity through cash-out refinancing and home sales, which helped to support consumption despite the decline in equity prices. As I noted earlier, I do not think that the household sector is overextended, and thus I do not believe that a large, autonomous increase in the personal saving rate is a serious risk to the economy. However, I would not be surprised to see the personal saving rate move up gradually over time to levels more consistent with its historical average. This rise presumably would be consistent with the expected shift in the pattern of growth in our economy - from an expansion that has been led mainly by the household sector to one led more by business spending. The second concern often expressed is that a bubble may have developed in house prices after several years of rapid increases. Some of the measured price rise results from improvements in the quality of houses: Houses are bigger and have more amenities than in the past, two characteristics that will lead to rising average house prices over time. But even after controlling for quality, increases in home prices have been outstripping general price inflation by a considerable margin in recent years. Once again, the low interest rates are probably an important factor. Houses, like other assets, generate an expected stream of future benefits. With low interest rates, these future benefits are discounted less heavily, which raises the asset’s price today. Low interest rates also push up house prices by boosting the demand for housing. Of course, some of that increased demand is being met by the rapid pace of construction of new housing. But building houses takes time, and in the interim, higher demand will push up the price of existing houses. Although we can identify the key forces behind the rise in house prices in recent years, we cannot be sure that the increases are fully justified by the prevailing fundamentals. Still, we need to keep the recent increases in house prices in perspective: Although house prices have been outstripping broad measures of inflation - even after adjusting for quality improvements - their rise is nothing like the increase in equity prices in the late 1990s. In fact, the speculative forces that can sometimes drive equity prices to extremes are less likely to emerge in housing prices. First, buying and selling houses is a lot more expensive and cumbersome than buying and selling equities, which makes taking a speculative position in houses much more difficult. Second, housing markets are much more local than equity markets, which are national, if not global, in scope. So if any speculative frenzy emerged, it would be much less likely to spread in the housing markets than in equity markets. Finally, financial institutions have a much more disciplined process around the housing and construction lending market than they did in past housing cycles. Lenders today are cautious about lending for speculative purposes, and appraised values undergo more scrutiny than in the past. The expansion of credit to higher risk households may also have driven banks to strengthen their underwriting procedures. That said, it is certainly possible for local housing markets to become overvalued and then to experience sharp price declines. House prices fell significantly in several parts of the country in the early 1990s. But because the transactions costs are much higher in the housing market than in the equity market, and because the underlying demand for living space is much more predictable than are the prospects for any given firm, the large rises and declines often observed in the stock market are less likely to occur in the market for houses. In addition, lenders are much more responsive to local economic conditions, and generally become more cautious in loan underwriting when unsold homes or local unemployment increase. Financial conditions of businesses The change in the economy that caught my attention in the second half of 2003 was that the decline in business fixed investment had finally ceased. Capital spending by businesses posted a solid increase in the second half of last year, and orders for nondefense capital goods - a key indicator of equipment spending - point to further sizable gains. Moreover, the tenor of anecdotes from the corporate sector has become comparatively upbeat, with corporate managers seeing stronger revenue growth and a much improved and accommodative financing environment. Four important factors have contributed to this improvement in financial conditions: low interest rates, a widespread restructuring of corporate liabilities during the past few years, a sharp rebound in corporate profitability from its trough in 2001, and a substantial narrowing in market risk premiums. In addition, the burden of underfunded pension plans, perhaps the most prominent negative financial factor that remains, has eased of late. I will discuss each factor in turn. First, firms are continuing to benefit from the accommodative stance of monetary policy. With the federal funds rate at 1 percent, short-term borrowing costs remain very low. For longer-term debt, the combination of low yields on benchmark Treasury securities and reduced risk spreads has kept borrowing costs attractive. Indeed, the yield on Moody’s Baa corporate bond index is at its lowest sustained level since 1968. Second, in response to low long-term rates and to nervous investors who were burned by some highprofile, unanticipated meltdowns, firms have greatly strengthened their balance sheets. Many firms have refinanced high-cost debt, which has reduced the average interest rate on the debt of nonfinancial corporations more than 1 percentage point since the end of 2000. The average cost of servicing debt would have fallen even further if not for a second major trend - the extension of debt maturities. Businesses replaced a substantial portion of their short-maturity debt with long-maturity debt, both to lock in low rates and to improve their ability to withstand a liquidity shock (since long-term debt does not need to be continually rolled over). In addition, many firms - especially in the most troubled industries - have retired debt through equity offerings and asset sales, which limited the growth of nonfinancial corporate debt in 2002 and 2003 to the slowest pace since the early 1990s. Third, firms have significantly tightened their belts. Over the past two years, the drive to cut costs has generated rapid productivity gains. This greater efficiency boosted corporate profitability in 2002 and 2003 despite rather tepid revenue growth. Moreover, a pickup in revenue growth in the second half of last year helped companies leverage those productivity gains, producing a dramatic recovery in overall corporate profitability. Over the course of 2003, operating earnings at S&P 500 corporations surged almost 25 percent, bringing profit margins to their highest levels in several years. Fourth, risk premiums fell substantially last year as corporate governance scandals receded and investor sentiment turned markedly more positive. The recovery in stock prices reflects this brighter view. In addition, spreads on corporate bonds have narrowed appreciably - especially for the riskiest firms - and they now stand at the lowest levels in several years. This decline in spreads has been helped along by the beneficial effect of the balance sheet improvements that I mentioned a moment ago. Indicators of corporate financial stress such as bond rating downgrades and default rates have returned to levels normally associated with economic expansion. Delinquency rates on business loans at commercial banks have also declined, and our surveys indicate that, on balance, banks have recently eased the terms and standards on such loans. In another sign of improved sentiment, money has been flowing into riskier securities. For example, equity mutual funds have registered strong net inflows for nearly a year, as have high-yield bond funds. The more favorable tone in the bond market has been associated with a notable pickup in junkbond deals amid a surge of corporate bond issues. Over the past two quarters, the market for initial public equity offerings has also come back to life; investors appear to be increasingly receptive to new issues, though (fortunately) they still appear to be more selective than during the boom in the late 1990s. These four points all suggest that financial conditions are capable of supporting a sustained, healthy pickup in economic growth. The much improved profitability can help finance expansion directly out of internal funds or indirectly by supporting firms’ borrowing capacity. Furthermore, firms will be able to draw on their liquid assets that have accumulated over the past couple of years. And given the successful efforts to pare costs, firms are set to benefit from new investment in plant and equipment. Perhaps the biggest hurdle still facing many corporations is the burden of underfunding in their defined-benefit (DB) pension plans, but even here we have seen some improvement from the situation a year ago. At that time, the value of pension assets had been significantly eroded by stock market losses, and sharply declining interest rates had raised the present value of plan liabilities. Just among the firms in the S&P 500, the combined effect was to subtract nearly half a trillion dollars from the net asset value of DB pension plans during 2000, 2001, and 2002. As a result, 90 percent of S&P 500 plans were underfunded at the end of 2002, with a net shortfall that exceeded more than $200 billion. Most companies with DB plans thus needed to make additional contributions to their pension plans, in some cases quite substantial contributions. For many, this situation was a sea change from the multiyear contribution holiday they experienced during the 1990s. Indeed, in 2002, S&P 500 firms contributed $46 billion to their pension plans - three times more than in either of the previous two years - and total contributions are estimated to have been even higher in 2003. But this drain on cash resources is likely to decline, or at least not worsen, over the next few years. DB pension assets have benefited from robust returns in equity markets since early last year, and pension liabilities are estimated to have risen only modestly in 2003. Automakers, in particular, have already bitten the bullet; together with the solid returns earned on plan assets last year, their cash contributions have apparently helped to wipe out much of their funding deficit. So what is the longer-term prognosis for firms with DB pensions? Assuming current discount rates and normal pension asset returns, S&P 500 firms would eventually need to make about $150 billion in contributions to close the remaining funding gap. And once the current funding hole is filled, these firms would still need to make contributions to cover their rising liabilities. Indeed, DB plans are increasingly concentrated in mature industries with aging workforces, for which the growth rate of liabilities is relatively high and rising. This longer-term challenge will remain even if the current favorable market conditions are sustained. Conclusion In summary, recent indicators suggest that the pace of economic activity remains solid, while inflationary pressures continue to be subdued. In addition, the household and business sectors are, by and large, in good financial shape. Although uncertainties remain, I believe the fundamentals are in place to generate sustainable economic growth.
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board of governors of the federal reserve system
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the Stanford Institute for Economic Policy Research Economic Summit, Stanford, California, 27 February 2004.
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Alan Greenspan: Intellectual property rights Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the Stanford Institute for Economic Policy Research Economic Summit, Stanford, California, 27 February 2004. * * * Market economies require a rule of law. A society without state protection of individual rights, especially the right to own property, would not build private long-term assets, a key ingredient of a growing modern economy. Since its early stirrings in eighteenth-century Britain, modern economic development has been characterized by an ebb and flow in the intensity of state involvement in shaping the economic environment. According to the legends of the early American West, the only law west of the Pecos River was administered by Judge Bean. I am not sure how much law that was, but I do know that much protection of property in sparsely settled western communities just after the Civil War had to be privately provided. Understandably, trade was limited in such an environment. Economic growth was greatly facilitated by the emergence of civil government, which provided, among other things, consistent and predictable enforcement of property rights. More recently, the states of the former Soviet Union suffered for a time many of the alleged characteristics of the American Wild West-legal chaos, rampant criminality, and widespread corruption. This difficult period of transition in the Soviet satellite countries followed four decades of central planning in which the arbitrary enforcement of an inefficient set of rules resulted in massive economic failure. With few exceptions, the new leaders of these countries recognize that their future economic success will depend on an efficient and predictable rule of law. *** A tension has always existed between a desired continuity in the laws and regulations governing trade and business practices and the necessary updating that is required to keep pace with a growing and, hence, changing economy. Uncertainties that stem from the arbitrary enforcement of the body of prevailing rules result in higher risk and an associated elevation of the cost of capital, which in turn inhibits economic growth. Implementing an effective rule of law, however, has its own difficulties. One key component, a law of contracts, governs the resolution of certain disputes between parties. Yet if adjudication were requested for more than a very small fraction of contracts, our court system would be swamped into immobility and the performance of our economy would suffer. Thus, if our market system is to function smoothly, the vast majority of trades must rest on mutual trust and only indirectly on the law. A more general concern is that laws can never be fixed in perpetuity. As societies and economies evolve, the details of the law, though generally not its fundamental principles, need to change. But any uncertainty about the clarity and fixity of the law adds to the risk of trade, which as I noted, is reflected in a higher real cost of capital. We in the United States endeavored to lessen legal uncertainty by embedding our most fundamental principles in a constitution, which we made difficult to amend. The commercially and economically salient specifics are typically expressed in federal or state statutes. In general, this arrangement seems to have provided us with a healthy balance of continuity and predictability and, yet, also the requisite flexibility to respond to evolving economic and societal circumstances. *** Reflecting that flexibility, the direction and the emphasis of legislative revision over the generations have mirrored the changing structure of our economy. In recent decades, for example, the fraction of the total output of our economy that is essentially conceptual rather than physical has been rising. This trend has, of necessity, shifted the emphasis in asset valuation from physical property to intellectual property and to the legal rights inherent in intellectual property. Though the shift may appear glacial, its impact on legal and economic risk is beginning to be felt. Over the past half-century, the increase in the value of raw materials has accounted for only a fraction of the overall growth of U.S. gross domestic product (GDP). The rest of that growth reflects the embodiment of ideas in products and services that consumers value. This shift of emphasis from physical materials to ideas as the core of value creation appears to have accelerated in recent decades. Technological advance is continually altering the shape and nature of our economic processes and, in particular, is promoting the trend toward increasing conceptualization of U.S. GDP. The size of our radios, for example, has been dramatically reduced by the substitution of transistors for vacuum tubes. Thin fiber optic cable has replaced huge tonnages of copper wire. New architectural, engineering, and materials technologies have enabled the construction of buildings enclosing the same space with far less physical material than was required, say, 50 or 100 years ago. More recently, mobile phones have markedly downsized as they have improved. The movement over the decades toward production of services requiring little physical input has also been a major contributor to the marked rise in the ratio of constant dollars of GDP to ton of input. This dramatic shift toward product downsizing during the past half-century stems from several causes. The challenge of accumulating physical goods and moving them in an ever more crowded geographical environment has clearly resulted in cost pressures to economize on size and space. Similarly, the prospect of increasing costs of discovering, developing, and processing ever-larger quantities of physical resources has shifted producers toward downsized alternatives. This shift appears effectively to have answered the dire concerns that were expressed, in a report from the Club of Rome three decades ago, about the prospects of running out of the physical resources that allegedly were necessary to support our standards of living. Another cause of product downsizing is that, as we moved the technological frontier forward and pressed for information processing to speed up, the laws of physics required the relevant microchips to become ever more compact. More generally, in the realm of physical production, where scarce resources are critical inputs, each additional unit of output is usually more costly to produce than the previous one; that is, production, at least eventually, is characterized by increasing marginal cost. By contrast, in the realm of conceptual output, much of production is characterized by constant, and perhaps even zero, marginal cost. For example, though the set-up cost of creating an on-line encyclopedia may be enormous, the cost of reproduction and distribution may be near zero if the means of distribution is the Internet. The emergence of an electronic platform for the transmission of ideas at negligible marginal cost may, therefore, be an important factor explaining the recent increased conceptualization of the GDP. The demand for conceptual products is clearly impeded to a much smaller degree by rising marginal cost than is the demand for physical products. But regardless of its causes, conceptualization is irreversibly increasing the emphasis on the protection of intellectual, relative to physical, property rights. Before World War I, markets in this country were essentially uninhibited by government regulations, but they were supported by rights to property, which in those years largely meant physical property. Intellectual property - patents, copyrights, and trademarks - represented a far less important component of the economy, which was mainly agricultural. One of the most significant inventions of the nineteenth century was the cotton gin. Perhaps it was a harbinger of things to come that the intellectual-property content of the cotton gin was never effectively protected from copiers. Only in recent decades, as the economic product of the United States has become so predominantly conceptual, have issues related to the protection of intellectual property rights come to be seen as significant sources of legal and business uncertainty. In part, this uncertainty derives from the fact that intellectual property is importantly different from physical property. Because they have a material existence, physical assets are more capable of being defended by police, the militia, or private mercenaries. By contrast, intellectual property can be stolen by an act as simple as broadcasting an idea without the permission of the originator. Moreover, one individual's use of an idea does not make that idea unavailable to others for their own simultaneous use. Even more importantly, new ideas - the building blocks of intellectual property - almost invariably build on old ideas in ways that are difficult or impossible to trace. From an economic perspective, this provides a rationale for making calculus, developed initially by Leibnitz and Newton, freely available, despite the fact that those insights have immeasurably increased wealth over the generations. Should we have protected their claim in the same way that we do for owners of land? Or should the law make their insights more freely available to those who would build on them, with the aim of maximizing the wealth of the society as a whole? Are all property rights inalienable, or must they conform to a reality that conditions them? These questions bedevil economists and jurists, for they touch on some fundamental principles governing the organization of a modern economy and, hence, its society. Whether we protect intellectual property as an inalienable right or as a privilege vouchsafed by the sovereign, such protection inevitably entails making some choices that have crucial implications for the balance we strike between the interests of those who innovate and those who would benefit from innovation. In the case of physical property, we take it for granted that the ownership right should have the potential of persisting as long as the physical object itself. In the case of an idea, however, we have chosen to strike a different balance in recognition of the chaos that could follow from having to trace back all the thoughts implicit in one's current undertaking and pay a royalty to the originator of each one. So rather than adopting that principled but obviously unworkable approach, we have chosen instead to follow the lead of British common law and place time limits on intellectual property rights. It is, thus, no surprise that, as a result of the increasing conceptualization of our GDP over the decades, the protection of intellectual property has become an important element in the ongoing deliberations of both economists and jurists. Of particular current relevance to our economy overall is the application of property right protection to information technology. A noticeable component of the surge in the trend growth of the economy in recent years arguably reflects the benefits that we have derived from the synergy of laser and fiber optic technologies in the 1960s and 1970s. This synergy has produced very little that is tangible in information technology. Yet the information flow that it facilitates has fostered the creation of vast amounts of wealth. The dramatic gains in information technology have markedly improved the ability of businesses to identify and address incipient economic imbalances before they inflict significant damage. These gains reflect new advances in both the physical and the conceptual realms. It is imperative to find the appropriate intellectual property regime for each. *** If our objective is to maximize economic growth, are we striking the right balance in our protection of intellectual property rights? Are the protections sufficiently broad to encourage innovation but not so broad as to shut down follow-on innovation? Are such protections so vague that they produce uncertainties that raise risk premiums and the cost of capital? How appropriate is our current system - developed for a world in which physical assets predominated - for an economy in which value increasingly is embodied in ideas rather than tangible capital? The importance of such questions is perhaps most readily appreciated here in Silicon Valley. Rationalizing the differences between intellectual property rights as defined and enforced in the United States and those of our trading partners has emerged as a seminal issue in our trade negotiations. If the form of protection afforded to intellectual property rights affects economic growth, it must do so by increasing the underlying pace of output per labor hour, our measure of productivity growth. Ideas are at the center of productivity growth. Multifactor productivity by definition attempts to capture product innovations and insights in the way that capital and labor are organized to produce output. Ideas are also embodied directly in the capital that we employ. In essence, the growth of productivity attributable to factors other than indigenous natural resources and labor skill, is largely a measure of the contribution of ideas to economic growth and to our standards of living. Understanding the interplay of ideas and economic growth should be an area of active economic analysis, which for so many generations has focused mainly on physical things. This work will not be easy. Even as straightforward an issue as isolating the effect of the length of patents on overall economic growth, a prominent issue recently before our Supreme Court, poses obvious formidable challenges. Still, we must begin the important work of developing a framework capable of analyzing the growth of an economy increasingly dominated by conceptual products.
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board of governors of the federal reserve system
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Economic Club of New York, New York, 2 March 2004.
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Alan Greenspan: Current account Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Economic Club of New York, New York, 2 March 2004. * * * It has been a number of years since the foreign exchange rate of the dollar has played so prominent a role in evaluations of economic activity. I have no intention today of discussing the foreign exchange policy of the United States. That is the province of the Secretary of the Treasury. Nor do I intend to project exchange rates. My experience is that exchange markets have become so efficient that virtually all relevant information is embedded almost instantaneously in exchange rates to the point that anticipating movements in major currencies is rarely possible. The exceptions to this conclusion are those few cases of successful speculation in which governments have tried and failed to support a particular exchange rate. Nonetheless, despite extensive efforts on the part of analysts, to my knowledge, no model projecting directional movements in exchange rates is significantly superior to tossing a coin. I am aware that of the thousands who try, some are quite successful. So are winners of coin-tossing contests. The seeming ability of a number of banking organizations to make consistent profits from foreign exchange trading likely derives not from their insight into future rate changes but from market making. This may seem a rather surprising conclusion, given that so many commentators apparently believe that they know the real value of the dollar must decline further because of the record current account deficit of the United States. It should be sobering to recall that three years ago - February 2001 - to be exact for similar reasons a vast majority of a large panel of forecasters were projecting a lower dollar against the euro. In the subsequent twelve months, the dollar rose nearly 6 percent against the euro. Rather than engage in exchange rate forecasting, today I will discuss certain developments in foreign exchange markets, and in the international financial system in general, which bear on the ultimate outcome of our current account adjustment process. Before raising the broader issues of adjustment, I should like to address the actions of certain of the players in the exchange market that are likely to delay the adjustment process, but only for a time. I refer to the heavy degree of intervention by East Asian monetary authorities, especially in Japan and China, and the apparent stepped up hedging of currency movements by exporters, especially in Europe. As all of you who follow these markets are aware, since the start of 2002, the extraordinary purchases by Asian central banks and governments of dollar assets, largely those by Japan and China, have totaled almost $240 billion, all in an apparent attempt to prevent their currencies from rising against the dollar. In particular, total foreign exchange reserves for China reached $420 billion in November of last year and for Japan more than $650 billion in December. The awesome size of Japan's accumulation results from persistent intervention to suppress what Japanese authorities have judged is a dollar-yen exchange rate that is out of line with fundamentals. One factor boosting the yen is a significant yen bias on the part of Japanese investors. This propensity, in my judgment, runs far beyond the normal tendency of investors worldwide to buy familiar domestic assets and eschew foreign-exchange risk. Nowhere else in the world will investors voluntarily purchase ten-year government obligations at an interest rate of 1 percent or less, especially given a rate of increase in the outstanding supply of government debt that has generally been running at 9 percent over the past year. Not surprisingly, very few Japanese government bonds (JGBs) are held outside of Japan. Aside from the holdings of the Bank of Japan, almost all JGBs are held by Japanese households, banks, insurance companies and the postal saving system. And none of them holds significant amounts of foreign assets; 99 percent of household assets are in yen, and, including the postal saving system, about 91 percent of the assets of financial institutions are in yen. Japanese nonfinancial corporations do hold a larger share of foreign assets in their securities' portfolios, but the absolute amounts are small. The Japanese have made significant foreign direct investments, especially in the United States, and the Ministry of Finance does, of course, hold large dollar balances as a consequence of exchange rate intervention. But the Japanese private sector, by and large, has exhibited limited interest in accumulating dollar or other foreign assets, removing what in other large trading economies would be a significant segment of demand for foreign assets. The degree of domestic currency bias in Japan, which far exceeds that of its trading partners, may thus have contributed to a foreign exchange rate for the yen that appears to be elevated relative to the dollar and possibly other internationally traded currencies as well.1 Of course, this preference for yen assets, while a persistent influence on the value of the yen, has at times been overwhelmed by other factors. Granted the level of intervention pursued by the Japanese monetary authorities has influenced the market value of the yen, but the size of the impact is difficult to judge. In any event, it must be presumed that the rate of accumulation of dollar assets by the Japanese government will have to slow at some point and eventually cease. For now, partially unsterilized intervention is perceived as a means of expanding the monetary base of Japan, a basic element of monetary policy. (The same effect, of course, is available through the purchase of domestic assets.) In time, however, as the present deflationary situation abates, the monetary consequences of continued intervention could become problematic. The current performance of the Japanese economy suggests that we are getting closer to the point where continued intervention at the present scale will no longer meet the monetary policy needs of Japan. China is a similar story. In order to maintain the tight relationship with the dollar initiated in the 1990s, the Chinese central bank has chosen to purchase large quantities of U.S. Treasury securities with renminbi. What is not clear is how much of the current upward pressure on the currency results from underlying market forces, how much from capital inflows owing to speculation on potential revaluation, and how much from capital controls that suppress the demand of Chinese residents for dollars and other currencies. No one truly knows whether easing or ending capital controls would lessen pressure on the currency and, in the process, also eliminate inflows from speculation on a revaluation. Many in China, however, fear that an immediate ending of controls could induce capital outflows large enough to destabilize the nation's improving, but still fragile, banking system. Others believe that decontrol, but at a gradual pace, could conceivably avoid such an outcome. Chinese central bank purchases of dollars, unless offset, threaten an excess of so-called high-powered money expansion and a consequent overheating of the Chinese economy. The Chinese central bank last year offset - that is, sterilized - much of its heavy dollar purchases by reducing its loans to commercial banks, by selling bonds, and by increasing reserve requirements. But the ratio of the money supply to the monetary base in China has been rising steadily for a number of years as financial efficiency improves. Thus the modest rise that has occurred in currency and commercial bank reserves has been enough to support a twelve-month growth of the M2 money supply in the neighborhood of 20 percent through 2003 and a bit less so far this year. Should this pattern continue, the central bank will be confronted with the choice of curtailing its purchases of dollar assets or facing an overheated economy with the associated economic instabilities. Lesser dollar purchases presumably would allow the renminbi, at least temporarily, to appreciate against the dollar. Other East Asian monetary authorities, in an endeavor to hold their currencies at a par with the yen and the renminbi, accumulated about $120 billion in reserves in 2003 and appear to have continued that rate of intervention since. *** There is a general view that this heavy intervention places upward pressure on the euro. It is assumed that the dollar's trade-weighted exchange rate reflects its worldwide fundamentals, and therefore if the Asian currencies are being suppressed, the euro and other non-Asian currencies need to appreciate as an offset. But a more likely possibility is that Asian currency intervention has had little effect on other currencies and that the trade-weighted average of the dollar is, thus, somewhat elevated relative to the rate that would have prevailed absent intervention. When Asian authorities intervene to ease their currencies against the dollar, they purchase dollar-denominated assets from private sector portfolios. With fewer The yen bias certainly existed in earlier decades, but it has become more evident as Japanese growth slowed. dollar assets in private hands, the natural inclination to rebalance portfolios will tend to buoy the dollar even against currencies that are not used in intervention operations, including the euro. These transactions raise the dollar against, for example, the yen, lower the yen against the euro, and lower the euro against the dollar. The strength of the euro against the dollar thus appears to be the consequence of forces unrelated to Asian intervention. As I will explain later, this does not mean that when Asian intervention ceases the dollar will automatically fall because other influences on the dollar cannot be foreseen. Some have argued that purchases of U.S. Treasuries by Asian officials are holding down interest rates on these instruments, and therefore U.S. interest rates are likely to rise as intervention by Asian monetary authorities slows, ceases, or even turns to net sales. While there are obvious reasons to be concerned about such an outcome, the effect of a reduction in the scale of intervention, or even net sales, on U.S. financial markets would likely be small. The reason is that central bank reserves are heavily concentrated in short-term maturities; moreover, the overall market in short-term dollar assets, combining both public and private instruments, is huge relative to the size of asset holdings of Asian monetary authorities. And because these issues are short-term and hence capable of only limited price change, realized capital losses, if any, would be small. Accordingly, any incentive for monetary authorities to sell dollars, in order to preserve market value, would be muted. *** A different issue arises with the apparent level of hedging by exporters in Europe and elsewhere. The effect, however, is the same as Asian official intervention: It slows the process of adjustment. Against a broad basket of currencies of our trading partners, the foreign exchange value of the U.S. dollar has declined about 12 percent from its peak in early 2002. Ordinarily, currency depreciation is accompanied by a rise in the dollar prices of our imported goods and services, because foreign exporters seek to avoid price declines in their own currencies, which would otherwise result from the fall in the foreign exchange value of the dollar. Reflecting the swing from dollar appreciation to dollar depreciation, the dollar prices of goods and services imported into the United States have begun to rise after declining on balance for several years. But the turnaround to date has been moderate and far short of that implied by the exchange rate change. Apparently, foreign exporters have been willing to absorb some of the price decline measured in their own currencies and the consequent squeeze on profit margins it entails in order to hold market share. In fact, given that the nearly 9 percent rise in dollar prices of goods imported from western Europe since the start of 2002 has been far short of the rise in the euro, profit margins of euro-area exporters to the United States may well have turned negative. Nonetheless, euro-area exports to the United States, when expressed in euros, have slowed only modestly. A possible reason is that European exporters' incentives to sell to the United States were diminished significantly less than indicated by the dollar price and exchange rate movements owing to accelerated short forward positions against the dollar in foreign exchange markets. A marked increase in foreign exchange derivative trading, especially in dollar-euro, according to the Bank for International Settlements, is consistent with increased hedging of exports to the United States and to other markets that use currencies tied to the U.S. dollar.2 However, most contracts are short-term because long-term hedging is expensive. Thus, although hedging may delay, and perhaps even smooth out, the adjustment, it cannot eliminate, without prohibitive cost, the consequences of exchange rate change. Accordingly, the currency depreciation that we have experienced of late should eventually help to contain our current account deficit as foreign producers export less to the United States. On the other side of the ledger, the current account should improve as U.S. firms find the export market more receptive. But in the process, dollar prices of imports will surely rise. *** When the temporary forestalling of the U.S. balance of payments adjustment process comes to an end, does that suggest a steepening of the decline in the dollar's exchange rate? That many exports even from Europe are priced in dollars is a trading convention. It does not affect the costs in domestic currencies that exporters incur. As I pointed out in the beginning, the most sophisticated analytical techniques have been unable to profitably project the exchange rates of major currencies. Yet, most commentators argue that because the current account deficit must eventually narrow, the price-adjusted value of the dollar must accordingly decline. But how can exchange rates and the current account be systematically related, if exchange rates are inherently unpredictable? The answer is that the point at which the U.S. current account deficit will be forced to narrow is itself inherently difficult to predict. The current account reflects the myriad forces that bring our transactions with foreign economies into balance at our borders, of which exchange rates are only one. But those forces that, in the end, are reflected in a current account surplus or deficit are both domestic and foreign. Indeed, our current account balance can be shown to be exactly equal to the difference between domestic saving and domestic investment. In fact, it is often instructive in longer-term analysis to view our current account in terms of its domestic counterparts. As I pointed out in a speech last November,3 virtually all of our trading partners share our inclination to invest a disproportionate percentage of domestic savings in domestic capital assets, irrespective of their differential rates of return. People seem to prefer to invest in familiar local businesses even where currency and country risks do not exist. For the United States, studies have shown that individual investors and even professional money managers have a slight preference for investments in their own communities and states. Trust, so crucial an aspect of investing, is most likely to be fostered by the familiarity of local communities. As a consequence, “home bias” will likely continue to constrain the movement of world savings into its optimum use as capital investment, thus limiting the internationalization of financial intermediation and hence the growth of external assets and liabilities and the dispersion of world current account balances that such growth implies. Nonetheless, during the past decade, home bias has apparently declined significantly. For most of the earlier post World War II era, the correlation between domestic saving rates and domestic investment rates across the world's major economies, a conventional measure of home bias, was exceptionally high.4 For the member countries of the Organization for Economic Cooperation and Development (OECD) , the GDP-weighted correlation coefficient was 0.97 in 1970. However, it fell from 0.96 in 1992 to less than 0.8 in 2002. For OECD countries excluding the United States, the recent decline is even more pronounced. These declines, not surprisingly, mirror the rise in the differences between saving and investment or, equivalently, of the dispersion of current account balances over the same years. The decline in home bias probably reflects an increased international tendency for financial systems to be more transparent, open, and supportive of strong investor protection.5 Moreover, vast improvements in information and communication technologies have broadened investors' vision to the point that foreign investment appears less exotic and risky. Accordingly, the trend of declining home bias and expanding international financial intermediation will likely continue. This process has enabled the United States to incur and finance a much larger current account deficit than would have been feasible in earlier decades. It is quite difficult to contemplate foreign savings in an amount equivalent to 5 percent of U.S. GDP being transferred to the United States two or three decades ago. *** It is unclear whether the burden of servicing our growing external liabilities or the rising weight of U.S. assets in global portfolios will impose the greater restraint on current account dispersion over the longer term. Either way, when that point arrives, will the process of reining in our current account deficit be benign to the economies of the United States and the world? Alan Greenspan, speech at the 21st Annual Monetary Conference, cosponsored by the Cato Institute and the Economist, Washington, D.C., November 20, 2003. See Martin Feldstein and Charles Horioka, “Domestic Saving and International Capital Flows,” The Economic Journal, June 1980, 314-29. Research indicates that home bias in investment toward a foreign country is likely to be diminished to the extent that the country's financial system offers transparency, accessibility, and investor safeguards. See Alan Ahearne, William Griever, and Frank Warnock, “Information Costs and Home Bias: An Analysis of U.S. Holdings of Foreign Equities,” Journal of International Economics, March 2004, pages 313 36. According to a Federal Reserve staff study, current account deficits that emerged among developed countries since 1980 have risen as high as double-digit percentages of GDP before markets enforced a reversal.6 The median high has been about 5 percent of GDP. Complicating the evaluation of the timing of a turnaround is that deficit countries, both developed and emerging, borrow in international markets largely in dollars rather than in their domestic currency. The United States has been rare in its ability to finance its external deficit in a reserve currency. This ability has presumably enlarged the capability of the United States relative to most of our trading partners to incur foreign debt. Besides experiences with the current account deficits of other countries, there are few useful guideposts of how high our country's net foreign liabilities can mount. The foreign accumulation of U.S. assets would likely slow if dollar assets, irrespective of their competitive return, came to occupy too large a share of the world's portfolio of store of value assets. In these circumstances, investors would seek greater diversification in non-dollar assets. At the end of 2002, U.S. dollars accounted for about 65 percent of the foreign exchange reserves of foreign monetary authorities, with the euro second at 19 percent. Approximately half of private cross-border holdings were denominated in dollars, with one-third in euros. *** More important than the way that the adjustment of the U.S. current account deficit will be initiated is the effect of the adjustment on both our economy and the economies of our trading partners. The history of such adjustments has been mixed. According to the aforementioned Federal Reserve study of current account corrections in developed countries, although the large majority of episodes were characterized by some significant slowing of economic growth, most economies managed the adjustment without crisis. The institutional strengths of many of these developed economies - rule of law, transparency, and investor and property protection - likely helped to minimize disruptions associated with current account adjustments. The United Kingdom, however, had significant adjustment difficulties in its early postwar years, as did, more recently, Mexico, Thailand, Korea, Russia, Brazil, and Argentina, to name just a few. Can market forces incrementally defuse a worrisome buildup in a nation's current account deficit and net external debt before a crisis more abruptly does so? The answer seems to lie with the degree of flexibility in both domestic and international markets. In domestic economies that approach full flexibility, imbalances are likely to be adjusted well before they become potentially destabilizing. In a similarly flexible world economy, as debt projections rise, product and equity prices, interest rates, and exchange rates could change, presumably to reestablish global balance. The experience over the past two centuries of trade and finance among the individual states that make up the United States comes close to that paradigm of flexibility even though exchange rates among the states have been fixed. Although we have scant data on cross-border transactions among the separate states, anecdotal evidence suggests that over the decades significant apparent imbalances have been resolved without precipitating interstate balance of payments crises. The dispersion of unemployment rates among the states, one measure of imbalances, spikes during periods of economic stress but rapidly returns to modest levels, reflecting a high degree of adjustment flexibility. That flexibility is even more apparent in regional money markets, where interest rates that presumably reflect differential imbalances in states' current accounts and hence cross-border borrowing requirements have, in recent years, exhibited very little interstate dispersion. This observation suggests either negligible cross-state-border imbalances, an unlikely occurrence given the pattern of state unemployment dispersion, or more likely very rapid financial adjustments. *** We may not be able to usefully determine at what point foreign accumulation of net claims on the United States will slow or even reverse, but it is evident that the greater the degree of international flexibility, the less the risk of a crisis.7 The experience of the United States over the past three years is Caroline Freund, “Current Account Adjustment in Industrialized Countries,” Board of Governors of the Federal Reserve System, International Finance Discussion Paper No. 692, December 2000. Although increased flexibility apparently promotes resolution of current account imbalances without significant disruption, it may also allow larger deficits to emerge before markets are required to address them. illustrative. The apparent ability of our economy to withstand a number of severe shocks since mid 2000, with only a small decline in real GDP, attests to the marked increase in our economy's flexibility over the past quarter century.8 *** In evaluating the nature of the adjustment process, we need to ask whether there is something special in the dollar being the world's primary reserve currency. With so few historical examples of dominant world reserve currencies, we are understandably inclined to look to the experiences of the dollar's immediate predecessor. At the height of sterling's role as the world's currency more than a century ago, Great Britain had net external assets amounting to some 150 percent of its annual GDP, most of which were lost in World Wars I and II. Britain in the early post World War II period was hobbled with periodic sterling crises when much of the remnants of Empire endeavored to disengage themselves from heavy reliance on holding sterling assets as central bank reserves and private stores of value. The experience of Britain's then extensively regulated economy, harboring many wartime controls well beyond the end of hostilities, provides testimony to the costs of structural rigidity in times of crisis. *** Should globalization be allowed to proceed and thereby create an ever more flexible international financial system, history suggests that the odds are favorable that current imbalances will be defused with little disruption to the economy or financial markets. But there are other outcomes that are less benign, and we must endeavor to limit the likelihood of these outcomes. One avenue by which to lessen the risk of a more difficult adjustment is for us to restore fiscal discipline. The rise in national saving that would accompany a reduction in the federal budget deficit will alleviate some of the burden of adjustment that would otherwise be required of the private sector through movements in asset prices. Even more worrisome than the lack of fiscal restraint are the clouds of emerging protectionism that have become increasingly visible on today's horizon. Over the years, protected interests have often endeavored to stop in its tracks the process of unsettling economic change. Pitted against the powerful forces of market competition, virtually all such efforts have failed. The costs of any new such protectionist initiatives, in the context of wide current account imbalances, could significantly erode the flexibility of the global economy. Consequently, it is imperative that creeping protectionism be thwarted and reversed. See Alan Greenspan, remarks before a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 30, 2002.
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board of governors of the federal reserve system
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Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the H Parker Willis Lecture in Economic Policy, Washington and Lee University, Lexington, Virginia, 2 March 2004.
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Ben S Bernanke: Money, gold and the Great Depression Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the H Parker Willis Lecture in Economic Policy, Washington and Lee University, Lexington, Virginia, 2 March 2004. The references for the speech can be found on the Board of Governors of the Federal Reserve System’s website. * * * I am pleased to be able to present the H. Parker Willis Lecture in Economic Policy here at Washington and Lee University. As you may know, Willis was an important figure in the early history of my current employer, the Federal Reserve System. While he was a professor at Washington and Lee, Willis advised Senator Carter Glass of Virginia, one of the key legislators involved in the founding of the Federal Reserve. Willis also served on the National Monetary Commission, which recommended the creation of the Federal Reserve, and he went on to become the research director at the Federal Reserve from 1918 to 1922. At the Federal Reserve, Willis pushed for the development of new and better economic statistics, facing the resistance of those who took the view that too many facts only confuse the issue. Willis was also the first editor of the Federal Reserve Bulletin, the official publication of the Fed, which in Willis's time as well as today provides a wealth of economic statistics. As an illustration of the intellectual atmosphere in Washington at the time he served, Willis reported that when the first copy of the Bulletin was presented to the Secretary of the Treasury, the esteemed Secretary replied, “This Government ain't going into the newspaper business.” Like Parker Willis, I was a professor myself before coming to the Federal Reserve Board. One topic of particular interest to me as a researcher was the performance of the Federal Reserve in its early days, particularly the part played by the young U.S. central bank in the Great Depression of the 1930s.1 In honor of Willis's important contribution to the design and creation of the Federal Reserve, I will speak today about the role of the Federal Reserve and of monetary factors more generally in the origin and propagation of the Great Depression. Let me offer two caveats before I begin: First, as I mentioned, H. Parker Willis resigned from the Fed in 1922, to take a post at Columbia University; thus, he is not implicated in any of the mistakes that the Federal Reserve made in the late 1920s and early 1930s. Second, the views I will express today are my own and are not necessarily those of my colleagues in the Federal Reserve System. The number of people with personal memory of the Great Depression is fast shrinking with the years, and to most of us the Depression is conveyed by grainy, black-and-white images of men in hats and long coats standing in bread lines. However, although the Depression was long ago - October this year will mark the seventy-fifth anniversary of the famous 1929 stock market crash - its influence is still very much with us. In particular, the experience of the Depression helped forge a consensus that the government bears the important responsibility of trying to stabilize the economy and the financial system, as well as of assisting people affected by economic downturns. Dozens of our most important government agencies and programs, ranging from social security (to assist the elderly and disabled) to federal deposit insurance (to eliminate banking panics) to the Securities and Exchange Commission (to regulate financial activities) were created in the 1930s, each a legacy of the Depression. The impact that the experience of the Depression has had on views about the role of the government in the economy is easily understood when we recall the sheer magnitude of that economic downturn. During the major contraction phase of the Depression, between 1929 and 1933, real output in the United States fell nearly 30 percent. During the same period, according to retrospective studies, the unemployment rate rose from about 3 percent to nearly 25 percent, and many of those lucky enough to have a job were able to work only part-time. For comparison, between 1973 and 1975, in what was perhaps the most severe U.S. recession of the World War II era, real output fell 3.4 percent and the unemployment rate rose from about 4 percent to about 9 percent. Other features of the 1929-33 decline included a sharp deflation - prices fell at a rate of nearly 10 percent per year during the early 1930s - as well as a plummeting stock market, widespread bank failures, and a rash of defaults and bankruptcies by businesses and households. The economy improved after Franklin D. Roosevelt's inauguration in March 1933, but unemployment remained in the double digits for the rest of the My professional articles on the Depression are collected in Bernanke (2000). decade, full recovery arriving only with the advent of World War II. Moreover, as I will discuss later, the Depression was international in scope, affecting most countries around the world not only the United States. What caused the Depression? This question is a difficult one, but answering it is important if we are to draw the right lessons from the experience for economic policy. Solving the puzzle of the Depression is also crucial to the field of economics itself because of the light the solution would shed on our basic understanding of how the economy works. During the Depression years and for many decades afterward, economists disagreed sharply on the sources of the economic and financial collapse of the 1930s. In contrast, during the past twenty years or so economic historians have come to a broad consensus about the causes of the Depression. A widening of the geographic focus of Depression research deserves much of the credit for this breakthrough. Before the 1980s, research on the causes of the Depression had considered primarily the experience of the United States. This attention to the U.S. case was appropriate to some degree, as the U.S. economy was then, as it is today, the world's largest; the decline in output and employment in the United States during the 1930s was especially severe; and many economists have argued that, to an important extent, the worldwide Depression began in the United States, spreading from here to other countries (Romer, 1993). However, in much the same way that a medical researcher cannot reliably infer the causes of an illness by studying one patient, diagnosing the causes of the Depression is easier when we have more patients (in this case, more national economies) to study. To explain the current consensus on the causes of the Depression, I will first describe the debate as it existed before 1980, and then discuss how the recent focus on international aspects of the Depression and the comparative analysis of the experiences of different countries have helped to resolve that debate. I have already mentioned the sharp deflation of the price level that occurred during the contraction phase of the Depression, by far the most severe episode of deflation experienced in the United States before or since. Deflation, like inflation, tends to be closely linked to changes in the national money supply, defined as the sum of currency and bank deposits outstanding, and such was the case in the Depression. Like real output and prices, the U.S. money supply fell about one-third between 1929 and 1933, rising in subsequent years as output and prices rose. While the fact that money, prices, and output all declined rapidly in the early years of the Depression is undeniable, the interpretation of that fact has been the subject of much controversy. Indeed, historically, much of the debate on the causes of the Great Depression has centered on the role of monetary factors, including both monetary policy and other influences on the national money supply, such as the condition of the banking system. Views have changed over time. During the Depression itself, and in several decades following, most economists argued that monetary factors were not an important cause of the Depression. For example, many observers pointed to the fact that nominal interest rates were close to zero during much of the Depression, concluding that monetary policy had been about as easy as possible yet had produced no tangible benefits to the economy. The attempt to use monetary policy to extricate an economy from a deep depression was often compared to “pushing on a string.” During the first decades after the Depression, most economists looked to developments on the real side of the economy for explanations, rather than to monetary factors. Some argued, for example, that overinvestment and overbuilding had taken place during the ebullient 1920s, leading to a crash when the returns on those investments proved to be less than expected. Another once-popular theory was that a chronic problem of “under-consumption” - the inability of households to purchase enough goods and services to utilize the economy's productive capacity - had precipitated the slump. However, in 1963, Milton Friedman and Anna J. Schwartz transformed the debate about the Great Depression. That year saw the publication of their now-classic book, A Monetary History of the United States, 1867-1960. The Monetary History, the name by which the book is instantly recognized by any macroeconomist, examined in great detail the relationship between changes in the national money stock - whether determined by conscious policy or by more impersonal forces such as changes in the banking system - and changes in national income and prices. The broader objective of the book was to understand how monetary forces had influenced the U.S. economy over a nearly a century. In the process of pursuing this general objective, however, Friedman and Schwartz offered important new evidence and arguments about the role of monetary factors in the Great Depression. In contradiction to the prevalent view of the time, that money and monetary policy played at most a purely passive role in the Depression, Friedman and Schwartz argued that “the [economic] contraction is in fact a tragic testimonial to the importance of monetary forces” (Friedman and Schwartz, 1963, p. 300). To support their view that monetary forces caused the Great Depression, Friedman and Schwartz revisited the historical record and identified a series of errors - errors of both commission and omission - made by the Federal Reserve in the late 1920s and early 1930s. According to Friedman and Schwartz, each of these policy mistakes led to an undesirable tightening of monetary policy, as reflected in sharp declines in the money supply. Drawing on their historical evidence about the effects of money on the economy, Friedman and Schwartz argued that the declines in the money stock generated by Fed actions - or inactions - could account for the drops in prices and output that subsequently occurred.2 Friedman and Schwartz emphasized at least four major errors by U.S. monetary policymakers. The Fed's first grave mistake, in their view, was the tightening of monetary policy that began in the spring of 1928 and continued until the stock market crash of October 1929 (see Hamilton, 1987, or Bernanke, 2002a, for further discussion). This tightening of monetary policy in 1928 did not seem particularly justified by the macroeconomic environment: The economy was only just emerging from a recession, commodity prices were declining sharply, and there was little hint of inflation. Why then did the Federal Reserve raise interest rates in 1928? The principal reason was the Fed's ongoing concern about speculation on Wall Street. Fed policymakers drew a sharp distinction between “productive” (that is, good) and “speculative” (bad) uses of credit, and they were concerned that bank lending to brokers and investors was fueling a speculative wave in the stock market. When the Fed's attempts to persuade banks not to lend for speculative purposes proved ineffective, Fed officials decided to dissuade lending directly by raising the policy interest rate. The market crash of October 1929 showed, if anyone doubted it, that a concerted effort by the Fed can bring down stock prices. But the cost of this “victory” was very high. According to Friedman and Schwartz, the Fed's tight-money policies led to the onset of a recession in August 1929, according to the official dating by the National Bureau of Economic Research. The slowdown in economic activity, together with high interest rates, was in all likelihood the most important source of the stock market crash that followed in October. In other words, the market crash, rather than being the cause of the Depression, as popular legend has it, was in fact largely the result of an economic slowdown and the inappropriate monetary policies that preceded it. Of course, the stock market crash only worsened the economic situation, hurting consumer and business confidence and contributing to a still deeper downturn in 1930. The second monetary policy action identified by Friedman and Schwartz occurred in September and October of 1931. At the time, as I will discuss in more detail later, the United States and the great majority of other nations were on the gold standard, a system in which the value of each currency is expressed in terms of ounces of gold. Under the gold standard, central banks stood ready to maintain the fixed values of their currencies by offering to trade gold for money at the legally determined rate of exchange. The fact that, under the gold standard, the value of each currency was fixed in terms of gold implied that the rate of exchange between any two currencies within the gold standard system was likewise fixed. As with any system of fixed exchange rates, the gold standard was subject to speculative attack if investors doubted the ability of a country to maintain the value of its currency at the legally specified parity. In September 1931, following a period of financial upheaval in Europe that created concerns about British investments on the Continent, speculators attacked the British pound, presenting pounds to the Bank of England and demanding gold in return. Faced with the heavy demands of speculators for gold and a widespread loss of confidence in the pound, the Bank of England quickly depleted its gold reserves. Unable to continue supporting the pound at its official value, Great Britain was forced to leave the gold standard, allowing the pound to float freely, its value determined by market forces. With the collapse of the pound, speculators turned their attention to the U.S. dollar, which (given the economic difficulties the United States was experiencing in the fall of 1931) looked to many to be the next currency in line for devaluation. Central banks as well as private investors converted a substantial quantity of dollar assets to gold in September and October of 1931, reducing the Federal Reserve's gold reserves. The speculative attack on the dollar also helped to create a panic in the U.S. banking Bernanke (2002b) gives a more detailed discussion of the evidence presented by Friedman and Schwartz. system. Fearing imminent devaluation of the dollar, many foreign and domestic depositors withdrew their funds from U.S. banks in order to convert them into gold or other assets. The worsening economic situation also made depositors increasingly distrustful of banks as a place to keep their savings. During this period, deposit insurance was virtually nonexistent, so that the failure of a bank might cause depositors to lose all or most of their savings. Thus, depositors who feared that a bank might fail rushed to withdraw their funds. Banking panics, if severe enough, could become self-confirming prophecies. During the 1930s, thousands of U.S. banks experienced runs by depositors and subsequently failed. Long-established central banking practice required that the Fed respond both to the speculative attack on the dollar and to the domestic banking panics. However, the Fed decided to ignore the plight of the banking system and to focus only on stopping the loss of gold reserves to protect the dollar. To stabilize the dollar, the Fed once again raised interest rates sharply, on the view that currency speculators would be less willing to liquidate dollar assets if they could earn a higher rate of return on them. The Fed's strategy worked, in that the attack on the dollar subsided and the U.S. commitment to the gold standard was successfully defended, at least for the moment. However, once again the Fed had chosen to tighten monetary policy despite the fact that macroeconomic conditions - including an accelerating decline in output, prices, and the money supply - seemed to demand policy ease. The third policy action highlighted by Friedman and Schwartz occurred in 1932. By the spring of that year, the Depression was well advanced, and Congress began to place considerable pressure on the Federal Reserve to ease monetary policy. The Board was quite reluctant to comply, but in response to the ongoing pressure the Board conducted open-market operations between April and June of 1932 designed to increase the national money supply and thus ease policy. These policy actions reduced interest rates on government bonds and corporate debt and appeared to arrest the decline in prices and economic activity. However, Fed officials remained ambivalent about their policy of monetary expansion. Some viewed the Depression as the necessary purging of financial excesses built up during the 1920s; in this view, slowing the economic collapse by easing monetary policy only delayed the inevitable adjustment. Other officials, noting among other indicators the very low level of nominal interest rates, concluded that monetary policy was in fact already quite easy and that no more should be done. These policymakers did not appear to appreciate that, even though nominal interest rates were very low, the ongoing deflation meant that the real cost of borrowing was very high because any loans would have to be repaid in dollars of much greater value (Meltzer, 2003). Thus monetary policy was not in fact easy at all, despite the very low level of nominal interest rates. In any event, Fed officials convinced themselves that the policy ease advocated by the Congress was not appropriate, and so when the Congress adjourned in July 1932, the Fed reversed the policy. By the latter part of the year, the economy had relapsed dramatically. The fourth and final policy mistake emphasized by Friedman and Schwartz was the Fed's ongoing neglect of problems in the U.S. banking sector. As I have already described, the banking sector faced enormous pressure during the early 1930s. As depositor fears about the health of banks grew, runs on banks became increasingly common. A series of banking panics spread across the country, often affecting all the banks in a major city or even an entire region of the country. Between December 1930 and March 1933, when President Roosevelt declared a “banking holiday” that shut down the entire U.S. banking system, about half of U.S. banks either closed or merged with other banks. Surviving banks, rather than expanding their deposits and loans to replace those of the banks lost to panics, retrenched sharply. The banking crisis had highly detrimental effects on the broader economy. Friedman and Schwartz emphasized the effects of bank failures on the money supply. Because bank deposits are a form of money, the closing of many banks greatly exacerbated the decline in the money supply. Moreover, afraid to leave their funds in banks, people hoarded cash, for example by burying their savings in coffee cans in the back yard. Hoarding effectively removed money from circulation, adding further to the deflationary pressures. Moreover, as I emphasized in early research of my own (Bernanke, 1983), the virtual shutting down of the U.S. banking system also deprived the economy of an important source of credit and other services normally provided by banks. The Federal Reserve had the power at least to ameliorate the problems of the banks. For example, the Fed could have been more aggressive in lending cash to banks (taking their loans and other investments as collateral), or it could have simply put more cash in circulation. Either action would have made it easier for banks to obtain the cash necessary to pay off depositors, which might have stopped bank runs before they resulted in bank closings and failures. Indeed, a central element of the Federal Reserve's original mission had been to provide just this type of assistance to the banking system. The Fed's failure to fulfill its mission was, again, largely the result of the economic theories held by the Federal Reserve leadership. Many Fed officials appeared to subscribe to the infamous “liquidationist” thesis of Treasury Secretary Andrew Mellon, who argued that weeding out “weak” banks was a harsh but necessary prerequisite to the recovery of the banking system. Moreover, most of the failing banks were relatively small and not members of the Federal Reserve System, making their fate of less interest to the policymakers. In the end, Fed officials decided not to intervene in the banking crisis, contributing once again to the precipitous fall in the money supply. Friedman and Schwartz discuss other episodes and policy actions as well, such as the Federal Reserve's misguided tightening of policy in 1937-38 which contributed to a new recession in those years. However, the four episodes I have described capture the gist of the Friedman and Schwartz argument that, for a variety of reasons, monetary policy was unnecessarily tight, both before the Depression began and during its most dramatic downward phase. As I have mentioned, Friedman and Schwartz had produced evidence from other historical periods that suggested that contractionary monetary policies can lead to declining prices and output. Friedman and Schwartz concluded therefore that they had found the smoking gun, evidence that much of the severity of the Great Depression could be attributed to monetary forces. Friedman and Schwartz's arguments were highly influential but not universally accepted. For several decades after the Monetary History was published, a debate raged about the importance of monetary factors in the Depression. Opponents made several objections to the Friedman and Schwartz thesis that are worth highlighting here. First, critics wondered whether the tightening of monetary policy during 1928 and 1929, though perhaps ill advised, was large enough to have led to such calamitous consequences.3 If the tightening of monetary policy before the stock market crash was not sufficient to account for the violence of the economic downturn, then other, possibly nonmonetary, factors may need to be considered as well. A second question is whether the large decline in the money supply seen during the 1930s was primarily a cause or an effect of falling output and prices. As we have seen, Friedman and Schwartz argued that the decline in the money supply was causal. Suppose, though, for the sake of argument, that the Depression was the result primarily of nonmonetary factors, such as overspending and overinvestment during the 1920s. As incomes and spending decline, people need less money to carry out daily transactions. In this scenario, critics pointed out, the Fed would be justified in allowing the money supply to fall, because it would only be accommodating a decline in the amount of money that people want to hold. The decline in the money supply in this case would be a response to, not a cause of, the decline in output and prices. To put the question simply, we know that both the economy and the money stock contracted rapidly during the early 1930s, but was the monetary dog wagging the economic tail, or vice versa? The focus of Friedman and Schwartz on the U.S. experience (by design, of course) raised other questions about their monetary explanation of the Depression. As I have mentioned, the Great Depression was a worldwide phenomenon, not confined to the United States. Indeed, some economies, such as that of Germany, began to decline before 1929. Although few countries escaped the Depression entirely, the severity of the episode varied widely across countries. The timing of recovery also varied considerably, with some countries beginning their recovery as early as 1931 or 1932, whereas others remained in the depths of depression as late as 1935 or 1936. How does Friedman and Schwartz's monetary thesis explain the worldwide nature of the onset of the Depression, and the differences in severity and timing observed in different countries? That is where the debate stood around 1980. About that time, however, economic historians began to broaden their focus, shifting from a heavy emphasis on events in the United States during the 1930s to an increased attention to developments around the world. Moreover, rather than studying countries individually, this new scholarship took a comparative approach, asking specifically why some countries fared better than others in the 1930s. As I will explain, this research uncovered an important role for international monetary forces, as well as domestic monetary policies, in explaining the Depression. Specifically, the new research found that a complete understanding of the Depression requires There was less debate about the period 1931-33, the most precipitous downward phase of the Depression, for which most economists were inclined to ascribe an important role to monetary factors. attention to the operation of the international gold standard, the international monetary system of the time.4 As I have already mentioned, the gold standard is a monetary system in which each participating country defines its monetary unit in terms of a certain amount of gold. The setting of each currency's value in terms of gold defines a system of fixed exchange rates, in which the relative value of (say) the U.S. dollar and the British pound are fixed at a rate determined by the relative gold content of each currency. To maintain the gold standard, central banks had to promise to exchange actual gold for their paper currencies at the legal rate. The gold standard appeared to be highly successful from about 1870 to the beginning of World War I in 1914. During the so-called “classical” gold standard period, international trade and capital flows expanded markedly, and central banks experienced relatively few problems ensuring that their currencies retained their legal value. The gold standard was suspended during World War I, however, because of disruptions to trade and international capital flows and because countries needed more financial flexibility to finance their war efforts. (The United States remained technically on the gold standard throughout the war, but with many restrictions.) After 1918, when the war ended, nations around the world made extensive efforts to reconstitute the gold standard, believing that it would be a key element in the return to normal functioning of the international economic system. Great Britain was among the first of the major countries to return to the gold standard, in 1925, and by 1929 the great majority of the world's nations had done so. Unlike the gold standard before World War I, however, the gold standard as reconstituted in the 1920s proved to be both unstable and destabilizing. Economic historians have identified a number of reasons why the reconstituted gold standard was so much less successful than its prewar counterpart. First, the war had left behind enormous economic destruction and dislocation. Major financial problems also remained, including both large government debts from the war and banking systems whose solvency had been deeply compromised by the war and by the periods of hyperinflation that followed in a number of countries. These underlying problems created stresses for the gold standard that had not existed to the same degree before the war. Second, the new system lacked effective international leadership. During the classical period, the Bank of England, in operation since 1694, provided sophisticated management of the international system, with the cooperation of other major central banks. This leadership helped the system adjust to imbalances and strains; for example, a consortium of central banks might lend gold to one of their number that was experiencing a shortage of reserves. After the war, with Great Britain economically and financially depleted and the United States in ascendance, leadership of the international system shifted by default to the Federal Reserve. Unfortunately, the fledgling Federal Reserve, with its decentralized structure and its inexperienced and domestically focused leadership, did not prove up to the task of managing the international gold standard, a task that lingering hatreds and disputes from the war would have made difficult for even the most-sophisticated institution. With the lack of effective international leadership, most central banks of the 1920s and 1930s devoted little effort to supporting the overall stability of the international system and focused instead on conditions within their own countries. Finally, the reconstituted gold standard lacked the credibility of its prewar counterpart. Before the war, the ideology of the gold standard was dominant, to the point that financial investors had no doubt that central banks would find a way to maintain the gold values of their currencies no matter what the circumstances. Because this conviction was so firm, speculators had little incentive to attack a major currency. After the war, in contrast, both economic views and the political balance of power had shifted in ways that reduced the influence of the gold standard ideology. For example, new labor-dominated political parties were skeptical about the utility of maintaining the gold standard if doing so increased unemployment. Ironically, reduced political and ideological support for the gold standard made it more difficult for central banks to maintain the gold values of their currencies, as speculators understood that the underlying commitment to adhere to the gold standard at all costs had been weakened significantly. Thus, speculative attacks became much more likely to succeed and hence more likely to occur. Critical early research included Choudhri and Kochin (1980) and Eichengreen and Sachs (1985). Eichengreen (1992, 2002) provides the most extensive analysis of the role of the gold standard in causing and propagating the Great Depression. Temin (1989) provides a readable account with a slightly different perspective. With an international focus, and with particular attention to the role of the gold standard in the world economy, scholars have now been able to answer the questions regarding the monetary interpretation of the Depression that I raised earlier. First, the existence of the gold standard helps to explain why the world economic decline was both deep and broadly international. Under the gold standard, the need to maintain a fixed exchange rate among currencies forces countries to adopt similar monetary policies. In particular, a central bank with limited gold reserves has no option but to raise its own interest rates when interest rates are being raised abroad; if it did not do so, it would quickly lose gold reserves as financial investors transferred their funds to countries where returns were higher. Hence, when the Federal Reserve raised interest rates in 1928 to fight stock market speculation, it inadvertently forced tightening of monetary policy in many other countries as well. This tightening abroad weakened the global economy, with effects that fed back to the U.S. economy and financial system. Other countries' policies also contributed to a global monetary tightening during 1928 and 1929. For example, after France returned to the gold standard in 1928, it built up its gold reserves significantly, at the expense of other countries. The outflows of gold to France forced other countries to reduce their money supplies and to raise interest rates. Speculative attacks on currencies also became frequent as the Depression worsened, leading central banks to raise interest rates, much like the Federal Reserve did in 1931. Leadership from the Federal Reserve might possibly have produced better international cooperation and a more appropriate set of monetary policies. However, in the absence of that leadership, the worldwide monetary contraction proceeded apace. The result was a global economic decline that reinforced the effects of tight monetary policies in individual countries. The transmission of monetary tightening through the gold standard also addresses the question of whether changes in the money supply helped cause the Depression or were simply a passive response to the declines in income and prices. Countries on the gold standard were often forced to contract their money supplies because of policy developments in other countries, not because of domestic events. The fact that these contractions in money supplies were invariably followed by declines in output and prices suggests that money was more a cause than an effect of the economic collapse in those countries. Perhaps the most fascinating discovery arising from researchers' broader international focus is that the extent to which a country adhered to the gold standard and the severity of its depression were closely linked. In particular, the longer that a country remained committed to gold, the deeper its depression and the later its recovery (Choudhri and Kochin, 1980; Eichengreen and Sachs, 1985). The willingness or ability of countries to remain on the gold standard despite the adverse developments of the 1930s varied quite a bit. A few countries did not join the gold standard system at all; these included Spain (which was embroiled in domestic political upheaval, eventually leading to civil war) and China (which used a silver monetary standard rather than a gold standard). A number of countries adopted the gold standard in the 1920s but left or were forced off gold relatively early, typically in 1931. Countries in this category included Great Britain, Japan, and several Scandinavian countries. Some countries, such as Italy and the United States, remained on the gold standard into 1932 or 1933. And a few diehards, notably the so-called gold bloc, led by France and including Poland, Belgium, and Switzerland, remained on gold into 1935 or 1936. If declines in the money supply induced by adherence to the gold standard were a principal reason for economic depression, then countries leaving gold earlier should have been able to avoid the worst of the Depression and begin an earlier process of recovery. The evidence strongly supports this implication. For example, Great Britain and Scandinavia, which left the gold standard in 1931, recovered much earlier than France and Belgium, which stubbornly remained on gold. As Friedman and Schwartz noted in their book, countries such as China - which used a silver standard rather than a gold standard - avoided the Depression almost entirely. The finding that the time at which a country left the gold standard is the key determinant of the severity of its depression and the timing of its recovery has been shown to hold for literally dozens of countries, including developing countries. This intriguing result not only provides additional evidence for the importance of monetary factors in the Depression, it also explains why the timing of recovery from the Depression differed across countries. The finding that leaving the gold standard was the key to recovery from the Great Depression was certainly confirmed by the U.S. experience. One of the first actions of President Roosevelt was to eliminate the constraint on U.S. monetary policy created by the gold standard, first by allowing the dollar to float and then by resetting its value at a significantly lower level. The new President also addressed another major source of monetary contraction, the ongoing banking crisis. Within days of his inauguration, Roosevelt declared a “bank holiday,” shutting down all the banks in the country. Banks were allowed to reopen only when certified to be in sound financial condition. Roosevelt pursued other measures to stabilize the banking system as well, such as the creation of a deposit insurance program. With the gold standard constraint removed and the banking system stabilized, the money supply and the price level began to rise. Between Roosevelt's coming to power in 1933 and the recession of 1937-38, the economy grew strongly. I have only scratched the surface of the fascinating literature on the causes of the Great Depression, but it is time that I conclude. Economists have made a great deal of progress in understanding the Great Depression. Milton Friedman and Anna Schwartz deserve enormous credit for bringing the role of monetary factors to the fore in their Monetary History. However, expanding the research focus to include the experiences of a wide range of countries has both provided additional support for the role of monetary factors (including the international gold standard) and enriched our understanding of the causes of the Depression. Some important lessons emerge from the story. One lesson is that ideas are critical. The gold standard orthodoxy, the adherence of some Federal Reserve policymakers to the liquidationist thesis, and the incorrect view that low nominal interest rates necessarily signaled monetary ease, all led policymakers astray, with disastrous consequences. We should not underestimate the need for careful research and analysis in guiding policy. Another lesson is that central banks and other governmental agencies have an important responsibility to maintain financial stability. The banking crises of the 1930s, both in the United States and abroad, were a significant source of output declines, both through their effects on money supplies and on credit supplies. Finally, perhaps the most important lesson of all is that price stability should be a key objective of monetary policy. By allowing persistent declines in the money supply and in the price level, the Federal Reserve of the late 1920s and 1930s greatly destabilized the U.S. economy and, through the workings of the gold standard, the economies of many other nations as well.
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Speech by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve System, at the 118th Assembly for Bank Directors, Las Croabas, Puerto Rico, 27 February 2004.
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Mark W Olson: A regulator's view of emerging issues in community banking Speech by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve System, at the 118th Assembly for Bank Directors, Las Croabas, Puerto Rico, 27 February 2004. * * * In 2003 community banks once again demonstrated their value to their shareholders, delivering solid profitability. Community banks - by that I mean commercial banks with assets less than $1 billion earned $12.9 billion in 2003, based on preliminary Call Report data. This figure translates into a return on assets of 1.18 percent and a return on equity of 11.55 percent. Fourth-quarter returns were a bit below that, following a familiar seasonal pattern. Overall, return on assets has been consistently between 1.10 percent and 1.20 percent and return on equity has been close to 12 percent. Higher non-interest income-including mortgage origination and servicing income - and decreases in required provisioning allowed earnings to remain strong despite pressure on margins. Only about 6 percent of community banks lost money for the year, representing less than 3 percent of their total assets. Consolidation continued in the industry in 2003. According to our preliminary figures, there were about 7,300 community banks at year-end 2003, some 140 fewer (1.9 percent) than a year earlier and about 500 (or 11 percent) fewer existed five years ago. The consolidation in the industry, and the search for efficiency and scope, should not be misunderstood. It does not signal a threat to the community banking franchise; far from it. The market for community bank charters makes this point clear. Seventy-seven new commercial bank charters were issued in the first nine months of 2003, and nearly five hundred since the beginning of 2000. Over that same period, for every five banks that disappeared through consolidation, another two new charters were granted. In total, that represents $2.4 billion in new equity capital invested in community bank charters. Community bank net interest margins continue to be above those of the industry as a whole. For 2003, the community bank margin was about 4.1 percent, nearly thirty-basis points higher than the comparable figure for the industry. To some extent, this reflects a different business mix, despite the role of high-spread credit card lending at larger institutions. A closer look at the Call Report shows that community banks seem to pay more for their nonmaturity deposits than do larger institutions. The average effective rate paid at community banks in 2003 was just below 1.00 percent, some 25 basis points higher than the industry-wide figure of 0.74 percent. Among other factors, this trend has contributed to narrowing margins over the last few years. Credit quality has also improved at community banks, supporting higher earnings, although it had not deteriorated as significantly as the industry did as a whole. Problem loans barely reached 1.00 percent of total loans in this credit cycle, compared with 1.27 percent for the industry as a whole. By late 2003, however, community banks had a problem asset ratio roughly equal to that of the larger institutions, at about 0.90 percent. Although there were many similarities, balance sheet developments at community banks in 2003 differed in many regards from those at larger institutions. Community bank holdings of mortgage-related securities were largely unchanged from those at the end of 2002, and their closed-end mortgage loan holdings declined about 5 percent, while larger institutions experienced significant growth in both categories. Commercial and industrial loans fell at community banks in both 2002 and 2003 but at a much slower rate of decline - less than half a percent in each year - than at larger institutions. Capitalization is another area of contrast. Strong capital ratios, well in excess of regulatory minimums, have been a key factor in managing credit concentrations and, indeed, a striking attribute of the most profitable community banks. The top one-fifth of community banks, in terms of profitability, typically hold 1.6 percentage points more capital relative to assets than other community banks. The most striking difference, however, is seen in loans for commercial real estate. Commercial real estate lending - made up of construction lending; loans secured by nonfarm nonresidential properties; and multifamily housing - continued to grow rapidly in 2003. The nominal growth in such loans at community banks - $29 billion - essentially accounted for all of the asset growth at these institutions, while amounting to only about one-seventh of asset growth for the industry as a whole. By the end of 2003, this lending had reached 25.1 percent of aggregate community bank assets. That is 7 percent higher than five years ago, and it has set a new record for community banks as the highest concentration in commercial real estate loans - yes, even higher than in the early 1990s. This increase appears to be fairly widespread across the population of community banks, and it is evident at highly profitable and less-profitable institutions. Commercial real estate lending is a traditional and natural part of the community banking franchise, and by all accounts underwriting practices continue to be much better than they were in the troubled days of the 1980s. For these reasons, there is no indication at this time that the overall credit quality of commercial real estate exposures at community banks has deteriorated. Moreover, market reports indicate the vacancy rates in some markets have turned around and are recovering. That said, there are a number of markets nationwide that have experienced weakness in recent years and continue to do so. Many of these markets are likely to take years to recover. Bank directors and management - as well as supervisors - will need to closely monitor further developments in this area. More generally, a critical “franchise” issue for community bankers has been recognizing and managing credit risk concentrations that also tend to be a natural part of the community banking business. When credit quality problems emerge at an institution, they of course cause lower returns and attract more attention from your friendly bank supervisors. The presence of lending concentrations indicates that such problems can develop more quickly and more broadly across a pool of borrowers. Successful management of concentrations requires adherence to good credit fundamentals. Important advances in the measurement and management of credit risk have been developed that community bankers should probably consider for their own use in the coming years. There are no magic bullets here, but community bankers may find that these advanced techniques provide useful tools and concepts that can reinforce existing disciplines in the credit management process. The near-term outlook for community bank profitability is good, but at this point prospects for the rate of earnings growth may be a bit less rosy than for larger institutions. Paradoxically, there is probably little more room to lower credit costs for community banks, unlike at larger institutions with still-elevated levels of problem loans. Provisions at community banks in 2003 were roughly 50 basis points of average loans, the lowest level seen at community banks since 1998 and a figure that would probably be considered “normal” and prudent over the longer term. This leveling of loan-loss provisions accompanied by the cooling of fees from mortgage refinancings and originations will heighten attention on new opportunities for asset growth and higher-margin assets. Most observers expect that business borrowers will soon resume more normal levels of borrowing activity. Although their return may provide one avenue for earnings growth to banks of all sizes, it is important that the competitive drive to win borrowers is not allowed to overcome the discipline of prudent lending practice. Directors and management should be particularly attentive to this possibility given the extended period of weak loan demand that we've recently experienced. A natural temptation for a banker when facing pressures for earnings growth would be to extend maturities in search of more attractive rates of return. I'd like to say a few cautionary words about this temptation. With a steep yield curve, the portion of community bank assets maturing beyond five years has grown steadily since year-end 2000, from 16.9 percent to 18.4 percent of assets. Larger institutions hold a greater share of their assets in long-term instruments and have also seen an increase in long-term assets over the same period. They arguably may have better access to derivatives markets and more sophisticated programs for managing their interest rate risk. Rather than resorting to the derivatives market - fewer than 600 commercial banks hold any derivatives contracts at all - most community bankers may simply choose to rely on the interest rate protection provided by their stable and reliable core deposit base. They may believe this base to be more stable and reliable than at larger institutions, and from a historical point of view that belief might be difficult to dispute. Community bankers depend on these deposits maintaining the stability and reliability they have exhibited in the past. As a result, interest rate and liquidity management become even more closely intertwined. Money market deposit accounts and savings deposits at community banks grew sharply in 2003, although they dropped slightly - less than $2 billion or 0.6 percent - in the fourth quarter. A drop of this size hasn't taken place at community banks for some years, and has not occurred at all at the larger banks. If our analysis is correct and deposit growth has been fueled by low interest rates and weakness in the equity markets, community bankers should be aware that they may face unexpected liquidity and interest rate pressures if their deposit customers shift their funds to other investment vehicles. This is not idle speculation. We need to remember that depositor behavior can change. An excellent example is the high-interest rate period we experienced in the late 1970s and early 1980s, when long-term certificates of deposit were redeemed early - despite the significant penalties assessed - in order to lock in higher market rates. The relative stability of these nonmaturity deposits and the liquidity they provide have been an important strength to community banks, although there have been too many instances in which rapidly growing banks have faced unexpected liquidity pressures because they relied more heavily on non-core or volatile funding sources. Careful planning of growth and funding needs is a key aspect of sound management and requires the appropriate degree of management attention. Conclusion The past year was a good year for the industry, one in which banks were able to adapt to a changing environment and still generate record profits. Community banks once again demonstrated their value to the marketplace and the prominent and vibrant position they rightly occupy in the industry. The industry is strong and resilient, but we should not gauge the industry's ability to withstand and adapt to challenges solely on the basis of what happened in 2003. As we reflect on this banner year, it will serve us well to bear in mind that the credit and business challenges the industry faced in recent years were certainly not as difficult as they might have been - and indeed may yet be at some point in the future. Asset quality certainly was an issue in this credit cycle, but never approached the levels experienced in the early 1990s. Similarly, a low-interest rate environment, together with a steep yield curve, can provide a forgiving setting for bankers, at least in the near term. To paraphrase the old adage, those who do not learn all of the lessons of history are destined to repeat them. Once again, the fundamental management challenge is to balance the opportunities of the present with the prospects for the future.
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Speech by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve System, at the Annual Conference of the Institute of International Bankers, Washington, 1 March 2004.
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Mark W Olson: US Banking industry performance highlights - 2003 Speech by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve System, at the Annual Conference of the Institute of International Bankers, Washington, 1 March 2004. * * * The banking industry enjoyed a very good year in 2003, one in which banks were able to adapt to a changing environment and still generate record profits. Several factors contributed to this favorable setting: low interest rates, a boom in mortgage banking and deposit-gathering, and favorable trends in market-sensitive businesses as the year went on. We are just getting our first look at year-end financial information from Call Reports. Although the figures are still preliminary, there are some interesting findings. In 2003, for the first time, insured commercial banks earned $100 billion dollars. These impressive profits were 14 percent higher than in 2002, which to that point was itself a record year for earnings. The industry's return on assets was almost 1.40 percent, and its return on equity was 15.3 percent. The level of earnings, even at $100 billion, may not be the most remarkable aspect of the industry's 2003 results. The industry not only earned record profits but, as the year progressed, changed the way they earned these profits. In other words, the industry adapted to changes in the business and economic environment and did well. Changes really began over the summer, when mortgage originations began to taper off as longer-term interest rates rose. For eight large bank holding companies with major mortgage banking operations, the collective mortgage loan origination volume fell 50 percent to about $200 billion in the fourth quarter. This rate of decline parallels what other market sources indicate. Naturally, the fees associated with these originations declined as well, although not as much as one might have expected. Mortgage originations of $200 billion were still strong for these institutions by historical standards, and income was aided by favorable developments in mortgage servicing, namely the accumulated buildup of servicing portfolios from the surge in mortgage lending and the revaluation of servicing assets due to slower prepayments. Net interest margins had been narrowing rather steadily since early 2002. A couple of things appeared to be at work. Typically, margin pressure tends to arise at banks facing stiff competitive pressure on loan yields and funding costs, perhaps an escalation in funding costs at banks experiencing rapid asset growth. The current situation is not a typical or normal environment. The low-interest rate environment had a lot more to do with this narrowing, along with sluggish loan demand. Historically low interest rates have significantly reduced the yields banks earn on their assets, especially mortgages. Banks built up their holdings of mortgages as market conditions generated such remarkable volumes of these loans, and as weak demand for commercial loans left a void in bank balance sheets and income. Historically low rates on new mortgage loans, together with rapid prepayment of higher-rate mortgages, have sharply reduced yields on bank mortgage portfolios. The preliminary data for 2003 indicate that the effective yield on mortgage-backed securities, including adjustable-rate products, fell to 4.22 percent; by late in the year, yields had fallen to only about 3.90 percent. Along with this pressure on yields, banks have faced an interesting new pressure on funding costs. For much of the last two years, households have been inclined to keep their assets very liquid and flexible. Interest rates have been low by historical terms, and didn't seem to provide much incentive for households to tie up their assets in time deposits. The stock market - at least through the spring of last year - was on a downward track and certainly not providing attractive returns. Flexible bank deposits offered a comfortable compromise, providing positive returns, deposit insurance, and flexibility to redeploy funds if alternative investments became more attractive. In this setting, bankers have valued core deposits even more highly, and have paid up for them. In particular, they have favored nonmaturity deposits such as money market or savings accounts. Smaller-denomination certificates of deposit, in contrast, have declined steadily over a period of some years. Influenced by the low interest rate environment, banks reduced the rates on their nonmaturity deposits by far less than money market rates had fallen. The result has been tighter margins, but with an important potential side benefit. The success that bankers had in raising these nonmaturity deposits created opportunities to reclaim some of the market share that bank deposits had lost over the previous decade or two. Money market and savings accounts, in particular, now fund 30 percent of bank assets. Remarkably, despite these pressures, it now appears that bank margins recovered to some degree late in 2003. The improvement was only about six basis points, but appears to be significantly influenced by slower prepayments and the resulting increases in mortgage asset yields. There were a host of other forces at work, suggesting that the improvement in margins may or may not be sustainable. Still, banks were able to turn around their shrinking margins. Perhaps the biggest contributor to strong earnings has been steady improvement in asset quality - consistent with a gradually improving economy - that allowed for lower charge-offs and lower provisions. By the end of 2003, problem assets had fallen to 0.94 percent of loans, down considerably from the peak level for this credit cycle of 1.27 percent in September 2002. Improvement in economic conditions is a key reason for the sustained decline, along with the liquidity and depth of secondary markets for troubled loans. We also think that better risk management - in particular, better diversification - contributed to this decline. With charge-offs and problem assets declining for more than a year, credit quality is on track to improve further, more so as the economy improves. As a result, we can expect that banks will be able to take their provisions still lower and maybe their reserves as well. One area in which bank profits lost ground was securities gains. Low interest rates had increased the market value of bank securities holdings, creating the opportunity for banks to sell these securities and take the resulting gains into income. Booking such gains significantly enhanced near-term profits, but of course at the price of lowering future net interest earnings. In any case, increases in longer-term interest rates over the summer meant that the opportunities for securities gains-taking faded. So did the current contribution to earnings from securities gains. Banks still have not seen significant relief from weak business loan demand. In this business cycle, firms have been reluctant to borrow - in part because of uncertainty about future prospects. The commercial loan business often carries attractive spreads, especially in the middle market. We have seen only the very early signs of recovery in loan demand, including a pickup in bond issuance and syndicated lending. By one indicator, at least, small business confidence appears to be improving; a development that should be important for community banks. The National Federation of Independent Businesses surveys its members regularly about their sales outlook for the coming three-month period. Those surveys show optimism rising since the summer of 2003. In fact, since November the number of firms expecting an increase in sales exceeds those expecting a decline by more than 30 percentage points. The survey hasn't shown that wide a margin with such a positive outlook for four years. At this point, the available indicators suggest that banks' earnings prospects are favorable. The market seems to share that outlook, perhaps one reason why bank stock valuations have been improving. Ongoing consolidation in the industry also plays a role, and we have seen a recent wave of merger announcements among the largest bank holding companies. Based on what I hear from community bankers, mergers and acquisitions among big institutions have historically created opportunities for community banks. I wouldn't be a bank regulator if I neglected to mention that bank capital ratios remain very strong. Nearly 99 percent of banks in the United States are well-capitalized, which is a higher proportion than we have ever seen. Some analysts have expressed concern that bankers would reduce their capital buffers in order to increase dividend payments, especially as the tax treatment of dividend income became more favorable to stockholders. But in spite of these changes in the tax code, the aggregate dividend payout ratio at commercial banks increased only modestly, from 76.4 percent of income to 77.4 percent of income. Conclusion In conclusion, the U.S. banking industry is healthy, strong, profitable and well-positioned to play its proper role in supporting growth and prosperity in our economy. Many of the factors that made 2003 such a remarkable year for the industry look like they will carry over into 2004 as well. New challenges will arise as we move ahead, of course, and perhaps some new opportunities as well. Adapting to change is an important aspect of the banking business, and the industry's ability to respond well to changing circumstances was a key to last year's record-setting results. I believe we can look forward with confidence to continued strong performance from the banking industry.
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Independent Community Bankers of America Convention, San Diego (via satellite), 17 March 2004.
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Alan Greenspan: Banking Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Independent Community Bankers of America Convention, San Diego (via satellite), 17 March 2004. * * * It is a pleasure once again to participate in the annual meeting of the Independent Community Bankers Association. I particularly hoped to attend this meeting in person, but events made such a trip infeasible. I wanted to be at your meeting to join in honoring the contributions of Ken Guenther. As everyone knows who has ever received Ken’s notes - known fondly to one and all as “Guenther-grams” - he thinks deeply and broadly about banking and financial matters. Having reflected on the kinds of issues that Ken has on his mind, I thought it would be fitting today if I shared with you some ideas about where the banking industry is today and about a few trends we see evolving. Asset growth and quality The weakness in credit quality that accompanied the recent recession has clearly been mild for the banking system as a whole, and the system remains strong and well positioned to meet customer needs for credit and other financial services. During the past three years or so, the industry extended its string of high and often record quarterly earnings, retained its historically high equity and risk-based capital ratios, and generally enjoyed robust asset growth. The industry and its supervisors had begun exceptionally early to address slippage in credit standards that accompanied the maturing of the last expansion, and their timely intervention was reflected in modest subsequent write-offs relative to earnings. Indeed, for each of the past several quarters the volume of problem assets at commercial banks has declined, and the size and the number of bank failures in recent years have been exceptionally small. Although the demand for business loans has remained weak, the banking industry has continued to benefit from strong demand for household credit, not least for residential mortgage products. The outlook for asset quality is also favorable. As economic activity continues to grow and businesses become more confident about their customers’ demands, business loan demand should increase, and pressures on banking margins should begin to ease. During the period of weakness and recovery, quite a large amount of core deposits flowed back into banks of all sizes reflecting lower interest rates on alternative assets, the softness of the stock market, and the public’s desire for safe assets. As a result, banks had ample liquidity and the resources to fund asset growth. More recently, with renewed interest in market securities and a slowing of mortgage re-financings - and their associated buildup in deposits - core deposits have weakened. History suggests that, as the economy strengthens further, deposit substitutes again will become more attractive to bank customers, requiring competitive responses in bank deposit offering rates and reliance on non-core sources. Community bankers in the last half of the nineties demonstrated their skill in competing successfully in such markets. Although their deposit patterns have been similar, community and larger banks have seen some interesting differences developing in their portfolios in the past two or three years that are worth noting. Banking commentary generally has emphasized the extent to which residential mortgage finance and consumer credit extensions have dominated the portfolio expansion of the banking industry. In fact, that growth, which dominates the aggregate statistics, has been mainly a large bank phenomenon. At community banks, the residential mortgage, credit card, and consumer installment loan portfolios have declined in each of the last three years. To be sure, this change may be a matter of choice. The data suggest, for example, that community banks have originated a significant volume of mortgage loans for securitization by others, continuing to acquire in the process a large amount of mortgagebacked securities. But some observers have noted that in the market for new originations of mortgages community banks are also under continued competitive pressure from mortgage bankers, nationwide mortgage lenders, and real estate agent relationships with out-of-market lenders, often through the Internet. The declining importance of traditional consumer credit business at community banks appears to stem from both sustained competition from captive finance companies and community banks’ withdrawal from the credit card market, where significant scale is required to service the resultant portfolios. Community bankers, however, continue to have success with home equity loans as a substitute for more traditional consumer lending and have experienced growth in such loans comparable to that at larger institutions. Particularly noteworthy is the longer-term trend at community banks that seems to have accelerated in the past three years - the increasing share of asset growth accounted for by nonresidential real estate finance, particularly construction and land development loans and commercial and industrial real estate financing. Last year these categories accounted for more than 90 percent of the net asset growth of banks with less than $1 billion in assets; multifamily real estate and farmland finance would bring the total to more than 100 percent, offsetting the declines in other categories. Such credit exposures are a natural evolution of community banking and are quite profitable, helping to sustain both the earnings and growing equity capital of community banks. Moreover, the evidence suggests that community banks have avoided the underwriting mistakes that led to so many problems ten to fifteen years ago. Borrower equity is much higher and credit criteria are much stricter. In the last recession and during the early weak recovery, we saw very few delinquencies in these credits. Nonetheless, bankers need to be aware of the historical real estate cycle that, in the past, placed such exposures under severe stress. One hopes these improvements in underwriting standards are lasting. But the painful lessons of banking history underscore the ever-present need for vigilance in managing geographic and business line concentrations. Consolidation Mergers and acquisitions in banking continue, driven by technology, reduced barriers to entry, relaxation of interstate banking restrictions, and globalization. Although attention has been focused on the larger banks, roughly 90 percent of mergers over the past decade have involved a target with less than $1 billion; three-quarters have involved an acquiree with assets of less than $250 million. Largely as a consequence, the number of banking organizations with assets of less than $1 billion has fallen since the mid-1990s by more than one-fifth. Neither the aggregate decline in the number of banking organizations of all sizes nor the increase in aggregate concentration ratios tells us much about the competitive effects of consolidation. Competition in banking is fought on the battlefield of the local market, especially for households and small and medium-sized businesses. By that test, concentration in local markets has actually declined somewhat since the mid-1990s in both urban and rural local markets. The apparent contradiction between aggregate consolidation and the virtually unchanged local market structure reflects the fact that many of the mergers and acquisitions by all sizes of banks have been out-of-market, or geographic-expansion, mergers. In addition, when consolidation occurs, it often induces de novo entry to take advantage of the inefficiencies or transition difficulties of the newly consolidated enterprise. Over the past five years, for every four bank mergers that have been approved, three de novo bank charters have been granted. To be sure, expansion by large banks through acquisitions and branching has increased the number of local markets - urban and rural - in which a large institution is a rival. Last year, 99 percent of the urban markets and 54 percent of the rural markets had an office of a banking organization with deposits of $25 billion or more. Such an increase in the presence of large banking organizations at the local level has occurred while community banks continue to face competition from thrifts, credit unions, securities firms, and loan production offices from out-of-market lenders, not to mention the Internet. These trends are irreversible. Nonetheless, as evidenced by their performance, community banks have the competitive skill of innovation and the competitive edge of local market knowledge not just to survive against such competition but to continue to prosper. Basel II Every indication to date also suggests that the proposed application of Basel II in the United States to only large banks should not be a matter of concern to community bankers. Indeed, your comments on our proposal to revise the Basel Accord suggest that you are comfortable, to say the least, with not having to invest in the institutional infrastructure to be required of the largest banks. The agencies believe that the generally strong capital position and straightforward balance sheets of most of the other banks make a wider application of Basel II neither cost effective nor necessary on prudential grounds. Of course, supervisors will continue reviewing credit-granting and risk-management policies at banks of all sizes, and I suspect that, in the years ahead, market-driven spin-offs from the new procedures at larger banks will be adopted by community banks. Apparently another fear exists. The comments received from some of you indicated a concern that perhaps the lower regulatory capital that some large banks may incur under Basel II on some portfolios may distort the competitive balance between adopters and non-adopters of the proposed new accord. The banking agencies and the Congress take such risks seriously. Indeed, we have indicated that if we see evidence supporting competitive distortions, we will make the necessary modifications to blunt them by doing one of the following: changing Basel II rules in the United States, where national discretion is allowed; modifying the proposed U.S. bifurcated application; or changing the capital rules that apply to non-adopters. In short, if we have evidence of a potential competitive problem, we will not be precluded from proposing any measure that we believe is necessary to retain a more level playing field. Two weeks ago, the Federal Reserve published the first two of four empirical studies on this issue that our staff is conducting. One addresses the concern that regulatory capital reductions at adopters of Basel II might induce more mergers and acquisitions, with the adopters acquiring the non-adopters. That paper finds little empirical evidence that, in the past, excess regulatory capital at the acquirer had been a significant factor in boosting consolidation. The second paper evaluates the fear that the lower on average, risk-based capital charges on loans to small- and medium-sized enterprises by Basel II adopters would put non-adopters at a competitive disadvantage. This study concludes that the empirical evidence suggests that, indeed, a competitive issue in this market might arise between adopters and large bank non-adopters, both of which make the same types of loans in the same markets. This potential effect must be addressed. But the study also concludes that, on the basis of empirical review, the types of small business loans generally made by community banks - relationship-based loans, which community banks do so well - are so different from the types of loans made by larger banks, and so differently priced, that the competitive effects on community banks of Basel II application to large banks are likely to be insignificant. Two other studies, exploring the competitive effects in the residential mortgage and credit card markets will be available in the next few months. The results of all four studies will be reviewed when we conduct later this year another Quantitative Impact Study on the revised Basel II now being developed. And, again, if updates of the completed studies or the analyses in the new studies demonstrate competitive problems, we will modify the proposals to address them. Summary In summary, the banking system is in a strong and profitable position to finance the credit demands of the current expansion. As that expansion continues, both large and community banks will have to once again look beyond their core deposit base to fund those demands. The competitive environment for banks, especially community banks, will continue to intensify. Both history and current behavior suggest, however, that community banks can innovate and meet these competitive challenges. The merger trends of both large and small banks will undoubtedly continue, but both public policy and new entry will also continue to limit concentration in local markets. If evidence shows that a bifurcated application of Basel II would distort competitive markets in the United States, the agencies are pledged to make whatever modifications are necessary to either the proposal or the current capital rules. And, finally, once again: Ken, I wish you a productive and enjoyable retirement.
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Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the Federal Reserve Board Models and Monetary Policy Conference, Washington, DC, 27 March 2004.
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Ben S Bernanke: Monetary policy modeling - where are we and where should we be going? Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the Federal Reserve Board Models and Monetary Policy Conference, Washington, DC, 27 March 2004. The references for the speech can be found on the Board of Governors of the Federal Reserve System’s website. * * * Our honorees, Dale Henderson, Richard Porter, and Peter Tinsley, have already received much welldeserved praise. I will add only one brief observation. Although I am a relative newcomer to the Federal Reserve, I have already had numerous occasions to be impressed by the research staff here. The Board staff has what a management expert might call a terrific corporate culture. They understand that they make crucial contributions to the policymaking process, not only in the realm of monetary policy but in banking, payments, consumer affairs, and other areas, and they bring great pride and professionalism to their work. Moreover, they understand the value of sophisticated and subtle economic analysis, which they apply both to day-to-day questions of policy and to more fundamental research questions. A culture like that doesn’t just happen; it requires senior people who lead by example. In their times at the Board, Dale Henderson, Dick Porter, and Peter Tinsley, each in his own way, have promoted a culture that combines the best in policy-oriented research with the intellectual rigor and curiosity needed to address questions that go beyond the immediate economic situation. That is an outstanding contribution, one that should be recognized in addition to the many intellectual contributions that each of these scholars has made to the economic literature. The theme of the panel is “Monetary Policy Modeling: Where Are We and Where Should Be Going?” Forecasting the direction of successful research is inherently very difficult. There is a kind of efficient markets principle at work; if a promising direction for research were obvious, someone would have already pursued it. So I think the best I can do is highlight three general areas in which much good work has already been done, including research by Messrs. Henderson, Porter, and Tinsley, but in which further progress would be enormously helpful to monetary policymaking in practice. The first area is the characterization of good monetary policy in increasingly realistic and complex model environments. Henderson, Porter, and Tinsley have all made significant contributions to macroeconomic modeling at the Board. For specificity, I will focus on a piece of recent research that I like very much and which has already received much attention at this conference: Dale Henderson’s paper with Christopher Erceg and Andrew Levin (2003). We have learned a great deal in recent years about the effects of monetary policy in dynamic, stochastic, sticky-price models, with Michael Woodford’s recent book (Woodford, 2003) perhaps best representing the state of the art. This line of research is potentially of great importance to applied macro modelers, because it addresses areas in which some may feel that our current policy models need to be strengthened, notably the treatment of expectations, the specification of model dynamics, and the relationship of the economic structure to the form of the policy rule. However, naturally enough, the earliest models in this genre have tended to be highly simplified representations of the economy, only loosely matched to the data. Like the models themselves, the optimal policy rules derived in the models are often unrealistically simple. For example, in some of these models, strict inflation targeting - a policy of keeping inflation at zero at all times - is the optimal policy. To make these models relevant for applied policy analysis, the natural next step is to add new frictions and more complex dynamics to the benchmark models. The Erceg-Henderson-Levin (EHL) paper explores the implications for monetary policy of a plausible complication, the inclusion in the model of nominal wage stickiness as well as price stickiness. As was discussed yesterday, this relatively simple addition makes an important qualitative difference in the policy results. Specifically, in the EHL model, monetary policy can no longer achieve a fully optimal outcome but instead faces tradeoffs among its objectives. Because the optimal rule in their model is relatively complex and depends on model parameters and shocks, EHL use model simulations to examine the performance of some simple policy rules. Interestingly, they find that relatively simple policy strategies can achieve results close to the optimum. The contribution of the EHL paper goes beyond the specific findings; equally important is the direction that this work sets for the collective research program. Erceg, Henderson, and Levin have shown by example that incorporating additional, realistic frictions into the basic new-Keynesian model changes both the behavior of the model and the nature of the optimal policy rule in nontrivial ways. The papers at this conference by Canzoneri, Cumby, and Diba (2004) and by Benigno and Woodford (2004) both take up the EHL challenge. For example, Canzoneri, Cumby, and Diba consider further complications of the sticky-price, sticky-wage model, including capital investment and habit formation in consumption, while Benigno and Woodford explore the case in which the steady state of the model is not Pareto optimal, as assumed by EHL. This progressive analysis of the implications of alternative assumptions is part of what Thomas Kuhn called “normal science.” The insights from these types of modeling efforts are already informing policy analysis at the Board, and their influence will only grow as they become more detailed and realistic. A second important area, one that will always be central to monetary policy, is macro forecasting. Because monetary policy works with a lag, the ability of policymakers to stabilize the economy depends critically on our ability to peer into our cloudy crystal balls and see something resembling the future. One of the key variables to be forecast is inflation. A variety of approaches to forecasting inflation are used at the Board, of course. One of Dick Porter’s many contributions was to develop a monetary approach to forecasting inflation at medium-term horizons. Dick’s so-called P-star approach, originally developed with Jeffrey Hallman and David Small and updated in a 2000 paper with Athanasios Orphanides, combines simplicity with insight. Porter’s analysis begins with an equation so basic that, at one time at least, it appeared on the California license plate of Milton Friedman’s personal automobile. That equation is of course the quantity equation, MV = PY, or money times velocity equals the price level times output. This equation can be used to define a link between money growth and inflation that depends on the evolution of the velocity of money. Hallman, Porter, and Small (1991) analyzed the predictive power of that relationship under the assumption that M2 velocity is a constant - an assumption that seemed reasonable at the time they wrote, but, as these things are wont to do, broke down soon after they did their initial work. Orphanides and Porter (2000) have developed a more sophisticated version of the P-star model, which employs information about the opportunity cost of holding M2 to track the evolution of equilibrium M2 velocity. This approach seems to work reasonably well at predicting inflation at medium-term horizons, and the forecasts of this model are reported routinely to the Board of Governors. Of course, something very similar to Porter’s approach was used by the Bundesbank prior to the formation of the euro area and is used by the European Central Bank today. My own view is that a reliable macroeconomic forecast requires looking at many different types of economic data and considering a variety of forecasting models; any single model or approach is likely to go off the rails at one time or another. For this reason, I am personally attracted to factor models, which summarize large amounts of data (as in Bernanke and Boivin, 2003), and to model averaging, along with more structured analyses. Interesting alternative models, like Porter’s P-star model, are useful because they give yet another perspective on the likely evolution of a critical macroeconomic variable and thus provide a check on other forecasts that one might have in hand. Because good forecasts are so crucial to good monetary policy, I hope and expect to see a great deal more work exploring the robustness of alternative forecasting methods. The third and final research area that I would like to highlight is the analysis of how the public forms its expectations, and of the effects of various expectations formation mechanisms on macroeconomic dynamics. For example, a rich recent literature on learning and macroeconomics has emphasized that actual inflation and inflation expectations may to some degree evolve independently, and that effective monetary policy stabilizes inflation expectations as well as inflation itself (Orphanides and Williams, 2003). Peter Tinsley, in a series of papers with Sharon Kozicki, has explored this theme in great detail. For example, Kozicki and Tinsley (2001) show that it is far easier to make sense of the term structure of Treasury yields if one assumes that expectations about long-run inflation adjust in a reasonable adaptive manner. In a paper presented at a recent conference at the Federal Reserve Bank of San Francisco, Kozicki and Tinsley (2003) develop an empirical model of the economy under the assumptions that the Fed’s implicit inflation target is subject to permanent shocks and that the public learns about the Fed’s target over time. Although simple, their model allows for a much richer and realistic description of the evolution of monetary policy and the economy. For example, their approach gives empirical content to the idea of imperfect monetary policy credibility; in their model, monetary policy is credible when private expectations of long-run inflation tend to align closely with the central bank’s true underlying inflation target. Their model also illustrates clearly the benefits of central bank credibility for macroeconomic stability. I think that further theoretical and empirical work on expectations formation mechanisms and their links to economic dynamics will prove highly fruitful. I will conclude by thanking the organizers for their hard work in putting together this conference. A research conference of the quality of this one is exactly the right way to honor the scholarly contributions of Dale, Dick, and Peter.
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Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the Distinguished Speaker Series, Fuqua School of Business, Duke University, Durham, 30 March 2004.
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Ben S Bernanke: Trade and jobs Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the Distinguished Speaker Series, Fuqua School of Business, Duke University, Durham, 30 March 2004. The references for the speech can be found on the Board of Governors of the Federal Reserve System’s website. * * * Economists are often accused of not being able to agree on anything. Although we are indeed a contentious bunch, one proposition commands almost unanimous assent within the economics community. That proposition is that free trade among nations promotes economic prosperity. The economist’s argument for free trade is disarmingly simple.1 Trade is beneficial because it facilitates the division of labor, allowing each person to specialize in the type of production at which he or she is relatively most efficient. At the most basic level, a world in which each person produced everything that he or she consumed would be primitive indeed, as no single person or family in isolation could produce more than a few rudimentary goods and services. In contrast, if each person concentrates on just a few activities, economies of scale and the development of specialized skills allow production to become much more efficient. Thus, if each of us focuses our efforts on just a few types of production and then trades our output with others, we can enjoy a far more varied and abundant supply of goods and services than we could if each person remained an isolated economic unit.2 Moreover, specialization tends to encourage innovation and hence promotes dynamism and growth as well as efficiency. What applies to individuals would seem to apply to nations as well. Two centuries ago the economist David Ricardo famously observed that, if England specializes in making cloth while Portugal specializes in producing wine, international trade allows both countries to enjoy more of both goods than would be possible if each country produced only for domestic consumption and did not trade. A telling confirmation of Ricardo’s insight is that, when nations go to war, the first order of business is often for each combatant to try to block the other’s access to trade. The Union won the Civil War in large part because its blockade of Southern ports prevented the Confederacy from exporting its cotton, and the outcomes of both World War I and World War II turned on the fact that Great Britain and its allies were able to disrupt German trade more successfully than Germany’s submarines could impede the flow of goods into and out of Great Britain. Despite what seems to economists to be a compelling case for trade, non-economists are far more skeptical. A perennial public concern, from the emergence of the “Rust Belt” in the 1980s, to the days of Ross Perot’s “giant sucking sound,” to the more recent debate about the effects of international outsourcing, is that the expansion of trade will cause production to move abroad, at the expense of domestic employment. Such worries become particularly acute at times like the present, when the labor market is weak and net job creation is depressed. From an economist’s perspective, focusing on the impact of trade on jobs alone is unduly narrow, as many of the benefits of trade accrue to consumers, in the form of greater access to goods and services, rather than to producers. Nevertheless, employment is certainly an important issue, particularly given recent experience. In my remarks today I will explore the much-debated connection between trade and jobs. I will begin by asking whether trade in general destroys jobs, then consider the specific case of trade in business services, often referred to as outsourcing abroad or “offshoring.” Broadly, I will argue that, although trade in general, and outsourcing abroad in particular, may bring with them structural change in the economy, they are not the principal reason for the current underperformance of the labor market. Rather, the sources of slow job creation are primarily domestic. I will conclude by discussing the role of government policies in addressing both the current weakness See Cox and Alm (2002) and Poole (2004) for brief and readable statements of the economist’s case for free trade. Irwin (2002) provides a more extensive analysis. Indeed, even if an individual is more efficient in every activity than other people, it will still be to his or her benefit to specialize in production and then to trade for other goods and services. of the U.S. labor market and the plight of displaced workers. I should note before beginning that the views I express today are not necessarily those of my colleagues at the Federal Reserve.3 Does trade destroy jobs? Does trade destroy jobs? Increases in trade or changes in trading patterns can indeed destroy some specific jobs. People here in North Carolina are all too aware that increased foreign competition has been a factor in the loss of jobs recently experienced in textiles, furniture, and other industries. These job losses can loom large in specific industries and geographic areas, creating hardships for affected workers, their families, and their communities. The appropriate social and political response to these undeniable job losses is a critical issue, one to which I will return. For now, however, I will point out that although trade does lead to the loss of jobs in some industries and locations, trade also creates jobs, both directly and indirectly. Directly, trade creates jobs in the United States by expanding the potential market for U.S. goods and services. To take one leading example, in 2003 the United States exported $47 billion in civilian aircraft, parts, and engines, while importing only $24 billion, for a trade surplus of $23 billion in that category. More relevant to North Carolina, U.S. agriculture sends much of its product abroad. For example, in the 2002-03 crop year, the United States exported 53 percent of its total wheat production, 69 percent of its output of cotton, 50 percent of its sorghum, 59 percent of rice production, 38 percent of the soybean crop, and 11 percent of its output of meat and poultry. Clearly, farmers benefit greatly from having access to international markets. Reflecting American creativity in the arts and in technology, in 2003 the United States ran a surplus of $28 billion in royalty payments and licensing fees. Trade also creates jobs indirectly, in a variety of ways. First, trade allows firms to obtain inputs to production that are cheaper, of higher quality, or both, than would be possible if all inputs were produced domestically. For example, imports of high-tech equipment have helped many U.S. firms, including large numbers of small businesses, to reduce costs and improve productivity, thereby enhancing their competitiveness in world markets. Obviously, firms that cannot compete in the world marketplace will not be able to provide jobs at home. Second, although imports may compete with domestic production, they also improve the lot of consumers by giving them better variety in and better prices for the goods and services they buy. Moreover, the savings that consumers enjoy because of the availability of lower-cost imports effectively increase household purchasing power, extra income that can be spent on other goods and services, including those produced domestically. Finally, openness to trade also means openness to international flows of capital. Foreign investments in the United States may be in a physical form (for example, BMW’s factory in South Carolina) or in a financial form (for example, foreign purchases of the stock and bond offerings of U.S. companies). Either type of foreign investment supports business expansion and employment domestically. If trade both destroys jobs and creates jobs, what is the overall effect of an open trading system on domestic employment? Both economic theory and the available evidence strongly suggest that trade has little net effect on the economy’s capacity to employ its workforce. In the long run, the workings of a competitive labor market, assisted perhaps by appropriate economic policies, ensure that jobs will be created that are commensurate with the size of the labor force and the available mix of worker skills. Thus, in the long run, factors such as population growth, education and training, labor force participation rates, and labor market institutions determine the level and composition of aggregate employment. In contrast, trade appears to have essentially no role in determining a country’s long-run employment potential. To illustrate, between 1960 and 2003, the U.S. trade balance went from a small surplus (that is, an excess of exports over imports) to a large deficit, equal to about 4-1/2 percent of gross domestic product (GDP). At the same time, the United States became a much more open economy; in dollar terms, imports (measured on a balance of payments basis) rose from just over 4 percent of GDP in 1960 to nearly 14 percent of GDP today. Yet the current unemployment rate of 5.6 percent is little changed from its level of 5.5 percent in 1960 - a year in which, much like today, the economy was in Although they are not responsible for my conclusions, I am grateful to Board staff members for superb assistance in the preparation of this talk. the recovery phase from a recession. And of course, aggregate employment in the United States has grown greatly since 1960, by more than 60 million jobs. This increase in employment is significantly faster, by the way, than the growth of the population over the same period, in large part because of increased labor force participation by women. Evidently, increased exposure to trade notwithstanding, over the years the American economy has been able to generate the jobs needed to accommodate millions of new entrants to the labor force. Evidence from international comparisons also runs strongly counter to the view that trade depresses aggregate employment. Notably, despite its large trade deficit, the United States has experienced a significantly greater expansion in employment over the past decade than either Germany or Japan, both of which have enjoyed perennial trade surpluses. Although the labor force and labor-market institutions determine employment in the long run, short-run cyclical influences, such as transitory changes in spending or productivity, may cause employment to deviate from its long-run sustainable level. Even in the short run, however, there is no discernable link between aggregate employment and changes in trade volumes or the trade balance. For example, over the past two decades, even as U.S. trade has expanded rapidly, the quarter-to-quarter volatility of both output and employment has decreased noticeably, and recessions have become less frequent and milder than in earlier decades (Bernanke, 2004). In recent years, the sharpest deterioration in the U.S. trade balance occurred between 1997 and 2000, a time during which domestic employment was growing at a rapid pace. My focus thus far on the net effect of trade on jobs ignores the fact that those who lose jobs for trade-related reasons are not necessarily the same people who get the new jobs created by trade. Trade, like other factors resulting in structural change, can have noticeable effects on the mix of jobs across industries, skill levels, and locations. Those who lose jobs, whatever the cause of the dislocation, have real reason to be unhappy, because job loss often entails economic hardship - a point that I will shortly discuss in more detail. However, in our dynamic economy, jobs are created and destroyed in great numbers all the time. How important are trade-related factors in this ongoing process of job creation and destruction? To address the key area of public concern, I will focus here on the job-loss side of the equation. Estimates of the gross number of job losses associated with increased import penetration vary widely, but one representative calculation, by Lori Kletzer (2001), put the gross job loss due to imports at nearly 310,000 per year for the period from 1979 to 1999. I stress that Kletzer’s estimate of gross job loss ignores any jobs created by trade, either directly or indirectly. The amount of “churn” in the U.S. labor market is enormous, a reflection of the continuous stream of entry, exit, and resizing of firms in our ever-changing economy. In order to get some perspective on Kletzer’s estimate of trade-induced job loss, then, we should compare it to the number of workers who are displaced each year in the United States for all reasons, including firm or plant closings, corporate restructuring, automation, or the ending of fixed-term employment. According to the Bureau of Labor Statistics (BLS), over the past ten years, gross job losses in the United States have averaged about 7.7 million jobs per quarter.4 Multiplying 7.7 million by four suggests that about 31 million U.S. jobs are eliminated each year. Research suggests, however, that because this number includes temporary layoffs, seasonal closings, and other job losses that are reversed within the year, it overstates longer-term job losses by about double (Davis, Haltiwanger, and Schuh, 1996). Hence, a reasonably conservative estimate is that, excluding seasonal and other short-term layoffs, about 15 million jobs are lost each year in the United States, equal to nearly 14 percent of the current level of nonfarm private employment. Of course, because net private-sector job creation in the United States over the past ten years has averaged more than 1.8 million per year, these losses were more than offset by the creation of about 17 million jobs per year during the same period. Truly, the U.S. labor market exhibits a phenomenal capacity for creative destruction. Comparing the 310,000 or so gross job losses per year that Kletzer (2001) attributes to increased imports to the 15 million total job losses, we find that only slightly more than 2 percent of gross job losses are the result of import competition. In other words, for the typical job loser during the past ten years, the chances are 98 percent that some factor other than competition from imports was the principal reason for displacement. Data are for the period 1992:Q3 to 2003:Q2 and are drawn from the BLS’s Business Establishment Dynamics survey. Kletzer’s calculations apply to the longer period since 1979. What about the current situation? Although U.S. employment stagnated for an extended period after the recovery got under way and has recently risen only slowly, there is little basis for blaming the recent poor employment performance on import competition. Indeed, as a share of GDP, imports to the United States have actually fallen since 2000, from 14.7 percent of GDP in 2000 to 13.7 percent in 2003. The worsening of the U.S. trade deficit as a share of GDP in recent years is entirely due to a fall in exports, from 10.9 percent of GDP in 2000 to 9.3 percent of GDP in 2003. Thus, to the extent that trade patterns are contributing at all to the current weakness in employment, the more relevant concern is that foreign economies are not growing as fast as our own and hence are not generating as much demand for our exports as we would like. Even if the overall level of employment is largely unaffected by trade, some have argued that trade adversely affects the composition of jobs, for example, by replacing relatively high-paid manufacturing jobs with lower-paid service-sector jobs. I will return shortly to the issue of why manufacturing employment has declined in the United States. I only note here that little evidence supports the view that trade has an adverse effect on wages or the mix of jobs in the economy as a whole. In particular, the often-expressed view that the ongoing shift of jobs from manufacturing to services has depressed earnings does not seem generally to be true. For example, during the 1990s, average earnings in manufacturing industries that showed net declines in employment (weighted by the number of job losses) were $10.63 per hour. During the same period, wages in expanding service-providing industries (weighted by the number of job gains) were $11.26 per hour, about 6 percent higher. What about outsourcing abroad? The debate about the effects of trade on employment has been intensified recently by an upsurge in trade in business services, popularly referred to as outsourcing abroad, or “offshoring.”5 New interest by U.S. corporations in outsourcing white-collar activities has been driven by several factors, including improvements in international communications; the computerization and digitization of some business services; and the existence of educated, often English-speaking, workers abroad who will perform similar services for less pay. When feasible, offshoring has obvious attractions for business. Comparative wage data suggest why. Estimated average wages for software developers are $6 per hour in India, compared with $60 per hour in the United States (McKinsey Global Institute, 2003). Similarly, average wages for telephone operators are estimated to be less than $1 per hour in India and about $12.50 per hour in the United States (Bardhan and Kroll, 2003). (A portion, but certainly not all, of these wage differentials reflects differences in skills; for example, programmers in India generally perform simpler and more routine tasks than do those in the United States.) The increase in outsourcing abroad - particularly of activities previously considered immune to foreign competition - has led to dire predictions about a wholesale “export” of U.S. jobs in coming years. Although globalization will continue to be a force for economic change, the pace of change is likely to be slower than implied by such predictions. Outsourcing abroad has proved profitable primarily for jobs that can be routinized and sharply defined. For the foreseeable future, most high-value work will require creative interaction among employees, interaction that is facilitated by physical proximity, personal contact, and shared cultural experiences. Moreover, in many fields, closeness to customers and knowledge of local conditions are also of great importance. These observations suggest that, for some considerable time, outsourcing abroad will be uneconomical for many types of jobs, particularly high-value jobs.6 Fundamentally, the outsourcing of business services abroad is not a new phenomenon. In an increasingly interdependent world economy, trade in services, like trade in goods, is being harnessed to the goals of cutting costs and expanding production. That outsourcing abroad benefits the receivers as well as the providers of outsourced services has been shown by empirical studies. For example, Catherine Mann (2004) has estimated that outsourcing abroad has reduced prices of IT hardware 10 to 30 percent, boosting the diffusion of information technology throughout the U.S. economy and The term outsourcing alone refers to the shift of activities outside the corporation, including the use of domestic as well as foreign suppliers. I will use the phrases outsourcing abroad or offshoring to denote outsourcing to foreign suppliers. The economic importance of physical proximity is the underlying reason that individuals and businesses are willing to pay high rents and other costs to live in or near major cities, where they can be near large numbers of other people and businesses that have related expertise and interests. raising both productivity and growth by a very significant amount - 0.3 percentage point per year.7 The McKinsey Global Institute (2003) finds that for every dollar of activity outsourced to India, the United States receives between $1.12 and $1.14 in economic benefits.8 As with trade in general, it is useful to ask how much outsourcing abroad contributes to gross job loss in the United States. Unfortunately, as with trade in general, measures of gross job loss associated with outsourcing abroad are scarce. An analysis by Goldman-Sachs (2003) estimated that U.S producers shifted between 300,000 and 500,000 jobs abroad during the past three years, an average of between 100,000 and 167,000 jobs per year since 2000. This estimate includes jobs both inside and outside manufacturing (that is, it includes both goods and services) and reflects increased imports from foreign affiliates of U.S. corporations. Based on this analysis, Goldman-Sachs argues that, over the next several years, offshoring of business services may rise to several hundred thousand jobs per year. Again, to gain perspective, we should compare these estimates with the overall rate of job displacement in the United States. Two hundred thousand jobs per year amount to a bit more than 1 percent of the 15 million or so jobs that are lost each year in the U.S. economy for all reasons. Quantitatively, outsourcing abroad simply cannot account for much of the recent weakness in the U.S. labor market and does not appear likely to be an important restraint to further recovery in employment. Moreover, a balanced discussion of outsourcing abroad should reflect the fact that, just as U.S. firms use the services of foreigners, foreign firms make considerable use of the services of U.S. residents. An underappreciated fact is that, in contrast to its trade deficit in goods, the United States runs a significant trade surplus in services. The official trade data do not have direct measures of outsourcing of services abroad, but much of what we would consider offshoring is likely included under the heading “Business, Professional, and Technical Services,” a category of trade in services.9 In 2002, the latest year for which complete data are available, the United States exported nearly $29 billion in business services. Against these exports, U.S. imports of business services in 2002 totaled less than $11 billion (about 0.1 of 1 percent of U.S. GDP), for an overall surplus in business services trade of $18 billion. Moreover, U.S. exports of business services have increased $3.5 billion since 2000, a period during which imports of business services increased only $2 billion.10 An important reason for the U.S. trade surplus in business services is that this country provides many high-value services to users abroad, including financial, legal, engineering, architectural, and software development services, while many of the services imported by U.S. companies are less sophisticated and hence of lower cost. As discussions of the outsourcing of business services tend to ignore the large amount of “insourcing” of services to the United States from other countries, so do discussions of American firms moving jobs abroad ignore the fact that foreign firms also move jobs to the United States. Between 1997 and 2001 (the most recent data available), employment of U.S. residents by affiliates of foreign companies operating within the United States increased by about 1.2 million jobs. In 2001, U.S. affiliates of foreign companies accounted for nearly $500 billion in gross output (about half in manufacturing) and about $164 billion in exports. Globalization and outsourcing work both ways. So why is the recovery jobless? We have little evidence to show that trade in general, or outsourcing abroad in particular, is a major source of net job loss. Yet, two-and-a-half years into the economic recovery, the pace of job creation Comparing data for 1999 and 2003 to eliminate the largest effects of the high-tech boom- and-bust cycle, Mann also shows that U.S. employment in several white-collar occupations related to IT or deemed vulnerable to IT-enabled outsourcing has in fact been stable or expanded modestly. Although my focus today is on the United States, we should not ignore the benefits of outsourcing to countries that provide these services. Software developers and telephone operators who provide offshore services from a country such as India are afforded a precious opportunity for economic advancement, and their country as a whole becomes richer, more competitive, and more integrated into the world trading system. Moreover, outsourced service jobs do not typically bring along collateral issues of potential environmental damage and poor working conditions that have concerned some critics of expanded trade. Some components of this category probably contain little outsourcing, for example, construction services, whereas some categories outside Business, Professional, and Technical Services, for example, telecommunications, may contain significant amounts of outsourced services. None of the conclusions drawn in the text is changed by considering the subcategories in greater detail. In the broader category of Other Private Services, of which Business, Technical, and Professional Services is a subset, in 2003 the United States had a trade surplus of $53.6 billion, up from $41.7 billion in 1997. in the United States has been distressingly slow. Job losses in manufacturing have been particularly deep, with employment in that sector apparently only now beginning to stabilize after falling by almost 3 million jobs since 2000. Why has the recovery been largely jobless thus far? In a speech presented last November (Bernanke, 2003), I discussed a number of factors underlying the reluctance of U.S. firms to increase their workforces. I concluded then, and continue to believe, that the single most important factor explaining lagging job creation is the astonishing gains in labor productivity that have been achieved in the U.S. economy in the past few years. According to the Bureau of Labor Statistics, labor productivity in the nonfarm business sector increased 4.3 percent in 2002 and 5.4 percent in 2003. For comparison, productivity advanced at an average rate of 2.5 percent per year from 1996 to 2000, a period that was viewed at the time to be one of exceptionally strong productivity growth. Most economists would agree that new information and communication technologies, together with organizational changes facilitated by those technologies, have been an important source of these impressive productivity gains. Note that, because the productivity figures are based on measures of domestically produced output and domestic employment, to a first approximation cost savings reflected by outsourcing abroad are not reflected in, and thus cannot explain, the recent surge in productivity.11 The gains in domestic labor productivity are great news for Americans in the long run, as they will promote higher wages, profits, and living standards in this country. In the short term, however, increased productivity has permitted the U.S. business sector to meet strong final demand for its output without having to hire significant numbers of new workers. The effect of productivity gains has been particularly marked in the U.S. manufacturing sector. Productivity gains of 3.8 percent in 2001, 6.4 percent in 2002, and 5.8 percent in 2003 (as reported by the BLS) have permitted U.S. manufacturers to reach levels of production only about two percent below the cyclical peak in mid-2000, despite the sharp decline in employment.12 The general trend toward higher productivity and decreased employment in manufacturing has been observed for decades in the United States, although the process has recently intensified. Other countries have had similar experiences. For example, while U.S. manufacturing employment has declined 18 percent since 1990, the comparable figure for Japan is nearly 22 percent and for the United Kingdom it is more than 27 percent. Developing countries have experienced a similar pattern. Even China, supposedly the destination of U.S. manufacturing jobs, has seen manufacturing employment shrink by more than 15 percent since its peak in 1995.13 The long-run trend in manufacturing in the United States and other industrialized countries is similar to what occurred earlier in agriculture. At one time a majority of the U.S. population lived on farms. However, agricultural productivity has improved so much over the years that, although farm workers make up only about 2-1/2 percent of the workforce, they are able both to feed the nation and (as noted earlier) export substantial quantities of food as well. When will the U.S. economy begin to create jobs in significant numbers? The recent rates of productivity growth are unprecedented, and hence likely unsustainable. Thus, if output growth continues at its current robust pace, job creation will surely follow. However, because we do not know exactly how either productivity or aggregate spending will evolve, predicting the timing of a jobs resurgence is difficult. Although, like many economists, I have been surprised by the unusually slow recovery of the labor market, I continue to believe that steady improvement in the labor market over the remainder of this year is the most likely outcome. The qualification to a first approximation is included because outsourcing will affect measured domestic labor productivity if it leads to a significant change in the skills and wage composition of domestic jobs. However, outsourcing abroad almost certainly explains little of the recent increase in labor productivity; indeed, if outsourcing results in the loss of high-skill, high-wage jobs in the United States, as many fear, its effect would be to lower rather than to raise domestic labor productivity. Production is measured here by the manufacturing component of the industrial production index. Data are from country sources and may not be precisely comparable. Latest data for China are for 2002. There are questions about the reliability of Chinese data, and part of the decline in Chinese manufacturing employment reflects the closure of state-owned enterprises. What can policy do? I have argued today that, in general, increased trade does not reduce employment and, more specifically, that trade bears little responsibility for the recent slow pace of job creation in the United States. Moreover, the economy taken as a whole clearly benefits from trade. Still, as I have noted, to say that the U.S. economy benefits from trade is not to say that every individual American worker or family benefits, or that the structural changes induced by trade are not disruptive. Clearly, some workers who have been displaced or have had a difficult time finding work during the past three years can accurately claim to have been made worse off by international competition. Job loss in particular causes significant hardships for affected workers. For example, an analysis by Henry Farber (2003), using BLS data on workers displaced for any reason, suggests that only about two-thirds of displaced workers found re-employment within three years, with some settling for part-time work. Even when successful in finding full-time work, displaced workers experience on average a decline in earnings on the new job of about 8 percent. Focusing on workers displaced by trade in particular, Kletzer (2001) found that job losers in industries facing high levels of import competition were slightly less likely to be re-employed and experienced greater earnings losses, at about 13 percent on average, than workers displaced from industries facing less import competition. What can be done to help workers who lose their jobs because of competition from imports? Attempts to restrict trade through the imposition of tariffs, quotas, or other trade barriers are not a good solution. Such actions may temporarily slow job loss in affected industries. But they do so by imposing on the overall economy costs that typically are many times greater than the benefits. In the short run, the costs of trade barriers include higher prices for consumers and higher costs (and thus reduced competitiveness) for U.S. firms. Trade barriers typically provoke retaliation from trading partners as well, with potentially large costs for exporters. And history shows that in the longer run, economic isolationism and retreat from international competition lead to bloated, inefficient industries, lower productivity, and lower living standards. The better policy approach is two-pronged. First, at the macro level, policy should be directed at helping to ensure that jobs become available for those who have been displaced. In particular, over time, appropriate monetary policies can help the economy achieve maximum employment with low inflation, irrespective of the trade situation. The nation’s trade policies, rather than attempting to restrict trade, should be used to push for even more trade. By opening markets abroad, trade policy provides greater opportunities for U.S. firms and workers. The second piece of a constructive policy toward trade is to help displaced workers train for and find new work. Some steps in this direction have been taken. Currently, the government’s principal program for helping workers displaced by trade is the Trade Adjustment Assistance program, or TAA. The Congress has recently extended the TAA through 2007, while adding a special TAA program for older workers and a separate TAA program for farmers. The TAA program offers up to two and a half years of job training, allowances for job search and relocation, and income support for eligible workers, the latter for up to 104 weeks after the initial 26 weeks of conventional unemployment insurance benefits have been exhausted. The recently passed legislation also provides for health insurance assistance for some eligible workers. The U.S. Department of Labor certified about 208,000 workers for trade adjustment assistance during fiscal year 2003, spending $551 million on the program. Finally, although current TAA legislation is generally interpreted to apply only to jobs displaced in manufacturing, bills to extend TAA to service-sector workers were introduced this month in both the House and Senate. TAA is certainly not a perfect program. A recent report by the General Accounting Office described the challenges of effectively retraining older, less-educated workers. It noted also that TAA does not address all the problems of communities that have suffered from plant closings and the like. More general criticisms can be raised about the program: First, in a complex and interdependent economy, identifying workers affected by trade is not always a straightforward matter. Second, one may well wonder why workers displaced by trade should be assisted but not workers displaced by other factors, such as restructuring or automation. Lately, a number of proposals have been advanced to help displaced workers more generally, including changes in law that increase the portability of pension and health benefits. Other proposals include a program of “wage insurance,” which would help to cushion the wage loss that often occurs when job losers take new jobs (Kletzer and Litan, 2001) and tax credits for firms that invest in worker training (Mann, 2003, 2004). Time does not permit me to evaluate these and other alternative proposals today. Instead I will conclude by noting that helping displaced workers is good policy for at least three reasons. First, reducing the burdens borne by displaced workers is the right and fair thing to do. Second, helping workers who have lost jobs find new productive work is good for the economy as well as for the affected workers and their families. Finally, if workers are less fearful of change, less pressure will be exerted on politicians to erect trade barriers or to take other actions that would reduce the flexibility and dynamism of the U.S. economy.14 In the long run, avoiding economic isolationism and maintaining economic dynamism will pay big dividends for everybody. According to opinion polls, the public is far more willing to accept free trade policies if they are accompanied by assistance for workers and firms that may be damaged by trade (Kull, Ramsay, Subias, and Lewis, 2004).
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Remarks by Mr Edward M Gramlich, Member of the Board of Governors of the US Federal Reserve System, at the Federal Reserve Board Models and Monetary Policy Conference, Washington, DC, 26 March 2004.
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Edward M Gramlich: The Board’s modeling work in the 1960s Remarks by Mr Edward M Gramlich, Member of the Board of Governors of the US Federal Reserve System, at the Federal Reserve Board Models and Monetary Policy Conference, Washington, DC, 26 March 2004. * * * I am delighted to be speaking at a conference honoring Dale Henderson, Dick Porter, and Peter Tinsley. I remember all of them from long ago. Peter and I joined the Board staff in September 1965, when Pat Hendershott and Bob Parry also joined. At least in terms of longevity, that was a pretty significant hiring month. I remember being on a panel with Dick at an academic conference in those days. He had not yet joined the Board, being an assistant professor at Ohio State. Being thoroughly a Michigan man now, I probably should not admit it, but I also met him, along with Dave Lindsey, when I interviewed for a job at Ohio State. The job interview didn’t pan out, I think mainly on my side but perhaps on theirs too. I also knew Dale back then. He joined the Board shortly after I left, but I met him socially in the early 1970s. Frankly, I still remember one thing he said to me. When I mentioned that I used to be on the Board’s staff, he said he knew - he had read some of my stuff. “Well,” I said expectantly. “Oh, some of it’s OK,” he said. With his subsequent international exposure, Dale has gotten much more diplomatic over the years. All three principals have made great contributions to economic modeling at the Board. Peter started with optimal control techniques and distributed lags, and continued with rational expectations estimation procedures. Dick’s work focused on money demand and monetary control techniques. Dale was instrumental in developing the Board’s global model. All three have generally promoted research at the Board, helped younger scholars get established, sponsored working paper series, and fought for better computers and other support. As for the models themselves, the topic of the conference, I feel like Rip Van Winkle. In the very early days, 1965-70, I was here and indeed right in the middle of the producer side of the model work. Then I went off and did other things for twenty-seven years, returning in 1997 as a consumer of models. Things changed a lot in those twenty-seven years. Most of you are reasonably familiar with what the model looks like now. But apart from the real graybeards, the three principals and I, most of you were probably in grade school when this work actually started. Let me recall a few stories from the old days. The main motivator at the Board in those days was Frank de Leeuw. For all who knew Frank, he was one of the most “market undervalued” economists of all time. All the young people at the Fed then felt he walked on water. Frank formed a team of economists here - Tinsley, Hendershott, Al Tella, and me among others - and an academic team featuring the late Franco Modigliani from MIT and the late Albert Ando from Penn. Bob Rasche, now research director at the St. Louis Fed, and Harold Shapiro, later to be my university president at Michigan, were also junior professors at Penn and part of the team. Jerry Enzler, whom many of you remember fondly, as I do, was somewhere in transition, starting as a Penn graduate student and moving to the Board staff, where he too stayed many years. The model we put together in those days has been enshrined in publications and I won’t describe it much. It probably had about the coverage of the present day FRBUS, and it had many of the then exotic channels of monetary policy. There was a consumption-wealth effect working through equity values and housing values, and both of those prices were endogenous. At one point, Franco got one of his graduate students, a lively kid named Larry Meyer, to do his thesis on this link. There was a foreign sector, but exchange rates were exogenous because we had pegged rates back then. There was also a credit-rationing channel based largely on the work of another Franco graduate student, Dwight Jaffee, who is now an authority on government-sponsored enterprises at Berkeley. What we didn’t have in those days was forward-looking expectations behavior. In qualitative terms we all knew the difference between adaptive and rational expectations, but nobody knew how to estimate rational expectations equations. This is one area where technical work over the years has made a large difference, and I gather that several people in the room, especially Peter Tinsley, have been responsible. In more immediate terms, the aspect of the model that still recalls frustration was that whenever we ran dynamic full-model simulations, the simulations would blow up. I can’t tell you how many hours Jerry Enzler and I spent feeding in our regression cards, and our simulation cards, to work on this issue. Yes, we fed in punch cards in those days. Nowadays when Board economists present the results of dynamic simulations in briefings, and the simulations look very reasonable, I think I am one of the few people in the room who is deeply impressed. Doctrinal historians will have fun with the naming of this model. Whenever Board people wrote about it, it was the Fed-MIT model, or perhaps the Fed-MIT-Penn model. When Ando wrote it became the MPS model - MIT-Penn-Social Science Research Council model. All the Social Science Research Council did was to give Ando a grant. And where was the Fed? We did do a lot of the early work on the model. A number of people have raised questions about monetary and fiscal policy itself in the 1960s - how could policy have been so misguided? First off, let me say that the modeling group was quite aware of the natural rate hypothesis then. We knew that an adaptive expectations Phillips Curve would explode if the lag coefficient was one - we just couldn’t get its estimated value to be one. We had yet to apply Kalman filters or other split-sample techniques and were yet to realize the problems with the sum of the lagged coefficients test. But even apart from lag effects, as papers by Bill Poole (another Division of Research and Statistics staff member from those days), George de Menil (another Franco student), and Jerry Enzler show, our nonlinear Phillips Curves became very, very steep at low unemployment rates, implying that inflation would become uncontrollable at low unemployment rates. On the point Athanasios Orphanides raises about the value of the natural rate, we probably were wrong about that. I remember being stunned by a Bob Hall paper in the 1970s that placed the natural rate at about 5 percent. By the way, in the mid-1970s Franco began calling this rate NIRU, and later Jim Tobin, I think, switched it over to NAIRU. But the main problems with policy in those days were, um, with the policymakers. First off, presidential interference on discount rate policy got the discount rate set below the funds rate in 1965, a problem we never fixed until two years ago. I think this artificially low discount rate may have held down the funds rate, leading to the overly expansionary monetary policy amply documented by John Taylor. It was obvious to virtually all economists that the country needed a permanent budget shift as Vietnam spending increased, but what came out of that was a delayed temporary tax increase. Anything else would have made the war less popular, and by then the Vietnam War was pretty darn unpopular. Quite possibly, our intellectual understanding was not where it should have been in the late 1960s, but 90 percent of the policy problems were political, with the policymakers themselves. These days the Board staff makes a baseline forecast and grafts on FRBUS to get the results for alternative scenarios. We actually began to do these types of experiments once our model was put together in the late 1960s. I was dying to present the results to the Board, but never could get past Lyle Gramley, our sponsor but also our gatekeeper. He didn’t trust the model enough when it was used as a pure forecasting device. Then, as I suppose now, we had the most trouble forecasting equipment investment - most of the other final demand sectors worked pretty well. The investment accelerator was also the reason our dynamic simulations ran off-track. When we would suspend the investment equation, things would work reasonably well. I have heard the modern day staff complain about estimating an accelerator effect for equipment and software and, believe me, I am sympathetic. Another place where the intervening years have made a real difference is the way in which the baseline forecast itself was put together. In our day it was totally anticipations data - leading indicators of this or that, for a quarter or two ahead at most. Today I hear Dave Stockton describe the baseline forecast in very model-oriented terms - this effect, that coefficient, and so forth. Nowadays the baseline forecast also runs out a few years, something the judgmental forecasters of earlier days would never have attempted, and it even has measures of forecast uncertainty. All of these are real improvements, far beyond what was done in the 1960s. For me, this work all came to an end in May 1970. At the time I felt we had brought the model as far as I thought we could bring it, at least for a while, and I really wanted to do some other kind of economics. Whether the external pastures were in fact greener I will never know - they just seemed greener at the time. So I left the Board staff, confident that I would never return either to the Board or to large-scale macro modeling. But sure enough, there were some other twists of fate and here I am, back, as a model consumer. And, I think, an ideal consumer because I realize how hard it is to do this kind of work.
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Remarks by Mr Edward M Gramlich, Member of the Board of Governors of the US Federal Reserve System, at the Los Angeles Chapter of the National Association for Business Economics Luncheon, Los Angeles, 31 March 2004.
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Edward M Gramlich: Budget and trade deficits - linked, both worrisome in the long run, but not twins Remarks by Mr Edward M Gramlich, Member of the Board of Governors of the US Federal Reserve System, at the Los Angeles Chapter of the National Association for Business Economics Luncheon, Los Angeles, 31 March 2004. Presented at the Euromoney Bond Investors Congress, London, England, 25 February 2004. * * * Thank you for inviting me to speak today. While I know that most of you would welcome any insights I might have about current U.S. monetary policy - whether the Open Market Committee will be raising or lowering interest rates at our next meeting - I prefer to focus instead on some issues that could become serious over the longer run. These issues involve the persistent budget and trade deficits facing the American economy, issues that could eventually involve significant economic adjustments around the world.1 Large budget and trade deficits are not a new phenomenon. They also arose in the United States in the mid-1980s. At that time, the business press and many economists began referring to the situation as one of “twin deficits.” With the current re-emergence of both deficits, the phrase has come back into common usage - too common, in my view. To be sure, in theoretical models there is a scenario by which budget deficits can create trade deficits, and one by which trade deficits can create budget deficits. But there are also many scenarios by which either deficit can arise independently, or even by which budget and trade deficits can move in opposite directions, as they did in the 1990s. In general, while budget and trade deficits can be linked, there are important differences between the two, both in how they respond to economic forces and in their long-run consequences. I start by examining the relationship between budget and trade deficits - why they are linked but not twins. I discuss the sustainability conditions for budget and trade deficits; the conditions that must be fulfilled for the debts on both accounts to be stabilized in relation to the size of the U.S. economy. Then I discuss what happens if either debt violates this condition and rises in relation to the size of the economy. This discussion, in turn, raises further interesting distinctions between the two deficits. The link The link between budget and trade deficits can be seen most naturally through the national income accounting framework. Any saving the nation does finances either private domestic investment directly or the accumulation of claims on foreigners. This means that national saving - the sum of private and government saving - equals private domestic investment plus that period’s accumulation of claims on foreigners, or the trade surplus. The trade surplus can also be thought of as net foreign lending. All of these relationships are accounting identities - true at every moment in time apart from data inconsistencies captured by a statistical discrepancy. In equation form, we have NS = S - BD = I - TD On the left side of the equation NS refers to national saving, S refers to overall private saving, and BD refers to the government budget deficit. This part of the equation says merely that total national saving equals the sum of all saving done in the economy by the private sector and the government sector. A budget surplus would be treated as governmental saving and added to private saving; a budget deficit would be treated as governmental dissaving and subtracted. The right side of the equation repeats the familiar open economy identity that national saving equals private domestic investment, I, plus the accumulation of claims on foreigners or less that domestic As with all such talks, I am speaking for myself and not for other members of the Federal Reserve Board or the Federal Open Market Committee. investment financed by foreigners. As was noted earlier, borrowing from foreigners involves either a reduction of claims on them or an increase of claims on us by them. It is by definition equal to the trade deficit TD. In the equation, then, a trade surplus means that some national saving goes to building up claims on foreigners (national saving is greater than domestic investment) while a trade deficit means that some investment is financed by foreigners (national saving is less than domestic investment). This identity first demonstrates the all-important role of national saving in shaping long-run economic welfare. National saving is the only way a country can have its capital and own it too. Models of the economic growth process identify national saving as one of the key policy variables in influencing a nation’s living standards in the long run. The identity also makes clear that the budget deficit and the trade deficit can move together on a dollar-per-dollar basis, but only if the difference between private domestic investment and private saving is constant. Typically that difference will not be constant. For example, if there were to be an investment boom, interest rates might rise to induce some new private saving and some new lending by foreigners. The implied trade deficit might rise and, because of the rise in income, the budget deficit might fall. In this case, the trade deficit would increase while the budget deficit fell. Conversely, suppose that expansionary fiscal policy resulted in a rise in budget deficits. If this expansion were totally financed by borrowing from foreigners, domestic interest rates would not change much, and domestic investment and private saving might not either. In this scenario, there could be a simultaneous dollar-per-dollar change in budget and trade deficits - the classic twin-deficit scenario. Such a situation is most likely to occur in small economies fully open to international trade and capital flows, economies in which domestic interest rates are determined by world capital markets and are independent of domestic economic variables. But if domestic interest rates do change, as they likely would in either a closed economy or a large open economy, private investment and saving would also likely change, and any strict link between budget and trade deficits would be broken. One could spin any number of scenarios, but these are enough to make the basic point. Because of the underlying relationship between saving and investment, budget and trade deficits could be strictly linked. But in a large open economy like the United States, it is easy to imagine plenty of scenarios in which they are imperfectly linked, and even some scenarios in which they move in opposite directions. Budget and trade deficits should be viewed as linked, but not as twins. Stability conditions Although the economic implications and reactions of budget deficits and trade deficits differ, both are deficits. Another elementary accounting identity says that last period’s debt level plus the current deficit equals the current period’s debt level. This identity is true whether we are talking about budget deficits building up the stock of outstanding government debt (a liability of the government sector to the private sector), or trade deficits building up the stock of external debt (the net stock of accumulated foreign claims against the United States).2 Economists have worried for years about optimal stocks of government and external debt. For government debt, the optimal stock turns out to be related to the optimal level of national saving, which can be defined as the level that maximizes the nation’s long-term path of consumption per worker. The optimal stock of net external debt can be determined in the same framework from an open economy perspective. While these models can be instructive, today I am going to focus on a weaker standard. Whatever the long-term optimal level of government debt, and whatever the optimal level of external debt, one can separately ask whether either debt level is becoming a more, or less, important economic factor over time. For government debt, this weaker standard, or stability condition, determines merely whether the ratio of debt to gross domestic product (GDP) is stable. If it is, interest payments on the debt will, in equilibrium, also settle down to a stable proportion of GDP. For external debt, a stable debt-to-GDP ratio means that the net interest and dividend payments of the United States to foreign investors will also settle down to a constant ratio to GDP. Both debt stocks would also include a valuation adjustment to deal with capital gains and losses. The appendix derives this stability condition generically. It is that d (g - i)/(1 + g) = p, where d is the stable ratio of debt to GDP, g is the nominal growth rate of the economy, i is the nominal interest rate in the economy, and p is the ratio of the primary deficit to GDP. For budget accounts, the primary deficit is the national income accounts budget deficit, but excluding interest payments. For trade accounts, the primary trade deficit is the current account deficit, excluding net interest and dividend payments to foreigners.3 As a general rule, the economy’s growth rate and interest rate will be fairly close. The equation says that if they are equal, the primary deficit must be zero to stabilize the debt-to-GDP ratio. If the interest rate is slightly above the growth rate, as it would be in models without risk for economies that save less than the theoretical optimum, a nation with outstanding debt would have to run a slight primary surplus to stabilize its debt-to-GDP ratio. If the effective interest rate on debt is slightly below the growth rate, as it has generally been found to be in the past for both deficits, a nation with outstanding debt could run slight primary deficits and not see the debt ratio grow.4 On the foreign side, this condition has until now been especially forgiving. Even with a large net debt position, our net investment income from foreigners has exceeded that paid out to foreigners. Since the net interest rate has been less than the GDP growth rate, the ratio of external debt to GDP could have been stabilized with a moderate primary trade deficit.5 Magnitudes It is well known that the U.S. economy now suffers both budget and trade deficits. But how do these deficits compare with the stability conditions? Historically, there have not been significant instabilities in U.S. federal budget deficits.6 Overall deficits have averaged about 2 percent of GDP over the past four decades, but figure 1 shows that when interest is deducted, primary budget deficits have averaged close to zero, the approximate level that stabilizes the debt-to-GDP ratio. Hence, the outstanding debt, while fluctuating in the range of 25 percent to 50 percent of GDP, has actually declined slightly as a share of GDP. It was 38 percent of GDP in the mid-1960s and is now only 37 percent of GDP. The ratio did rise as high as 50 percent in the high-deficit years of the early 1990s, but it dropped sharply thereafter with the primary budget surpluses of the late 1990s. Looking ahead, things might not be so favorable. As a result of recent fiscal changes, the budget has lately fallen into primary deficit again; this primary deficit is now more than 2 percent of GDP (1.5 percent after cyclical adjustment). The deterioration reflects the much-discussed recent rapid growth in expenditures, along with significant tax cuts. Perhaps more significant, in a few years the United States will face huge looming costs for retirement and health programs. It will take extraordinary fiscal discipline just to keep the present primary deficit near its current level of 1 to 2 percent of GDP over the short, medium, and long run. And even at that level, the stability condition is violated by at least 1 percent of GDP, suggesting that the debt-to-GDP ratio is likely to climb steadily upward.7 This primary trade deficit differs from the trade deficit component of GDP mentioned earlier because it includes foreign transfers and other small items. Laurence Ball, Douglas W. Elmendorf, and N. Gregory Mankiw, “The Deficit Gamble,” Journal of Money, Credit, and Banking, vol. 30, no. 4, (November 1998), pp. 699-720, show that interest rates on domestic government debt have generally been slightly less than the GDP growth rate in past decades. The rate-of-return puzzle is in turn a question about why foreign direct investment in the United States has such a low rate of return. See Raymond J. Mataloni, Jr., “An Examination of the Low Rates of Return of Foreign-Owned U.S. Companies,” Survey of Current Business, vol. 80 (March 2000), pp. 55-73. Even though the previous identity referred to the consumption budget for the entire government sector, in this section I switch over to the familiar concept of the total budget for the U.S. federal government. State and local governments more or less finance their current spending and do not have much outstanding debt apart from that backed by capital formation; and federal capital investment is very small. These statements are based on estimates of the Congressional Budget Office, The Budget and Economic Outlook, Fiscal Years 2005 to 2014 (January 2004). A further discussion of the long-run budget outlook can be found in Alan J. Auerbach, On the trade side, figure 2 shows that the trend is definitely more worrisome. While the budget debt has fluctuated between 25 percent and 50 percent of GDP over the past several decades, the net external debt has grown steadily. Until 1985, this external debt was not even positive; that is, until that time the United States had net claims on foreigners. But because the United States has run persistent and sizable primary trade deficits since 1990, the net external debt is now 25 percent of GDP and rising sharply. The primary trade deficit is now 5 percent of GDP, violating the stability condition by nearly this same amount. At this rate, the external debt ratio will climb very quickly. While the trade deficit does have equilibrating tendencies, as will be discussed later, there are also forces that tend to increase it. Econometric studies of the basic demand for imports and exports find that the U.S. income elasticity of demand for imports is higher than the foreign income elasticity of demand for U.S. exports. This means that even if the world economy grows at the same rate as the U.S. economy, our trade deficit is likely to widen, (apart from any changes in relative prices).8 Indeed, the U.S. primary trade deficit has widened steadily since 1990. Adjustments I have just argued that the U.S. is now in violation of the stability condition for both budget and trade deficits - recently and moderately on the budget side, persistently and significantly on the trade side. What are the implications? With each deficit there is probably a credibility range. By that, I mean a limited range within which a country may be able to violate its stability condition and have its debt-to-GDP ratio trend upward without further economic consequences. For budgets, there may be a range within which the debt-to-GDP ratio can grow without significant changes in interest rates.9 As equation 1 indicates, economic performance in this range is by no means optimal, because the persistent deficits are subtracting funds that would otherwise be devoted to capital investment and future growth in living standards. But there may not be significant relative price effects. The same is true on the trade side; there could be a range in which foreign claims on the United States just build up without major impact on relative prices. Once the economy gets outside of the credibility range, more significant relative price adjustments become likely. On the trade side, for example, the continued accumulation of foreign claims on the U.S. economy will raise the issue of whether foreign investors will want to hold an ever-increasing share of their wealth in the form of U.S. assets. Or, as is the focus of the stability condition above, whether the U.S. economy can indefinitely pay out ever-higher shares of GDP in the form of interest and dividend payments. The conventional view is that at some point there should be a relative price adjustment - some combination of rising U.S. interest rates (to make U.S. assets more attractive), rising foreign prices (to make imports more expensive), moderating U.S. prices (to make U.S. exports more competitive), or a change in exchange rates. Each of these reactions is likely to occur naturally, and each moves in the direction of lowering the external imbalance. That is why foreign trade deficits are typically thought of as self-correcting. The main risk here is that the natural adjustments may not occur gradually, but so rapidly as to threaten various types of dislocations. There are complicating factors. One involves the currency denomination of the net debt. Countries with large trade deficits often have their external liabilities denominated in a foreign currency. Hence, when their own currency depreciates, the value and burden of foreign debt automatically increases. The United States does not have this problem because most of its debt is denominated in dollars say, foreign holdings of U.S. Treasury bills. If the dollar were to fall, the value of our debt in terms of foreign currencies would then automatically decline, inducing foreign wealth-holders to make further William G. Gale, Peter R. Orszag, and Samara R. Potter, “Budget Blues: The Fiscal Outlook and Options for Reform,” in Henry J. Aaron, James Lindsay, and Pietro Nivola (eds.), Agenda for the Nation (The Brookings Institution, 2003). See also the General Accounting Office, Truth and Transparency: The Federal Government’s Financial Condition and Fiscal Outlook (September 17, 2003) and Rudolph G. Penner and C. Eugene Steuerle, Budget Crisis at the Door (The Urban Institute, October 2003). See, for example, Peter Hooper, Karen Johnson, and Jaime Marquez, “Trade Elasticities for G-7 Countries”, Princeton Studies in International Economics, vol. 87, (August 2000). Even this claim may be overoptimistic. See, for example, Thomas Laubach, “New Evidence on the Interest Rate Effects of Budget Deficits and Debt,” Finance and Economics Discussion Series working paper (April 2003). Among other things, Laubach has an interesting way to remove cyclical effects from his dependent variables, interest rates. portfolio shifts, perhaps even including increasing their stock of dollar-denominated debt. This denomination effect would not permanently prevent any relative price adjustment, but it could lengthen the process. Beyond that, for pragmatic reasons this conventional adjustment process could be extended or distorted even further. By way of illustration, Asian central banks have now accumulated more than a trillion dollars of international currency reserves - largely in dollar-denominated assets - equal to roughly half of the outstanding net debt of the United States. These central banks are not traditional wealth-holders motivated by expected risks and returns. Instead, they seem motivated more by the prospect of preserving low domestic currency values for their exporters.10 To pursue this objective, they can print money to buy U.S. securities. This monetary expansion could generate domestic inflation unless it is sterilized with other open market sales of securities - and the mere scale of present and expected future debt stocks may make continued sterilization impossible. But if these central banks continue behaving this way, the so-called credibility range could be extended significantly. While trade deficits should ultimately correct themselves, perhaps after a long trek through the credibility range, there are really no natural self-corrective mechanisms for budget deficits. Once the U.S. economy gets through the credibility range, interest rates on the increasing government debt will have to rise to induce people to hold the debt. This rise increases the interest burden and causes total deficits to rise further, all the time subtracting more and more funds from capital accumulation. Once this process begins, market psychology may hasten the adjustment.11 Hence, while natural forces lessen the basic external imbalance, they increase the basic budget imbalance. In the long run, the only way to correct budget deficits is for policymakers to correct them. Outside forces There are several outside forces - both natural and as a result of policy - that could influence budget and trade deficits. One generally helpful influence is productivity growth. Say the U.S. economy benefits from an exogenous positive shock to productivity growth, as it seemed to have in the late 1990s. This shock would raise the trend path of income, meaning that slightly higher primary budget and trade deficits could still be consistent with debt-to-GDP stability; in effect, a higher level of g can be plugged into equation 2 (at least as long as it is not offset by a higher i). Higher productivity could also help lengthen the credibility range, the range in which moderate changes in the debt ratio might not lead to adverse changes in relative prices. Among other things, higher productivity could raise the marginal product of capital and make investment in U.S. assets relatively attractive. But even with these favorable developments, the stability conditions discussed above still hold. If they are violated, the natural adjustment mechanisms will eventually take over for the trade deficit, and the primary budget deficit will eventually have to be reduced to stop a growing government debt ratio. One unhelpful measure is trade protectionism. While it might appear that trade protectionism would correct trade deficits, it probably will not. Over the medium and long run, the economy should be producing near its natural growth path, perhaps because of timely monetary and/or fiscal policy, perhaps because of natural equilibrating forces in the economy. In this event, trade protectionism would not stimulate added national production. Even if protectionist measures reduce imports, the added spending demands for import-competing industries will crowd out other types of production. Put another way, equation 1 shows that the trade deficit is ultimately determined by national saving and investment. Without a change in these, protectionism merely shifts the types of goods that are produced. It does not increase overall production and, short of cutting off trade altogether, does not even change the trade balance. Moreover, as is well known, over the long run, trade protection lowers a nation’s standard of living. This view is given in Michael Dooley, David Folkerts-Landau, and Peter Garber, “An Essay on the Revived Bretton Woods System,” NBER Working Paper 9971 (National Bureau of Economic Research, September 2003). An argument that market psychology will hasten the adjustment is given by Robert E. Rubin, Peter R. Orszag, and Allen Sinai in “Sustained Budget Deficits: Large Run US Economic Performance and the Risk of Financial and Fiscal Disarray,” paper presented at the meetings of the American Economic Association (San Diego, California, January 4, 2004). Finally, suppose politicians actually do correct budget deficits, again assuming an economy near its medium-term growth path. As mentioned above, such a fiscal austerity policy is the only known way to correct persistent budget deficits. The reduction in deficits should lower domestic interest rates and trigger changes in exchange rates that lower imports and raise exports. Hence, well-designed fiscal austerity measures could solve all the problems simultaneously. They correct budget deficits directly, they reduce trade deficits indirectly, and the implied higher level of national saving also permits more funds to flow into capital formation and long-term productivity enhancements. Fiscal austerity is the one tried and true approach to dealing with budget and trade deficits simultaneously. Conclusions There are obviously strong links between budget and trade deficits, and the deficit-debt dynamic relationships are very similar. At the same time, it is misleading simply to equate the two deficits, as is often done in the twin-deficit literature. Budget deficits typically involve a reduction in national saving and, if large, a steadily growing government debt-to-GDP ratio. They typically will not be corrected without explicit action. Trade deficits, on the other hand, typically involve an increase in foreign claims on the U.S. economy. As these claims grow in relation to national income, at least some natural forces are set in motion to correct the imbalance. From a policy standpoint, neither deficit may be terribly harmful in the short run, and at least the recent fiscal deficits have been useful in stabilizing movements in output. Moreover, there is likely to be a credibility range in which debt levels could rise relative to GDP without much change in relative prices. In the long run, however, both deficits could become much more worrisome. There are forces tending to increase both deficits: political and demographic for budget deficits, income elasticities for trade deficits. At some point, continued large-scale trade deficits could trigger equilibrating, and possibly dislocating, changes in prices, interest rates, and exchange rates. Continued budget deficits will steadily detract from the growth of the U.S. capital stock and may also trigger dislocating changes. Appendix: Derivation of the stability condition Let P denote the primary deficit (for either budget or trade), D the debt for either, and i the nation’s nominal riskless interest rate. Then apart from valuation adjustments (A1) D = D-1 (1 + i) + P Divide through by GDP (Y): (A2) D/ Y = (D-1 /Y-1 )* (1 + i)/(1 + g) + P/Y. Use lower case letters to refer to the ratio of a variable to GDP. This ratio is a measure of the proportionate importance of the variable. (A3) d = d -1 (1 + i)/(1 + g) + p. If there is stability in the debt-to-GDP ratio, d = d -1 = d. Then (A4) d (1 - (1 + i)/(1 + g)) = p and (A5) d (g - i)/(1 + g) = p This is equation 2 in the text. Note that if i = g, p must equal 0. If d is positive and i > g, p must be less than zero, a primary surplus. If d is positive and i < g, p can be greater than zero, a primary deficit.
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board of governors of the federal reserve system
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Remarks by Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve System, at the 2004 Washington Economic Policy Conference, presented by the National Association for Business Economics (NABE) and the Association for University Business and Economic Research (AUBER), Washington, DC, 25 March 2004.
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Donald L Kohn: Monetary policy in a time of macroeconomic transition Remarks by Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve System, at the 2004 Washington Economic Policy Conference, presented by the National Association for Business Economics (NABE) and the Association for University Business and Economic Research (AUBER), Washington, DC, 25 March 2004. * * * The current stance of monetary policy is highly accommodative. With the target level of the nominal federal funds rate at a historically low 1 percent and inflation running at a similar rate, the real funds rate is around zero. Low short-term interest rates, in turn, have held down longer-term rates, raised asset prices, and fostered an improvement in financial conditions more generally. This policy stance was adopted, as you know, in response to a sharp retrenchment in aggregate demand during the past few years. As a consequence of weak output, declining employment, and a decrease in core inflation to a low level, the Federal Reserve eased policy aggressively. The intended funds rate fell from 6-1/2 percent in late 2000 to less than 2 percent in late 2001, and then to just 1 percent by the middle of 2003. I anticipate that a principal challenge facing the Federal Reserve in coming years will be to return monetary policy from its current, stimulative stance to a more neutral posture in a way that will promote full employment while maintaining price stability. In doing so, we will need to assess and respond to three interrelated transitions: the transition of aggregate demand from weakness to solid growth; the transition of the growth of potential supply from extraordinary to merely rapid; and the transition from disinflation to a more balanced price outlook. The nature of these transitions and the risks around them are likely to define the future policy environment. Today I plan to examine these transitions and then discuss some of their possible implications for the strategy of monetary policy. I should emphasize that these are my own thoughts and views; I am not speaking for my colleagues on the Federal Open Market Committee. The transition from weakness to solid growth of aggregate demand During the past several years, a confluence of forces restrained aggregate demand. After the investment boom of the 1990s, firms reassessed their need for capital and sharply cut back investment spending. Reinforcing this tendency to curtail capital outlays was a deterioration in the financial conditions of businesses: Profits sagged and decreasing equity prices and widening risk spreads inhibited access to external funds. Heightened geopolitical risks after the terrorist attacks of September 11 and in the run-up to the Iraq war added to businesses’ caution. In the last several quarters, these restraining forces have been abating. The excess physical capital that had developed earlier appears to have been worked off in most sectors, and the need to replace older equipment has become more pressing. At the same time, the financial condition of businesses has improved considerably; their profitability and cash flow have surged, and low interest rates have facilitated a restructuring of their balance sheets. Equity valuations have also turned around. After dropping roughly 50 percent between early 2000 and late 2002, the Wilshire 5000 has now reversed nearly half of that decline. Investor confidence seems to have recovered, at least somewhat, from the corporate governance and accounting scandals revealed in 2002 and 2003. With house prices rising as well, household wealth has been increasing again, and more rapidly than income. Clearly, geopolitical risks persist, but not to the nearly paralyzing degree seen earlier. As a consequence, aggregate demand has strengthened considerably, aided greatly by stimulative fiscal and monetary policies. Reductions in personal taxes have supported disposable income despite a lagging labor market. In addition, the partial-expensing provision for new business equipment is lowering the cost of capital and thereby likely boosting investment spending. The accommodative stance of monetary policy has raised the prices of assets on household balance sheets and lowered the cost of acquiring houses and durable goods, while also reducing the cost of capital for businesses and helping them to strengthen their financial positions. Looking ahead, the prospects for growth in household and business spending seem bright. Rising energy prices and a heightening of concerns about global terrorism appear to have eroded some of the optimism of late last year without as yet undermining the forward thrust of the economy. Consumer outlays held up well in late 2003 and have increased so far in 2004 despite surprising and troubling weakness in labor markets. For reasons I will come back to later, I anticipate that labor demand will begin to strengthen noticeably in coming quarters. The accompanying lift to personal income should lend support to future household spending, even as the impetus from the tax cuts to consumption growth diminishes. Business purchases of equipment and software rose more than 15 percent at an annual rate in the second half of 2003, and recent data on orders and shipments of capital goods point to another large gain in the first quarter. Investment should continue to be spurred by several factors: the accelerator effects of sales growth, favorable cash flow and financial conditions, ongoing opportunities to upgrade capital stocks with new technologies, and for this year, partial expensing. Meanwhile, the decline in the dollar over the past two years and faster growth among our trading partners suggest that less of the strengthening of our domestic demand will be met by higher imports than it would be otherwise, and that rising exports will help to stimulate production in the United States. Indeed, the global nature of the pickup in economic activity encourages me to think that we are seeing a fundamental turnaround in confidence and spending propensities that is likely to be self-reinforcing. All told, the U.S. economy has apparently made the transition from weakness to solid growth. However, even if these positive signs are borne out, the path of economic expansion will undoubtedly be uneven, and significant risks remain. One downside risk lies in spending by the household sector. Purchases of new houses and durable goods have boomed over the past several years, raising the stocks of those capital goods in the hands of households. In addition, the saving rate is very low by historical standards. I expect that the growth in household investment will taper off, but a more pronounced pullback in spending cannot be ruled out, especially once interest rates rise. Some observers have expressed concern that weakness in hiring, should it persist, would hold down the growth of labor income and weigh on consumer confidence, and thus could depress spending at some point. In recent quarters, however, slow hiring has been accompanied by strong productivity growth. Over time, higher productivity will show up in higher wages. But even in the short-run, these new efficiencies have boosted capital income, and the resulting increases in dividend income and stock prices have, in the aggregate, provided at least a partial offset to restrained growth of wages and salaries. On the upside, business spending could turn out to be even more robust than I expect. Businesses’ caution about making commitments to meet future demand appears still to be eroding only slowly. Should confidence return more quickly, we could see a more marked strengthening in capital spending, inventory accumulation, and hiring. The transition from extraordinary to merely rapid growth of potential aggregate supply The transition to more-rapid and self-sustaining increases in aggregate demand is critical to the outlook, but it is only part of the story. The full tale also requires an assessment of the economy’s productive potential - both its level and its rate of growth. Unfortunately, potential supply cannot be observed directly, and inferring its behavior from variables that can be observed is a daunting task. But the task is essential nonetheless: Changes in potential supply have been among the most important influences on the behavior of the economy over the past ten years. I should note that the course of aggregate demand is not independent of the course of potential aggregate supply. Both economic theory and empirical evidence suggest that households and businesses make decisions about spending with an eye to future incomes and sales, so that a rosier long-term outlook tends to raise demand today. Thus, as the FOMC notes frequently in its statements, robust underlying growth in productivity is providing ongoing support to economic activity. Nevertheless, owing to the restraints that I spoke of earlier, demand has fallen well short of potential supply during the past several years, as can be seen in the elevated unemployment rate, the depressed rate of capacity utilization, and the decline in inflation. Certainly, potential supply appears to have increased at an extraordinary rate in recent years, even compared with the accelerated pace of the late 1990s. Between 1973 and 1995, labor productivity in the nonfarm business sector increased at an annual average rate of 1-1/2 percent; between 1995 and 2000, productivity climbed 2-1/2 percent per year; and since 2000, productivity has jumped more than 4 percent per year on average. Understanding the reasons for this surge is critical to judging the likely path of productivity and potential supply going forward. Some of the step-up in productivity growth since 2000 probably reflects cyclical influences or factors that may offer only one-time improvements in the production process. For example, businesses’ ability to find efficiencies on such a large scale in recent years probably stems in part from learning how to take better advantage of the large amount of capital equipment and new technology that they acquired in the late 1990s. Moreover, in the past few years businesses have displayed unusual caution in their decisions not only about investment in capital goods but also about hiring. As firms have focused on controlling costs in an uncertain environment, they have naturally tried to avoid taking on new workers and have tried instead to extract the greatest possible output from their existing workforces. To the extent that these processes have revealed inefficiencies in production, they have raised the level of productivity on a permanent basis; however, they are unlikely to be a source of continued productivity gains. All that said, some of the recent step-up in productivity growth may well persist. Rapid technological change and continued declines in the cost of high-tech equipment should enable more substantial efficiency gains in a wide array of industries. Moreover, healthy profits and low borrowing costs should encourage firms to acquire new capital assets, which will give workers more and better equipment to use and thus make them more productive. Taken together, these arguments suggest that productivity will continue to advance at a rapid rate, but not at the extraordinary pace of recent years. This transition, combined with solid growth in aggregate demand, should result in stronger hiring and a narrowing of the output gap. As with the transition in demand, the transition to less-spectacular growth of potential supply involves important risks. We have been persistently surprised by the extent of the pickup in productivity and could be facing a higher level and growth rate of productivity than many expect. If we are so fortunate as to be confronting these circumstances, policymakers will need to be alert to the need for a faster expansion of aggregate demand to match the stepped-up pace of supply. Conversely, perhaps the transitory factors boosting productivity will recede more sharply than most observers anticipate, and the output gap will close more rapidly. It appears to me that uncertainty in our current situation is at least as great for potential output as it is for demand. The transition from disinflation to more balanced risks for inflation Let me turn now to the implications of these demand and supply transitions for inflation. Over the past several years, slack in resource utilization and declining unit labor costs owing to rapid productivity growth have reduced the inflation rate. The chain-weighted price index for personal consumption expenditures increased more than 2 percent in the four quarters of 2000, but it rose only 1-1/2 percent last year. PCE inflation excluding food and energy items has eased a similar amount, with core prices rising 1-1/2 percent in 2000 but just 1 percent last year. The CPI and core CPI show even steeper decelerations than do PCE prices. Moreover, leaving aside the reduction in inflation, the level of core inflation is now quite low - in the neighborhood of 1 percent when measured by either the CPI or the PCE price index. Allowing for measurement biases in these series, the U.S. economy has entered a zone of price stability. Indeed, last spring the FOMC noted the risk that, for the first time in forty years, inflation in the United States might fall too low. The incoming data contain some indications that underlying inflation is no longer declining, but the evidence is inconclusive thus far. In particular, recent monthly changes in core prices have been within the range of increases seen in 2003, but this flattening out of inflation has not persisted long enough to be clearly distinguished from the normal volatility in these data. Still, if aggregate demand and potential aggregate supply follow the paths that I outlined earlier, the slack in resource utilization should diminish, unit labor costs should begin to move higher, and the underlying rate of inflation should stabilize. Sources of potential upward pressure on prices have become more prominent in recent months. Overall inflation has been boosted by a jump in energy prices. Such a jump could raise core inflation temporarily if it is passed through to other prices or if it contributes to increasing inflation expectations. Indeed, by several measures, near-term inflation expectations have risen of late. However, futures market participants have priced in some decline in energy prices from these elevated levels; and even if energy prices remain high, they would not be adding to inflation over time. Another factor some observers have cited as possibly boosting inflation is a tendency for increases in resource utilization to generate bottlenecks that can push up some prices more rapidly. Indeed, periods like the current one with rising global demand have often been accompanied by marked accelerations in the prices of crude and, to a lesser extent, intermediate materials, which seem to be most sensitive to changes in demand. But this variation in upstream producer prices has left little imprint on consumer prices in the past - perhaps because these inputs account for a small share of the final value of industrial output and even less of total consumption. A related concern is the effect of a declining dollar on import prices and the prices of competing domestic goods. Over time, however, foreign producers seem to be absorbing a greater share of the impact of a falling dollar in their profit margins rather than passing it on fully in their prices, and I expect the drop in the dollar to have only a modest effect on U.S. inflation. At the same time, other forces are likely to be acting to restrain inflation. Importantly, slack in resource utilization will probably be eliminated only gradually, so competition for jobs and for market share should remain intense. In addition, because hourly compensation has lagged productivity, unit labor costs have fallen markedly. The resulting markup of prices over unit labor costs is quite elevated, further encouraging firms to reach for market share as well as providing scope for workers’ real wages to rise without pushing up inflation. Overall, the tenor of the inflation outlook has shifted over recent quarters. Solid growth in economic activity, higher prices in some sectors, and hints of the stabilization of overall inflation, along with perceptions by businesses that “pricing power” may be returning, are marking a transition from asymmetric risks of additional disinflation to more nearly balanced risks of rising and falling inflation. This transition is another key piece of the backdrop for monetary policy. Monetary policy strategy As I noted at the outset of my talk, the federal funds rate is quite low: It is low relative to interest rates associated in the past with sustained high employment and stable prices; and it is low relative to recent rates of economic growth - a disparity that has attracted increasing attention from some observers. In fact, the low funds rate has been necessary to promote growth that, to date, has been just sufficient to begin reducing substantial margins of slack in resource utilization. Still, as my analysis indicates, the unusual shocks that have impinged on demand and bolstered potential supply over the past several years are abating, or should soon do so. As the output gap closes, economic stability will require that interest rates eventually move up from unusually low levels if we are to preserve price stability. The FOMC stated again last week that it believes it can be patient in removing its policy accommodation. One set of reasons for patience in my view can be found in the levels of inflation and resource utilization likely to prevail for a while. As I have already noted, a considerable gap exists today between actual and potential output, and consumer price inflation is very low. In addition, the transitions I have discussed in aggregate demand, potential aggregate supply, and inflation are gradual processes. The move to solid growth of demand and some easing in the growth of potential supply are unlikely to lead to a rapid closing of the gaps in resource utilization or a marked rise in inflation. The risks around the likely course of the economy, and the costs and benefits of erring to one side or the other of the anticipated outcomes, also support a strategy of patience. Given our uncertainty about the rate of growth of potential supply, actually observing a closing output gap will be particularly important for policymakers. Given our uncertainty about the level of potential supply and thus the level of the output gap, observing stable inflation will also be particularly important. Moreover, the low current levels of inflation and resource utilization imply, from my perspective, that the welfare costs of the economy running stronger than expected for a while are considerably lower than the costs of its running weaker. In these circumstances, I think policy action can await convincing evidence that labor market slack is on a declining trend and that inflation is no longer decreasing. I would note that patience in policy action can take several forms. One form would be to wait before taking any action; another would be a damped trajectory for the funds rate once tightening begins. A more gradual increase that begins sooner might enable the Federal Reserve to better gauge the financial and economic response to its actions and reduce the odds that a sharp tightening tack would be required at some point to prevent the economy’s overshooting. However, this approach might also run a larger risk of prematurely truncating the expansion - especially if markets interpret the first tightening move as presaging a rapid return to a so-called neutral policy. Undoubtedly, the FOMC will choose a strategy that does not fit neatly into any box, but these considerations will likely play a role in our deliberations. Some observers argue that the Federal Reserve has already been too patient. They are concerned that continued policy accommodation is distorting interest rates and asset prices and encouraging a build-up of debt, and thereby laying the groundwork for financial and economic instability. Clearly, the low funds rate has held down long-term interest rates and boosted asset prices. These movements are, in fact, some of the key channels through which monetary policy has stimulated demand. Whether prices in some markets have gone beyond what one might have expected from easier monetary policy is unclear. When interest rates increase, prices will undoubtedly adjust to some extent - in some cases simply by rising less rapidly than they would otherwise - and debt-service obligations will move up. Households, businesses, and financial institutions need to be prepared for this adjustment. But I think the hurdle is high - and appropriately so - for a central bank to tighten policy, and in the process damp an expansion of economic activity in the short run, on the suspicion that movements in asset prices and increases in debt threaten economic stability over the longer run. Conclusion In sum, monetary policy will be facing some interesting challenges over the next several years, even if the economy proceeds along the favorable path I have outlined today. And, as all forecasters know, the odds are always high that events will deviate from our expectations, requiring policy to adapt. Still, the challenges are likely to be more favorable than those presented by the economic weakness of the past few years. The economy seems to be on a path toward higher levels of output and stable prices. The Federal Reserve will be trying to do its part to foster these welcome developments.
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Remarks by Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve System, at the Federal Reserve Board Models and Monetary Policy Conference, Washington, DC, 26 March 2004.
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Donald L Kohn: Research at the Federal Reserve Board - the contributions of Henderson, Porter, and Tinsley Remarks by Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve System, at the Federal Reserve Board Models and Monetary Policy Conference, Washington, DC, 26 March 2004. * * * I try not to reflect too much on my growing role as the one left behind who speaks at retirements and occasions such as this; but I am pleased, nonetheless, to participate in this conference and to have the opportunity to pay tribute to these three leaders of research at the Federal Reserve. I have known Dale, Dick, and Peter a long time in my various roles here as staff economist, Division director, and Board member. Actually, I met Dale first, when I was still at the Federal Reserve Bank of Kansas City, visiting Washington to interview for a job in the Research and Statistics Division at the Board. At that time Dale spent a whole afternoon trying to help me figure out the analytics of an article I was writing for the Kansas City economic review. A frustrating experience I am sure for Dale, and a frustration that Peter and Dick were soon to encounter, but one that improved the piece immeasurably. I had decided to come here in any case if I got a job offer, but my experience with Dale just reinforced my desire and my excitement at the opportunity to work with people of his caliber and his willingness to understand and help his colleagues and would-be colleagues. I began to work with Dick and Peter sometime after I arrived here. It took a while, inasmuch as they were over at the Watergate in temporary quarters while the Martin building was under construction. I suspected that folks over there were having more fun than those of us slaving away in the Eccles Building under adult supervision - a suspicion later confirmed when I found out that the “One Step Down” so often mentioned by Watergate economists did not refer to the entrance to the computer center, but rather to a certain watering hole on Pennsylvania Avenue. The Watergate seemed somewhat alien and forbidding territory to a current analyst. But as I became more involved in the research work and as they migrated back to the Martin Building, I found Dick and Peter and the other researchers just as stimulating and congenial colleagues as I had anticipated. I want to highlight and celebrate their careers here, but I want to do so in the context of our overall research effort and its critical role at the Board. Their accomplishments illustrate nicely what is best about what we do here, though I am sure they would agree that their leadership of the overall research effort and the path they set it on represent a more important contribution than their individual output. Research at the Board - the historical context The importance of economic research was recognized very early at the Federal Reserve. The Board encouraged and supported research activities virtually from the founding of the System. Throughout its history, it also provided an inviting and collegial environment for research economists, including many who continued their research at other policy institutions or universities and some of whom also came back to the Federal Reserve in leadership positions over the years. By the 1920s, Board economists had already made a number of important research contributions. In part, these early research efforts were driven by necessity. When the Federal Reserve started its operations in 1914, aggregate data for the United States were virtually non-existent. Early research efforts at the Federal Reserve included the pathbreaking compilation of statistical indexes that permitted policymakers, for the first time in the nation’s history, to monitor macroeconomic developments with some degree of accuracy. Besides measures of credit and indexes of industrial production that the Federal Reserve still produces today, during those early years the Board staff developed and published various other indexes for such critical concepts as aggregate sales, employment, payrolls, and prices. Coupled with advances in estimating seasonal factors and secular trends, these early efforts vastly improved economists’ understanding of the interrelationships of prices, production, employment, and credit and facilitated a more systematic study of the business cycle and the role of monetary policy. Another important advance was the recognition of the powerful role of open market operations in the policy process. Open market operations were not new when the Federal Reserve was created. But in the 1920s, the Federal Reserve first showed how they could be employed for effective monetary control, and this demonstration proved an invaluable contribution to the development of modern central banking. Further, Federal Reserve economists and policymakers developed criteria and guidelines for monetary policy aimed at achieving and maintaining economic stability. The policy framework outlined in the Board’s tenth annual report (for 1923) is widely praised by monetary historians. Indeed, by 1923, when the Board organized the Division of Research and Statistics (the precursor of all three modern research divisions at the Federal Reserve), research economists at the young institution were at the forefront of policy-relevant economic research and the Federal Reserve had probably become the first central banking institution at which economic policy research provided a solid analytical basis for policy discussions and decisions. To be sure, economic knowledge does not evolve in a straight path and setbacks are inevitable and unfortunate - the monetary policy failures of the 1930s and those of the 1970s are powerful reminders of that. But the research tradition that had started in the early days of the System is still with us, and today arguably plays a more central role in the policy process than ever before. Characteristics of research at the Board For the most part, research at the Board has for many years been closely intertwined with policy and with current analysis and forecasting. In many other countries, it is not. At many central banks, research and current analysis are carried out in separate divisions, and interaction between the two groups of economists is limited. At the Board, the mixing of research and operational work was not quite as thorough as it is today. In the 1970s and 1980s, many researchers, such as our three honorees, were doing work directly applicable to policy. But others had few day-to-day responsibilities and were fairly free to concentrate on long-run research projects, some of which appeared to have only tenuous connection to the work of the Board. Such a division of the staff was not popular with everyone, and tensions did arise. Partly for this reason, the distinction between operational and research sections was largely eliminated by the early 1990s. This move not only improved morale, it also led to a cross-fertilization of ideas that improved the quality of both research and policy analysis. Researchers actively engaging in policy analysis and participating in Federal Open Market Committee preparations better understand the issues facing policymakers and can target their efforts. On occasion - rare, I suspect - research economists actually benefit from the ideas of the policymakers. They also come to appreciate that policymakers need to hear sensible stories in clear English about the concepts being presented so that the policymakers in turn can explain understandably to the public why they are following a particular strategy. Getting some researchers to write in English has proved daunting, and too often, the policymakers themselves have not lived up to their side of the bargain. The engagement of researchers in the policy process has served to remind them that social welfare is not necessarily enhanced by pursuing only academically fashionable topics. In fact, Board staff, like monks in the Middle Ages, kept policy research alive through the dark night that initially settled on academic analysis of monetary policy following the Lucas critique and real-business-cycle theory. From the policymaker’s perspective, researchers have improved the decisionmaking process by keeping in view the overall economy, with all its interactions. They remind us that if you push on the system in one place - altering an assumption or an implicit equation - it will have consequences elsewhere. Those little ad hoc adjustments policymakers find so convenient are not a free good. Researchers set high standards for analytical rigor. Policy must have a sound intellectual base. Policymakers should be able to write down their models, even if in only a sketchy literary form. If those models cannot be articulated, they are probably flawed. And researchers can improve the policy process by thinking creatively and bringing new ideas and approaches to the table - ideas they have generated themselves or have harvested from recent academic work that may not be easily accessible to the policymakers. Contributions of Henderson, Porter, and Tinsley to Board research Henderson, Porter, and Tinsley have contributed to policymaking in all those ways. I have chosen to outline their contributions by grouping them into the broad subject areas that have occupied much Board research. Large-scale macromodels In many important respects, large-scale modeling of the U.S. and world economies has been at the crossroads of policy and research at the Federal Reserve since the 1960s. Those models are used in forecasting and policy analysis; their results show up in every Greenbook, many Bluebooks, and in briefings to the Board and the FOMC. Dale, Dick, and Peter have all been deeply involved and very influential in these efforts. Peter’s contributions to large-scale modeling in R&S have been immense. They came in two waves, but with remarkable intellectual consistency and foresight. In the late 1960s and early 1970s, he wrote a number of papers related to the design of structural models, in early efforts to combine forward-looking behavior with significant costs of adjustment. Of course, more recently, in the 1990s, he returned to these themes and worked them out in guiding the construction of FRB/US. Perhaps even more important, Peter pioneered the use of these models in policy analysis with his work on optimal control in the 1970s. It did not find a very receptive audience back then, but it has returned more recently in policy simulations to a slightly warmer welcome - owing in part to the influence of the better modeling mousetrap Peter and his colleagues constructed. A few years after he arrived here as a visiting professor, Dick became head of the section in R&S that housed the MPS model. As head of the section from the mid-1970s to the late 1980s he fought for the resources necessary to continue developing the model and expanding its policy use, an important undertaking under any circumstances but particularly so during that tumultuous period for policy-relevant modeling work. Dick also played a crucial role in advancing a set of internal projects to produce operational procedures for the estimation and simulation of large-scale rational expectations models - tools that facilitated later model development work at the Board and elsewhere. Although Dale never directly oversaw the large modeling efforts in the International Finance Division, he has played a key role in the Division’s efforts through the years. Dale made several contributions to the basic economics of the Multi-Country Model, and one of his models was used to set forth the MCM’s properties. Dale was a major advocate of the model development efforts that led to FRB Global. He also played a large role in the two Brookings model projects that greatly advanced the large modeling field. Other model-based analysis The building and simulation of large models is not the only way researchers can contribute to policy design. Policymakers are looking for insights that are not so dependent on the particular model construct. All three of our honorees have been involved in an enormous volume of research in this area. Dale did path-breaking work on the international policy coordination problems that arose with the breakdown of the Bretton Woods system. Along with other Brookings Project participants, Dale carried out much of the original research into simple interest rate policy rules, with important and influential insights on the characteristics that might be helpful in jointly stabilizing activity and prices. He is now involved in the investigation of optimal strategies in the context of DGE models. And I certainly would not want to neglect his recent insightful work that places inflation targeting under a skeptical microscope. A good deal of Dick’s output in this area has involved the monetary aggregates. He has worked on virtually every aspect of the aggregates: the demand for money; their definition and measurement; their control; and their use in policy design - including the P-star model that developed an idea by a certain A. Greenspan. It is easy to forget how central the aggregates were to policymaking at a time when structural change and rapid changes in inflation expectations reduced the usefulness of large-scale models. Dick’s work was integral to providing and explaining the framework that broke the back of inflation in the late 1970s and early 1980s, and it has been widely used by other central banks. While the discipline provided by stricter monetary aggregate guides became much less crucial once inflation was brought under control, Dick’s work has continued to provide us with useful reminders of the value of monitoring money. Moreover, the only reason that we have some confidence that one-half to two-thirds of U.S. currency is held abroad is because Dick’s inquisitive mind wondered along such paths as differential seasonality across countries and fish migration. Peter also was deeply involved in the monetary aggregates research in the 1970s - so much so that he was willing to go mano-a-mano with Steve Axilrod on the definition of M1 at the Board table losing, of course, but winning the hearts, if not the minds, of his colleagues for his valor. Later in his career, Peter came up with innovative approaches to policy at the zero bound for interest rates, a potentially critical issue in a period of very low inflation. Asset prices Asset markets are of particular interest to policymakers as the transmission channel through which movements in money or short-term interest rates primarily affect the economy. Because their prices incorporate market expectations for the future, they are also an area in which policy indicators might be found. The huge literature on speculative attacks in exchange markets started with Dale’s work with Steve Salant on gold. It significantly influenced the thinking of an intern at the Board, one P. Krugman, who, in his pre-political mode, extended the thinking to foreign exchange crises. Dale’s understanding of exchange markets intersected with his understanding of macroeconomics and policy in a number of studies that have tried to inject sense and analysis into discussions of sterilized interventions. Dick’s work on asset markets includes his seminal work with Steve LeRoy on variance bounds tests on present-value relations. Their demonstration that equity prices were excessively volatile relative to what would be consistent with the efficient capital markets model posed a fundamental challenge to the theory of finance and spearheaded a vast literature aimed at improving our understanding of asset pricing and market efficiency. During the 1980s, Peter also contributed to understanding in this area through his work on commodity price determination and the indicator properties of such prices for monetary policy. More recently, Peter - working jointly with Sharon Kozicki - has been busy advancing our understanding of bond market dynamics. In a sequence of papers, they have demonstrated the important role played in these dynamics by changes in the market’s perception of long-run “end-points,” such as the implicit target for inflation and the economy’s equilibrium real interest rate. Empirical methodology Because we are a policy institution held accountable for actual outcomes, research at the Board has always involved empirical testing. And in this area, Board researchers have often been found pushing out the production-possibility frontier for the profession more generally. Our heroes have battled in this area as well, both through their insistence on the best possible empirical work and their own contributions to methods of computation and testing. Early in his career, Dick contributed to the literature on filtering and seasonal time series analysis topics of perennial interest at the Federal Reserve. He also worked on the use of survey sample weights in the linear model, on estimating linear models with partial prior information, and on other topics, always motivated by pressing empirical questions and ready to explore and adopt new methods and techniques whenever they promised to improve the odds of a more reliable answer. Back in the mid-1970s, Peter was an early advocate of using advanced statistical techniques in policy analysis - at a time when IBM mainframes were a long way from a Pentium 4. Working with P.A.V.B. Swamy and others, Peter carried out the herculean task of estimating random-coefficient models. He also investigated the gains to forecast accuracy from pooling the predictions of multiple models, a path that eventually led to the ambitious model-linkage project of the 1980s. Unsung contributions Policy work need not always pay off in lots of published papers or even in success to have a favorable influence. Dick’s work on currency demand and the amount of U.S. currency held abroad has been published, of course, but its greatest public policy payoff has come behind the scenes, in helping the U.S. government look more effectively for counterfeiters. Peter burned countless hours of staff and machine time chasing the holy grail of a monthly estimate of GDP. Monthly GDP remained an elusive quarry, but the techniques he pioneered in the process became an integral part of the tool kit used by sector analysts to translate high-frequency indicators into predictions of near-term movements in quarterly GDP and its components. Dale has slaved many hours helping refine the Division of International Finance positions on hardy perennials like the sustainability of the U.S. current account and the effectiveness of sterilized intervention. Leadership The most important contributions these three made were as colleagues and leaders. They have reminded us every day in our interactions with them that ideas are important and that policy must have a rigorous intellectual framework - one capable of being discussed and tested. They have insisted that policy analysis incorporate the latest insights from economic theory and econometrics. They have fought the Philistines who saw research as a soft target in times of budget crunch; they made sure the Board did not eat its intellectual seed corn. They recognized that one role of research at the Board has been to challenge the policymakers, to be an irritant - sometimes with considerable success - to think outside the tidy intellectual boxes too often found in the minds of Division directors and Board members. My early encounter with Dale on my Kansas City Fed article was indeed characteristic. Each has always been willing to lend a hand working through a tough problem and helping explain to a slower colleague - over-and-over again, in my case. They have been active recruiters and mentors to generations of economists, leading as much by example as by the particular position they happened to occupy in the staff bureaucracy. They have been worthy inheritors of the proud tradition and have made it even better. Dale, Dick, Peter, on behalf of all your colleagues past, present, and future, thank you.
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Remarks by Mr Roger W Ferguson, Jr, Vice Chairman of the Board of Governors of the US Federal Reserve System, at the Twelfth District Community Leaders Luncheon, Federal Reserve Bank of San Francisco, San Francisco, 8 April 2004.
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Roger W Ferguson, Jr: Macroeconomic outlook and uncertainties Remarks by Mr Roger W Ferguson, Jr, Vice Chairman of the Board of Governors of the US Federal Reserve System, at the Twelfth District Community Leaders Luncheon, Federal Reserve Bank of San Francisco, San Francisco, 8 April 2004. * * * It is a pleasure to be with you today to speak about the current state of the U.S. economy. As you know, the economy appears to be engaged in a gradual process of recovery. As has often been the case in previous recoveries, however, the pace and breadth of the expansion thus far have been uneven. In particular, production and aggregate income have increased strongly in the past few quarters, but the labor market has been surprisingly weak. The most recent data suggest that the labor market is improving gradually; but the question of whether this improvement is fundamental and durable will take some time to answer. Although prices for some commodities have risen, underlying consumer price inflation only now looks to be stabilizing at a low level after falling for some time. In the remainder of my time with you today, I will first sketch more fully some of the recent developments in the economy and what I believe to be the most likely path forward. Then I will discuss two uncertainties regarding that outlook that have garnered attention lately - namely the possibility that the labor market will continue to underperform and the possibility that financial stress in the household sector may cause the expansion to falter. As I will discuss in greater detail shortly, it seems to me that the evidence suggests that while neither risk can be ruled out, nor is either likely to come about. That said, of the two, the greater concern for me is the future performance of the labor market. As always, the views I will be expressing are my own and do not necessarily represent those of other members of the Board of Governors or the Federal Open Market Committee. Recent economic developments For the most part, the past year has been one of continued recovery in the U.S. economy. After averaging just 2-1/2 percent at an annual rate in the first half of last year, the pace of real GDP growth surged to more than 6 percent in the second half. For 2003 as a whole, the pace of growth was the fastest since 1999. As has been the case for some time, households in 2003 provided considerable impetus to the economy. Supported importantly by last summer’s tax cuts, low interest rates, and rising household wealth, consumer spending continued to trend up, while low mortgage rates have kept both home sales and new housing starts close to record highs. In addition, the economic environment now seems more conducive to business investment. For much of the past three years, businesses were reluctant to invest in new capital equipment. At first, the downturn in investment seemed to be a reaction to what in hindsight appears to have been a substantial overinvestment in high-tech equipment in the late 1990s. As business investment subsequently lagged the improvement in household spending, however, a marked degree of caution seemed to settle on the business community. This caution - which appears to have had its roots in the uncertainty associated with terrorism, geopolitical risks, and a wave of corporate governance scandals - induced firms to focus on restructuring rather than expanding their operations, and it left them quite hesitant to increase their investment outlays. By the middle of last year, however, firms were beginning to boost their capital spending. And, in the second half, real fixed investment rose more than 10 percent at an annual rate, the fastest two-quarter rate of increase since early 2000. To be sure, a sizable portion of the recent strength in investment has been for high-tech equipment, and much of it probably reflects replacement of outdated machines rather than an expansion of existing production capacity. However, spending on other types of equipment now seems to be picking up as well, and the caution that had previously restrained capital spending seems to be in the process of lifting. Against this backdrop, inflation has remained quite low despite some sizable increases in energy prices. Overall, the consumer price index increased 1.7 percent over the twelve months ending in February, while the core index - which excludes the volatile food and energy components - increased only a little more than 1 percent. Outlook and labor market uncertainties The consensus in the forecasting community is that GDP growth will not continue at the 6 percent pace posted in the second half of last year. But, with interest rates still quite low and fiscal policy generally stimulative, most forecasters are projecting relatively robust gains in output for the coming year, with ongoing increases in both household and business spending. Continued strong economic expansion seems to me, as well, to be the most likely outcome. Nonetheless, the economic outlook still bears some important uncertainties, two of which I would like to focus on today. The first relates to the labor market. As has been widely recognized, one notable shortcoming of the current expansion has been the dearth of job creation over the past two years. Last week’s report that employers added 308,000 workers to their payrolls in March was encouraging and may signal that the recovery in the labor market is gaining traction. Even so, the level of private employment remains more than 500,000 - or 1/2 percent - below that at the trough of the recession in November 2001. The weak performance of the labor market over this period has been quite unusual by the standards of past economic recoveries, and, indeed, it is even weaker than during the infamous “jobless recovery” of the early 1990s. For example, employment rose about 2 percent in the twenty-eight months following the 1990-91 recession. And, in the other seven post-World War II recoveries, employment growth averaged more than 8 percent over a period of comparable length. Economic forecasters’ consensus is that, as the expansion matures, employment will continue to improve sufficiently to make noticeable gains in the utilization of labor resources. I judge that to be a reasonable assessment. Nonetheless, one cannot definitively rule out the possibility that hiring will fall short of expectations over the next several months as it had up until the most recent report. In particular, the lackluster performance we have seen in the labor market, even as real GDP has been moving up strongly, raises the question of whether an unusually large portion of the job cuts implemented by firms in recent years represent permanent layoffs that will only gradually be offset by job creation elsewhere in the economy. A number of hypotheses have been put forth as potential causes of the generally disappointing performance of the labor market, and, indeed, it seems likely that several factors have contributed to the shortfall in hiring. But any meaningful explanation must account for the surprising strength in productivity growth in recent years. In particular, labor productivity in the nonfarm business sector rose 4-1/4 percent in 2002 and nearly 5-1/2 percent in 2003, the largest back-to-back increases since the early 1960s. Let me review the major hypotheses advanced to explain labor market developments. One possibility is that the same factors that induced businesses to take an unusually cautious approach to capital spending also influenced their willingness to add new workers. If so, then some of the surprising weakness in employment growth and some of the strength in productivity may have reflected a tendency by employers to stretch their existing work forces beyond a level that is sustainable in the longer run. The sizable increase over the past year in employment at temporary help agencies another potential margin of adjustment for firms unwilling to take on permanent employees - is consistent with this view. And, further supporting this hypothesis, one hears reports of longer hours worked by many white-collar and nonproduction workers. If this hypothesis is correct, then the recent strength in business investment bodes well for an upturn in the labor market if the pickup in capital spending is an indication that businesses have become more optimistic about the future course of the economy. Indeed, according to this hypothesis, the improvement in hiring could be rapid as businesses respond not only to further increases in output but also hire to alleviate the growing strains on their more experienced workers. The chief argument against this story is that the combination of a weak labor market and strong productivity growth has been ongoing for quite some time. And it certainly seems possible that a portion of the extraordinary productivity growth of recent years represents a permanent increase in efficiency. According to proponents of this view, some of these productivity improvements may have resulted from firms’ focusing on restructuring and cost-cutting in ways that provide ongoing efficiencies. They may have been able to do so, in part, because they have realized a delayed efficiency payoff to the substantial investments in high-tech equipment in the late 1990s. Regardless of its source, however, the possibility that some of the productivity improvement - and some of the job cuts - of recent years are permanent suggests that the weak labor market may, in part, be associated with an increase in the economy’s potential output. This possibility implies that a given rate of increase in GDP may be consistent with a more gradual pickup in hiring than in the preceding scenario. Finally, a couple of other influences probably damped hiring somewhat but seem unlikely to have been major factors. For example, the recent sizable increases in health insurance costs and in pension costs are cited by some as a reason for businesses to avoid hiring new employees. In the aggregate, however, health insurance costs represent only about 6 percent of overall compensation costs, and many firms seem to have responded to these higher costs by reducing increases in either wages or other parts of the benefits package. Similarly, although a number of corporations have had to make sizable contributions to underfunded defined-benefit pension plans, the shrinking share of workers covered by these plans suggests that such contributions probably have not had a material affect on hiring decisions. Moreover, during the second half of the 1990s, when pension plans were overfunded and, in many cases, improving the bottom lines of firms, one rarely, if ever, heard anecdotes suggesting that low pension-funding costs were boosting employment. Other observers have pointed to the outsourcing of production abroad as a reason for the weakness in the labor market. Again, however, the magnitude of this phenomenon seems too small to explain more than a small part of the decline in employment over the past two years. Private-sector estimates of outsourcing are on the order of 1 percent of the gross job losses that occur each year. Moreover, because outsourcing abroad represents a shift of both production and labor input to a foreign country, outsourcing is probably not a major explanation for our recent history of elevated productivity growth. What does all of this imply for economic policy? In the short-term, the weakness in the labor market reflects a shortfall of aggregate demand relative to the economy’s potential, which is an important part of the rationale for the currently accommodative stance of monetary policy. The real federal funds rate is now close to zero, and market participants expect it to remain near that level for a while. Obviously, we monetary policy makers will have to determine the degree to which the improvements in the labor market signaled in the most recent report indicate that the economy is meaningfully closing the gap between aggregate demand and the economy’s productive capability, and the pace with which that gap is being narrowed. As I said earlier, it will take some time to make that determination. But we also have to recognize that maintaining the current level of the funds rate for too long will eventually result in an unwelcome increase in inflationary pressures. In the longer run, it is important that we as a society recognize the considerable economic benefits associated with sustainable increases in productivity and intensify our efforts to ensure that as many individuals as possible profit from the substantial productivity gains associated with innovation and increased competition. Unless we do so, the support of the population for flexible markets, technological change, and free and open trade - so crucial to the ongoing improvement of our standard of living - will erode further. In my view, the best long-run response to the inevitable turbulence of a dynamic market economy is to increase our investment in the education and skills of the workforce. An improvement of this type would pay handsome dividends in many respects - allowing not only workers who retain their jobs to be more productive and earn higher wages but also allowing those who lose their jobs to gain reemployment in more stable jobs with less loss in earning power. With experienced workers, society’s challenge is to provide opportunities for those adversely affected by economic change to build on their previous work experience and to retool their skills to meet the changing requirements of the economy. An important source of such opportunity has been our community colleges, which have experienced sizable increases in enrollments since the early 1970s, particularly among adults. In addition, many four-year public colleges and universities now offer programs specifically tailored to the schedules of adults, many of whom are attempting to balance part-time schooling with family and work responsibilities. For our future workforce, we must ensure that our educational system is adequately equipping students with the greater skills demanded by employers operating in an increasingly complex economy. I do not have the answers to these educational challenges. But I do know how important it is that we address them. And given our successes in the past, I am confident that we can. Financial health of households Let me now turn to a second important uncertainty in the outlook - namely, the financial health of U.S. households. As I mentioned earlier, a key element in the current cyclical expansion has been robust spending for consumption and housing. An oft-expressed concern has been that many households have become overextended, will eventually have to cut back on spending, and in doing so may short-circuit the expansion. It is easy to see the basis for this concern. First, consider the rise in household debt. Relative to disposable income, debt has been hitting record highs annually since 1993. Indeed, with house prices rising rapidly and interest rates at historically low levels, mortgage borrowing surged 12-1/2 percent in each of the past two years, twice the rate of growth of disposable income. Meanwhile, the personal bankruptcy rate, although relatively stable in recent quarters, is still near its record high. Despite these ominous sounding numbers, and while remaining alert to the possibility of more acute financial distress, I believe that, in the aggregate, households fundamentally are in good financial shape. Even with the heavy borrowing they have undertaken, households have kept their debt-payment burdens in check. At the aggregate level, one can evaluate debt burdens in two ways. One measure is the debt service ratio. The numerator of this ratio is the minimum payment required on mortgage and consumer debt - for example, car loans, student loans, and credit card debt - and the denominator is after-tax income. The debt service ratio captures such things as the effects of changes in interest rates, loan maturities, and loan demand on the debt obligations of households. A somewhat broader measure - and one that the Federal Reserve has only recently introduced - is the financial obligations ratio. This measure adds required payments on rent, auto leases, homeowners’ insurance, and property taxes to debt service. This broader measure recognizes that both homeowners and renters have fixed financial obligations, and it recognizes that there is no essential difference between payments for an auto loan and those for an auto lease. Moreover, unlike the simple ratio of debt to income, both the debt service ratio and the financial obligations ratio have receded slightly, on net, from their respective peaks. Similarly, delinquency rates for a wide range of household loans turned down over the second half of 2003. Those who are most concerned about the macroeconomic consequences of household debt argue that although these measures of financial stress have stopped getting worse, they still are at very high levels by historical standards; the risk, they argue, is that the household sector could be quite vulnerable to an adverse shock. This is a legitimate argument, but other factors limit my concern about this possibility. First, most debt is held by households that also have substantial assets. Indeed, according to the 2001 Survey of Consumer Finances, 96 percent of total debt is owned by households with positive net worth - that is, assets greater than their liabilities. Moreover, looking at the question from the perspective of the number of households, fully 90 percent of all households in 2001 had assets greater than their liabilities. Even if one disaggregates these numbers further and focuses on the amount of debt held by lower-income households or by households particularly vulnerable to an adverse shock, the numbers are relatively small. For example, households in the lowest fifth of the income distribution hold only 3 percent of all household debt. Widening the scope to the entire lower half of the income distribution, these households have only about 20 percent of outstanding debt. In other words, 80 percent of debt is held by households in the upper half of the income distribution, and these are households that also hold substantial assets. Reflecting these debt patterns, the bulk of the available statistical evidence suggests that adverse movements in broad indicators of household financial health do not have much incremental predictive power for overall consumer spending. In essence, the research says that - after taking account of current and expected income, wealth, and interest rates - debt burdens, delinquency rates, and the like do not provide significant additional value in explaining movements in consumer spending. Some commentators have argued that the real fragility in the system will be exposed when interest rates return to more-normal levels. According to this argument, higher rates will boost required monthly payments, which in turn will lead to a jump in loan defaults, severe strains on financial institutions, and a sharp cutback in household spending. It is important to recognize, however, that an increase in short-term interest rates does not automatically increase household debt payments across the board. A rise in rates will indeed increase borrowing costs on new credit extensions. However, most outstanding debt will not be affected by changes in the federal funds rate because the majority of mortgages carry a fixed rate, as do the bulk of other loans to consumers. Moreover, as short-term rates rise, households will take out smaller loans or take out loans with longer maturities. And households will trim their borrowing, preferring in some instances to pay for purchases with cash instead of credit. The empirical evidence suggests that, in the face of rising interest rates, households curb their use of debt enough to almost entirely offset the higher average cost of debt, leaving debt burdens little changed. Another factor that tempers my concern is that interest rates will rise from their current low level only when the economic expansion is on more solid footing. Thus, while households very likely will, at some point in the future, face a higher cost of credit on new borrowing, they will also be undertaking that new borrowing against a backdrop of greater job security and continued strong growth of incomes. That said, if the increase in rates crimps spending more than anticipated, I can assure you that we will move once again, as we have done consistently throughout this cyclical episode, to provide appropriate support to the economic expansion. Clearly some households have become burdened with excessive debt and may face considerable financial stress should their income become disrupted. Indeed, in order to help households like these acquire the information they need to make good financial decisions for themselves and their families, the Federal Reserve System in 2003 initiated a national campaign to raise the visibility and highlight the importance of financial education. But financially overextended households represent a small fraction of the total economy, and at the macroeconomic level, financial distress in the household sector seems unlikely to cut off the expansion. Conclusion Overall, the macroeconomic outlook for the United States is favorable. Over the past year, the economy has made considerable progress: Aggregate income is growing rapidly, business investment has begun to recover, the stock market has rebounded, and interest rates and inflation remain very low. To be sure, there are uncertainties regarding the outlook. While my concern about the labor market is somewhat alleviated by the most recent data, it remains at the top of my list. Another important uncertainty is the possibility that an adverse shock will expose an underlying weakness in the financial condition of households. But, I believe the economy most likely will steer clear of substantial damage from this source.
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Speech by Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve System, at the Banking and Finance Lecture Series, Widener University, Chester, 1 April 2004.
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Donald L Kohn: Monetary policy and imbalances Speech by Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve System, at the Banking and Finance Lecture Series, Widener University, Chester, 1 April 2004. * * * Interest rates in the United States have been very low for some time. The Federal Reserve targets the overnight federal funds rate, and for almost a year this rate has stood at 1 percent. By comparison, the funds rate averaged more than 5 percent during the 1990s, and was last at 1 percent in the 1950s. Similarly, the yield on a ten-year Treasury note now stands near 4 percent - a level not seen since 1963 and more than 3 percentage points below the average of the past twenty years. These low rates are no accident. The economy began to weaken in late 2000, and aggregate activity began to contract in early 2001. Starting in January of 2001, the Federal Reserve moved to counter this weakness by lowering the funds rate to its present level in a series of steps that ended last June. This prompt and aggressive action undoubtedly served to limit the decline in economic activity, and, in fact, the recent recession was one of the mildest on record. The Federal Reserve recognizes that the federal funds rate is currently lower than it can be on a sustainable basis: At some point, as the economy moves back toward higher levels of employment, policy accommodation will no longer be needed and the funds rate will be raised. But it does not appear that we are as yet at that point. The Federal Reserve has opted to keep its policy rate quite low and has said it can be patient in removing the degree of accommodation. Although the economy has indeed strengthened over the past few quarters, job growth has been anemic and considerable slack persists in labor markets. At the same time, inflation has been quite low and shows few signs that it is in the process of picking up. Recently, some observers have been calling for the Federal Reserve to begin the tightening process sooner rather than later. In a few cases, the reasoning appears to be that we are risking a major increase in inflation by waiting. But most of the calls for a prompt policy tightening are instead based on the concern that the Federal Reserve, by keeping the funds rate so low and signaling that it is likely to stay low for a while, is sowing the seeds for different kinds of future problems. In particular, these critics worry that a continued environment of low interest rates is giving rise to economic imbalances excessive indebtedness, and elevated prices of houses, equities, and bonds - that in the longer run will come back to haunt us. They fear that the return to more-normal levels of short-term interest rates might eventually be accompanied by an especially sharp upswing in bond and mortgage rates, a softening in the prices of houses and equities, and problems for households in meeting higher debt obligations that, in turn, could result in a substantial weakening in spending. Those worried about these possibilities say that the Federal Reserve should begin to remove its policy accommodation promptly to limit any further buildup of debt and distortions of asset prices. Most of these analysts acknowledge that such an action will entail some short-run pain - a slower recovery and a weaker rebound in labor markets. But they see this near-term loss as more then compensated for by the long-run gain of avoiding severe problems in the more distant future. Today I would like to examine this line of reasoning. The issue may seem abstract and arcane to an audience of non-economists - inside baseball as played in the financial markets and in the Board Room of the Federal Reserve. But the approach taken to this policy question could have serious consequences for the U.S. economy, and it illustrates nicely the types of subtle but fascinating issues policymakers must confront. I must emphasize that these are my own views and not necessarily those of my colleagues at the Federal Reserve. The effects of low interest rates As I have already discussed, the current level of the federal funds rate came about in response to a weakening economy in 2001 and a recovery that has been characterized by the persistence of considerable slack in labor markets and low and declining inflation. Stimulative monetary policy helps the economy recover from a spell of economic weakness largely through its effects on interest rates and asset prices. Long-term interest rates - the ones most relevant to the borrowing and spending decisions of households and firms - have been held down by easy monetary policy and the expectation that short-term rates will remain low for some time. And these low rates in turn have boosted the prices of houses and the value of corporate equity. Under the influence of increased wealth and low borrowing costs, households have bought more and larger houses and cars, have taken on more debt, and generally have spent more than would have been the case if interest rates had been higher. On the business side, low rates have helped firms reduce debt servicing and rebuild financial resilience by issuing long-term debt and paying off short-term debt, setting the stage for a step-up in investment. Stronger balance sheets and higher profits have induced investors to reduce the risk premiums they require to lend to businesses, which has further supported business spending. Nothing is necessarily wrong with these developments; in fact, they are by-and-large the intended and logical consequences of the Federal Reserve’s efforts to reduce economic slack through low interest rates. To be sure, when short-term interest rates rise, bond yields will also rise, the amount of income needed to service debt will increase, and the prices of houses and equity will begin to reflect the greater competition for savers’ dollars. But as long as interest rates and asset prices are reasonably well aligned with the forces likely to affect the economy, and as long as the public has reasonably accurate expectations about the size and timing of the eventual increase in interest rates and its effect on wealth and debt service, then the economy should not experience any particularly severe bumps when these developments unfold. Under these circumstances, households and firms, in the aggregate, should not end up looking back on their borrowing and spending actions as a mistake. If they do not view them as a mistake, they are unlikely to make major revisions in spending plans or asset valuations, and the effects on financial markets and the economy should be limited. Of course, expectations cannot be entirely accurate; the path interest rates will follow depends on future economic developments, many of which inevitably will be surprises, and in response markets will need to adjust, perhaps substantially. Moreover, some households and firms probably harbor unrealistic expectations about the future based on extrapolations of recent interest rates or trends in asset prices, and they run the risk of experiencing serious difficulties as a result. But as long as myopia appeared to be restricted to a relatively small portion of the population, and asset prices and expectations in the aggregate seemed realistic given what we know today, we would have little reason to anticipate serious problems as interest rates adjust. However, if imbalances were thought to exist if expectations appeared unrealistic and asset prices distorted - then we would judge that the potential for a sharp correction in financial markets and associated economic instability was greater. Is there evidence that imbalances are emerging? Determining whether such imbalances are present is a difficult task, and assessing whether those imbalances are related to current policy is even more challenging. But given their potential consequences for the economy, these are issues that policymakers cannot ignore. Let me begin with the question of whether interest rates and asset prices have been pushed away from appropriate levels. Some observers worry that recent Federal Reserve policy, by keeping short-term rates at very low levels for an extended period, has encouraged investors to “reach for yield” - that is, to shift their portfolios toward riskier and longer-term securities, which generally have higher yields, to keep realized returns from falling. They also worry about the effects of a related behavior in which financial intermediaries borrow at low short-term rates to lend at higher long-term rates - the so-called “carry trade” - and about the effects of low interest rates on the prices of houses. To a considerable extent, these processes are part of the efficient functioning of markets: Investors should compare the return they would receive on holding short-term deposits or the cost of borrowing short-term to the potential returns on riskier assets and make investment decisions on the basis of the trade-off between return and risk. Indeed, behaviors of this sort transmit accommodative monetary policy through financial markets to accomplish its intended effect of stimulating demand. The issue is whether this process has gone too far - that is, whether investors are failing to take adequate account of the risks of those alternative investments. Forming such a judgment requires a view on the level of asset prices that would be “appropriate” given economic fundamentals. Unfortunately, economists are not very good at this, but neither is anyone else, including Wall Street analysts. The Treasury securities market has been one focus of some concern. Some observers argue that, in part because of the carry trade and similar sorts of strategies, rates on intermediate- and longer-term Treasury securities are too low. An important observation, however, is that the yield curve is currently quite steep, implying that market participants have priced in a substantial rise in short-term rates. Indeed, the current shape of the yield curve suggests that investors expect short-term rates will eventually be in the neighborhood of 4 to 5 percent. This expected rate is not unusually low by historical standards; it is near or even above the expectations during the low-inflation period of the 1950s and early 1960s, and it is well within the range of expectations since the mid-1990s. The yield curve implies a fairly gradual transition to those long-run levels, and some could argue that this implied adjustment is too gradual. However, this pattern in part reflects the Federal Reserve’s statements about policy patience and the fact that the economic expansion so far has made only limited progress in reducing slack, particularly in the labor market, even at very low interest rates. Overall, the question of whether the yield curve is steep enough is difficult to answer. Some analysis suggests that Treasury yields should be a bit higher, and we cannot rule out the possibility that long-term rates will rise once labor markets begin to strengthen convincingly. Nonetheless, it would be hard to argue with much confidence that yields are substantially out of line with plausible configurations of fundamental influences. Corporate bonds have also been the subject of some concern - specifically, whether the risk spreads on bonds issued by domestic corporations, which have narrowed dramatically, particularly for lower-rated issuers, are too low to offer adequate compensation for the probability of future defaults. It would be surprising had we not seen a narrowing of credit spreads over this period. Corporate profits have expanded quite briskly of late, and various measures of business financial difficulties have declined substantially. Moreover, the outlook for corporations appears favorable, considering that we are now in the early stages of what we hope will be an extended period of economic expansion. Many spreads remain above levels they reached through much of the 1990s, and while they may be thin, they do not appear to be clearly unreasonable in the context of recent and expected developments. Warnings about a possible “bubble” in house prices have been sounded for a number of years now. About a year ago, I examined this issue in some detail and concluded that, while one could never be very confident about such a judgment, house prices were not obviously too high and the housing stock was not clearly too large.1 Since then, however, prices have climbed further, and by more than the rise in rents - a proxy for the return on houses. Consequently, the odds have risen that these prices could be out of line with fundamentals. We still cannot be very confident about whether a significant misalignment exists, however. Moreover, some factors, including increasing prosperity and wealth associated in part with rapid gains in labor productivity and earning power, should help support house prices in the future and thereby reduce the risk of a sizable correction in which prices actually fall across a large number of localities. Finally, concerns have been expressed about the level of debt in our economy, especially household debt. Debt owed by households is high relative to their income, and so too are the payments required by that debt and by other regular obligations. But the vast majority of households are not encountering problems meeting obligations, and they have protected themselves to a considerable extent against increasing interest rates by borrowing for longer terms at fixed rates. As a consequence, debt servicing obligations will rise very gradually even if market interest rates increase rapidly. Moreover, any increase in rates would most probably occur in circumstances in which income and employment were also rising briskly, and thus adding to the resources available to consumers. And, while debt has been increasing, assets on household balance sheets have been rising even more rapidly. Barring a collapse in house or equity prices when interest rates rise, household net worth should remain comfortably above the levels of a few years ago. This has been a very fast and somewhat cursory tour through U.S. financial markets. But the main point should be clear: Although one can never be certain, in my view, the odds are that any imbalances that have emerged in U.S. asset markets or in the level of borrowing by U.S. households and businesses are not so substantial that they will disrupt the economy when they begin to correct. To be sure, the prices of assets and the level of debt seem to reflect expectations of a benign economic environment - one in which policy will tighten only gradually, the economy will continue to Donald Kohn, “The Strength in Consumer Durables and Housing: Policy Stabilization or Problem in the Making?” Paper given at the conference on Finance and Macroeconomics, sponsored by the Federal Reserve Bank of San Francisco and the Stanford Institute for Economic Policy Research, Federal Reserve Bank of San Francisco, February 28, 2003. strengthen and inflation will remain low, and the demand for houses and equities will remain solid. Although these expectations could leave markets exposed to unfavorable news, they are not obviously unreasonable. In the absence of any substantial distortions in asset prices and debt levels, households and businesses, on average, have not likely been engaging in misguided decisions that they, or the central bank, will come to regret. Nevertheless, as emphasized above, policymakers face a tremendous amount of uncertainty regarding this judgment. Some borrowers and lenders will be caught by surprise when rates rise and will suffer losses; houses could be overvalued in some markets and subject to correction; and even small, largely predictable changes in interest rates and asset prices could interact in unexpected ways. And asset prices and interest rates that look roughly in line with fundamentals today, may not be tomorrow. Because they cannot rule out the chance that some asset prices might correct more than anticipated, policymakers must consider how the economy might withstand such a correction. Corrections in interest rates and asset values may have the most potential for disruption when they impair the financial health of borrowers and lenders and thereby cause them to pull back even further than might be warranted by the change in rates or prices. In that regard, we have some reason to be optimistic that the players are well positioned to absorb these adjustments. We have already discussed the reasons for confidence that household borrowers will be able to meet their obligations. Lenders, too, appear well positioned to weather any such adjustments. Commercial banks remain highly profitable and well capitalized, and other financial intermediaries show few signs of widespread problems. I am encouraged by the way our financial system came through the very difficult circumstances of the last few years, including the plunge in equity values, the recession, the subsequent period of slow growth, and the spike in credit problems. To be sure, pockets of difficulty emerged, and lenders became more cautious, but, for the most part, credit continued to flow, and problems remained isolated, not systemic. Our increasingly sophisticated financial market was able to effectively distribute risk so that lenders were sufficiently diversified to survive some quite stressful developments. In addition, financial markets have important automatic-stabilizer properties. If investors sense that asset-price adjustments are undermining the expansion, interest rates will fall back because investors will anticipate a lower trajectory for the federal funds rate. For its part, the Federal Reserve will adapt its monetary policy to unexpected developments in an effort to keep the economy on track toward high employment and stable prices. Implications for the current policy setting That brings me to what I see as the implications of this analysis for the Federal Reserve’s current monetary policy of keeping the federal funds rate low and being patient in removing policy accommodation. I hope that the discussion has cast some doubt on the argument that this policy is generating substantial imbalances in the economy. I am not disputing the argument that current policy has contributed to higher asset prices, more household indebtedness, and strong activity in interest-sensitive sectors such as housing. But I am questioning the apparently firm conclusion of some that these developments represent distortions or imbalances that are likely to correct in an abrupt and harmful manner. At the very minimum, one cannot reach this conclusion with a great deal of confidence. The distortions in the markets I have reviewed do not appear all that large, given the stance of monetary policy, and should we experience much higher interest rates and softer asset prices our resilient markets and flexible economy probably could absorb such a shock. Nonetheless, I cannot rule out the possibility that destabilizing imbalances are building. Should policymakers adjust policy today to slow the growth of debt and limit potential overshooting in bond and housing markets? Such a policy would clearly have near-term costs: It would slow the expansion in demand, damp the creation of new jobs, and keep inflation lower than it otherwise would be. Those costs could be significant, given that the economy is already operating with substantial slack and that any further decline in inflation would leave it at uncomfortably low levels. In my view, policymakers face a very high burden of proof when it comes to accepting fairly predictable short-term pain in the form of slower expansion in exchange for the possibility of gain over the longer run in the form of reduced risks of fluctuations in output, induced by sharp and unanticipated variations in interest rates and asset prices. Despite some signs that values are stretched in some markets, I do not believe this burden of proof has been met at this time. Can actions be taken to limit the longer-run risks without near-term policy adjustments? At least two considerations come to mind. For one, policymakers should continue to remind people that the federal funds rate very probably will have to move up at some point, and that they should be prepared for that adjustment. Households with high debt loads need to take account of the fact that the interest payments on their floating-rate loans will increase, probably taking a higher portion of their spendable funds. Those lending to such households also need to take into account the rise in rates when they judge credit worthiness. Households and those that lend to them also cannot count on large increases in house prices persisting. Rising rates are sure to cool the housing market, and possibly could cause prices to soften in some localities. Investors, too, must be aware that short-term interest rates, and hence the opportunity cost of their longer-term investments, will increase. Borrowing short and lending long is risky and not a sure-fire way to eternally high profits. Investors are unlikely to be able to exit from these bets before the market starts to adjust; it is highly probable that many folks in similar circumstances will be trying to squeeze through the same door at the same time, in which case prices could adjust sharply. The second consideration is that regulators of financial institutions should strive to ensure that these institutions have risk-management systems in place that help to assess and control vulnerability to potential adjustments in interest rates and asset prices. In doing so, supervisors reinforce market discipline. Banking supervisors at the Federal Reserve, for example, in the course of the ongoing examination process, have been paying close attention to the sorts of vulnerabilities we have reviewed and have been discussing these risks with the commercial banks they oversee. Conclusion Interest rates are at unsustainable levels, and monetary policy will need to tighten eventually if the economy is to be kept on a path to high employment and price stability. My remarks today were not focused on the medium-term macroeconomic outlook and its implications for policy. Instead, I addressed a different and difficult set of issues for policymakers - whether policy adjustment should be made that might make the medium-term outlook less favorable but might at the same time lower the odds on longer-term economic instability stemming from possible imbalances in financial markets. This issue has been the subject of considerable research and discussion in recent years, and I have not had time to touch on all its aspects. In recent months some central banks have cited similar types of financial imbalances when they tightened policy. But the economies in which these central banks operate have been running at higher levels of resource utilization and have experienced faster increases in some asset prices than has the United States. My conclusion is that for the United States at this time, the balance of costs and benefits does not favor policy action to address possible imbalances. In the process, I hope that I have given you a sense of the difficult judgments facing a policymaker in an uncertain world and that you have also gotten a taste of the intellectual interest and excitement of working through such issues. This exercise is very similar to many others you would find in the public sector, and so I also hope you keep these challenges and rewards in mind when considering your career path.
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Testimony of Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Committee on Education and the Workforce, US House of Representatives, Washington DC, 11 March 2004.
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Alan Greenspan: Education Testimony of Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Committee on Education and the Workforce, US House of Representatives, Washington DC, 11 March 2004. * * * The United States economy has long been characterized by a strong tradition of entrepreneurial spirit among our business people, a high level of skill among our workers, and an openness by firms and workers alike to intense competition within and beyond our borders. Those attributes have given us a standard of living unparalleled for so large a population - and one that has risen steadily over the history of our nation. But with that bounty have also come the inevitable stresses and anxieties that accompany economic advance. One concern that has persisted for some time is the fear that we are irreversibly losing manufacturing jobs because of businesses’ efforts to extract rapid gains in production efficiencies and to cut labor costs by tapping the lower-wage economies of Asia and Latin America. More recently, similar concerns have arisen about the possibility that an increasing number of our better-paying white-collar jobs will be lost to outsourcing, especially to India and China. Many of these jobs are in the service sector, and they were previously perceived as secure and largely free from the international competition long faced in the manufacturing sector. There is a palpable unease that businesses and jobs are being drained from the United States, with potentially adverse long-run implications for employment and the standard of living of the average American. Job insecurity is understandably significant when nearly two million members of our workforce have been unemployed for more than six months. The issue is both important and sensitive, dealing as it does with the longer-term wealth of our nation and with the immediate welfare of so many individuals and communities. In the debate that has ensued, a large gulf is often perceived between the arguments of economists, who almost always point to the considerable benefits offered over the long term by exposure to free and open trade, and the obvious stress felt by those caught on the downside of turbulence created by that exposure. It is crucial that this gulf be bridged. As history clearly shows, our economy is best served by full and vigorous engagement in the global economy. Consequently, we need to increase our efforts to ensure that as many of our citizens as possible have the opportunity to capture the benefits that flow from that engagement. For reasons that I shall elucidate shortly, one critical element in creating that opportunity is the provision of rigorous education and ongoing training to all members of our society. This proposal is not novel; it is, in fact, the strategy that we have followed successfully for most of the past century and a strategy that we now should embrace with renewed commitment. Over the long sweep of American generations and waves of economic change, we simply have not experienced a net drain of jobs to advancing technology or to other nations. Since the end of World War II, for example, the unemployment rate in the United States has averaged less than 6 percent with no apparent trend; and as recently as 2000, it dipped below 4 percent. Moreover, real earnings of the average worker have continued to rise. Over the past century, per capita real income has risen at an average rate of more than 2 percent per year, declining notably only during the Great Depression of the 1930s and immediately following World War II. Incomes trended higher whether we had a trade deficit or a trade surplus and whether international outsourcing was large or small. More fundamental economic forces have apparently been at work. Research on wealth creation in both emerging and developed nations strongly suggests that it is the knowledge and the skill of our population interacting under our rule of law that determine our real incomes, irrespective of the specific jobs in which these incomes are earned and irrespective of the proportion of domestic consumption met by imports. These upward trends in the standard of living, however, mask the stress that significant parts of our workforce endure. Joseph Schumpeter, the renowned Harvard professor, called the process of progress “creative destruction,” the continuous scrapping of old technologies to make way for the new. Standards of living rise because the cash flows of industries employing older, increasingly obsolescent, technologies are marshaled, along with new savings, to finance the production of capital assets that almost always embody cutting-edge technologies. Workers migrate with the capital. This is the process by which wealth is created, incremental step by incremental step. The process of creative destruction has been accompanied by an ever-growing conceptualization of economic output. Ideas rather than materials or physical brawn have been by far the greatest contributors during the past half-century to our average annual increase of 3-1/4 percent in real gross domestic product. Technological advance is continually altering the shape, nature, and complexity of our economic processes. To effectively manage this ever-increasing complexity, our labor force has had to become more and more technically oriented. Years of schooling, a rough proxy for skills, averaged nine and one-quarter years in 1950. A half-century later, schooling averaged more than twelve years. At the risk of some oversimplification, if the skill composition of our workforce meshed fully with the needs of our increasingly complex capital stock, wage-skill differentials would be stable, and percentage changes in wage rates would be the same for all job grades. This was largely the case through the 1960s when the addition of skilled college graduates to the labor force, in part the result of schooling financed by the GI Bill, was sufficient to hold wage increases among the highly skilled to average gains. Real wages of the lesser skilled also rose significantly, in part as a result of effective high-school educations and the many skills learned during the war. In the 1970s, the supply of skilled workers received another boost from the rapid expansion of our nation’s community colleges. In short, technical proficiencies across all job grade levels appeared to rise about in line with the needs of our, even then, complex stock of capital. But for the past twenty years the real incomes of skilled, especially highly skilled, workers have risen more than the average of all workers, whereas real wage rate increases for lesser-skilled workers have been below average, indeed virtually nonexistent. This difference in wage trends suggests that, at least in relative terms, we have developed a shortage of highly skilled workers and a surplus of lesser-skilled workers. Although in recent years the proportion of our labor force made up of those with at least some college education has continued to grow, we appear, nonetheless, to be graduating too few skilled workers to address the apparent imbalance between the supply of such workers and the burgeoning demand for them. Perhaps the accelerated pace of high-tech equipment installations associated with the large increases in productivity growth in recent years is generating unachievable demands for skilled graduates over the short run. If the apparent acceleration in the demand for skilled workers to staff our high-tech capital stock is temporary, as many presume, the pressure on our schools would ease as would the upward pressure on high-skilled wages. More broadly, in considering the issue of expanding our skilled workforce, some have a gnawing sense that our problems may be more than temporary and that the roots of the problem may extend back through our education system. Many of our students languish at too low a level of skill, and the result is an apparent excess of supply relative to a declining demand. These changing balances are most evident in the failure of real wages at the lower end of our income distribution to rise during the past quarter-century. The hypothesis that we should be able to improve upon the knowledge that our students acquire as they move from kindergarten to twelfth grade gains some support from international comparisons. A study conducted in 1995 revealed that, although our fourth-grade students were above average in both math and science, by the time they reached their last year of high school they had fallen well below the international average.1 Accordingly, we apparently have quite a distance to go before we catch up. Early last century, technological advance required workers with a higher level of cognitive skills - for instance the ability to read manuals, to interpret blueprints, or to understand formulas. Youth were pulled from rural areas, where opportunities were limited, into more-productive occupations in business and an advancing manufacturing sector. Our educational system responded: In the 1920s and 1930s, high-school enrollment in this country expanded rapidly. It became the job of these institutions to prepare students for work life. In the context of the demands of the economy at that time, The Third International Math and Science Study is a project of the International Study Center, Lynch School of Education, Boston College. A complete set of TIMSS publications is available on the center’s web site, http://timss.bc.edu/timss1995i/ TIMSSPublications.html. a high-school diploma represented the training needed to be successful in most aspects of American enterprise. The economic returns for having a high-school diploma rose and, as a result, high-school enrollment rates climbed. By the time that the United States entered World War II, the median level of education for a seventeen-year-old was a high-school diploma - an accomplishment that set us apart from other countries. I cannot dismiss the notion that we can learn something from that period and perhaps from other countries. Still, I realize that the world was different from today in many ways. Societal changes have been numerous and profound, and our schools are being asked to do a great deal more than they have in the past. We need to be forward-looking in order to adapt our educational system to the evolving needs of the economy and the realities of our changing society. One area in which educational investments appear to have paid off is our community colleges. These two-year institutions are playing a similar role in preparing our students for work life as did our early twentieth-century high schools in that less technically oriented era. But to an even greater extent, our population today is adjusting to an ever-faster turnover of jobs. We are also growing more aware that in the current intensely competitive economy, the pace of job creation and destruction implies that the average work life will span many jobs and even more than one profession. The desire of workers to learn skills that build on their previous work experiences or to acquire new skills is apparent. Currently almost one in three of the enrollees in community colleges and almost one of two part-time enrollees at four-year undergraduate schools are aged thirty or older, statistics that suggest that these individuals have had previous job experience. The increase in these enrollments over the past thirty years attests to the success of these institutions in imparting both general and practical job-related training. A rising proportion of the population is also taking advantage of workrelated instruction. More broadly, our system of higher education bears an important responsibility for ensuring that our workforce is prepared for the demands of economic change. America’s reputation as the world’s leader in higher education is grounded in the ability of these versatile institutions to serve the practical needs of the economy by teaching and training and, more significantly, by unleashing the creative thinking that moves our economy forward. *** I do not doubt that the vast majority of us would prefer to work in a less stressful, less competitive environment. Yet, in our roles as consumers, we seem to relentlessly seek the low product prices and high quality that are prominent features of our current frenetically competitive economic structure. Retailers who do not choose their suppliers, foreign or domestic, with price and quality uppermost in mind, risk losing their customers to retailers who do. Retailers are afforded little leeway in product sourcing. If consumers are stern taskmasters of their marketplace, business purchasers of capital equipment and production materials inputs have taken the competitive paradigm a step further and applied it on a global scale. Those who have lost jobs as a consequence of this process, I know, are not readily consoled by the fact that job insecurity concerns are not new. But keeping the current period in context is instructive. Jobs in the United States were perceived as migrating to low-wage Japan in the 1950s and 1960s, to low-wage Mexico in the 1990s, and most recently to low-wage China. Japan, of course, is no longer characterized by a low-wage workforce, and many in Mexico are now complaining of job losses to low-wage China. In response to these strains and the dislocations they cause, a new round of protectionist steps is being proposed. These alleged cures would make matters worse rather than better. They would do little to create jobs; and if foreigners were to retaliate, we would surely lose jobs. Besides enhancing education, we need to further open markets here and abroad to allow our workers to compete effectively in the global marketplace. *** As our economy exhibits increasing signals of recovery, job loss continues to diminish. But new job creation is lagging badly - the ironic consequence of accelerated gains in productivity. In all likelihood, employment will begin to increase more quickly before long as output continues to expand. We have reason to be confident that new jobs will displace old ones as they always have, but America’s job-turnover process will never be without pain for those caught on the downside of creative destruction. We do have a choice. We can erect walls to foreign trade and even discourage job-displacing innovation. The pace of competition would surely slow, and tensions might appear to ease. But only for a short while. Our standard of living would soon begin to stagnate and perhaps even decline as a consequence. Time and again through our history, we have discovered that attempting merely to preserve the comfortable features of the present, rather than reaching for new levels of prosperity, is a sure path to stagnation. In closing, I have emphasized the importance of redressing the apparent imbalances between the supply and demand for labor across the spectrum of skills. Those imbalances have the potential to hamper the adjustment flexibility of our economy overall. But these growing imbalances are also aggravating the inequality of incomes in this country. Historically, we have placed much greater emphasis on the need to provide equality of opportunity than on equality of outcomes. But equal opportunity requires equal access to knowledge. We cannot expect everyone to be equally skilled. But we need to pursue equal access to knowledge to ensure that our economic system works at maximum efficiency and is perceived as just in its distribution of rewards.
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Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, before The Investment Analysts Society of Chicago, Chicago, 15 April 2004.
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Ben S Bernanke: What policymakers can learn from asset prices Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, before The Investment Analysts Society of Chicago, Chicago, 15 April 2004. The references for the speech can be found on the Board of Governors of the Federal Reserve System’s website. * * * Central bankers naturally pay close attention to interest rates and asset prices, in large part because these variables are the principal conduits through which monetary policy affects real activity and inflation. But policymakers watch financial markets carefully for another reason, which is that asset prices and yields are potentially valuable sources of timely information about economic and financial conditions. Because the future returns on most financial assets depend sensitively on economic conditions, asset prices - if determined in sufficiently liquid markets - should embody a great deal of investors’ collective information and beliefs about the future course of the economy. I thought you might find it interesting to hear a bit about how the staff of the Federal Reserve uses financial-market information to try to improve forecasts and help guide policy decisions. As you will see, asset prices provide information, particularly about market expectations, that is difficult to obtain elsewhere. However, a recurring theme of my remarks will be that extracting accurate information from asset prices and yields is more difficult and requires greater sophistication than is commonly supposed. Ongoing research in financial economics thus has great potential to provide practical assistance to monetary policy makers. As usual, the views I will express today are not necessarily those of my colleagues in the Federal Reserve System.1 Market expectations of inflation: the information in inflation-indexed securities I will begin by discussing what financial markets can tell us about inflation expectations. The inflation expectations of financial-market participants are of particular interest to central bankers, for several reasons. First, as price stability is a key objective of monetary policy, the Federal Reserve puts substantial resources into forecasting inflation. To the extent that financial markets serve to aggregate private-sector information about the likely future course of inflation, data on asset prices and yields might be used to validate and perhaps improve the Fed’s forecasts. Second, inflation expectations are of interest to policymakers independent of inflation itself. A considerable literature suggests that successful monetary policies should stabilize, or “anchor,” inflation expectations so as to prevent them from becoming a source of instability in their own right (Goodfriend, 1993; Evans and Honkapohja, 2003). Finally, knowledge of the expectations of inflation in financial markets permits the calculation of real interest rates, which are important indicators of both the condition of the economy and the stance of monetary policy. Although clues about inflation expectations abound in financial markets, inflation-indexed securities would appear to be the most direct source of information about inflation expectations and real interest rates.2 Government securities whose realized yields depend on inflation, known on the Street as “linkers,” have become increasingly common in industrial countries, Japan being the latest nation to introduce an inflation-indexed government bond. The U.S. Treasury began issuing TIIS (for Treasury inflation-indexed securities), more popularly known as TIPS (for Treasury inflation-protected securities), in January 1997. TIPS promise a yield-to-maturity that is guaranteed in real terms. To provide the promised real yield, TIPS coupon and principal payments are escalated based on increases in the consumer price index from the time at which the security was issued. The difference between the real yield guaranteed by an inflation-linked security and the nominal yield provided by a conventional security of the same maturity is known as the breakeven inflation rate or, alternatively, as inflation compensation. The top panel of Figure 1 shows the yield on nominal ten-year Thanks are due to James Clouse and Brian Sack for superb assistance. Indeed, their potential usefulness in this respect was an explicit motivation for their introduction in the United States. Treasury bonds (top line) and the real yield on ten-year TIPS since 1999 (bottom line). The vertical distance between the two lines is known as breakeven inflation at the ten-year horizon. The bottom panel uses overlapping issues of nominal securities and TIPS to disaggregate breakeven inflation into the rate that applies to bonds maturing five years from now and the implied forward breakeven rate from five to ten years out. The breakeven rate of inflation is often treated as a direct reading of investors’ expectations of inflation. Under this interpretation, the lower line in the bottom panel of Figure 1 is an estimate of market inflation expectations over the next five years, and the upper line represents five-year forward expectations of inflation, that is, today’s expectation of what average inflation will be between 2009 and 2014. Unfortunately, as a measure of market participants’ expected inflation, breakeven inflation has a number of problems (Sack, 2000; Shen and Corning, 2001). First, and probably the most important, breakeven inflation includes a return to investors for bearing inflation risk, implying that the breakeven rate likely overstates the market’s expected rate of inflation. Estimates of the inflation risk premium for bonds maturing during the next five to ten years are surprisingly large, generally in a range between 35 and 100 basis points, depending on the time period studied (Ang and Bekaert, 2003; Goto and Torous, 2003; Buraschi and Jiltsov, 2004). If the inflation risk premium averages 50 basis points, for example, then breakeven inflation will overstate the market’s true expectation of inflation by half a percentage point, a substantial amount. A further complication is that inflation risk premiums are not constant but instead appear to vary over time as economic circumstances change. Second, although the issuance of inflation-protected securities has risen significantly, the outstanding quantities of these securities remain much smaller than those of conventional Treasury securities. Moreover, TIPS are attractive to buy-and-hold investors, in contrast to nominal Treasury securities, which are extensively used for trading and hedging (Sack and Elsasser, 2004). For both reasons, the market for TIPS remains significantly less liquid than those for most Treasury securities. All else equal, the likely presence of a liquidity premium in the TIPS return tends to make breakeven inflation an underestimate of expected inflation, thus offsetting to some degree the effect of the inflation risk premium.3 Like inflation risk premiums, liquidity premiums on TIPS appear to vary over time, further complicating the interpretation of breakeven inflation. A third issue is that the real values of the coupon payments on an indexed security are fixed by construction, while the real coupons of a nominal bond usually decline over its life. Hence, an indexed security typically has a longer duration with respect to real interest rate changes than does the nominal security, a difference that affects the relative riskiness of real and nominal securities.4 More generally, because TIPS returns are imperfectly correlated with the yields on both nominal Treasuries and stocks, some investors demand TIPS for general diversification purposes - a demand that appears to have increased significantly as investors have become more familiar with this new type of asset. As the supply of TIPS has been fairly limited, the rise in demand by institutional investors and others may push down the equilibrium real return on TIPS and thus raise measures of breakeven inflation.5 A separate issue that bears on the relevance of breakeven inflation for policymaking is that TIPS returns depend on the overall consumer price index (CPI), whereas for many purposes policymakers are more interested in the behavior of core inflation, a measure of inflation that strips out volatile food and energy prices. In fact, TIPS returns appear sensitive to fluctuations in oil prices. As a partial fix of this problem, the breakeven inflation rates shown in Figure 1 are calculated by comparing the yields of TIPS and so-called off-the-run securities. Within a given class of securities, say Treasury bonds with ten years until maturity, off-the-run securities are securities other than those most recently issued. Because off-the-run securities are less liquid than newly issued (on-the-run) securities, they provide a more appropriate benchmark against which to compare the yields of relatively illiquid inflation-indexed bonds. As Sack (2000) has pointed out, this difference in duration implies that the breakeven inflation rate may be sensitive to the expected profile of future short real rates or be affected by differences in risk premiums arising from different exposure to interest-rate risk. Sack addressed the issue of differing durations of nominal securities and TIPS by comparing yields on TIPS to yields on artificial securities constructed to provide the same pattern of real payments as a TIPS security, thereby eliminating the differences in duration noted in the text. He found, however, that the duration mismatch is less important quantitatively than differences in liquidity between on-the-run nominal securities and TIPS. A number of technical issues, such as the lags in the inflation adjustment procedure, affect the relationship of breakeven inflation and expected inflation. One such potential complication arises if the tax rates applicable to the marginal TIPS investor and to the marginal holder of nominal government securities are not the same, in which case the equilibrium breakeven inflation level will be affected. Roll (2004) discusses the effects of taxation on the breakeven inflation rate. As you can see in Figure 1, breakeven inflation rates have proven surprisingly volatile over their short history. For example, when nominal Treasury yields swung sharply during the spring and summer of 2003, ten-year breakeven inflation moved sharply as well, declining about 40 basis points as the bond market rallied, then rising about 80 basis points when nominal yields came back up (top panel). This effect was seen also in inflation compensation at the five-to-ten-year horizon (bottom panel), a rather counterintuitive result. What should we make of the volatility of breakeven inflation over recent years? One interpretation is that inflation expectations are not as well anchored as policymakers would like (see Bernanke, 2004, for additional evidence on this point). The fact that inflation compensation tends to react strongly both to releases of macroeconomic data and to unexpected changes in monetary policy (Gurkaynak, Sack, and Swanson, 2003) supports this interpretation. Still, at this point I think we need to be cautious about drawing strong conclusions about the short-run behavior of expected inflation from the data on breakeven inflation. The fact that the volatility of breakeven inflation is so much greater than that of standard survey measures of inflation expectations (such as those collected by the Federal Reserve Bank of Philadelphia for professional forecasters or by the University of Michigan for consumers) should give us pause. The responsiveness of breakeven inflation to what might be construed primarily as liquidity disturbances, such as the Russian debt crisis and recent bouts of mortgage hedging activity that roiled Treasury markets, suggests that variable liquidity premiums, together with varying inflation risk premiums, contaminate breakeven inflation as a measure of expected inflation.6 I have emphasized some reasons to be cautious in interpreting breakeven inflation as expected inflation. Nevertheless, I expect that the usefulness of inflation-indexed securities as a tool for measuring expected inflation will increase over time. The liquidity of TIPS should continue to improve as the share of government debt issued in inflation-linked form continues to rise, particularly if the Treasury decides to expand the range of maturities of indexed bonds that it offers. Moreover, as I will discuss briefly later in the talk, our ability to model risk and liquidity premiums is improving, which will help us control for an important source of volatility in breakeven inflation. Finally, the universe of inflation-linked financial assets seems to be increasing, which will allow for fruitful comparisons and cross-checking. For example, futures on the CPI were recently introduced on the Chicago Mercantile Exchange. Although these contracts are not yet widely traded, they may at some point provide useful measures of breakeven inflation out to the maturity of the shortest-term TIPS, thereby filling in an important portion of the term structure of breakeven inflation. Interest rates and spreads as leading indicators An alternative approach to extracting information from financial markets is to examine a range of asset prices and yields to determine whether they are useful as leading indicators of economic developments. Financial prices meet several key criteria for being useful leading indicators. As I already noted, asset prices and yields are inherently forward looking and thus may contain information about future economic conditions not evident in other series. Moreover, asset prices, unlike many data series, are available on a timely and continuous basis and are not revised. At least since the 1930s, when Wesley Mitchell and Arthur Burns (1938) published their pioneering work, economists have noted the usefulness of asset prices in forecasting economic activity - though perhaps we should keep in mind Paul Samuelson’s wry observation that “the stock market has predicted nine of the last five recessions.” Although many financial quantities have been used in forecasting (an index of stock prices is included in the official index of leading indicators), interest rates on various financial instruments have perhaps been most often cited for their value as leading indicators.7 For example, in a 1992 paper, Alan Blinder and I found evidence that the federal funds rate, the short-term interest rate used by the Federal Indeed, Shen and Corning (2001) note that breakeven inflation is correlated with other measures of liquidity premiums, such as the spread between on-the-run and off-the-run securities. Perli and Sack (2003) discuss the volatility in Treasury bond markets associated with mortgage hedging activity. Stock and Watson (2003b) provide an exhaustive survey of the literature on the predictive power of asset prices for output and inflation. Parts of my discussion in this section draw from their paper. Reserve as its policy instrument, has significant predictive power for a variety of measures of economic activity. Various yield spreads have also been found to be informative about the future course of the economy. In 1989, James Stock and Mark Watson proposed a new index of leading indicators based on seven variables with exceptionally good forecasting track records up to that date. Among these variables were the spread between the ten-year and one-year Treasury yields (the term spread), the yield differential between commercial paper and Treasury bills (the public-private spread), the change in the ten-year Treasury yields, and the nominal exchange rate.8 Thus, Stock and Watson found that two of the best seven macroeconomic forecasting variables were interest rate spreads, and four of the best seven forecasters were financial in nature. Of these variables, the term spread (also known as the slope of the yield curve) had been recognized for some time as a useful indicator of cyclical conditions. Figure 2 shows the historical behavior of the term spread (top panel, here measured as the ten-year rate less the three-month rate), as well as that of the federal funds rate and the spread between commercial paper and three-month T-bill yields for comparison. The shaded areas indicate periods of recession as designated by the National Bureau of Economic Research. It is interesting that the slope of the Treasury yield curve has turned negative (top panel), at least briefly, at between two and six quarters before every U.S. recession since 1964 (Ang, Piazzesi, and Wei, 2003). It has given only one false signal, in 1966, when an economic slowdown - but not an official recession - followed the inversion of the yield curve. The slope of the yield curve is potentially informative for several reasons. To some extent, it captures the stance of monetary policy. For example, when the yield curve is sharply upward sloping, as is the case today, one can usually conclude that monetary policy is in an expansionary mode (because the short-term policy rate lies below the average of expected future short-term rates). Either an expected pickup in economic growth or higher expected future inflation would also tend to raise long-term rates relative to short rates, steepening the yield curve. Evidence for the predictive power of the slope of the yield curve has been found for other industrialized countries as well as for the United States.9 Although the evident information content of the term spread and other yields and spreads is intriguing, these variables - like breakeven inflation - hardly provide a foolproof forecasting tool. For example, the Stock-Watson indicator and other indicators based on interest rates and spreads signaled the 1990-91 recession very weakly and rather late. The yield curve was inverted from June 2000 through March 2001, which presaged the 2001 recession, but other financial indicators (such as the public-private spread) missed the downturn entirely (Stock and Watson, 2003a), as you can see in Figure 2. More generally, Stock and Watson (2003b) have recently documented that simple forecasting relationships are typically quite unstable, presumably because both the nation’s economic structure, the conduct of policy, and the mix of shocks that buffet the economy change over time. Although the use of financial data as leading indicators is not without risks, I suspect that economists will continue to try to find better ways to extract the information in these data. I see two general approaches as being especially promising. First, forecasting relationships that simultaneously use information from a large number of data series may be more robust than prediction equations based on only a few variables (Stock and Watson, 2003b). One effective way to summarize the information in large data sets is through the estimation of statistical models that extract the common information conveyed by many variables.10 Currently, the U.S. Treasury uses a model of this type in preparing its forecasts of gross domestic product (GDP), and the Chicago Fed’s national activity index, which draws on earlier work by Stock and Watson, is also based on these methods. The Board staff is currently investigating the potential of this approach for forecasting the economy. Friedman and Kuttner (1993) independently recognized the rather remarkable forecasting record of the public-private spread. For example, Estrella and Mishkin (1997) studied the predictive value of the term premium using data from France, Germany, Italy, the United Kingdom, and the United States. Estrella and Mishkin found that the slope of the yield curve is useful for predicting growth at about a six-quarter horizon, with the link being somewhat stronger in the United States than in Europe. They also found that the slope of the yield curve helps to predict inflation (as measured by the GDP deflator), but at much longer horizons of about five years. Also using international data, Kozicki (1997) found that the term spread is a good short-run forecaster of output, but that the level of yields is a more useful predictor of inflation. In other work, Stock and Watson (1999) have shown that these so-called factor models can provide superior and more robust forecasts than methods based on only a few variables. Forni, Hallin, Lippi, and Reichlin (2000) and Bernanke and Boivin (2003) have obtained related results. The other promising approach is to combine financial and macroeconomic information in a more structured way. For example, Ang, Piazzesi, and Wei (2003) have used modern financial theory to construct a model of the Treasury yield curve that closely links the behavior of real GDP and a few key interest rates. In particular, their framework incorporates the possibility of two-way causality, allowing for both interest-rate effects on the economy and the impact of economic developments on interest rates. These authors show that combining financial and macroeconomic elements in a single model permits better forecasts of both GDP and of interest rates than can be achieved through less formal methods.11 Other work, for example by Ang and Bekaert (2003), shows how modeling the links between interest rates and the economy may help us obtain more efficient forecasts of inflation. These methods are also being studied at the Federal Reserve Board. One important advantage of this theory-based modeling approach is that it permits the estimation of risk premiums. For example, presumably the predictive power of the term spread would be enhanced if we could separate changes in the spread resulting from changes in rate expectations from those arising from changes in risk premiums. Similarly, better estimates of inflation risk premiums would prove useful for adjusting breakeven inflation rates from TIPS to get more reliable measures of expected inflation. Market expectations of monetary policy What do markets expect about the future course of monetary policy? The question is important to policymakers, not because we are concerned necessarily that we should meet the market’s expectations - such a strategy quickly degenerates into a hall of mirrors - but as a check on the efficacy of our communication. If the policy expectations of the market differ significantly from the policy expectations of central bankers, then the two leading possibilities are, first, that the policy committee has not accurately communicated its outlook and objectives or, second, that the market hears the policy committee’s message but is skeptical of it. A number of financial instruments provide readings on the market’s policy expectations. Two of the most useful are federal funds futures contracts and eurodollar futures contracts. These contracts are traded in highly liquid markets.12 Moreover, by their nature they are closely tied to expectations of monetary policy changes, as both reflect rates paid in the interbank market, the market that is targeted by the Federal Reserve’s open-market operations.13 Implied forward values of short-term interest rates at various horizons can be extracted from federal funds and eurodollar futures contract prices in a straightforward way. Figure 3 provides an illustration. The lower, dashed line shows the path of the expected federal funds rate through 2008 as implied by federal funds and eurodollar futures at the close of the market on April 1, 2004, with an adjustment for the average level of term premiums. The upper, solid line shows the path of expected funds rates as of the market close on the next day, April 2. As you probably know, the payroll employment numbers announced on April 2 significantly exceeded market expectations. Figure 3 shows that the payroll data seems to have caused the market to price in an expectation of a higher federal funds rate target over the entire policy horizon. Of course, that change in policy expectations is consistent with the significant rise in Treasury yields that occurred after the employment report. Observing market expectations of policy provides useful feedback to the policymakers. Yet again, however, caution is needed in interpreting these data. As with inflation-indexed securities, forward interest rates implied by futures contracts do not necessarily correspond to market expectations of the short-term rate, because of the presence of premiums for interest-rate risk.14 Indeed, research Kozicki and Tinsley (2001), Hordahl, Tristani, and Vestin (2002), Ang and Piazzesi (2003), Craig and Haubrich (2003), Diebold, Rudebusch, and Aruoba (2003), and Rudebusch and Wu (2003) are among the many interesting papers in the recent “macro-finance” literature on the term structure. The volume of federal fund futures contracts traded has grown about sixfold in the past four years, to about 8.3 million contracts 2003. Gurkaynak, Sack, and Swanson (2002) examined the predictive power of federal funds and eurodollar futures contracts for settings of the federal funds rate target and found that in this respect they outperform other financial instruments. Specifically, they found that the federal funds futures contract dominates alternative instruments for forecasting the funds rate out to a horizon of several months, while eurodollar futures do slightly better than alternative instruments at longer horizons. Liquidity premiums are less of an issue for these markets. suggests that risk premiums in federal funds and eurodollar futures contracts are not trivial and may vary over time. For example, a study by Piazzesi and Swanson (2004) has found that risk premiums on federal funds futures are both strongly countercyclical and predictable at longer horizons. The implication is that, although futures prices provide good estimates of market expectations of policy at short horizons of six months or so, at longer horizons they can be misleading. In particular, Piazzesi and Swanson (2004) find that if analysts ignore risk premiums in federal funds and eurodollar futures, they will estimate longer-horizon policy expectations that “lag behind” actual market expectations, remaining too high when the Fed is easing and too low when the Fed is tightening.15 Fortunately, this research also shows how to correct the futures data to account for the time variation in risk premiums. Once again, we see that some subtlety is required to extract the information available in asset prices. A great advantage of market-based measures of policy expectations, relative to periodic surveys that ask market participants about their expectations, is that market measures are available essentially continuously.16 These measures thus lend themselves to “event studies” of two types, both of which are employed at the Board of Governors. The first type analyzes how various events, such as Federal Reserve statements; the release of minutes, testimony, or speeches by members of the Federal Open Market Committee (FOMC); and macroeconomic news affect market expectations of monetary policy. One simply compares the implied policy expectations before and after the event being studied. We have already considered an example, the effects of the most recent payroll report, in Figure 3. Analyses of this type provide insights for policymakers into the question of what economic factors the “market,” viewed collectively, is focusing on at a given time. The second type of event study uses market-based measures of policy expectations to analyze the effects of policy changes on the economy. In particular, when the FOMC chooses to set the target for the federal funds rate at a value different from that expected by the market, asset prices tend to react strongly. For example, in a recent paper, Kenneth Kuttner and I (2004) studied the effects on stock prices of unanticipated changes in monetary policy, as measured by settings of the federal funds rate target that differ from those implied by federal funds futures market. We found that a surprise increase of 25 basis points in the funds rate target typically results in a decline in broad equity indexes of about 1 percent, whereas a change in the funds rate that is expected by the market has essentially no effect on stock prices.17 Our work is just one example of a number of event-study analyses that may well shed light on the effects of monetary policy and the channels of monetary policy transmission. Policymakers are concerned not only about market expectations of output, inflation, interest rates, and other key variables, but also about the extent of market uncertainty about those and other variables. Financial data provide insight about market uncertainty that is obtainable nowhere else. For example, the Board’s staff regularly analyzes the prices of options on eurodollar futures to estimate the degree of uncertainty that market participants have about monetary policy at different horizons. Indeed, by examining options with different strike prices, and under some reasonable additional assumptions, one can produce a full probability distribution of market expectations for the level of the federal funds rate at various dates in the future. Likewise, analysis of various types of options can generate distributions of expectations for economic and financial variables ranging from oil prices to the exchange value of the dollar to future stock prices.18 Conclusion Financial markets aggregate enormous amounts of information and thus provide a rich hunting ground for central bankers trying to learn about the economy. Today I have tried to provide a small taste of the many types of financial data that are analyzed by the staff at the Federal Reserve as well as to give Sack (2004) also allows for time-varying risk premiums, making the assumption that the risk premium is related to the slope of the eurodollars futures curve at longer horizons. Like Piazzesi and Swanson (2004), he finds that time variation in the risk premium has little effect on estimated policy expectations at shorter horizons (six to twelve months, in his study) but becomes increasingly important at longer horizons. Another advantage is that, unlike survey participants, traders back up their forecasts with their money - a powerful incentive to make forecasts that are as accurate as possible. Our analysis used daily data. Using intraday data, Gurkaynak, Sack, and Swanson (2004) found an effect of similar magnitude. A caveat: These probability distributions are derived under an assumption of risk neutrality. Thus, unobserved risk premiums are potentially a problem here as well. you some sense of the techniques that they bring to bear. A message that I also hope to leave with you is that some of the potentially most valuable information in financial markets often requires considerable theoretical and empirical sophistication to extract. For this reason, and as I mentioned at the beginning, financial research of the type being conducted at the Board, in academia, and in the investment community will prove invaluable to the Federal Reserve in our efforts to support a stronger and more stable economy.
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the 2004 Financial Markets Conference of the Federal Reserve Bank of Atlanta, Sea Island, Georgia, (via satellite), 16 April 2004.
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Alan Greenspan: Capitalising reputation Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, at the 2004 Financial Markets Conference of the Federal Reserve Bank of Atlanta, Sea Island, Georgia, (via satellite), 16 April 2004. * * * Recent transgressions in financial markets have underscored the fact that one can hardly overstate the importance of reputation in a market economy. To be sure, a market economy requires a structure of formal rules - for example, a law of contracts, bankruptcy statutes, a code of shareholder rights. But rules cannot substitute for character. In virtually all transactions, whether with customers or with colleagues, we rely on the word of those with whom we do business. If we could not do so, goods and services could not be exchanged efficiently. The trillions of dollars of assets that are priced and traded daily in our financial markets before legal confirmation illustrate the critical role of trust. Even when followed to the letter, rules guide only a few of the day-to-day decisions required of business and financial managers. The rest are governed by whatever personal code of values that managers bring to the table. Market transactions are inhibited if we cannot trust the reliability of counterparties’ information. The ability to rely on the word of a stranger is integral to any sophisticated economy. A reputation for honest dealings within a business or financial corporation is critical for effective corporate governance. Even more important is the way outsiders view the corporation itself. The reputation of a corporation is an exceptionally important market value that in principle is capitalized on a balance sheet as goodwill. Reputation and trust were valued assets in freewheeling nineteenth-century America. Throughout much of that century, laissez-faire reigned, and caveat emptor was the prevailing prescription for guarding against wide-open trading practices. A reputation for honest dealing was thus particularly valued. Even those inclined to be less than scrupulous in their private dealings had to adhere to a more ethical standard in their market transactions, or they risked being driven out of business. To be sure, the history of business is strewn with Fisks, Goulds, and numerous others treading on, or over, the edge of legality. But they were a distinct minority. If the situation had been otherwise, the United States at the end of the nineteenth century would never have been poised to displace Great Britain as the world’s leading economy. Reputation was especially important to early U.S. bankers. It is not by chance that many bankers in the nineteenth century could effectively issue non-interest-bearing liabilities in the form of currency. They worked hard to develop and maintain a reputation that their word was their bond. For these institutions to succeed and prosper, people had to trust their promise to redeem banknotes in specie. The notion that “wildcat banking” was rampant before the Civil War is an exaggeration. Certainly, crooks existed in banking as in every business. Some banks that issued currency made redemption inconvenient, if not impossible. But these banks were fly-by-night operators and rarely endured beyond the first swindle. In fact, most bankers, especially on Wall Street, competed vigorously for reputation. Those who had a history of redeeming their banknotes in specie, at par, were able to issue substantial quantities, effectively financing their balance sheets with zero-interest debt. J.P. Morgan marshaled immense power on Wall Street in large part because of his widespread reputation for fulfilling his promises. Over the past half century, the American public has embraced the protections of the myriad federal agencies that have largely substituted government financial guarantees and implied certifications of integrity for business reputation. As a consequence, the market value of trust so prominent in the nineteenth century seemed unnecessary and by the 1990s appeared to have faded to a fraction of its earlier level. Presumably, we are better protected and, accordingly, better off as a consequence of these governmental protections. But corporate scandals of recent years have clearly shown that the plethora of laws of the past century have not eliminated the less-savory side of human behavior. We should not be surprised then to see a re-emergence of the market value placed on trust and personal reputation in business practice. After the revelations of corporate malfeasance, the market punished the stock prices of those corporations whose behaviors had cast doubt on the reliability of their reputations. Recent allegations on Wall Street of breaches of trust or even legality, if true, could begin to undermine the very basis on which the world’s greatest financial markets thrive. Guilty parties should be expeditiously punished. Some practices and rules have outlived their usefulness and require updating. But in so doing we need to be careful not to undermine the paradigm that has so effectively governed voluntary trade. Rewriting rules that have served us well is fraught with the possibility for collateral damage. I hope and anticipate that trust and integrity again will be amply rewarded in the marketplace as they were in earlier generations. There is no better antidote for the business and financial transgressions of recent years.
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Statement of Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Committee on Banking, Housing, and Urban Affairs, US Senate, Washington, 20 April 2004.
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Alan Greenspan: The state of the banking industry Statement of Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Committee on Banking, Housing, and Urban Affairs, US Senate, Washington, 20 April 2004. * * * Chairman Shelby, Senator Sarbanes, and members of the committee, I am pleased to be here this morning to discuss the condition of the U.S. banking system and various related matters. They include improved risk-management practices of banks, the current status and direction of our regulatory efforts to revise capital standards for internationally active banks, deposit insurance, and the ongoing consolidation process within our domestic banking industry. Growth in the size and complexity of the largest U.S. and foreign banking organizations, in particular, has substantially affected financial markets and the supervisory and regulatory practices of the Federal Reserve and other bank regulatory agencies around the world. It has, in part, required authorities to focus more than before on the internal processes and controls of these institutions and on their ability to manage risk. Only through steady and continued progress in measuring and understanding risk will our banking institutions remain vibrant, healthy, and competitive in meeting the growing financial demands of the nation while keeping systemic risk at acceptable levels. Therefore, the regulatory authorities must provide the industry with proper incentives to invest in risk-management systems that are necessary to compete successfully in an increasingly competitive and efficient global market. When I last discussed the condition of the banking industry with this committee in June 2001, the industry’s asset quality had begun to decline, but from a relatively high level, and banks were generally well positioned to deal with the emerging problems. Moreover, as early as the late 1990s, both the industry and bank supervisors had begun to address the slippage in credit standards that was one of the causes of the drop in asset quality. By most measures, this was an unusually early stage in the economic cycle to begin addressing such deterioration. Today, with the benefit of hindsight, we can see that the weaknesses I cited then have indeed been mild for the banking system as a whole and that the system remains strong and well positioned to meet customer needs for credit and other financial services. During the past two years, in particular, the industry extended its string of high and often record quarterly earnings. For the full year 2003, commercial banks reported net profits of more than $100 billion while maintaining historically high equity and risk-based capital ratios and enjoying brisk asset growth. Although the demand for business loans and the underwriting of equity securities have been weak over the past few years, banking organizations have continued to benefit from strong demand for household credit, not least for residential mortgage products as interest rates declined substantially. Moreover, the volume of problem assets in commercial banks declined each quarter last year, including a drop in the fourth quarter of nearly 10 percent, which brought the ratio of problem assets to total loans and foreclosed assets to less than 1 percent - its lowest level since year-end 2000. As a result of this favorable performance, both the size and the number of bank failures in recent years have been exceptionally small. Last year, for example, only two banks, with combined assets of just $1.5 billion, failed. The results of last year’s interagency review of large syndicated loans and internal reports about the level and distribution of their criticized and classified credits lead us to expect still further improvement in the industry’s asset quality this year. Notably, the pool of “special mention” credits that are weak but still performing (and which tend to produce the more serious problem assets) has shrunk both in the annual Shared National Credit review and in the quarterly bank reports. Risk measures derived from prices of publicly traded bank securities - stocks, debt securities, and credit default swaps - also signal that market participants are taking an increasingly positive view of the future of banks. Indeed, these measures suggest the lowest level of market concern about these companies that we have seen during the five-years in which we have tracked them. The banking industry’s relatively benign experience with loan losses these past few years may not be surprising given that the recession was mild by most measures. The experience is more notable, however, when one considers the broader range of shocks and developments that have occurred during this period, including the September 11 attacks, Argentina’s credit default, the continuing shift by large and not-so-large firms in this country from bank to capital market financing, and the concentration of recent economic pressures on specific industries and business sectors. These events tended to reduce the overall quality of corporate loan portfolios at banks and contributed significantly to banks’ efforts to improve their measurement and management of risks, especially after the substantial credit losses they suffered in the late 1980s and early 1990s. These efforts, aided by the continued trend toward industry consolidation, helped moderate previous concentrations of credit exposures in bank portfolios and fueled greater use of new methods of hedging and managing risk. At present, credit risk-management practices are perhaps least developed in measuring risk associated with exposures related to construction projects and to the financing of commercial real estate, which have grown rapidly, particularly among regional and community banks. At all banks, such lending represented nearly 19 percent of all bank loans at year-end 2003 - the highest level thus far recorded - and accounted for essentially all the loan growth last year at banks with less than $1 billion in assets. Despite the limited development of formal risk-management practices, credit standards applied to these loans have apparently been quite high. At least, we see as yet no signs of rising credit losses from such lending, and supervisory and market sources indicate that the poor lending practices of the late 1980s and early 1990s have been largely avoided. Nonetheless, the historical record provides ample evidence of the risks associated with this form of lending and of accumulating large credit concentrations in any form of exposure. Supervisors continue to monitor these concentrations and the lending practices and market conditions that will ultimately determine their effects on the banking system. These and other gradual changes in the balance sheets of banks, along with the sustained decline in market rates, helped compress net interest margins at many banks, as they chose not to reflect the full effect of lower market rates into rates paid on deposits without a specified maturity. As a percentage of earning assets, net interest income of all insured commercial banks declined 27 basis points last year, to 3.80 percent, the lowest level in more than a decade. Although this compression eased slightly during the fourth quarter, we cannot yet tell whether margins have begun to rebound. This compression of margins needs to be understood in the fuller context of the banks’ sensitivity to changes in interest rates and, in particular, the effect of historically low rates on banks’ financial performance and condition. At the same time that declining rates were adversely affecting the industry’s interest margins, they were also spurring growth in mortgage-related assets and associated loan-origination fees and were producing significant capital gains in bank investment portfolios. Lower interest rates, along with the decline in equity valuations experienced during 2000-2002, also contributed to a substantial inflow of liquid deposits by lessening their opportunity cost. Under these circumstances, and with a steep yield curve, a banker’s natural inclination might be to shift the credit mix and extend the maturity of assets in an attempt to bolster asset yields. To some extent such actions have been taken. Residential mortgage loans and pass-through securities have increased from 17.5 percent of assets in 2000 to 20 percent in 2003. But the manner in which this growth has occurred suggests a balanced assessment of risk. Call Report data indicate that a substantial portion of the increase in mortgage assets has been in adjustable-rate or shorter-term mortgages, particularly at smaller banks. For their part, large institutions also have significant capacity to offset on-balance-sheet exposures through off-balance-sheet transactions. All told, the available data, industry and supervisory judgments, and the long and successful experience of the U.S. commercial banking system in dealing with changing rates suggest that, in general, the industry is adequately managing its interest rate exposure. Many banks indicate that they now either are interest-rate neutral or are positioned to benefit from rising rates. These views are based partly on specific steps that they have taken to adjust portfolios and partly on judgments about the effects that rising interest rates would have in easing pressure on interest margins. That is, many banks seem to believe that as rates rise - presumably along with greater economic growth - they can increase lending rates more than they will need to increase rates paid on deposits. Certainly, there are always outliers, and some banks would undoubtedly be hurt by rising rates. However, the industry appears to have been sufficiently mindful of interest rate cycles and not to have exposed itself to undue risk. In other areas, earlier concerns about the effect of the century date change on computer systems, the destruction of infrastructure in the September 11 attacks, and the increased volume and scope of banking transactions generally have also required financial institutions, particularly large institutions, to devote more effort and resources to contingency planning in order to ensure the continuity of their operations. Last fall’s power outage and Hurricane Isabel may have offered only limited tests of the industry’s improved procedures, but financial firms handled those challenges extremely well. As the nation’s central bank and as a bank supervisor, the Federal Reserve has a strong interest in the continued operation of the U.S. financial system after a disruptive event. To that point, last year, the Federal Reserve Board, the Securities and Exchange Commission, and the Office of the Comptroller of the Currency jointly issued an interagency paper, “Sound Practices to Strengthen the Resilience of the U.S. Financial System.” That paper provides guidance that supplements long-standing principles of business continuity planning and disaster recovery and is directed at the entities that pose systemic risk to the financial system, particularly in the context of their clearing and settlement activities. Through the Federal Financial Institutions Examination Council, we also issued revised examination guidance on business continuity planning. This guidance covers a variety of threats to business operations, including terrorism, and will be used in future examinations. Improved risk management in banks Independent of continuity planning for unusual events, the basic thrust of recent efforts to improve the management of risk has been better quantification and the creation of a formal and more-disciplined process for recognizing, pricing, and managing risk of all types. In the area of credit risk, by providing those involved with a stronger, more-informed basis for making judgments, this development has enhanced the interaction between lending and risk-control officers. Operating with better information does not mean that banks will necessarily reduce credit availability for riskier borrowers. It does mean that banks can more knowingly choose their risk profiles and price risk accordingly. Better, more-informed lending practices should also lead to a more-efficient allocation of scarce financial capital to the benefit of the economy at large. Greater internal transparency and quantification of risk have helped bank managers monitor portfolio performance and identify aspects of the risk-measurement and credit-granting process that begin to move off track. As risk-measurement and disclosure practices evolve, investors and uninsured creditors will also become more motivated and better positioned to understand the risk profile of banks and convey their own views of banking risks. Indeed, accommodating greater and more-informed market discipline is an important goal of bank supervisors. Perhaps most important, better risk management has already begun to show real potential for reducing the wide swings in bank credit availability that historically have been associated with the economic cycle. Sound procedures for risk quantification generally lead to tighter controls and assigned responsibilities and to less unintended acceptance of risk during both the strengthening and weakening phases of the business cycle. Earlier detection of deviations from expectations leads to earlier corrective actions by bank managers and, as necessary, by bank supervisors. Better methods for measuring credit risk have also spurred growth in secondary markets for weak or problem assets, which have provided banks with a firmer, sounder basis for valuing these credits and an outlet for selling them and limiting future loss. Insurance companies, hedge funds, and other investors acquire these assets at discounts that they judge are sufficient to meet their expected returns and balance their portfolio risks. The result is greater liquidity for this segment of bank loan portfolios and the earlier removal of weakening credits from bank balance sheets. Portfolio risks have also been increasingly hedged by transactions that do not require asset sales, such as derivatives that transfer credit risk. With greater use, more-thorough review, and more-extensive historical data, risk modeling has improved in accuracy and will continue to do so. Supervisors are also learning these techniques and are pressing banks to improve their own methods and systems to keep up with the latest developments. In the United States, our leading banking organizations began the process years ago and, in many respects, were in the vanguard of the effort worldwide. Nevertheless, they and the risk-measurement process itself have much further to go. Recent initiatives of the Basel Committee on Banking Supervision to revise international capital standards have helped focus attention on risk-measurement practices and have encouraged further investment in this area. Moreover, the very improvements in technology that facilitated better bank risk measurement and management have undermined the current regulatory capital regime by creating transactions and instruments that were not conceived when the current regulatory standard was developed. Although these developments have sometimes helped banks circumvent existing rules, they have also enabled banks to hedge portfolio risk in ways that the current accord does not address well. As a result, the current regulatory capital standard is increasingly unable to establish capital requirements for our largest and most-complex banking organizations that reflect their true underlying risks. We need a more accurate, more risk-sensitive measure of capital adequacy to provide these institutions with appropriate risk-management incentives and to provide ourselves with a more reliable basis for supervising them in a way that focuses on true risks. In the process, such a measure should also enhance our efforts in taking prompt corrective action. For all these reasons, I believe the U.S. banking agencies must remain committed to the process of developing and applying a revised regulatory capital standard for the world’s international banks. Proposed capital standards Last summer, the U.S. banking agencies took another step toward adopting the new capital standard by issuing for public comment an advance notice of proposed rulemaking (ANPR). The conception and design of the proposed standard, referred to as Basel II, are based on techniques developed in recent years by the largest banks, especially those, as I noted, in this country. As the scale and complexity of their activities grew, the banks needed to find better and more efficient ways to understand, manage, and control their risk-taking activities; to promote and respond to the emergence of new markets, such as those for securitized assets; and to make greater use of available technology and financial theory in measuring and managing their risks. Before the agencies issued the ANPR, numerous changes in the proposed Basel II Accord had already been made in light of earlier comments. Reflecting the comments received on the ANPR, the Basel Committee agreed to extend the period for reaching an agreement in principle until mid-2004 to permit more time for revisions of the proposal to be formulated. Indeed, we have already negotiated some major changes in the international proposal to reflect U.S. public comments. These changes include the adoption of a framework based on unexpected loss and a revised set of rules on securitization. We have also modified the implementation process to ease the burden on banking organizations that operate across borders. These technical changes were high on the list of modifications suggested by commenters. The shift from a combined “expected” and “unexpected” loss framework to one that focuses on unexpected loss only is crucial to ensuring that the regulatory capital framework is consistent with standard internal banking practices, both here and abroad. That change will also simplify other parts of the proposal. The modification on securitization was imperative to permit U.S. banks to continue participating in important funding markets that they pioneered and to ensure a prudent risk-sensitive capital treatment for securitization exposures. Beyond these achievements, working groups in Basel are considering other U.S. proposals related to refining measures of expected loss, an issue that a number of commenters raised. The U.S. agencies are still trying to reach a consensus on a revised proposal for capital charges on retail credit to put before our colleagues in Basel. The Federal Reserve, for its part, will continue to make every effort to reach consensus on this issue that is both risk-sensitive and workable. I believe that all the federal banking agencies are committed to achieving a revised accord that reflects the realities of the twenty-first century; that meets our needs for a safe, sound, and competitive banking system; and that addresses the legitimate concerns of the industry. The Federal Deposit Insurance Corporation has raised important issues about capital adequacy, and the Office of the Comptroller of the Currency has expressed significant concerns about a capital structure that may inadvertently disrupt retail credit operations of banks. All the agencies are addressing these concerns by jointly developing proposals to bring to Basel. In working to reach full agreement among ourselves, and ultimately with our colleagues abroad, we all seek a solution that promotes sound banking practices and that we can adequately implement and enforce. I hope that in the days ahead the agencies can close the gap on credit cards within such an overarching framework. If we can do so, the Basel Committee should be able to reach agreement in principle on a new proposal around midyear, and the U.S. banking agencies expect to evaluate that proposal through another “quantitative impact study” that we plan to conduct at large U.S. banks this fall. Committee members are aware that this survey and public comments on a forthcoming Notice of Proposed Rulemaking may raise still further issues that will need to be addressed before we can implement Basel II in the United States. Of course, other countries have their own national and European Union-wide review processes to conclude, and those consultations too, may raise issues that will require additional attention. As this committee knows, the U.S. agencies have proposed that in this country the most-advanced version of Basel II is to be required only of the largest, most-complex banking organizations, although we anticipate that some of the other larger banks also will choose to adopt that version. Non-adopters in the United States will continue to operate under the current capital rules. The current regulatory capital regime, as I noted, has become less effective for the largest organizations while consolidation has sharply increased the scale and scope of their activities. In this country, the Basel II proposal focuses on them. The current rules remain appropriate and prudent for other banking organizations in the United States, and the agencies have decided that imposing the cost of new rules on these banking organizations does not pass a cost-benefit test. Nonetheless, change in the procedures for calculating regulatory capital for larger banks creates uncertainty among those entities to which the new rules would not apply. The comments we received on the ANPR and from the Congress last year indicate that some smaller banks are concerned that their competitive environment will change. More specifically, these fears include the possibility that Basel II will induce adopters, who are likely to have reductions in regulatory capital requirements, to redeploy their capital by acquiring non-adopters or to gain a competitive advantage, particularly in the markets for small business and residential mortgage loans. To judge the merits of these concerns, the Federal Reserve conducted two technical and empirical analyses of the underlying issues and made the papers available to the public last month; congressional staff members were also briefed. A third study will be completed shortly, and a fourth will commence soon. The first of these papers, dealing with mergers and acquisitions, found virtually no statistical support for the view that either the level of, or changes in, excess regulatory capital have played a role in past merger and acquisition decisions, which suggests that any future effect of Basel II on such decisions is also likely to be quite small. Moreover, reductions in regulatory capital requirements for adopters relative to the requirements for non-adopters are unlikely to lead to an acceleration in the pace of consolidation. The second study evaluated the likely effect of Basel II on the competition between adopters and non-adopters in the market for small- and medium-sized business loans. It estimated that the marginal cost of such loans at adopting banks would decline no more than about 16 basis points, on average, and is likely to decline by less than that in most cases. Importantly, the study also found that most small business loans made by community banks are sufficiently different from those made by either required or likely adopters of Basel II as to make any marginal cost differences virtually irrelevant. Moreover, being riskier, the small business loans made by most community banks are priced so much above the loans made by the large banks that the marginal cost benefit to adopters would not be a material competitive factor. The study did find, however, that the types of small- and medium-sized business loans made by adopters and other large banks are, indeed, similar and similarly priced, so that adopting institutions may have a competitive advantage in many cases over other large banks that choose not to adopt Basel II. I will return to the implication of this finding in a moment. A paper analyzing competitive effects in the residential mortgage market will be available later this spring, and once the U.S. agencies agree on a proposal regarding the treatment of credit cards, staff members can begin analyzing potential competitive effects of the proposal in that market, as well. All four papers will then be re-evaluated early next year when new data become available from the agencies’ next quantitative impact study. If the evidence following these reviews and a public comment process suggests that implementation of bifurcated capital standards in this country may affect competition in certain markets, the proposals for Basel II may need to be reconsidered. We may need, for example, to modify the application of Basel II in the United States, where permissible under the Basel agreement; negotiate further changes in the international agreement itself; or change the way the current capital rules are applied to institutions that do not adopt the new standard. In short, if we have sufficient indications that implementation of a new capital standard will distort the balance of competition, we can and will apply policies to mitigate this effect consistent with the risk profile of individual institutions. We cannot, however, respond to an unsubstantiated and generalized fear of change. Such concerns should not halt the evolution of regulatory capital standards for the large, complex banking organizations that play such an important role in our banking system and in global financial markets. Bank consolidation Legislation designed to deregulate U.S. banking markets, technology, and other factors have contributed to significant structural change in the banking industry and to a decline of nearly 40 percent in the number of banking organizations since the mid-1980s, when industry consolidation began. Consolidation activity has slowed sharply in the past five years, but a recent uptick in merger announcements, including a couple of very large transactions, may signal a return to a more rapid pace of bank merger activity. Since 1995, the ten largest U.S. banking organizations have increased their share of domestic banking assets from 29 percent to 46 percent at year-end 2003. Yet, over the past decade, roughly 90 percent of bank mergers have involved a target with less than $1 billion in assets, and three-quarters have involved an acquiree with assets of less than $250 million. This ongoing consolidation of the U.S. banking system has not, in my judgment, harmed the overall competitiveness of our banking and financial markets. Although they have facilitated consolidation, the reduced barriers to entry - such as were provided by the Riegle-Neal Act’s relaxation of interstate banking laws - have provided net competitive benefits to U.S. consumers of financial services. Other economic forces, such as technological change and globalization, have stimulated competition among depository institutions and between depositories and nonbank providers of financial services. In addition to other credit-extending businesses, our system of depository institutions alone continues to be characterized by many thousands of commercial banks, savings institutions, and credit unions. Measures of concentration in local banking markets, both urban and rural, have actually declined modestly not just since 2000 but since the mid-1990s. Significantly, most households and small and medium-sized businesses obtain the vast majority of their banking services in such local markets. Deposit insurance I would like to turn now to the issue of deposit insurance reform and to the need for some legislative change in this area. As the committee knows, most depository institutions have not paid any deposit insurance premiums since 1996, and in fact, some large institutions that have been chartered in the past eight years have never paid them at all. Under current conditions, not only is a government guarantee being provided free, but also depositories having similar or identical risks are exposed to potentially disparate treatment should one, but not the other, of the deposit insurance funds fall below its funding target. In that situation, the FDIC would be required to impose a charge on one set of depository institutions while continuing to provide free deposit insurance to those in the other fund. Because some depository institutions today have commingled BIF- and SAIF-insured deposits as a result of bank and thrift mergers, this disparate treatment could apply even to different deposit accounts within the same depository institution. At this time, the Congress has the opportunity to provide the FDIC with greater flexibility to charge risk-based premiums, possibly using market data (for example, rates on uninsured deposits) for the largest banks, to allow such premiums to increase or decrease in a gradual manner over a wider range of fund reserve ratios, and to treat all depositories with similar risk ratings equally and equitably. Such reforms should be implemented in a manner that does not unnecessarily create additional moral hazard and that strengthens, rather than erodes, market discipline. Higher coverage limits, for example, would exacerbate moral hazard problems without apparent and offsetting benefits. The current level of coverage seems adequate to meet the needs of an overwhelming majority of depositors. First, depositors have certain flexibility in distributing large balances among multiple accounts and depository institutions to obtain higher insurance coverage. Second, the Federal Reserve’s latest survey of consumer finances indicates that at year-end 2001 less than 4 percent of U.S. depositor households had any uninsured deposits. Moreover, the median bank IRA/Keogh account balance was only $15,000, well below the existing insurance limit. Finally, community banks have shown themselves just as adept as the largest banks in attracting uninsured deposits when necessary to fund customer loan demand. Conclusion In closing, Mr. Chairman, let me reiterate that the past decade has been one in which the banking industry has recorded persistent record profits while providing an ever-wider range of products and services to much more diverse groups. The industry’s experience during the past several years in dealing with clear weakness in key economic sectors demonstrates the importance of strong capital positions and sound risk-management practices. Bank supervisors worldwide are working to encourage further progress in these areas, through more-accurate and more-effective regulatory capital standards based on even better internal risk-management procedures.
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Testimony by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Joint Economic Committee, US Senate, Washington, 21 April 2004.
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Alan Greenspan: The economic outlook Testimony by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Joint Economic Committee, US Senate, Washington, 21 April 2004. * * * Mr. Chairman and members of the committee, I am pleased to be here today to offer my views on the outlook for the U.S. economy. The economy appears to have emerged around the middle of last year from an extended stretch of subpar growth and entered a period of more vigorous expansion. After having risen at an annual rate of 2-1/2 percent in the first half of last year, real GDP increased at an annual pace of more than 6 percent in the second half. Aided by tax cuts, low interest rates, and rising wealth, household spending continued to post sizable gains last year. In addition, an upturn in business investment, which followed several years of lackluster performance, and a sharp rise in exports contributed importantly to the acceleration in real GDP over 2003. Although real GDP is not likely to continue advancing at the same pace as in the second half of 2003, recent data indicate that growth of activity has remained robust thus far this year. Household spending has continued to move up, and residential home sales and construction remain at elevated levels. In addition, the improvement in business activity has become more widespread. In the industrial sector, nearly two-thirds of the industries that make up the index of industrial production have experienced an increase in output over the past three months. More broadly, indicators of business investment point to increases in spending for many types of capital equipment. And importantly, the latest employment figures suggest that businesses are becoming more willing to add to their workforces, with the result that the labor market now appears to be gradually improving after a protracted period of weakness. Looking forward, the prospects for sustaining solid economic growth in the period ahead are good. Monetary policy remains quite accommodative, with short-term real interest rates still close to zero. In addition, fiscal policy will likely continue to provide considerable impetus to domestic spending through the end of this year. Importantly, the caution among business executives that had previously led them to limit their capital expenditures appears to be giving way to a growing confidence in the durability of the expansion. That confidence has, no doubt, been bolstered by favorable borrowing conditions, ongoing improvements in efficiency, and rising profitability, which have put many firms on a more solid financial footing. Nevertheless, some of the strains that accompanied the difficult business environment of the past several years apparently still linger. Although businesses are replacing obsolescent equipment at an accelerated pace, many managers continue to exhibit an unusual reluctance to anticipate and prepare for future orders by adding to their capital stock. Despite a dramatic increase in cash flow, business fixed and inventory investment, taken together, have risen only moderately. Indeed, internal corporate funds exceeded investment over the course of last year for the first time since 1975. Similar cautious behavior has also been evident in the hiring decisions of U.S. firms, during the past several years. Rather than seeking profit opportunities in expanding markets, business managers hunkered down and focused on repairing severely depleted profitability predominately by cutting costs and restricting their hiring. Firms succeeded in that endeavor largely by taking advantage of the untapped potential for increased efficiencies that had built up during the rapid capital accumulation of the latter part of the 1990s. That process has not yet played out completely. Many firms seem to be continuing to find new ways to exploit the technological opportunities embodied in the substantial investments in high-tech equipment that they had made over the past decade. When aggregate demand accelerated in the second half of 2003, the pace of job cuts slowed. But because of the newfound improvements in the efficiency of their operations, firms were able to meet increasing demand without adding many new workers. As the opportunities to enhance efficiency from the capital investments of the late 1990s inevitably become scarcer, productivity growth will doubtless slow from its recent phenomenal pace. And, if demand continues to firm, companies will ultimately find that they have no choice but to increase their workforces if they are to address growing backlogs of orders. In such an environment, the pace of hiring should pick up on a more sustained basis, bringing with it larger persistent increases in net employment than those prevailing until recently. Still, the anxiety that many in our workforce feel will not subside quickly. In March of this year, about 85,000 jobless individuals per week exhausted their unemployment insurance benefits - more than double the 35,000 per week in September 2000. Moreover, the average duration of unemployment increased from twelve weeks in September 2000 to twenty weeks in March of this year. These developments have led to a notable rise in insecurity among workers. Most of the recent increases in productivity have been reflected in a sharp rise in the pretax profits of nonfinancial corporations from a very low 7 percent share of that sector’s gross value added in the third quarter of 2001 to a high 12 percent share in the fourth quarter of last year. The increase in real hourly compensation was quite modest over that period. The consequence was a marked fall in the ratio of employee compensation to gross nonfinancial corporate income to a very low level by the standards of the past three decades. If history is any guide, competitive pressures, at some point, will shift in favor of real hourly compensation at the expense of corporate profits. That shift, coupled with further gains in employment, should cause labor’s share of income to begin to rise toward historical norms. Such a process need not add to inflation pressures. Although labor costs, which compose nearly two thirds of consolidated costs, no longer seem to be falling at the pace that prevailed in the second half of last year, those costs have yet to post a decisive upturn. And even if they do, the current high level of profit margins suggests that firms may come under competitive pressure to absorb some acceleration of labor costs. Should such an acceleration of costs persist, however, higher price inflation would inevitably follow. The pace of economic expansion here and abroad is evidently contributing to some price pressures at earlier stages of the production process and in energy markets, and the decline in the dollar’s exchange rate has fostered a modest firming of core import prices. More broadly, however, although the recent data suggest that the worrisome trend of disinflation presumably has come to an end, still-significant productivity growth and a sizable margin of underutilized resources, to date, have checked any sustained acceleration of the general price level and should continue to do so for a time. Moreover, the initial effect of a slowing of productivity growth is more likely to be an easing of profit margins than an acceleration of prices. As I have noted previously, the federal funds rate must rise at some point to prevent pressures on price inflation from eventually emerging. As yet, the protracted period of monetary accommodation has not fostered an environment in which broad-based inflation pressures appear to be building. But the Federal Reserve recognizes that sustained prosperity requires the maintenance of price stability and will act, as necessary, to ensure that outcome.
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Remarks by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, at the European Institute Roundtable on Financial and Monetary Affairs, Washington, DC, 23 April 2004.
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Roger W Ferguson, Jr: Global imbalances Remarks by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, at the European Institute Roundtable on Financial and Monetary Affairs, Washington, DC, 23 April 2004. * * * I am pleased to participate in a discussion with such distinguished colleagues and to share my thoughts about some key issues confronting economic policy makers. As you are all well aware, the global economy is becoming ever more tightly knit, with national economies increasingly drawn together through trade and financial market transactions - all facilitated by continuing advances in telecommunications and related technologies. The economic slowdown that the U.S. economy entered in 2001 was shared by Europe, East Asia, and Latin America. Similarly, the revival in growth that our economy has enjoyed since the middle of last year has also shown up, to greater and lesser degrees, in other parts of the world. Although growth rates in different regions of the global economy are somewhat synchronous, such shared movements in output do not ensure that external deficits or surpluses will remain small. With the United States now running a current account deficit equal to about 5 percent of the gross domestic product, the rest of the world must run a correspondingly large net current account surplus. And when the U.S. deficit starts to decline, then trade flows abroad will adjust as well, reducing their overall surplus. Because of its size and persistence, as well as recent declines in the value of the dollar, the U.S. current account balance is receiving an extraordinary amount of attention at present. Observers routinely ask the following questions: Is the deficit unusually, or even abnormally, large? How long can it be sustained? How might a correction of the deficit affect the United States and its trading partners, including Europe? One must always be mindful of the possibility that the inevitable adjustment process related to global imbalances may be disorderly, but the tone of these questions is often more pessimistic than I think is warranted. Nevertheless, these questions are important, and I will devote the remainder of my remarks to addressing them. Is the U.S. current account deficit “abnormal”? The economics profession has no consensus model to tell us, for a given economy, what the appropriate level of the current account balance is. At best, economists can agree on some general principles. I will emphasize only two. First, current account imbalances allow countries to smooth consumption over time, for example, in response to the ups and downs of the world price of a major export. Second, current account imbalances - which represent the difference between domestic savings and domestic investment - allow savings to be allocated to those parts of the world where they can be invested most productively. On the basis of these considerations, some analysts have argued that industrial countries should run current account surpluses and invest their abundant savings in developing countries, which, being labor-rich and capital-poor, would offer higher rates of return. However, examples of high or persistent current account deficits abound among industrialized economies, including Canada (averaging 2.5 percent of GDP from 1975 through 1998), the United Kingdom (1.9 percent of GDP from 1984 through 2003), and Australia (4.1 percent of GDP from 1974 through 2003). Global investors have confidence that in countries such as these as well as in the United States they can safely seek the highest possible return for their funds. Some of the factors that lie behind such confidence are political stability, a legal system that effectively protects property rights and enforces commercial contracts, economic policies that promote and strengthen the role of markets, a financial system that efficiently channels resources to their most productive uses, and an educational system that produces highly skilled workers and supports rapid technological development. These elements are present in many mature economies, including those of the United States and Europe. Rates of return on investments in the United States have also been driven by the rapid diffusion of technological innovation. Labor productivity in the United States accelerated to a rate of about 3 percent in the period 1996-2003. Over the same period, smoothing through the recent cycle, the value of U.S. equities rose about 80 percent compared with 60 percent for European equities and a decline of 30 percent for Japanese. These developments attest to the expansion of favorable investment opportunities in the United States. Thus, it is neither surprising nor abnormal that, beginning in the mid-1990s, capital flows to the United States - primarily in the form of direct investment and equity inflows - began to pick up substantially, including, importantly, investment flows from Europe. These capital inflows exerted upward pressure on the dollar and provided the financing for our widening current account deficit. How long can the current account deficit be sustained? To say that a current account deficit is unsurprising or explainable is not to say that it is sustainable in the long run. With the net external debt of the United States rising more rapidly than GDP, some narrowing of the deficit is inevitable. However, such shrinkage does not mean that the current account deficit will be eliminated. Moreover, to say that the current account deficit cannot stay large on a permanent basis is not to say just when or how adjustment will occur. One can envision several developments that could trigger adjustment, many of which would be very positive for the global economy. A pickup in perceived rates of return abroad could divert capital flows from the United States to other countries and prompt adjustments in external balances. In Europe, for example, a considerable expansion in the use of information technologies in recent years has not, to date, appreciably boosted growth rates of labor productivity. It is conceivable that such high-tech investments may finally lead to higher productivity growth, further boosting investment spending, and weakening trade performance, as occurred in the United States in the 1990s. In Japan, corporate and financial sector restructuring appears to be making gains. In Latin America, improved policies and more flexible exchange rates may set the stage for renewed capital inflows. And in Asia, a revival of domestic demand could give the authorities confidence that, if they allow capital inflows to strengthen their currencies and narrow their current account surpluses, high rates of economic growth will be maintained. Even if rival sources of demand for global capital do not emerge, another factor that would induce adjustment of the current account, if it were to occur, would be a diminishing appetite for additional U.S. assets and, therefore, a reduced willingness to finance the deficit. One cannot know whether or at what point such concerns might become pressing. However, by several measures, the imprint of U.S. financing needs on global capital markets has not been so large as to be problematic. At roughly 25 percent of GDP, the net external debt of the United States is still below that of several other industrial economies, including the Netherlands (30 percent), Finland (40 percent), and Australia (60 percent). Moreover, even though the United States has been a net debtor since 1986, the net income on the international investment position has remained positive, as the rate of return on U.S. investments abroad continues to exceed that on foreign investments in the United States. From the standpoint of investor portfolios, notwithstanding years of large current account deficits, the share of U.S. equities in global equities actually fell from 49 percent in 1997 to 47 percent in 2002; the U.S. share in the global bond market moved up only marginally during the same period, from 42 percent to 44 percent. Finally, current account adjustment may be prompted by increases in U.S. saving. Concerns about the expanding budget deficit may prompt some reining in of fiscal policy, leading to a reduction of public sector dissaving. In the private sector, personal saving rates remain extremely low by historical standards and thus may revert to earlier norms at some point. Either of these developments would boost total domestic savings and, all else being equal, cut into the current account deficit. Although we cannot know the time frame over which capital flows may begin to shift or U.S. demand for imports to lessen, so far there appears to have been no loss of appetite for dollar-denominated assets. The dollar has declined since early 2002, but net private capital inflows have remained strong. In the first two months of this year, net private foreign purchases of U.S. securities, which are admittedly volatile, averaged about $60 billion, well above the $33 billion monthly pace reached in 2001 and 2002, when the dollar was much higher. Moreover, while I am not privy to their plans, I note that foreign authorities, who are increasingly large holders of dollars, currently show few signs of substantially adjusting the composition of their balance sheets. How might a current account adjustment affect the U.S. and global economies? If a substantial current account adjustment is required, how might it take place, and what might be its effects? As to the first of these questions, three mechanisms might induce a narrowing of the current account deficit. First, a fall of U.S. prices below foreign prices could raise our competitiveness. Prices have become relatively stable, by historical standards, in the United States and its trading partners, however, and, it is not clear how much of a dent this could put in the trade deficit. A second possibility is that an increase of foreign growth above U.S. growth could boost our exports. Between 1970 and 1995, foreign GDP growth, weighted by U.S. trade, exceeded U.S. growth by nearly 2/3 percentage point annually; since then, U.S. growth has exceeded foreign growth by 1/4 percentage point. Thus, there is some potential for foreign growth to rise relative to U.S. growth. Finally, price adjustments through exchange rate adjustment, by encouraging exports and making imports more costly, could play a role in current account adjustment. I must emphasize that, no matter how the U.S. external imbalance is narrowed, the level and composition of demand, both in the United States and abroad, would have to change. Such a change, in turn, would require adjustments of relative prices. In the United States, to accommodate increases in exports relative to imports, changes in relative prices would be needed to shift production toward internationally traded goods and services and to shift consumption toward nontraded goods and services. By the same token, adjustment by our trading partners to a reduction in the U.S. current account deficit would require both an increased domestic demand to maintain the overall level of economic activity and an adjustment of relative prices to raise the share of nontraded goods in production and of traded goods in consumption. The prospect of a correction in the current account is often portrayed in ominous tones, a dark storm cloud looming on the economic horizon. Yet, the economic adjustments I have just described are both feasible and, properly managed, need not lead to undue distress, either in the United States or abroad. After the dollar correction of the mid-1980s, for example, economic activity in the United States continued to expand as the growth of domestic demand eased but was replaced by strong contributions from net exports. During that period, analogous adjustments helped to maintain economic performance among our trading partners. The pace of GDP growth in the foreign G7 economies, weighted by U.S. exports, increased from about 2-1/2 percent during 1982-84 to nearly 4 percent in 1985-87 as greater domestic demand growth compensated for weaker performance in net exports. U.S. current account adjustment could, in fact, be associated with quite favorable scenarios for the global economy. For example, the rise in foreign productivity growth that I touched on earlier could work through several channels to narrow the U.S. trade deficit as funds were attracted abroad. Strong domestic demand among our trading partners would likely outweigh any drag resulting from appreciation of their currencies, while U.S. exports would benefit from both a change in relative prices and stronger foreign growth. Of course, the financial press frequently points to less-favorable scenarios, including the so-called disorderly correction, that is, a rapid fall in the dollar that engenders a steep falloff in U.S. bond and equity prices and that perhaps disrupts other national markets as well. I have seen little evidence to suggest that this scenario is likely, notwithstanding its popularity. The fall in the dollar since early 2002 has not disrupted financial markets, nor did the dollar's previous correction in the 1980s. Moreover, most U.S. external debt is in dollars, so currency depreciation is unlikely to lead to the balance-sheet problems that arise during financial crises in developing countries, although obviously some parties that have not taken precautions would take losses. That said, central bankers are paid to be prudent and watchful, and we will obviously continue to monitor closely international financial markets and their effects on the U.S. economy. Looking ahead, I see no obvious indications that the external sector poses significant concerns for growth or stability. Not only has the decline in the dollar to date failed to disrupt U.S. financial markets, but most would judge that, on balance, it has had only modest effects on inflation. Consumer spending is continuing to rise strongly and, although activity in housing markets has eased a bit, on balance, from the brisk pace of late last year, both sales and construction remain at high levels. In the business sector, spending on equipment and software appears to be increasing quite strongly, although outlays for nonresidential structures have remained weak. As has been the case over the past half-year, because of sizable increases in productivity, businesses seem to be able to boost production without adding much to their payrolls. Going forward, policy makers will have to determine whether the improvements signaled in some recent labor market measures indicate that the economy is on a sustainable path to closing the pool of underutilized resources. Although it has depressed job creation in the short run, increasing productivity is positive for the economy's long-run outlook and the creation of wealth. Due, in part, to these same increases in productivity, inflationary pressures have generally been muted. Now the process of disinflation appears to have ceased, and inflation has apparently stabilized. However, we cannot be complacent regarding inflation and inflation expectations. Should the Federal Reserve conclude that the maintenance of price stability is in jeopardy, I am confident that it will act appropriately. Conclusion To conclude, a change in the tone of international financial markets that required a substantial adjustment of the U.S. current account would obviously have important implications for spending and economic activity, both here and abroad. However, such adjustment, properly handled, need not derail the global economy nor cloud the bright prospects that the United States and Europe - linked by myriad ties of commerce, communications, culture, and political tradition - share.
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board of governors of the federal reserve system
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Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the Bond Market Association Annual Meeting, New York, 22 April 2004.
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Ben S Bernanke: The economic outlook and monetary policy Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve System, at the Bond Market Association Annual Meeting, New York, 22 April 2004. The references for the speech can be found on the Board of Governors of the Federal Reserve System’s website. * * * I am pleased to have the opportunity to address the members of the Bond Market Association. I know that you have a keen interest in the likely future course of the economy and of monetary policy, so I will use my time today to comment on both topics. I will begin with the economic outlook, discussing prospects for economic growth, the labor market, and inflation, and conclude by drawing some implications for monetary policy. As always, my views are my responsibility alone and are not to be ascribed to my colleagues in the Federal Reserve System.1 The prospects for economic growth Broadly, the economy has shown substantially increased vitality since the middle of last year, and with the passage of time the economic recovery has shown increasing signs of becoming self-sustaining. Judging from the most recent data, growth in domestic spending appears consistent with growth in real gross domestic product (GDP) in the range of 4-1/2 to 5 percent for the first quarter and at a rate of 4 percent or higher for 2004 as a whole. One reason for increased confidence that the recovery is becoming self-sustaining is that the expansion of aggregate demand has become more broad-based, with households, firms, and government all making contributions to spending growth. Household spending, which has not slackened significantly at any point in the past three years, has continued its advance, supported by positive wealth effects and tax cuts. Except for a modest decline in auto sales (relative to the strong pace of the previous quarter), consumer expenditures on most major categories of goods and services were well sustained in the first quarter, as recent data on retail sales testify. Household spending is likely to continue to grow at a solid pace for the remainder of this year, especially if the job market improves as expected. A question that many have asked is whether household spending, including spending on new homes, will remain strong if interest rates rise. I think that consumers are not badly positioned for a normal cyclical increase in interest rates. The balance sheets of most households are in good shape: Perhaps most important, the ratio of household net worth to income is relatively high, not far below its pre-recession level. Also, households took advantage of low long-term rates during the last cycle to reduce their exposure to short-term and high-interest debt. Although household debt burdens have risen, most household debt today is in the form of mortgage debt, of which some 85 to 90 percent is at fixed rates and thus insulated from interest-rate increases. The decision to purchase a home is probably the most interest-sensitive decision made by households. Private housing starts rebounded in March from a possibly weather-related dip in February, and sales of new and existing homes during the first quarter remained close to record levels. I expect residential investment to continue strong this year. Mortgage rates have risen in the past month but remain low relative to historical experience, while new household formation, improved job prospects, and income growth should ensure a continued healthy demand for housing. However, residential investment is unlikely to rise much further from current high levels and thus its contribution to GDP growth over the next year or two can be expected to decline. Energy price increases have reduced households' real disposable personal income by about $30 billion since December. This development will probably shave a tenth or two from the growth in personal consumption expenditures in 2004 but thus far, at least, the rise in energy prices does not materially affect the outlook. A key factor in the economic turnaround in the third quarter of 2003 was the resurgence in business fixed investment, particularly in equipment and software. That component of spending seems set to I thank Charles Struckmeyer, Jeremy Rudd, Jonathan Pingle, and other members of the Board staff for assistance. continue to expand as output grows, profits improve, and firms become more confident in the durability of the recovery. Double-digit growth in real spending on equipment and software seems quite possible this year, in part because the expiration of partial expensing allowances at the end of 2004 will lead some firms to move forward investment they otherwise would have made in 2005. Given the very low inventory stocks currently held by businesses, inventory investment should also support growth. In contrast, nonresidential investment remains weak, reflecting low capacity utilization rates in factories and high vacancy rates in office buildings, and the improvement in that sector seems likely to be gradual. The Federal government's budget deficit is expected to peak this year at something between $450 billion and $500 billion. Both increased government expenditures and reduced taxes will support growth in aggregate demand in 2004, though fiscal policy will provide somewhat less impetus and may even be slightly restrictive in 2005. U.S. exports are likely to continue their recent rise, because of a weaker dollar and economic recovery among our trading partners. However, rising U.S. incomes will spur imports as well. On net, the external sector will probably continue to be a slight drag on U.S. growth, and little if any progress is likely to be made in closing the current account deficit this year. The state of the labor market As you know, the recovery in labor markets has not kept pace with the recovery in output, an issue that has been central in recent debates about economic policy. As has been widely noted, the leading explanation for the slow recovery in the labor market has been the remarkable ability of employers and workers to increase labor productivity. Over the four quarters of 2003, output per hour in the nonfarm business sector is estimated to have risen 5.4 percent, up from an already robust 4.3 percent gain the previous year. Output per hour probably grew at a rate exceeding 4 percent in the first quarter of this year, accounting for the lion's share of growth during the quarter. Although these productivity increases are unalloyed good news for the U.S. economy in the longer term, in the short run they have allowed firms to expand production rapidly while adding fewer workers than would be normal in a cyclical expansion. I and many others have argued that this situation cannot persist: As managers exhaust the possibilities for outsized productivity gains and become convinced of the durability of the expansion, they should become increasingly more willing to add employees (Bernanke, 2003b). Unfortunately, the pace of productivity gains and hence of employment growth has proved difficult to forecast. If we look past the erratic month-to-month changes in payrolls, the labor market does appear to be gradually improving. On average, private nonfarm payrolls grew by 161,000 per month in the first quarter, up from 58,000 per month in the fourth quarter of 2003. Recent employment gains have not been confined to a few industries. For example, in March the one-month employment diffusion index, which measures the proportion of industries with expanding employment relative to the share of industries with contracting employment, reached its highest value since July 2000. Initial claims for unemployment insurance have also been falling and are now at pre-recession levels. The decline in initial claims is consistent with other data that suggest that the pace of layoffs has slackened considerably. The rate of new hiring has been exceptionally sluggish for the past several years, however, and the available evidence suggests modest improvement at best in hiring rates so far this year. Although the labor market appears to be sitting up and taking fluids, it has not hopped out of bed and begun a round of jumping jacks. Despite the strong payroll gains in March, nonfarm payrolls remain 343,000 below their level of November 2001, the official trough of the recession, and private nonfarm payrolls are more than half a million below the trough level. The average workweek of production and nonsupervisory workers declined slightly in March; at 33.7 hours, the workweek is low on an absolute basis and barely above the 33.6 hours average attained during the third quarter of last year, the lowest quarterly figure in 2003. The data I have cited thus far come from reports provided by employers, through what is known as the payroll survey. Much has been made of the differences between the results of the payroll survey and those from the household survey, which is based on the responses from a random sample of households.2 When its coverage is adjusted to be comparable to that of the payroll survey, the Formally, the payroll survey is known as the Current Employment Statistics survey and the household survey as the Current Population Survey. The Bureau of Labor Statistics produces both surveys. household survey shows a net gain of about 1.7 million jobs since the November 2001 trough, compared with the already noted loss of more than 300,000 jobs reported by the payroll survey. Since June of last year, when the pace of output growth picked up significantly, employment as measured by the household survey (on a comparable payroll basis) has risen by 1.42 million jobs, more than double the increase of 689,000 jobs reported by the payroll survey. Recent revisions of both surveys - in the case of the household survey, to take into account the likelihood that immigration to the United States since 2003 has been below earlier estimates - have only modestly reduced the gap in estimated job creation.3 Although resolving the differences between the two surveys is important, my own assessment of the labor market does not change markedly even if substantial credence is given to the data drawn from the household survey. For example, although the unemployment rate (measured by the household survey) has fallen to 5.7 percent from its peak of 6.3 percent last June, that rate remains high relative to recent experience and in comparison to most plausible recent estimates of the sustainable rate of unemployment. The evidence suggests, moreover, that the official unemployment rate of 5.7 percent understates to some extent the true amount of slack in the labor market. Notably, to a greater degree than in past cycles, discouraged job seekers have been withdrawing from the labor market rather than reporting themselves as unemployed. According to the household survey, the labor force participation rate has actually declined significantly since the official trough of the cycle, from 66.7 percent of the working-age population in November 2001 to 65.9 percent in March 2004.4 From its peak last June, the unemployment rate has fallen by 0.6 percentage point, from 6.3 percent to 5.7 percent. However, during the same period, the labor force participation rate also fell by 0.6 percentage point, from 66.5 percent to its current value of 65.9 percent. The net result is that the employment-to-population ratio has barely changed since the middle of last year. Thus even the household survey, its relatively more encouraging job-creation numbers notwithstanding, paints a picture of ongoing softness in the labor market. So long as the labor market is weak, the economic recovery will be incomplete. Indeed, by reducing confidence and spending, a failure of the labor market to improve could conceivably threaten the sustainability of the expansion. One way to see the extent of the slack in the labor market, as measured even by the household survey, is to ask how much job creation would be needed to bring the unemployment rate down further. Underlying the household survey's employment calculations is an estimate that the adult non-institutional population grew in March by 193,000 people. If the population grows by the same absolute amount in April and the labor force participation rate remains unchanged at 65.9 percent, the labor force will grow by about 127,000 during the month. To keep the unemployment rate at 5.7 percent in April, then, household employment (as opposed to payroll employment) would have to grow by 120,000 jobs. To reduce the unemployment rate under these assumptions, of course, more than 120,000 net new jobs would be needed. The standard calculation I just presented was based on the assumption that the rate of labor force participation does not change, an assumption that may not be valid during a cyclical recovery in the labor market. If people perceive a significant improvement in the job market, new job seekers may enter or re-enter the labor force as employment grows. To illustrate the possible implications, let us suppose that improving job prospects lead the participation rate to rise 0.1 percentage point in April, from 65.9 percent to 66.0 percent. (Remember, the rate was 66.5 percent as recently as last June.) This increase in the participation rate would imply a total increase in the labor force (including the portion attributed to the rise in population) of some 350,000 people and hence a need for more than 330,000 net new jobs to keep the unemployment rate from rising. The implication is that, with the labor market still in a relatively early stage of its cyclical recovery, an unusually high rate of job creation may be required for a time to bring the labor market back into balance. In short, the unusual rate of productivity growth has driven a wedge between the recovery in output and the recovery in the labor market, leaving considerable cyclical slack in the labor market despite Although recent additions to payrolls are much greater according to the household survey, as of March 2004 the payroll survey reports a higher level of employment, by about 600,000 jobs, than the household survey (on a comparable payroll basis). At face value, this fact seems to be a bit of evidence against the view that the payroll survey systematically undercounts some jobs that are being captured by the household survey. Bernanke (2003c) provides more discussion of the two surveys. Conceivably, part of the decline in the participation rate could reflect factors other than simple discouragement. However, I will proceed under the plausible assumption that most of the decline is a response to labor market conditions. ongoing growth in output. The economic recovery will not be fully realized, in my view, until the labor market has established a more normal cyclical pattern of expansion.5 The outlook for inflation Forecasts of inflation, particularly core inflation (which excludes the more volatile energy and food price components), are of course another key input to monetary policy decisions. The core inflation data for the past couple of months have been slightly above market expectations. More time will be needed to assess the significance of these recent numbers; possibly, they may reflect the unwinding of some downward surprises to core inflation late last year. Based on the information currently available, my own best guess is that core inflation has stopped falling and appears to be stabilizing in the vicinity of 1-1/2 percent, comfortably within my own preferred range of 1 to 2 percent. The dominant fundamental factors influencing the inflation outlook are the ongoing resource slack and the remarkable rate of productivity growth. Together, these factors imply that unit labor costs will either continue to fall or at least remain quiescent. Moreover, price-cost margins are at high levels (as can be seen in the strong growth of profits), providing an additional cushion for absorbing any inflation pressures that may emerge on the cost side. These forces should largely offset the effects on core consumer price inflation of the rising costs of raw materials - the byproduct of the gathering global recovery and continuing rapid growth in East Asia - and last year's decline in the foreign exchange value of the dollar. As I discussed in some detail in a speech earlier this year (Bernanke, 2004a), the direct effects of commodity price increases and a depreciating dollar on inflation at the consumer level are generally small. This modest direct impact reflects the small share of total costs accounted for by raw materials and imported inputs as well as the fact that a portion of cost increases tends to be absorbed in producers' margins. In thinking about the implications of higher commodity prices for inflation, one should also make the distinction between a one-time rise in commodity prices and an ongoing process of commodity price inflation. Commodity prices can only contribute to inflation at the consumer level when they are rapidly rising. Commodity prices may well remain high in an absolute sense over the next few years because of the high global demand for raw materials. Yet if the rate of increase in commodity prices slows significantly, as is implied for example by futures prices, the effect of commodity prices on the rate of inflation will eventually become negligible. Similarly, dollar depreciation contributes to inflation only to the extent that it is ongoing; we cannot predict whether last year's decline in the dollar will continue, of course, but so far this year it has not. In describing what I consider to be the most likely scenario for inflation, I do not wish to convey an unwarranted degree of certainty. Like employment, inflation is difficult to forecast. One factor that may be of great importance in inflation determination but can be particularly hard to gauge is the state of the public's inflation expectations (Poole, 2004). For example, wages and prices that are set for some period in the future will of necessity embody the inflation expectations of the parties to the negotiation; increases in expected inflation will thus tend to promote greater actual inflation. More subtly, my conclusion that the effects on inflation of transitory changes in commodity prices or in the value of the dollar tend to dissipate in the longer run depends on the assumption that the public's inflation expectations are well anchored. If expectations are not well tied down, inflationary impulses that are in themselves transitory may become embedded in expectations and hence affect inflation in the longer term. Therefore, an essential prerequisite for controlling inflation is controlling inflation expectations. My presumption that the current slack in the labor market is primarily cyclical, rather than structural, is based on several observations. First, the recent high rates of productivity growth are clearly above secular trends and suggest that firms have been working employees more intensely, deferring maintenance, and taking other temporary measures to raise output, behavior that is characteristic of the early stages of an employment expansion. Second, I see little evidence (for example, in the job flows data) to suggest that the pace of structural change today is greater than it was after the 1990-91 recession or in the expansion of the mid- to late-1990s. Third, factors affecting labor supply and the efficiency of job matching, including demographic changes, greater worker experience and education, increases in incarceration rates, increases in disability rolls, increased use of temporary help firms, and increased job search through the Internet, suggest strongly that the sustainable rate of unemployment has steadily declined since the mid-1980s, to a level below the current rate. The relatively sharp disinflation of recent years is consistent with that view. Finally, an increasing tendency of low-skilled workers to leave the labor force rather than remain formally unemployed has also likely lowered the sustainable rate of unemployment (Juhn, Murphy, and Topel, 2002). Assessing the current state of inflation expectations in the United States is not entirely straightforward. Survey measures of near-term inflation expectations, including those based on interviews of professional forecasters, individual consumers, and firm managers, have in some cases ticked up slightly in recent months, though long-term inflation expectations appear stable. The spread between the yields on Treasury debt and inflation-indexed Treasury securities of similar maturity, known as the breakeven inflation rate and conventionally treated as an indicator of expected inflation, has also risen. From a policy perspective, a difficulty with all these measures is that they reflect expectations of headline inflation rather than the core inflation measures usually emphasized in the monetary policy context. Headline inflation has of course been significantly affected by the recent surge in energy prices. The breakeven inflation rate derived from indexed Treasury securities has additional problems as a measure of expected inflation. As I discussed in a recent speech (Bernanke, 2004b), breakeven inflation may differ substantially from the market's true expectation of inflation because of possibly time-varying risk and liquidity premiums. I will discuss inflation expectations further in the context of monetary policy, to which I turn next. Monetary policy The federal funds rate stands at a historically low level of 1 percent, and the Federal Open Market Committee (FOMC) has declared its intention to be “patient in removing policy accommodation.” As a number of my FOMC colleagues have noted in various public venues, inevitably the funds rate will have to return to a more normal level. What considerations should the Committee keep in mind as it plans this normalization process? Before addressing this question, I would like to point out that, in an appropriately broad sense, monetary conditions in the United States are already in the process of normalizing. I base this statement on my view that the stance of monetary policy should be judged not only by the current setting of the federal funds rate but also by the level of rates that are tied directly or indirectly to expectations about the future path of monetary policy, of which the yields on Treasury securities are the leading examples. In part because of the FOMC's communication strategy, which has linked the future stance of policy to the level of inflation and the extent of slack in resource utilization, market interest rates have generally responded continuously and in a stabilizing manner to economic developments. The March employment report, which cited an unexpectedly high rate of job creation, provides a recent example. Treasury yields rose sharply on its release as market participants traced out the report's presumed implications for monetary policy. Mortgage rates, corporate bond rates, and other yields and asset prices moved in sympathy, with important effects on the cost of borrowing and hence, presumably, on aggregate demand. For practical purposes, therefore, monetary conditions tightened significantly the day of the March employment report, notwithstanding the fact that the federal funds rate itself was unchanged. This episode illustrates both the power and the importance of clear communication by monetary policymakers about their objectives and their evaluation of economic conditions. With respect to future decisions about the policy rate, for me two considerations are most relevant: first, the degree of confidence one can place in the sustainability of the economic expansion and, second, the evolution of inflation and inflation expectations. As I have indicated, the economic expansion is showing increasing signs of being both strong and self-sustaining. However, to my mind, some uncertainty about that sustainability remains, arising primarily from the slow recovery of the labor market. Indeed, if one takes into account the long delay between the official recession trough and the trough in employment, the labor market today remains at what effectively is an early stage of its normal cyclical expansion. Although the recent improvement in employment is encouraging, from the data in hand it is not yet clear that employers have overcome their reluctance to hire at a normal pace. Additional confirmation that the recovery in the job market is both sustainable and quickening would be most welcome. Regarding inflation, as I noted earlier, the economic fundamentals appear consistent with core inflation's remaining under control, in the general range of 1 to 2 percent. In particular, I see no indication that the U.S. economy is in imminent danger of overheating, productivity growth is keeping the lid on labor costs, and the effects on inflation of the increases in commodity prices and the decline in the dollar to date, which are likely to be small in any event, may well have dissipated a year from now. As I have acknowledged, however, there are risks to my relatively sanguine inflation forecast. In particular, a rise in the public's expectations of inflation, whether “justified” by underlying forces or not, may put upward pressure on the actual rate of inflation. Moreover, expectations of inflation can themselves be destabilizing, as when an “inflation scare” in the bond market inappropriately raises long-term yields, with adverse effects for the real economy. To avoid instability in expected inflation, and the volatility in actual inflation, output, and employment that might result, I believe that the Federal Reserve should maintain at all costs its hard-won credibility for keeping the inflation rate low and stable. That involves, at a minimum, formulating policy with a close eye to indicators of inflation and inflation expectations. More generally, as I have suggested in earlier talks, I believe that the FOMC's credibility and clarity would be enhanced if it announced the inflation range with which it would be comfortable in the medium term (Bernanke, 2003a, 2003b). In particular, policy would be both more coherent and more predictable if FOMC members shared an explicit common objective for inflation at the medium-term horizon. To conclude, monetary policy is now in a transition phase. That short-term interest rates must eventually be normalized is a given. However, the remaining uncertainty about the likely paths of both employment and inflation of necessity implies that the timing of policy changes at this point also remains uncertain. Like my colleagues on the FOMC, I will continue to watch the relevant data very closely. The challenge that lies before the Committee is to manage policy in a way that permits the economy to realize its productive potential while simultaneously maintaining firm control of inflation and inflation expectations.
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board of governors of the federal reserve system
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Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the Economic Growth and Regulatory Paperwork Reduction Act Banker Outreach Meeting, Nashville, Tennessee, 22 April 2004.
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Susan Schmidt Bies: The economic outlook and financial health of bank customers Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the Economic Growth and Regulatory Paperwork Reduction Act Banker Outreach Meeting, Nashville, Tennessee, 22 April 2004. * * * I am delighted to be back in Tennessee today and to have a chance to visit with some old friends. I also want to thank you for giving so much of your time to help us identify ways to reduce unnecessary and unduly burdensome regulatory requirements on financial institutions. There is a real need to continually review the cost-benefit nexus of regulations, especially with the fast pace of evolution in financial markets and institutions. Thus, my colleagues in the Federal Reserve System and I are strong supporters of the goals of today's meeting. It is a critical supplement to our own efforts, which include a review of our regulations every five years to revise or rescind out-of-date or unnecessary rules. I thought that after lunch you might find it interesting to shift to a discussion of the financial health of bank customers and the economy. In that spirit, I would like to briefly share with you my assessment of the economic outlook and then to discuss in more detail how the evolution of household and business balance sheets in recent years is affecting economic activity. You should understand, however, that I am expressing my own opinions, which are not necessarily those of my colleagues on the Board or on the Federal Open Market Committee. The economic outlook As you know, real GDP grew at an annual rate of 6.2 percent in the second half of 2003, and the economic fundamentals seem to be in place for another sizable advance this year. Indeed, the central tendency range of FOMC-member forecasts is 4-1/2 to 5 percent. Yet despite the recent strong pace of economic activity, the labor market has improved at an unusually slow pace by historical standards. The most recent data - indicating a jump in payrolls in March - was good news, and I am cautiously optimistic that job growth will pick up further over the remainder of this year. My business contacts tell me that companies have become more optimistic about economic prospects and that their plans do include increases in the size of their payrolls. The latest data on consumer prices suggest that the process of disinflation may have come to an end. In March 2004, the twelve-month change in the core CPI rose to 1.6 percent - essentially the same pace as in March 2003, and the core PCE price index change from twelve months earlier moved back above the 1 percent level in both February and March. Although the increased pace of economic activity has put some upward pressure on prices at earlier stages of processing and higher energy prices are being passed through to the prices of some products, strong productivity growth and slack in resource utilization have kept core retail price increases in check. Household financial conditions Some commentators have expressed concern about the rapid growth in household debt in recent years, fearing that households have become overextended and will need to rein in their spending to keep their debt burdens under control. My view, however, is considerably more sanguine. Although there are pockets of financial stress among households, the sector as a whole appears to be in good shape. As bankers, you are well aware that households have taken on quite a bit of debt over the past several years. According to the latest available data, total household debt grew at an annual rate of 10 percent between the end of 1999 and the fourth quarter of 2003; in comparison, after-tax household income increased at a rate of 5 percent. But looking below the aggregate data, we must understand that the rapid growth in household debt reflects largely a surge in mortgage borrowing, which has been fueled by historically low mortgage interest rates and strong growth in house prices. Indeed, many homeowners have taken advantage of low interest rates to refinance their mortgages, some having done so several times over the past couple of years. Survey data suggest that homeowners took out cash in more than one-half of these “refis,” often to pay down loans with higher interest rates. On net, the resulting drop in the average interest rate on household borrowings, combined with the lengthening maturity of their total debt, has tempered the monthly payment obligations from the growing stock of homeowners' outstanding debt. The Federal Reserve publishes two series that quantify the burden of household obligations. The first series, the debt service ratio, measures the required payments on mortgage and consumer debt as a share of after-tax personal income. The second series, the financial obligations ratio, is a broader version of the debt service ratio that includes required household payments on rent, auto leases, homeowners' insurance, and property taxes. Both ratios rose during the 1990s, and both reached a peak in late 2001. Since then, however, they have receded slightly on net from their respective peaks, an indication that households, in the aggregate, have been keeping an eye on repayment burdens. Because the debt service ratio and the financial obligations ratio are calculated from aggregate data, they do not necessarily indicate whether the typical household is experiencing financial stress. Nonetheless, we have found that changes in either ratio help predict future changes in consumer loan delinquencies. Accordingly, the fact that these ratios have come off their recent peaks is a hopeful sign about household loan performance. Indeed, delinquency rates for a wide range of household loans turned down over the second half of 2003. Another often-cited indicator of household financial conditions is the personal bankruptcy rate. Movements in the bankruptcy rate, to be sure, partly reflect changes in the incidence of financial stress, but the rate has been trending up for more than two decades for a variety of other reasons. The Bankruptcy Reform Act of 1978 made bankruptcy a more attractive option for most households by increasing the amount of wealth that households could retain after bankruptcy. Other factors that have likely contributed to the upward trend are the decrease in the social stigma of filing for bankruptcy and the growing access to credit in the United States. As lenders have become more sophisticated in their ability to assess the riskiness of borrowers, they have extended loans to households that were previously denied credit. These households are more likely to default on their obligations than the typical borrower, but this increased risk is priced into loan terms. Although the bankruptcy rate remains elevated, it has edged down on balance in recent months, likely because of the pickup in economic growth in the United States since mid-2003. This relatively upbeat assessment of household credit quality seems to be shared by lenders and by investors in securities backed by consumer debt. According to the Federal Reserve's survey of senior loan officers, the number of banks tightening their standards on consumer loans has fallen over the past year. This behavior certainly does not point to much concern about household loan performance. Moreover, one gets an even more positive message from the credit spreads on securities backed by auto loans and credit card receivables. In recent months, the spreads between the yields on these securities and swap rates of comparable maturities have narrowed across the credit spectrum. Thus far, I have focused on the liability side of the household balance sheet, but there have been favorable developments on the asset side as well. Equity prices rallied strongly last year and have continued to rise this year, reversing a good chunk of the losses sustained over the previous three years. In addition, home prices appreciated sharply during each year from 1997 to 2003. The cumulative rise since the late 1990s has exceeded the growth in per capita income by a wide margin. All told, the ratio of household net worth to disposable income - a useful summary of the sector's financial position - recovered last year to stand at a level about equal to its average over the past decade. Before I turn to the business sector, let me address the frequently expressed concern that a bubble may have developed in house prices after several years of rapid increases. Some of the measured price rise results from improvements in the quality of houses. Houses are bigger and have more amenities than in the past, two characteristics that will lead to rising average house prices over time. But even after one controls for quality, increases in home prices have been outstripping general price inflation by a considerable margin in recent years. Once again, the low interest rates are probably an important factor. Houses, like other assets, generate an expected stream of future benefits. With low interest rates, these future benefits are discounted less heavily, which raises the asset's price today. Low interest rates also push up house prices by boosting the demand for housing. Of course, some of that increased demand is being met by the rapid pace of construction of new housing. But building houses takes time, and in the interim, higher demand will push up the price of existing houses. Although we can identify the key forces behind the rise in house prices in recent years, we cannot be sure that the increases are fully justified by the prevailing fundamentals. Still, we need to keep the recent increases in house prices in perspective: Although house prices have been outstripping broad measures of inflation - even after adjusting for quality improvements - their rise is nothing like the increase in stock market prices in the late 1990s. In fact, the speculative forces that can sometimes drive equity prices to extremes are less likely to emerge in housing prices. First, buying and selling houses is a lot more expensive and cumbersome than buying and selling equities, which makes taking a speculative position in houses much more difficult. Second, housing markets are much more local than equity markets, which are national, if not global, in scope. So if any speculative frenzy emerged, it would be much less likely to spread in the housing markets than in equity markets. Finally, financial institutions have a much more disciplined process regarding the housing and construction lending market than they did in past housing cycles. Lenders today are cautious about lending for speculative purposes, and appraised values undergo more scrutiny than in the past. The expansion of credit to higher risk households may also have driven banks to strengthen their underwriting procedures. That said, local housing markets can certainly become overvalued and then experience sharp price declines. House prices fell significantly in several parts of the country in the early 1990s. But because the transactions costs are much higher in the housing market than in the equity market and because the underlying demand for living space is much more predictable than are the prospects for any given firm, the large increases and decreases often observed in the stock market are less likely to occur in the market for houses. In addition, lenders are much more responsive to local economic conditions and generally become more cautious in loan underwriting when unsold homes or local unemployment increase. Financial conditions of businesses The change in the economy that caught my attention in the second half of 2003 was that the decline in business fixed investment had finally ceased. Capital spending by businesses posted a solid increase in the second half of last year, and orders and shipments for nondefense capital goods - key indicators of equipment spending - point to further sizable gains. Moreover, the tenor of anecdotes from the corporate sector has become comparatively upbeat, with corporate managers seeing stronger revenue growth and a much improved and more accommodative financing environment. Four factors have contributed to this improvement in financial conditions: low interest rates, a widespread restructuring of corporate liabilities during the past few years, a sharp rebound in corporate profitability from its trough in 2001, and a substantial narrowing in market risk premiums. In addition, the burden of underfunded pension plans, perhaps the most prominent negative financial factor that remains, has eased of late. I will discuss each factor in turn. First, firms are continuing to benefit from the accommodative stance of monetary policy. With the federal funds rate at 1 percent, short-term borrowing costs remain very low. For longer-term debt, the combination of low yields on benchmark Treasury securities and reduced risk spreads has kept borrowing costs attractive. Indeed, the yield on Moody's Baa corporate bond index is at its lowest sustained level since 1968. Second, in response to low long-term rates and to investors' concerns arising from some high-profile, unanticipated meltdowns, firms have greatly strengthened their balance sheets. Many firms have refinanced high-cost debt, which has reduced the average interest rate on the debt of nonfinancial corporations more than 1 percentage point since the end of 2000. Businesses also have substituted long-term debt for short-maturity debt to improve their balance sheet liquidity and to reduce the risk of rolling over funds. In addition, many firms - especially in the most troubled industries - have retired debt through equity offerings and asset sales, which limited the growth of nonfinancial corporate debt in 2002 and 2003 to the slowest pace since the early 1990s. Third, firms have significantly tightened their belts. Over the past two years, the drive to cut costs has generated rapid productivity gains. This greater efficiency boosted corporate profitability in 2002 and 2003 despite rather tepid revenue growth. Moreover, a pickup in revenue growth in the second half of last year helped companies leverage those productivity gains, producing a dramatic recovery in overall corporate profitability. Over 2003, economic profits before tax surged more than 18 percent, bringing profit margins to their highest levels in several years. Fourth, risk premiums fell substantially last year as corporate governance scandals receded and investor sentiment turned markedly more positive. The recovery in stock prices reflects this brighter view. Spreads on corporate bonds have narrowed appreciably - especially for the riskiest firms - and they now stand at the lowest levels in several years. This decline in spreads has been helped by the beneficial effect of the balance sheet improvements that I mentioned a moment ago. Indicators of corporate financial stress, such as bond rating downgrades and default rates, have returned to levels normally associated with economic expansion. Delinquency rates on business loans at commercial banks have also declined, and our surveys indicate that, on balance, banks have recently eased the terms and standards on such loans for both large and small firms. Another sign of improved sentiment is that money has been flowing into riskier securities. For example, net inflows to equity mutual funds have been strong for about a year, and high-yield bond funds, too, registered strong net inflows in 2003. Junk bond issuance has picked up notably, and the market for initial public equity offerings has also shown signs of recovery, while investors still appear to be more selective than during the boom in the late 1990s. These four points all suggest that financial conditions are capable of supporting a sustained, healthy pickup in economic growth. The much improved profitability can help finance expansion directly out of internal funds or indirectly by supporting firms' borrowing capacity. Furthermore, firms will be able to draw on their liquid assets that have accumulated over the past couple of years. And given the successful efforts to pare costs, firms are set to benefit from new investment in plant and equipment. Perhaps the biggest financial hurdle still facing many corporations is the burden of underfunding in their defined-benefit (DB) pension plans, but even here we have seen some improvement. Stock market losses during 2000 to 2002 had significantly eroded the value of pension assets, while sharply declining interest rates had raised the current value of plan liabilities. As a result, the majority of S&P 500 plans were underfunded at the end of 2002, with a net shortfall that exceeded $200 billion. Thus, many companies needed to make additional contributions, in some cases quite substantial, to their pension plans. In 2002, S&P 500 firms contributed $46 billion to their pension plans - three times more than in either of the previous two years - and total contributions are estimated to have been even higher in 2003. This drain on corporate sponsors' cash resources is likely to ease in the near term, but longer-term issues remain. DB pension asset values have benefited from robust returns in equity markets since early last year. And earlier this month the President signed legislation that allows firms to reduce plan contributions for two years by permitting them to use a corporate bond rate rather than a Treasury bond rate to calculate liabilities. But beyond the near-term, firms with DB pensions tend to be in maturing industries with aging workforces, for which the growth of liabilities are high and rising. This longer-term challenge will remain even if the current favorable market conditions are sustained. Conclusion In summary, recent indicators suggest that the pace of economic activity remains solid, while inflationary pressures continue to be subdued. In addition, the household and business sectors are, by and large, in good financial shape. Although uncertainties remain, I believe that the fundamentals are in place to generate sustainable economic growth.
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Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Center for Strategic &International Studies, Washington, DC, 27 April 2004.
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Alan Greenspan: Energy Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System, before the Center for Strategic & International Studies, Washington, DC, 27 April 2004. * * * The dramatic rise in six-year forward futures prices for crude oil and natural gas over the past few years has received relatively little attention for an economic event that can significantly affect the long-term path of the U.S. economy. Six years is a period long enough to seek, discover, drill, and lift oil and gas, and hence futures prices at that horizon can be viewed as effective long-term supply prices. These elevated long-term prices, if sustained, could alter the magnitude of and manner in which the United States consumes energy. Until recently, long-term expectations of oil and gas prices appeared benign. When choosing capital projects, businesses could mostly look through short-run fluctuations in prices to moderate prices over the longer haul. The recent shift in expectations, however, has been substantial enough and persistent enough to influence business investment decisions, especially for facilities that require large quantities of natural gas. Although the effect of these developments on energy-related investments is significant, it doubtless will fall far short of the large changes in our capital stock that followed the 1970s surge in crude oil prices. The energy intensity of the United States economy has been reduced by almost half since the early 1970s. Much of the energy displacement occurred by 1985, within a few years of the peak in the real price of oil. Progress in reducing energy intensity has continued since then, but at a lessened pace. This more-modest pace should not be surprising, given the generally lower level of real oil and natural gas prices that prevailed between 1985 and 2000 and that carried over into electric power prices. *** The production side of the oil and gas markets also has changed dramatically over the past decade. Technological changes taking place are likely to make existing energy reserves stretch further and to keep long-term energy costs lower than they otherwise would have been. Seismic techniques and satellite imaging, which are facilitating the discovery of promising new reservoirs of crude oil and natural gas worldwide, have nearly doubled the success rate of new-field wildcat wells in the United States during the past decade. New techniques allow far deeper drilling of promising fields, especially offshore. The newer innovations in recovery are reported to have increased significantly the average proportion of oil and, to a lesser extent, gas reserves eventually brought to the surface. One might expect that, as a consequence of what has been a dramatic shift from the hit-or-miss wildcat oil and gas exploration and development of the past to more-advanced technologies, the cost of developing new fields and, hence, the long-term supply price of new oil and gas would have declined. And, indeed, these costs have declined, but by less than might otherwise have been the case. Much of the innovation in oil development outside OPEC, for example, has been directed at overcoming an increasingly inhospitable and costly exploratory environment, the consequence of more than a century of draining the more immediately accessible sources of crude oil. Still, distant futures prices for crude oil moved lower, on net, during the 1990s as a result of declining long-term marginal costs of extraction. The most-distant futures prices fell from a bit more than $20 per barrel just before the first Gulf War to $16 to $18 a barrel in 1999. Distant futures for natural gas, which were less than $2 per million Btu at the time of the first Gulf War drifted up to $2.50 per million Btu by 1999, although those prices remained below the prices of oil on an equivalent Btu basis. Such long-term price tranquility has faded noticeably over the past four years. Between 1990 and 2000, although spot prices ranged between $11 and $35 per barrel, distant futures exhibited little variation. Currently prices for delivery in 2010 of light sweet crude, roughly equal to West Texas intermediate, have risen to more than $27 per barrel. A similar pattern is evident in natural gas. Even the spikes in the spot price in 2000 had only a temporary effect on distant natural gas futures prices. That situation changed in 2001, however, when the distant futures prices for gas delivery at the Henry Hub began a rise from $3.20 per million Btu to almost $5 today. The reasons for the sharp increases in both crude and gas distant futures prices seem reasonably straightforward, though they differ in important respects. The strength of crude oil prices presumably reflects fears of long-term supply disruptions in the Middle East that have resulted in an increase in risk premiums being added to the cost of capital. Although there are competitive spillovers from the higher price of oil, the causes of the rise in the long-term supply price of natural gas appear related primarily to supply and demand in North America. *** Today's tight natural gas markets have been a long time in coming. Little more than a half-century ago, drillers seeking valuable crude oil bemoaned the discovery of natural gas. Given the lack of adequate transportation, wells had to be capped or the gas flared. As the U.S. economy expanded after World War II, the development of a vast interstate transmission system facilitated widespread consumption of natural gas in our homes and business establishments. By 1970, natural gas consumption, on a heat-equivalent basis, had risen to three-fourths that of oil. But in the following decade consumption lagged because of competitive inroads made by coal and nuclear power. Since 1985, natural gas has gradually increased its share in total energy use and, owing to its status as a clean-burning fuel, is projected by the Energy Information Administration of the United States to maintain that higher share over the next quarter century. Dramatic changes in technology in recent years, while making existing natural gas reserves stretch further, have been unable, in the face of inexorably rising demand, to keep the underlying long-term price for natural gas in the United States from rising. *** Over the past few decades, short-term movements in domestic prices in the markets for crude oil have been determined largely by international market participants, especially OPEC. But that was not always the case. In the early years of oil development, pricing power was firmly in the hands of Americans, predominately John D. Rockefeller and Standard Oil. Reportedly appalled by the volatility of crude oil prices in the early years of the petroleum industry, Rockefeller endeavored with some success to control those prices. After the breakup of Standard Oil in 1911, pricing power remained with the United States - first with the U.S. oil companies and later with the Texas Railroad Commission, which raised allowable output to suppress price spikes and cut output to prevent sharp declines. Indeed, as late as 1952 U.S. crude oil production still accounted for more than half of the world total. However, that historical role came to an end in 1971, when excess capacity in the United States was finally absorbed by rising demand. At that point, the marginal pricing of oil, which for so long had been resident on the gulf coast of Texas, moved to the Persian Gulf. To capitalize on their newly acquired pricing power, many producing nations in the Middle East nationalized their oil companies. But the full magnitude of their pricing power became evident only in the aftermath of the oil embargo of 1973. During that period, posted crude oil prices at Ras Tanura rose to more than $11 per barrel, significantly above the $1.80 per barrel that had been unchanged from 1961 to 1970. The sharp price increases of the early 1970s brought to an abrupt end the extraordinary period of growth in U.S. oil consumption and the increased intensity of its use that was so evident in the decades immediately following World War II. Between 1945 and 1973, consumption of oil products rose at a startling 4-1/2 percent average annual rate, well in excess of growth of real gross domestic product. However, since 1973, oil consumption has grown, on average, only 1/2 percent per year, far short of the rise in real GDP. Although OPEC production quotas have been a significant factor in price determination for a third of a century, the story since 1973 has been as much one of the power of markets as of power over markets. The signals provided by market prices have eventually resolved even the most seemingly insurmountable difficulties of inadequate domestic supply in the United States. The gap projected between supply and demand in the immediate post-1973 period was feared by many to be so large that rationing would be the only practical solution. But the resolution did not occur quite that way. To be sure, mandated fuel-efficiency standards for cars and light trucks accompanied slower growth of gasoline demand. Some observers argue, however, that, even without government-enforced standards, market forces would have produced increased fuel efficiency. Indeed, the number of small, fuel-efficient Japanese cars that were imported into the United States markets grew significantly in the late 1970s after the Iranian Revolution drove up crude oil prices to nearly $40 per barrel. Moreover, at that time, prices were expected to go still higher. Projections of $50 per barrel or more were widely prevalent. Our Department of Energy had baseline projections showing prices reaching $60 per barrel - the equivalent of more than twice that in today's prices. The failure of oil prices to rise as projected in the late 1970s is a testament to the power of markets and the technologies they foster. Today, despite its recent surge, the price of crude oil in real terms is only half of what it was in December 1979. As I indicated earlier, the rise in six-year oil and gas futures prices is almost surely going to affect the growth of oil and gas consumption in the United States and the nature of the capital stock investments currently under contemplation. However, the responses are likely to differ somewhat between plans for oil and those for gas usage. OPEC, the source of greatest supply flexibility, has endeavored to calibrate crude oil liftings to price. They fear that significant supply excesses will drive down prices and revenues, whereas too low a level of output will elevate prices to a point that will induce long-term reductions in demand for oil and in the associated long-term revenues to be earned from oil. Natural gas pricing, on the other hand, is inherently far more volatile than oil, doubtless reflecting, in part, less-developed, price-damping global trade. Because gas is particularly challenging to transport in its cryogenic form as a liquid, imports of liquefied natural gas (LNG) into the United States to date have been negligible, accounting for only 2 percent of U.S. gas supply in 2003. Environmental and safety concerns and cost considerations have limited the number of terminals available for importing LNG. Canada, which has recently supplied a sixth of our consumption, has little capacity to significantly expand its exports, in part because of the role that Canadian gas plays in supporting growing oil production from tar sands. Given notable cost reductions for both liquefaction and transportation of LNG, significant global trade is developing. And high natural gas prices projected by distant futures prices have made imported gas a more attractive option for us. According to the tabulations of BP, worldwide imports of natural gas in 2002 were only 23 percent of world consumption, compared with 57 percent for oil. Clearly, the gas trade has a long way to go. The gap in the behaviors of the markets for oil and for natural gas is readily observable. The prices of crude oil and products are subject to much price arbitrage, which has the effect of encouraging the transportation of supplies from areas of relative surplus to those of relative shortage and of thereby containing local price spikes. This effect was most vividly demonstrated in 2003, when Venezuelan oil production was essentially shut down. American refiners with unlimited access to world supplies were able to replace lost oil with diversions from Europe, Asia, and the Middle East. If North American natural gas markets are to function with the flexibility exhibited by oil, more extensive access to the vast world reserves of gas is required. Markets need to be able to adjust effectively to unexpected shortfalls in domestic supply in the same way that they do in oil. Access to world natural gas supplies will require a major expansion of LNG terminal import capacity and the development of the newer offshore re-gasification technologies. Without the flexibility such facilities impart, imbalances in supply and demand must inevitably engender price volatility. As the technology of LNG liquefaction and shipping has improved and as safety considerations have lessened, a major expansion of U.S. import capability appears to be under way. These movements bode well for widespread natural gas availability in North America in the next decade and beyond. The near term, however, is apt to continue to be challenging.
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Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the Bank Administration Institute's Fiduciary Risk Management Conference 2004, Las Vegas, Nevada, 26 April 2004.
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Susan Schmidt Bies: Current issues in corporate governance Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the Bank Administration Institute's Fiduciary Risk Management Conference 2004, Las Vegas, Nevada, 26 April 2004. * * * Introduction Good morning. Thank you for the invitation to open the Bank Administration Institute's important and timely conference on audit, compliance, and e-security. Today, I will share some of my views on effective corporate governance and risk management with a special focus on certain aspects of the current risk environment. I will also talk about the role of internal auditing in both the enterprisewide risk-management environment and the new world of the Public Company Accounting Oversight Board's standards. Finally, I will mention two current accounting and reporting developments. Corporate governance Events at some corporations over the past three years have called into question the effectiveness of operational, financial reporting, and compliance controls; corporate governance practices; and the professionalism of auditors. Governance issues have also been raised concerning securities underwriting, bank lending practices, mutual funds, and a major stock exchange. Revelations of significant corporate governance and accounting failures, with Parmalat and Shell serving as recent examples, demonstrate that these are serious concerns worldwide, not just here in the United States. Events at the international level have renewed the resolve of companies around the globe to implement high-quality corporate governance practices and accounting and disclosure standards, and for auditors to employ rigorous and sound auditing techniques. Internal control fundamentals and enterprise risk management When we talk about corporate governance, we typically start at the top of the organization, with the board of directors and senior management, and work downward. We do this for good reason. The directors and senior management set the governance tone within organizations and lead the way. It's apparent that boards of directors and senior management have a very full plate these days. They must assess the quality of corporate governance within their organization and ensure that the firm has effective accounting practices, internal controls, and audit functions. They must respond to the new requirements of the Sarbanes-Oxley Act. They must establish more stringent anti-money-laundering programs and comply with the USA Patriot Act. Some large financial institutions must address issues relating to Basel II and the implementation work that needs to be done. Firms are considering how they can be more effective in managing the business risks they face, including the rise in operational risks due to increased reliance on technology and homeland security issues. And, of course, they must still find the time and resources to run their businesses profitably. The Committee of Sponsoring Organizations (COSO) Internal Control Integrated Framework is still the U.S. standard on internal controls.1 The COSO model serves as the basis for meeting the internal control assessment and reporting requirements for depository institutions laid out in section 112 of the Federal Deposit Insurance Corporation Improvement Act (FDICIA 112). This model is also broadly applicable to public companies in complying with section 404 of the Sarbanes-Oxley Act. Under COSO, directors have responsibility for overseeing internal control processes so that they can reasonably expect that their directives will be followed. Although directors are not expected to understand the nuances of every line of business or to oversee every transaction, they are responsible COSO defines internal control as “a process, effected by an entity's board of directors, management and other personnel, designed to provide reasonable assurance regarding the achievement of: effectiveness and efficiency of operations, reliability of financial reporting, and compliance with applicable laws and regulations.” Internal Control Integrated Framework is available for purchase from the American Institute of Certified Public Accountants; an executive summary is available at http://www.coso.org/publications/executive_summary_integrated_framework.htm. for setting the tone regarding their corporations' risk-taking and for establishing an effective monitoring program. The implication is that directors should be vigilant in maintaining a clear understanding of how COSO is being implemented in their organizations. Directors should also keep up with innovations in corporate governance. For example, directors should be aware that a new COSO framework has been proposed to encompass Enterprise Risk Management.2 A draft of the updated COSO framework was released for comment last summer, and a final document is expected later this year. For those of you not familiar with the new COSO framework, let me briefly explain that enterprisewide risk management is a discipline that an organization can use to identify events that may affect its ability to achieve its strategic goals and to manage its activities consistent with its risk appetite. Such events include not only those that may result in adverse outcomes, but also those that give rise to opportunities. When embraced, an enterprisewide risk management framework improves the quality and flow of information for decisionmakers and stakeholders, focuses attention on the achievement of organizational goals, and improves the overall governance of an organization. Some key steps in effective enterprisewide risk management include identifying and assessing the key risks within an organization and determining the appropriate response to those risks. Companies should determine the level of risk they are willing to accept given the return they can achieve. Management then must implement effective processes to limit risk to the acceptable level. Once these steps have been taken, business line managers are expected to monitor actual risk levels and test the effectiveness of the risk responses. Several elements are essential to the successful implementation of enterprisewide risk management. One is clearly articulated risk-management goals which provide a foundation for the enterprisewide risk management program and for related training and communication. A second is a common risk language which is critical because it enables individuals throughout the organization to conduct meaningful cross-functional discussions about risk. A third element essential to the implementation of successful enterprisewide risk management is that individuals clearly understand their roles in the risk-assessment and risk-management framework. In today's environment, all organizations should consider embracing this discipline. Indeed, the Federal Reserve is currently considering how enterprisewide risk management can better be integrated into its management processes. Tone at the top It is also important that a strong culture of compliance be established at the top of the organization and that a proper ethical tone be set for governing the conduct of business. In many instances, senior management must move from thinking about compliance as chiefly a cost center to considering the benefits of compliance in protecting against legal and reputational risks that can have an impact on the bottom line. The board and senior management are obligated to deliver a strong message to others in the firm about the importance of integrity, compliance with the law, fair treatment of customers, and overall good business ethics. Leaders should demonstrate their commitment through their individual conduct and their response to control failures. While the ethical tone of a financial institution comes from the top, a successful ethics program must be demonstrated by staff at all levels and throughout the organization. The environment should empower any employee to elevate ethical or reputational concerns to appropriate levels of management without fear of retribution. In other words, the culture of the organization should raise issues to senior management that they may not be aware of; management can then demonstrate their commitment by responding appropriately. Role of internal audit This leads me to the importance of the role of the internal audit function within an organization. The Federal Reserve is very supportive of an independent audit function at financial services companies. As indicated in our amended interagency policy statement released last year, the audit committee A copy of the draft can be obtained at the COSO web site at http://www.coso.org/publications.htm. should provide for an independent, objective, and professional internal audit process.3 The audit committee must set the tone for the internal audit function. To support this goal, the audit committee should ensure that internal audit has an effective quality assurance process. This becomes increasingly important as organizations grow in scale, enter new lines of business, become more complex, or acquire organizations with different cultures. As organizations grow, internal auditors must learn new technical skills, manage larger staffs, and be continually alert for emerging gaps or conflicts of interest in the system of internal controls. This often requires that the quality assurance process around the internal audit process become better defined and alerts the general auditor and the audit committee to weaknesses in the internal audit program promptly. Risk-focused audit programs should be reviewed regularly to ensure that audit resources are focused on the higher-risk areas as the company grows and produces and as processes change. As lower-risk areas come up for review, auditors should do enough transaction testing to be confident in their risk rating. Audit committees should receive reports on all breaks in internal controls in a form that will help them determine where the controls and the auditing process can be strengthened. Before a company moves into new or higher-risk areas, the board of directors and senior management should receive assurances from appropriate management and internal audit that the tools and metrics are in place to ensure that the basics of sound governance will be adhered to. The audit committee should actively engage the internal auditor to ensure that the bank's risk assessment and control process are vigorous. Many of the organizations that have seen their reputations tarnished in the past few years have simply neglected to consider emerging conflicts of interest when adding new products and lines of business. It is important to make sure that appropriate firewalls and mitigating controls are in place before the product or activity begins. The audit committee should also require the highest possible level of independence for the internal audit process and eliminate any threats to this independence, such as the tendency for some internal auditors to act as management consultants within the organization. Internal auditors add value by being effective independent assessors of the quality of the internal control framework and processes. Auditors lose their independence when they perform management consulting roles for which they later will have to render an opinion. Internal audit is one of the few corporate functions with both the ability and the responsibility to look across all of the management silos within the corporation and make sure that the system of internal controls has no gaps and that the control framework is continually reviewed to keep up with corporate strategic initiatives, reorganizations, and process changes. When an auditor becomes part of the management process subject to internal audit review, the independent view is lost. I would also like to add that internal auditors are the eyes and ears of the audit committee around the organization. As the complexity of financial products and technology has grown, the financial services industry has increased its reliance on vendors and third-party service providers for a host of technological solutions. Be mindful that these outsourcing arrangements may pose additional types of risks for the organization, such as security or data privacy risks. Internal auditors should remain vigilant in identifying risks as the organization changes or new products are delivered to the marketplace. The U.S. Public Company Accounting Oversight Board While we are discussing the importance of effective internal controls, let me point out that the Public Company Accounting Oversight Board (PCAOB) has recently approved Auditing Standard No. 2, An Audit of Internal Control over Financial Reporting Performed in Conjunction with an Audit of Financial Statements.4 The new standard is clearly an improvement over the previous one. It highlights the benefits of strong internal controls over financial reporting and furthers the objectives of the Sarbanes-Oxley Act. This standard requires external auditors of public companies to evaluate the A copy of the interagency policy statement, which was released on March 17, 2003, can be obtained at http://www.federalreserve.gov/boarddocs/press/bcreg/2003/20030317/default.htm. A copy of the auditing standard can be obtained at the PCAOB web site at http://www.pcaobus.org/pcaob_standards.asp. process that management uses to prepare the company's financial statements. External auditors must gather evidence regarding the design and operations effectiveness of the company's internal controls and determine whether evidence supports management's assessment of the effectiveness of the company's internal controls. While the new standard allows external auditors to use the work of others, including that performed by internal auditors, it emphasizes that external auditors must perform enough of the testing themselves so that their own work provides the principal evidence for making a determination regarding the company's controls. Based on the work performed, the external auditor must render an opinion as to whether the company's internal control process is effective, which is a relatively high standard. In addition, as part of its overall assessment of internal controls, the external auditor is expected to evaluate the effectiveness of the audit committee. If the audit committee is deemed to be ineffective, the external auditor is required to report that assessment to the company's board of directors. This new standard will certainly put more demands on external auditors and public companies alike. But this is the price to be paid for “raising the bar” to achieve greater reliability in corporate financial statements and to regain the confidence of the public and the trust of financial markets. Risk management in the e-commerce environment Let's now turn our focus to risk management in today's e-commerce environment. We know that an important component of risk management involves monitoring and managing environmental and external risks. This is an area in which business and operations risk are increasing. Over the past few years, the global community has experienced a series of “cyberincidents” - primarily in the form of increasingly virulent viruses and worms, and some hacking incidents have involved company insiders. The extensive electric power outages experienced by a large section of the United States and parts of Canada last August, along with collateral effects involving the telecommunication, transportation, and water sectors, further underscore the need for financial institutions to integrate the risk of a wide-scale disruption into their risk- management strategies. Let me say at the outset that the financial sector has performed extraordinarily well in responding to these incidents. Moreover, we are extremely proud that financial markets and participants have been able to meet these challenges and continue critical operations without any systemic effects or loss of confidence in our financial system. This is no accident. Financial institutions have increasingly devoted resources to addressing operations risk, business continuity, security (physical and cyber), and information-sharing. I would like to highlight some of the key developments we have observed and discuss where our business-risk-management efforts should be focused. Operations risk Since the mid-1990s, the concept of operations risk has received increasing attention in connection with the evolution of enterprise risk management. By “operations risk” I mean any risk that arises from inadequate or failed internal processes, people, or systems or from external events. Examples of operations risk include employee fraud, failed information system conversions, missent wires, and weaknesses in security procedures for protecting assets and information. In February 2003, the Basel Committee on Banking Supervision released a paper titled “Sound Practices for the Management and Supervision of Operational Risk” that outlines a set of broad principles that should govern the management of operational risk at depository institutions of all sizes.5 These principles will likely play a key role in shaping our ongoing supervisory efforts in the United States with regard to operations risk management. As with COSO's enterprise risk management framework, I encourage you to read the operations risk paper. Operations risk has always been a part of banking. But the increasing complexity of financial organizations, an increase in the number and variety of products and services they provide, the evolution of business processes (including substantially greater reliance on information technology and telecommunications), and changes in the ethical environment in which we live have all contributed to more observable exposures to this type of risk. Many of the community bank failures in recent years The paper can be obtained on the BIS web site at http://www.bis.org/publ. have been due to operations risks. In a few cases, dominant chief executives perpetrated fraud by manipulating the internal controls. In others, the management information systems necessary to monitor exposures in riskier lines of business were never built. As a result, other managers and the boards of directors did not have the information necessary to monitor and understand the growing risks inherent in what appeared to be profitable strategies. Operations risk was a primary focus of Y2K preparations a few years ago. Identification of critical computer-reliant systems and infrastructures gave us a much clearer understanding of the financial system's dependence on technology and of the complexities of managing operations risk. Once institutions understood the considerable business risks that would result if they could not serve customers, they moved the management of Y2K preparations out of the back office and onto the desks of product-line and senior managers - where it belongs. Moreover, it became clear that financial institutions needed to plan for the possibility that an external threat - a failure in the critical infrastructure or by a major service provider or material counterparty might severely impact a financial institution's business operations. There was an increased understanding of the interdependencies across market participants and of how credit, liquidity, and operations risks at one organization could have a cascading impact on other financial institutions. IT and physical security As a former banker, I can attest to the fact that banking organizations have long understood the need for strong internal IT controls and physical security. The trust and confidence consumers have that their assets and confidential information are completely secure is a pillar of the U.S. financial system. The increasing role of information system networks and the Internet in business operations as a means of conducting business with customers has engendered new cybersecurity risks for financial institutions. Thankfully, banking organizations recognized these risks from the outset and became leaders in addressing cyberprotection issues. For example, financial services was the first private sector to incorporate encryption into business processes on a wide scale. Nevertheless, each year the continuous stream of cyberattacks, such as the Bugbear.B virus (which targeted banks) and the SoBig.F worm, demonstrate that cybersecurity will need to be an ongoing battle. Experience to date shows that banking organizations are effectively managing cybersecurity risk. There have been relatively few serious intrusions, and there have been virtually no disruptions of critical systems. Nevertheless, financial institutions can expect to remain a target of cyberattacks. I believe there is a need for heightened attention to managing this risk. This includes monitoring warnings carefully, acting quickly to apply patches in a controlled environment, and taking other steps necessary to preclude any damage to information systems. Moreover, I urge you to review your internal security requirements to make sure that effective controls are in place and being followed. You may recall that my definition of operations risk includes employee fraud. We are still seeing evidence that most successful - or nearly successful - hacking incidents can be traced back to current or former employees. We regulators have been mindful of the tremendous growth in your reliance on information technology, such as the shift from mainframe computing to the use of distributed systems and the Internet, increased reliance on commercial off-the-shelf software, and a general expansion of potential external access to enterprise data. This increase in operations risk raises significant safety and soundness concerns for financial institutions and privacy concerns for consumers. In January 2003, the FFIEC (Federal Financial Institutions Examination Council) issued revised guidance for examiners and financial institutions to use in identifying information security risks and evaluating the adequacy of controls and applicable risk-management practices.6 The guidance, contained in the Information Security Booklet, describes how an institution should protect and secure the systems and facilities that process and maintain information. It calls on financial institutions and technology service providers to maintain effective security programs that are tailored to the complexity of their operations. Several years ago, as part of the shift to a risk-focused approach to supervision, the Federal Reserve integrated information technology reviews into safety and soundness examinations. This assures that The Information Security Booklet can be accessed at the FFIEC web site under the Information Technology Examination Handbook InfoBase at http://www.ffiec.gov. our evolving understanding of the elements of operations risk is reflected in supervisory assessments of the adequacy of risk management across the entire enterprise. I hope that you are already familiar with the supervisory expectations in the Information Security Booklet. I would also like to remind everyone of the importance of securing customer information. This privacy requirement goes beyond the IT systems themselves to the output of those systems. Distributed processing means paper copies of customer information tend to proliferate. Information security should include protection of paper documents, including their safe disposal, so that customers' private information does not inadvertently fall into the wrong hands. On the physical security side, I am aware that some of you have had to step up physical security protocols to ensure that your facilities and staff are protected. Over the past year, we have had several occasions when the government raised the threat level to Orange (High). Responding responsibly to physical threat warnings is costly and can be confusing, but it cannot be avoided. The Department of Homeland Security has provided some general guidelines on how to adjust security measures to its threat-level warning system. Industry groups have been sharing information on the measures they plan to take at various threat levels - including measures to protect staff by conducting operations from homes or back-up locations. This discussion has led to a greater awareness and commitment by financial institutions to ensure that all practical measures are taken to protect employees and facilities. I commend the industry for the work it has done in responding to homeland security issues. I hope you will continue to share information on ways to protect your businesses in the post-September 11 environment. I also suggest that you make every effort to coordinate with local protection authorities so that they are aware of your special needs and you understand their emergency protocols. Allowance for loan and lease losses Finally, I want to talk about two accounting and reporting issues. Financial regulators want to encourage banking organizations to strengthen their processes and documentation associated with their determination of the adequacy of their allowance for loan and lease losses (ALLL). As you know, accounting standardsetters recently questioned the methodology for loan loss reserves and proposed new guidance. The good news is that they now recognize that reaffirming existing guidance could address many of the questions raised. But the fact that loan loss reserve methodology is a recurring issue reflects the reality that concerns about how the ALLL is being estimated and its impact on earnings do arise from time to time. In general, these situations can be addressed through strengthened audit procedures rather than changes in accounting standards. Furthermore, management of financial institutions should be reminded to take the time to review the estimation procedures for determining their loan-loss reserves. Banking institutions should be applying an ALLL methodology that is well defined, consistently applied, and auditable. Institutions are required to maintain written documentation to support the amounts of the ALLL and the provision for loan and lease losses reported in the financial statements. This methodology should be validated periodically and should be modified to incorporate new events or findings as needed. Interagency supervisory guidance specifies that management, under the direction of the board of directors, should implement appropriate procedures and controls to ensure compliance with the institution's ALLL policies and procedures. Given that many banks use credit models, it is important that those models be validated periodically. Institutions should be vigilant to ensure the integrity of their credit-related data and that the loan review process provides the most up-to-date and accurate information possible for management to consider as part of its ALLL assessment. Call report modernization I also want to mention that the federal banking agencies are using advances in technology in their own business practices. One example is a project that is currently under way to improve the collection, validation, distribution, and use of the Call Report data that is submitted by banks to the banking agencies. This effort is referred to as the Call Report Modernization Initiative. Under the sponsorship of the FFIEC, the banking agencies are developing a central data repository to be a shared resource for all those who provide Call Report data or rely on these data in their business. A primary goal of the project is to allow for faster validation of the Call Report data, which will ultimately allow for faster release of these data to the public. This project has been under way for a couple of years now and is scheduled to go “live” in September 2004. You can find more information about the Call Report modernization project on the FFIEC web site (www.ffiec.gov/find/). The Federal Reserve is also making improvements in the reporting process for bank holding companies (BHCs). All BHCs are now required to file the Y-9 financial reports electronically, thereby eliminating paper-copy reporting. In addition, similar to the Call Report modernization effort that has been undertaken on an interagency basis, the Federal Reserve will be implementing a process that more quickly validates the BHC Y-9 data so that the data are released faster to the public. You can contact your district Federal Reserve Bank if you would like additional information on this initiative. Information is also available on a Federal Reserve web site (www.reportingandreserves.org/). Conclusion I have touched on a number of important topics today. While some of them, such as loan loss reserve accounting, cybersecurity, and corporate ethics, are rather specific, these risk issues cannot be viewed in isolation. I want to note that these are just aspects of the broader issues of corporate governance and enterprisewide risk management. Successful risk management is integrated into an organization's corporate governance processes, with appropriate controls, testing, and oversight. Boards of directors and senior management have the responsibility to establish effective risk-management and assessment processes across their organizations and to integrate the results of those efforts into their strategic and operating planning processes. The internal audit function can play an important role in reviewing the quality of corporate governance, internal control, and enterprisewide risk management because of its unique, firmwide perspective and its independence.
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board of governors of the federal reserve system
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Speech by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the Financial Executives International 2004 Summit, San Diego, California, 27 April 2004.
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Susan Schmidt Bies: Innovation in financial markets and banking relationships Speech by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve System, at the Financial Executives International 2004 Summit, San Diego, California, 27 April 2004. * * * I am very pleased to be here for the Financial Executives International 2004 Summit. As many of you know, before my appointment to the Board of Governors, I was quite active in this organization, particularly on the Committee on Corporate Reporting. I also served on the Financial Accounting Standards Board's Emerging Issues Task Force. Now, as a member of the Federal Reserve Board, and Chair of the Board's Committee on Supervisory and Regulatory Affairs, I find myself focusing on the growth and evolution of the financial system from a slightly different perspective than when I was a chief financial officer. The continuing evolution of the banking and financial markets has created opportunities both for providers and for users of financial products, and this evolution has been beneficial to the economy. However, innovations in financial products also have given rise to some new challenges for market participants and their supervisors in the areas of corporate governance and compliance. The events of the past three years demonstrate again that fraudulent conduct and weak corporate governance at a few firms can dramatically change the cost of capital and impose additional regulatory burden on even well-managed organizations. When similar events occurred in the 1980s, FEI, one of the five members of the Committee of Sponsoring Organizations (COSO) of the Treadway Commission, took the lead in defining best practices for internal controls. FEI should be proud that the COSO Internal Control Framework was the basis of much of the internal control mandates of the Sarbanes-Oxley Act and still is seen as the seminal work in its field. Fundamental elements of corporate governance and compliance naturally become more challenging as activities become more complex. The major breaks in the internal controls of corporations in the past few years, and the role of bankers in those events, has led bank regulators to change their view of bankers' relationships with their corporate clients. Today, I'd like to touch on some of these challenges and on how financial institutions and their corporate customers can adopt new ways of working together. I am going to talk about some new regulatory guidance on complex structured finance transactions and guidance on industry best practice regarding credit risk transfer instruments. I also want to speak about an issue that is confusing to many companies: antitying regulation as it relates to services provided by banking organizations. But before I talk about these issues, I would like to step back and discuss some broader, longer-term issues that affect accounting and corporate governance. Looking beyond the isolated cases of outright fraud, I believe a fundamental problem is this: As organizations have grown in size and scope, innovative financing techniques have made it more difficult for outside investors to understand a particular firm's risk profile and the performance of its various lines of business. Traditional accounting standards have not kept pace with the risk-management tools employed by sophisticated corporations. Thus, more meaningful disclosure of firms' risk-management positions and strategies is crucial for improving corporate transparency for market participants. Financial innovations and disclosure Over the past few decades, firms have acquired effective new tools with which to manage financial risk. For example, securitization helps a firm manage the risk of a concentrated exposure by transferring some of that exposure outside the firm. By pooling assets and issuing marketable securities, firms obtain liquidity and reduce funding costs. Of course, moving assets off the balance sheet and into special purpose entities, with the attendant creation of servicing rights and high risk residual interests retained by firms, generates its own risks and reduces transparency unless the firm takes additional steps to enhance disclosure. Several types of securitization have grown rapidly over the past decade. One of the fastest growing has been asset-backed commercial paper, which soared from only $16 billion outstanding at the end of 1989 to about $690 billion as of year-end 2003. Commercial mortgage securitizations have also proliferated noticeably since the early 1990s. The dollar amount of outstanding securities backed by commercial and multifamily mortgages has risen from $36 billion at the end of 1989 to just under $450 billion as of this past September. In addition, commercial banks and finance companies have moved business loans off their books through the development of collateralized debt obligations. Securitized business loans amounted to $100 billion in the third quarter of 2003, up from a relatively miniscule $2 billion in 1989. Firms also use derivatives to manage their risk exposures to price fluctuations in currency, commodity, energy, and interest rate markets. More recently, firms have used credit derivatives, a relatively new type of derivative that allows them to purchase protection against the risk of loss from the default of a given entity. By purchasing such protection, financial and nonfinancial firms alike can reduce their exposures to particular borrowers or counterparties. Credit derivatives also allow financial firms to achieve a more diversified credit portfolio by acquiring credit exposure to borrowers with which they do not have a lending relationship. For example, European insurance companies reportedly have used credit derivatives to acquire exposure to European corporations that, because they rely primarily on bank lending, have little publicly traded debt outstanding. The improvements in technology, the quick pace of financial innovation, and the evolving risk-management techniques almost ensure that businesses will increasingly use almost limitless configurations of products and services and sophisticated financial structures. Accordingly, outsiders will have ever more difficulty understanding the risk positions of many large, complex organizations. These developments represent significant challenges to standard setters and to firms. For market discipline to be effective, accounting standards must evolve to accurately capture these developments. Company managers must also do their part, by ensuring that public disclosures clearly identify all significant risk exposures - whether on or off the balance sheet - and their effects on the firm's financial condition and performance, cash flow, and earnings potential. With regard to securitizations, derivatives, and other innovative risk-transfer instruments, accounting measurement of a company's balance sheet at a point in time is insufficient to convey the full effect of a company's financial risk profile. Organizations should continue to improve their enterprise-wide risk-management and reporting functions. The FEI's leadership in the proposed COSO Enterprise Risk Management Framework demonstrates this organization's recognition of the importance of this new discipline. I would like to challenge companies to use their new risk-management discipline as a framework also to begin disclosing this information to the market, perhaps in summary form, paying due attention to the need for keeping proprietary business data confidential. Disclosures would not only provide more qualitative and quantitative information about the firm's current risk exposure to the market but also help the market assess the quality of the risk oversight and risk appetite of the organization. My last comment on disclosures is that less than fully transparent disclosures are not limited to “complex” off-balance-sheet transactions. One glaring example is the treatment of expenses associated with defined-benefit pension plans. In recent years we have seen how the accounting rules for these plans can produce, quite frankly, some very misleading measures of corporate earnings and balance sheets. In effect, firms use expectations of the long-term return on assets in defined-benefit plans to calculate current-period pension costs (income). At the same time, they use a spot rate to discount the future liabilities. This accounting is reconciled with economic reality by gradual amortization of the discrepancies between the assumed and the actual returns experienced on pension assets. As many of you are aware, this smoothing feature can create very large distortions between economic reality and the pension-financing cost accruals embedded in the income statement. A recent study by Federal Reserve staff indicates that “full disclosure” of the underlying details, by itself, does not appear to be a panacea.1 The study adopts the premise that most of what investors need to know about the true pension-financing costs, not the mixed-attribute accounting costs, can be reflected in two numbers disclosed in the pension footnote. These two numbers are the fair market value of pension assets and the present value of outstanding pension liabilities. The study finds that these direct measures of pension assets and liabilities tend to be ignored by investors in favor of the potentially misleading accounting measures, and as a result, the average firm with a defined-benefit plan in 2001 may have been 5 percent to 10 percent overvalued relative to an otherwise similar firm without a defined-benefit plan. Julia Coronado and Steve Sharpe, “Did Pension Accounting Contribute to a Stock Market Bubble?” Brookings Papers on Economic Activity, July 2003. In general, the test for useful disclosure should be the following questions: Are the firm and its accountants providing investors with what is needed to accurately evaluate the financial position of the firm and the risks that it faces? And is the information provided in a manner that facilitates accurate assessments by investors? Ultimately, improved transparency would benefit corporations by reducing uncertainty about the value of their securities, which would lower the cost of, and increase access to, market funding. Complex structured finance transactions Financial innovation also has given rise to an increase in the sophistication of complex structured finance transactions. While we can hope that we are seeing the end of the corporate governance scandals that have plagued companies world-wide, we must remain alert to the underlying causes of these scandals - inadequate corporate governance structures, compliance frameworks, and internal controls - and redouble our efforts to create a new compliance environment. This new compliance environment must address the growth in complex structured finance transactions. What do we mean by complex structured finance transactions? Although each deal can vary, complex structured finance transactions generally have four common characteristics. First, they typically result in a final product that is often nonstandard and structured to meet the specific financial objectives of a customer. Second, they often involve professionals from multiple disciplines within the financial institution and may involve significant fees or high returns in relation to the market and credit risks associated with the transaction. Third, they may be associated with the creation or use of one or more special-purpose entities designed to address the economic, legal, tax, or accounting objectives of the customer or the use of a combination of cash and derivatives products. Fourth, and perhaps most important, they may expose the financial institution to elevated levels of market, credit, operations, legal, or reputational risks. As we are all too aware, in the most extreme cases, complex structured finance transactions appear to have been used in fraudulent schemes to misrepresent the financial condition of public companies or evade taxes. As a result, the corporations that engaged in these improper transactions and the financial institutions that structured and advised on these transactions have been subject to civil and administrative enforcement actions. The existence of these schemes has also sparked an investigation by the Permanent Subcommittee on Investigations of the Senate Committee on Governmental Affairs, as well as numerous lawsuits by private investors. Although these events have raised serious concerns, it is important to recognize that structured finance transactions and other market innovations, when used and designed appropriately, play an important role in financing corporate America. Structured finance transactions, as well as financial derivatives for market and credit risk, asset-backed securities with customized cash flow features, and specialized financial conduits that manage pools of purchased assets, have served the legitimate business purposes of bank customers and are an essential part of U.S. and international capital markets. However, financial institutions may assume substantial risks when they engage in these transactions without a full understanding of their economic substance and business purpose. These risks often are difficult to quantify but the result can be severe damage to the reputations of the companies engaging in the transactions and their financial advisers, and in turn, impaired public confidence in those institutions. These potential risks and the resulting damage are particularly severe when markets react through adverse changes in pricing for similarly structured transactions that are designed appropriately. Assessments of the appropriateness of a transaction for a client traditionally have required financial firms and advisers to determine if the transaction is consistent with the market sophistication, financial condition, and investment policies of the customer. Given recent events, it is appropriate to raise the bar on appropriateness assessments by taking into account the business purpose and economic substance of the transaction. For those of you who are CFOs or other senior officials of corporations seeking to engage in complex structured finance transactions, you should expect to receive more questions from your bankers on why you wish to engage in certain transactions, how you will account for them for financial reporting and tax purposes, and how you will explain them to your shareholders and other stakeholders. You can expect this heightened level of inquiry because, when banking organizations provide advice on, arrange, or actively participate in complex structured finance transactions, they may assume legal and reputational risks if the end-user enters into the transaction for improper purposes. The Federal Reserve has been working with the other federal banking agencies and the Securities and Exchange Commission to develop interagency guidance on complex structured finance transactions. We believe it is important for all participants in complex structured transactions to understand the agencies' concerns and supervisory direction. Our goal is to highlight the “lessons learned” from recent events as well as what we believe to be sound practices in this area on the basis of supervisory reviews and experience. As in other operational areas, strong internal controls and risk management procedures can help institutions effectively manage the risks associated with complex structured finance transactions. Here are some of the steps that financial institutions should take to establish such controls and procedures: • Ensure that the institution's board of directors establishes the institution's overall appetite for risk (especially reputational and legal) and effectively communicates the board's risk tolerances throughout the organization. • Implement firm-wide policies and procedures that provide for the consistent identification, evaluation, documentation, and management of all risks associated with complex structured transactions - in particular, the credit, reputational, and legal risks. • Implement firm-wide policies and procedures that ensure that the financial institution obtains a thorough understanding of the business purposes and economic substance of transactions identified as involving heightened legal or reputational risk and that these transactions are approved by appropriate senior management. • Clearly define the framework for approval of a complex structured finance transaction or a new complex structured finance product. • Implement monitoring, risk reporting, and compliance processes for creating, analyzing, offering, and marketing complex structured finance products. Of course, these internal controls need to be supported and enforced by a strong “tone at the top” and a firm-wide culture of compliance. As a result of recent public and supervisory attention to complex structured finance transactions, we expect that banks will be asking more questions, requesting additional documentation, and scrutinizing financial statements more carefully to guard against reputational and legal risk. For example, for transactions identified as involving heightened risks, we expect that the bank's staff would obtain and document, before approval of the transaction, complete and accurate information about the customer's proposed accounting treatment of the transaction, financial disclosures relating to the transaction, and the customer's objectives for entering into the transaction. This enhanced due diligence may appear to impose some documentation burdens on the corporate customers of banking organizations, but this information should be substantially similar to the information that corporate customers are providing to their own senior management and boards of directors as part of their own internal review and approval process for complex structured finance transactions. Our supervisory reviews indicate that many financial institutions have already taken steps to enhance their internal controls and due-diligence processes in order to filter out transactions with unacceptable levels of reputational and legal risk. As a result, some financial institutions have turned down deals with unfavorable risk characteristics that they may have accepted in the past. While we applaud these developments, we hope that the guidance we are developing will help further improve the awareness, among both banking organizations and their corporate customers, of sound practices in this area. Credit risk transfer and conflicts of interest Financial market innovation and the development of increasingly complex structures for credit risk transfer also may give rise to legal or reputational risk. In recent years, we have seen considerable advances in the management and transfer of credit risk, including credit default swaps and collateralized debt obligations. These practices and the development of new and more liquid markets have come about because of better risk measurement techniques. They have the potential, I believe, to substantially improve the efficiency of world financial markets through the diversification benefits that credit risk transfer mechanisms can provide. However, the fundamental elements of risk management must be kept firmly in mind if these innovations are to succeed. By their design, credit risk transfer instruments segment risk for distribution to the parties most willing to accept them. A key point, however, is that market participants must be able to recognize and understand the risks underlying the instruments they trade and be able to successfully absorb and diffuse any subsequent loss. Another consideration is whether one party to the transaction is entering into the trade with an unfair advantage by virtue of its role as a lender to the same or a related entity. Financial firms that have large corporate loan portfolios increasingly have accessed the credit derivatives market to help them manage their risk while continuing to extend credit to corporate customers. While this development has created market efficiencies and investment opportunities, these positive factors have been somewhat overshadowed by concerns that some credit market participants who receive material nonpublic information in the ordinary course of their normal business activities may need to better control access to that information. Specifically, access to material nonpublic information needs to be walled off from personnel who conduct securities and derivatives trading. The potential for conflicts of interest between loan origination and credit derivatives trading activities has been recognized by the industry as well as regulators, and that is a commendable development. In October 2003, the Joint Market Practices Forum, a collaborative effort of the Bond Market Association, the International Association of Credit Portfolio Managers, the International Swaps and Derivatives Association, and the Loan Syndications and Trading Association, issued a Statement of Principles and Recommendations Regarding the Handling of Material Nonpublic Information by Credit Market Participants. The statement articulates principles and recommendations regarding the handling and use of material nonpublic information by credit market participants that maintain loan portfolios or engage in other activities that generate credit exposures and, in that connection, enter into transactions in securities or security-based swaps, including certain credit derivatives. The statement of principles fulfills a number of objectives. The most critical, in my view, is the promotion of fair and competitive markets in which the inappropriate use of material nonpublic information is not tolerated. At the same time, the statement allows lenders to effectively manage credit portfolio activities to facilitate borrower access to more-liquid and more-efficient sources of credit. This effort recognizes that the liquidity and efficiency of our financial markets are related directly to the integrity of, and public confidence in, those markets. The joint statement describes two models of credit portfolio management: the “private side” model and the “public side” model. In reality, most banking organizations appear to have adopted a hybrid model that lies at some point along a continuum between pure private and pure public. In general, in a private-side model, credit derivatives traders may have access to material nonpublic information, but traders must pre-clear each transaction they execute. In a public-side model, traders are walled off from private-side information and personnel to prevent their access to material nonpublic information. Accordingly, the circumstances in which a transaction is restricted because of the trader's possession of material nonpublic information is limited. The forum's statement of principles also provides several meaningful recommendations, some of which already have been adopted by the major participants in the credit derivatives markets. Among other things, the recommendations call for market participants to have in place policies and procedures for handling material nonpublic information, internal controls, an independent compliance function, recordkeeping requirements, and training programs. Additional specific recommendations are advanced for credit portfolio management activities conducted from the private side and from the public side. At a recent Bond Market Association conference, attendees noted that the principles contained in the statement generally are workable. However, questions of interpretation do arise under the statement and can be expected to continue to arise as the market develops additional innovations in credit portfolio management. Questions of interpretation may arise in determining whether and to what extent information is public or private, especially for organizations operating in global markets. Does material nonpublic information on one name in an index fund taint the entire index? Are the bank's internal ratings or changes in internal ratings private information? Issues of “signaling” private information also arise when public-side traders become aware of transactions entered into on the private side. That is, to what extent can traders infer material nonpublic information through action (or inaction) in private-side business lines? Last, but certainly not least, information may be confidential or proprietary even if it does not rise to the level of material nonpublic information. The misuse of confidential or proprietary information that is not material nonpublic information may not give rise to securities law violations, but it may give rise to common law claims. The statement and recommendations of the Joint Market Practices Forum brings to light important potential conflicts of interest in credit derivatives trading and helps to identify issues that may arise in connection with credit portfolio management. The statement and recommendations provide guidance on credit portfolio management for financial institutions that may be new to the derivatives markets and provide a catalyst to further improvements in the risk management environment. Credit risk transfer is still a relatively young market, and attention to issues such as these should help participants develop confidence in both the new instruments and markets that will lead to more liquid and reliable transactions. Anti-tying restrictions on banks Finally, I want to discuss the nature of anti-tying regulations for financial institutions, an issue that can be very confusing to nonbankers. As innovations create new financial instruments, services, and markets, and as firms expand the scope of the types of financial services they offer, the business-decision process is similar to that which many of you apply in your own business. Financial institutions are trying to build customer loyalty by offering a broader menu of financial services to corporate customers. The concern addressed by anti-tying restrictions is that banks may force customers to take unwanted products to obtain needed services. The Federal Reserve Board and the other federal banking agencies have long required that banking organizations establish and maintain policies and procedures to ensure compliance with the anti-tying restrictions, and the agencies monitor these policies and procedures through the supervisory process. In addition, more-targeted examinations may be conducted to review marketing programs, training materials, internal risk management reports, internal audits, and any internal investigations. In 2002 and 2003, the federal banking agencies received a number of inquiries concerning the scope, effectiveness, and impact of the anti-tying restrictions on banks. Some of these inquiries suggested that commercial banks were unfairly competing for investment banking business by tying the provision of bank credit to investment banking business. In this connection, a March 2003 survey by the Association of Financial Professionals indicated that 24 percent of the 218 large corporate respondents to the survey had been told explicitly by a commercial bank that the company had been denied credit or had been extended credit on less favorable terms because the company did not award the bank underwriting business. In response, the commercial banks stated that they were not involved in impermissible tying but rather engaged in the pursuit of relationship banking that is completely legal, efficient from an economic perspective and, indeed, encouraged by the GrammLeach-Bliley Act as a means to provide customers with “one-stop financial shopping.” Some of the confusion surrounding the tying debate may stem from a misunderstanding of the law. Not all tying arrangements are illegal ties. The statute expressly permits certain forms of tying and authorizes the Board to grant additional exemptions by regulation or order. The anti-tying law and the Board's regulations expressly permit a bank to condition the availability or price of a product or service on a requirement that the customer also obtain a traditional bank product from the bank or an affiliate of the bank. A traditional bank product generally is a loan, discount, deposit, or trust service. On the other hand, conditioning the availability or price of a loan on a requirement that the customer engage the bank for an underwriting, or obtain some other product or service that is not a traditional bank product, clearly is prohibited. Incidentally, the anti-tying statute applied to banks is tougher than the general corporate antitrust laws. Unlike the general anti-tying laws, the statute applicable to banks does not require a showing of market power to support a violation. It can be difficult to determine whether a violation of the anti-tying statute has occurred, as it generally involves a careful analysis of specific facts and circumstances that are not memorialized and can involve divining the intent of the parties to a transaction. In light of these complexities, the Board published and sought public comment on an interpretation of the anti-tying statute and related supervisory guidance. The proposed interpretation was published to help banking organizations and corporate customers clarify permissible practices under this complex statute in today's financial services environment. Importantly, the interpretation proposes guidelines that could be followed when a bank seeks to engage in traditional “relationship banking,” that is, serving customers based on the profitability of the overall customer relationship, including the establishment of some regulatory “safe harbors.” The guidance would communicate our expectations as to the types of policies, procedures, internal controls, and training programs that should help banks comply with the anti-tying restrictions. It would also emphasize the importance of the compliance and internal audit functions in ensuring compliance with the law and regulations. Among the comments received on the anti-tying guidance was a November 7, 2003, letter from the Department of Justice and published on its own website. The Justice Department has recommended that the Board interpret the anti-tying statute in a manner consistent with, and no broader than, the interpretation of federal antitrust laws. If this limitation is precluded, the Justice Department urged the Board to exercise its statutory authority to expand the scope of exemptions so as to limit the scope of the statute to ties involving small businesses and individual consumers. The letter expressed concern that the anti-tying statute may prohibit some pro-competitive practices, in particular, multiproduct discounting. The Board's staff continues to review and analyze the comments that have been received, and we expect to issue final guidance later in the year. Conclusion FEI's focus on providing corporate financial officers with information to keep them aware of evolutions in best business practices and process has contributed to the financial strength of businesses today. The organization also provides an effective source of dialogue on emerging issues in finance and governance. I encourage you, as senior officers of your firms, to keep this discussion alive within your firms. When businesses have a strong focus on corporate ethics, a robust internal control culture, and transparent disclosure, financial markets can provide capital efficiently.
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Remarks by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve System, at the 26th Conference of the American Council on Gift Annuities, Orlando, Florida, 5 May 2004.
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Mark W Olson: The Federal Open Market Committee and the formation of monetary policy Remarks by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve System, at the 26th Conference of the American Council on Gift Annuities, Orlando, Florida, 5 May 2004. * * * Thank you very much for inviting me here this evening. When my longtime friend Lance Jacobson extended this invitation more than a year ago, I readily accepted. Several months later, the 2004 calendar of Federal Open Market Committee (FOMC) meetings was released, and I discovered that this meeting would occur on the day following the Committee's May meeting. Because FOMC members observe a blackout on discussions of the economy for the week before and the week of the FOMC meetings, I prefer not to talk about current economic conditions. However, I can provide you with some insight into the way the FOMC functions and the impact of monetary policy on the U.S. and global economies. My former Federal Reserve colleague Laurence Meyer provided the blueprint for this presentation in a 1998 speech entitled “Come with Me to the FOMC.”1 That title, in turn, was borrowed from remarks given back in 1951. While my remarks are not identical in either style or substance, I have borrowed heavily from Larry's presentation, and you have the assurance that they have a long history. First, a comment or two on who we are. Nineteen policymakers participate in FOMC meetings, although at most only twelve vote at any one time. At times vacancies on the Board mean that the FOMC has fewer than twelve voting members. The Board has now operated at full strength for almost two years, after several years with two vacancies. Each of the Board members is appointed by the President of the United States and confirmed by the Senate. Our Chairman, Alan Greenspan, has two designations: The President has appointed him both as a Board member and as Chairman. A Board member's term is fourteen years, and the Chairman has a term of four years. Though Alan Greenspan's chairmanship expires this June, his term as a Board member extends through January 2006. As you may know, President Bush announced last year that he intended to reappoint Mr. Greenspan as Chairman. The Board Vice Chairman is also appointed by the President for a fouryear term. The current Vice Chairman, Roger Ferguson, was reappointed last fall. In addition to the Board of Governors, five of the twelve Reserve Bank presidents vote in any given year. The President of the New York Fed is a permanent voting member whereas the other Bank presidents vote every other or every third year. If you find this construct confusing, or unduly complex, perhaps a bit of background is in order. The Federal Reserve System is generically described as the central bank of the United States. In the late eighteenth and early nineteenth centuries there were two attempts to establish a central bank of the United States, and neither endured for more than twenty years - in contrast to most European nations, where central banks were well established by the nineteenth century. Though you may not be familiar with the history of our central bank, you may well remember learning about the debates on the concept of federalism by our nation's founders, when the forces favoring decentralization, led by Thomas Jefferson, fought the proponents of a more centralized government, led by Alexander Hamilton. The Jeffersonian forces largely prevailed. As a result, the United States lacked a strong central bank presence but had no authority even to grant national charters to commercial banks until the Abraham Lincoln Administration. All bank charters were originally granted by the states and, as a consequence, the United States at one time had more than 25,000 bank charters. Today, we have about 8,000 separate bank charters. By contrast, most other developed nations have fewer than 100 separately chartered banks. In the early part of the last century, a monetary panic stimulated the legislation leading to the Federal Reserve Act of 1913. And consistent with our tradition of dispersed economic power, the new central bank of the United States was created with a significant grass roots component. As a result, twelve Federal Reserve Banks were created, owned by member banks in each District, headed by a Reserve Come with Me to the FOMC, Laurence H. Meyer, the Gillis Lecture, Williamette University, Salem Oregon, April 2, 1998. Bank president, and supervised by the Federal Reserve Board in Washington. To give you a sense of the dispersal of resources within the Federal Reserve, more than 22,000 employees work in the System, meaning both the Banks and the Board. Of that number, about 1,700 work for the Board in Washington, and the remaining 20,000-plus work in the twelve Banks. Of the 1,700 Washington employees, roughly 250 are Ph.D. economists, the majority of whom support the Board's monetary policy responsibilities. The FOMC has eight scheduled meetings each year, roughly every six weeks. Financial markets follow the FOMC's actions very carefully and examine each word in the statement released after each meeting. Today I would like to share with you my perspectives gleaned from thirty months on the Board and twenty FOMC meetings. I was most impressed at my first FOMC meeting in December 2001 by the extraordinary level of preparation by and for the FOMC members. Let me begin by describing the contributions of the twelve Bank presidents. Each of the twelve Banks is staffed with economists who monitor the economic conditions in their respective Districts. A summary of the regional analysis is compiled in what we call the Beige Book (because it has a beige cover) and released to the public about two weeks before the FOMC meeting. Today we are in Florida, which is part of the Atlanta Fed's District, so let me speculate on how developments in this area's economy may enter our deliberations. Jack Guynn, president of the Atlanta Fed, comes to the meeting prepared to discuss the outlook for the entire Sixth Federal Reserve District. With respect to this particular part of the District, Jack may discuss Florida's citrus crop, the relative health of the tourism industry, and trends in Florida real estate prices. Because Florida is also a gateway to Latin America, he may also discuss factors affecting trade with that part of the world. Similar preparations take place at each of the other eleven Banks. Though only five presidents vote at each meeting, all twelve prepare reports and participate fully in FOMC discussions. The president of the New York Federal Reserve Bank is accorded a special role on the FOMC. That person - currently Timothy Geithner - is always a voting member and is traditionally elected as Vice Chairman of the FOMC. This role is largely a reflection of the New York Fed's responsibility for implementing monetary policy decisions through its open market desk operations. Typically, after the approval of the minutes of the previous FOMC meeting, the first order of business is a report from the System Open Market Account (SOMA) Manager at the New York Fed. The Manager discusses market activity since the most recent FOMC meeting and may also report on any other domestic or international market activity that may reflect trends in the U.S. and world economies. The SOMA Manager's report is followed by reports by senior Board economists, including the directors of the Division of Research and Statistics and the Division of International Finance. Each report summarizes what we refer to as the Greenbook, which is prepared by a team of economists. The time between receipt of the Greenbook and the reports by the directors is a time of intense study and preparation by the FOMC members. Governors often schedule briefings from Fed economists besides conducting their own individual reviews. The materials typically arrive on our desks late Thursday or early Friday and our Board review of economic conditions occurs the following Monday morning. In our household, my family has learned that my time during the weekend before an FOMC meeting is often largely consumed in preparation for it. While the preparation for FOMC members is very intense, I would be remiss if I did not give full credit to the effort of the economists preparing the reports. Fed staff economists hold off their Greenbook preparation until the last possible minute and supplement it just before the meeting with the most up-to-date economic data releases and developments. The Federal Reserve Board has, over time, developed powerful econometric modeling tools to assist our understanding of the many interrelated economic forces. In large part because human behavior cannot be modeled, we cannot fully anticipate all the factors that can affect our economic policy, and no econometric model can predict perfectly. Therefore we often review alternative scenarios that may reflect different ways in which the economy may respond in a variety of situations. After the economists' reports, we turn to the presidents and governors. Typically the presidents report first on regional economic developments as well as on their independent views on the national economy. Not surprisingly, economists from the Banks and the Board largely agree, but occasionally discernable differences exist, particularly with respect to economic forecasts. The presidents' reports often include anecdotal updates from businesses or other sources to provide real-time information on regional economic activity. Following the presidents' presentations, the Fed governors provide their individual analyses. Our presentations focus largely on analysis of the current condition of the economy and, for the most part, do not contain monetary policy recommendations. After each of the FOMC members has spoken, the director of the Division of Monetary Affairs presents the Bluebook, with prospective policy options for the Committee's consideration. In my time on the FOMC, generally two or three options have been presented, each accompanied by a list of pros and cons. After the presentation of policy alternatives, FOMC members resume their discussion, focusing now on their policy preferences. In the twenty FOMC meetings in which I have participated, Chairman Greenspan's participation in the discussion until this point has been limited. I suspect that this fact might surprise most FOMC observers as Chairman Greenspan, like virtually all of his predecessors, is considered almost the personification of monetary policy. Yet before the Chairman offers his first substantive comments at these meetings, eighteen other participants, representing literally hundreds of hours of study and analysis, have provided their input. Considering the complexity of the U.S. economy and the implications of monetary policy on the world economy, the issue facing each FOMC member is deceptively simple. We establish a target interest rate for what is known as federal funds - or, more commonly, fed funds. Fed funds constitute an interbank arrangement that allows banks with surplus balances at their Federal Reserve Bank to loan those funds overnight to banks that temporarily need to borrow to meet their balance requirements. An individual bank's balances on their Federal Reserve accounts can vary significantly depending on the dollar amount of the checks cleared that day, the volume and sequence of wire transfers in and out of the bank's account, and changes in investment or lending at the bank. In the aggregate, fed funds are an important indicator of liquidity in the banking system and, by implication, the money supply. All fed funds loans are for a single day, and the interest rate is reestablished daily. Fed funds rates thus are an excellent barometer of both the price of money and the changes in the money supply. The Federal Reserve Act requires that monetary policy promote maximum employment, stable prices and moderate long-term interest rates. Happily, in this instance, congressional intent is also sound monetary policy. Former Federal Reserve Chairman Paul Volcker once said, “No central bank can - or should, in my judgment - conduct policies for long that are out of keeping with basic, continuing objectives of the political system.”2 When I was a young banker in the 1960s, many of my loan customer's decisions were affected at least in part by memories of the Great Depression. While depression fears were widespread, the ravages of high inflation elsewhere, such as post-World War I Europe, had not been experienced here. In fact, many people had a positive view of inflation as leading rising property values and were not convinced that inflation was inherently bad. Public policy decisions with inflationary implications - often expressed as funding both "guns and butter" - were broadly supported. Only after the high-inflation years of the late 1970s and early1980s, after the spending power of incomes had been seriously eroded, were the consequences of inflation fully understood. Part of the success in achieving consistent economic growth in the United States is due in significant part to broad public support for our mandated monetary policy objectives. FOMC monetary policy affects the money supply through the Open Market Desk at the New York Federal Reserve Bank. A team of young (I mean young - half my age or less), whip-smart men and women begin each workday by analyzing all the factors affecting the money supply. They then gauge the appropriate amount of buying or selling for the Fed's portfolio of government securities required to maintain our target rate. When more liquidity is required, the Domestic Trading Desk purchases securities. If tightening is in order, the Desk sells into the market, replacing idle balances with investment securities and thereby marginally reducing the liquidity in the banking system. Though these professionals are young, money market activity conducted by the New York Fed is an established discipline more than eighty years old. As a result, the team knows from experience how best to maintain the target rate. The daily determination to buy or sell is communicated to a group of pre-selected securities dealers known as primary dealers, which ensures a consistent and reliable group of market participants and a competitive bid process for these transactions. The buy or sell orders are communicated electronically to the primary dealers early each day, and when the bidding is opened shortly after 9:30 a.m., the day's transactions are completed within seconds. The Human Factor and the Fed, Paul C. Volcker, in David C. Colander and Dewey Daane, eds., The Art of Monetary Policy, (Armonk, N.Y.: 1994), pp. 21-33. However, the FOMC members know that our decisions affect more than the money supply. Many other interest rates are indexed directly or indirectly to the fed funds rate. Further, FOMC decisions are viewed as an indication of the economy's underlying strength or weakness. In part, because of these broad implications, efforts have been made in recent years to improve our communication practices. The FOMC's current practice is to issue a news release after our regular meetings, about 2:15 p.m. (ET). The release currently has three parts. The first part states the fed funds target rate of interest; the second briefly explains and updates our analysis of current economic conditions. The third provides our assessment of the balance of risks with respect to the prospects for price stability and economic growth. The FOMC decision is communicated to the Domestic Trading Desk at the New York Fed, and the revised policy is then initiated and becomes the policy guideline for the next six or seven weeks. However, the FOMC can reconvene and reconsider its monetary policy stance at any time, at the call of the Chairman, as changes in the economy warrant. I said earlier that one of my first impressions of FOMC meetings related to the extraordinary level of preparation by both economists and members. Let me share two other impressions as well. At most FOMC meetings, the vote on the final FOMC target and the accompanying statement has been unanimous. This pattern raises an obvious question as to the extent to which votes contrary to the will of the Chairman - or the majority - are tolerated. Having spent several years on Capitol Hill where unanimous votes on major issues rarely occur, I am particularly conscious of the contrast. One reason many votes are unanimous is that there is no “loyal opposition bloc” within the Committee. The FOMC contains neither caucuses nor coalitions representing either political or philosophic differences. Second, and in stark contrast to other environments, there is a notable absence of posturing, which I define as an isolated or “throw away” vote to make a statement or to call attention to an individual cause. Yet there are clearly discernable differences in economic philosophy among FOMC members. Over the years, FOMC watchers have labeled some of the Committee members as either inflation-fighting hawks or growth-promoting doves based on previous voting patterns and public statements. In recent months, news articles have pointed out the different approaches to policy represented by Governors Ben Bernanke and Donald Kohn, the Board's two newest members. Governor Bernanke, a widely respected researcher and monetary policy textbook author, has advocated inflation targeting - that is, publicly identifying an acceptable range for inflation. Several other monetary authorities, including the Bank of England, have adopted this approach. Governor Kohn, a career Federal Reserve System economist with an equally stellar reputation in his field, disagrees, preferring that FOMC members establish monetary policy not with a predetermined range of acceptable inflation rates but by considering a broader range of economic factors. I find this relatively public debate to be both instructive and healthy. It provides evidence of the depth of understanding and analysis by FOMC members and supports the integrity of FOMC voting patterns when observers note that Ben and Don have recorded identical votes during their tenures. One other thought on the FOMC tendency for unanimous votes concerns the nature of Chairman Greenspan's leadership. The Chairman encourages forthright and thorough discussion. He seeks consensus among FOMC members, and the personal views he interjects into the discussion serve more as a beacon than a command. As a result, he achieves consensus through the quality of his leadership and the depth of his analysis. A final observation concerns the limitations of monetary policy. During the months between my nomination and swearing-in to the Board, I read numerous articles and talked with many monetary policy authorities. A common theme during that time of preparation concerned monetary policy's limitations. In his Come with Me to the FOMC article, Larry Meyer wrote eloquently on this very point. I will try to make the same point. The primary role of monetary policy is to achieve price stability. Inflation, as Milton Friedman famously said, is always a monetary phenomenon. To control the supply of money is also, in the long run, to control the rate of inflation. By contrast, monetary policy does not as directly influence employment or output. Therefore, much of the historic strength and resilience of the U.S. economy is only tangentially influenced by monetary policy. Obviously, output and employment benefit from the environment of price stability that monetary policy works to achieve. Monetary policy is also a blunt instrument. It does not, and cannot, target a particular segment of society or of the economy. FOMC members become very conscious of this fact as every part of the economic cycle seems to benefit some and penalize others. Overwhelmingly, however, monetary policy aimed at achieving price stability and maximum sustainable employment over time provides the best environment for job creation and improving living standards. It has been my privilege to associate with the men and women who constitute the Federal Open Market Committee. Without exception, it is a dedicated, committed, and talented group that fully understands both the responsibilities and the limitations of making monetary policy for the United States. I hope this presentation has provided some insight into how we carry out our responsibilities.
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