FROM THE OFFICE OF PUBLIC AFFAIRS

The US in the World Economy

 It has been a challenging and not uninteresting time to be working on economic policy in Washington.  Since I arrived at Treasury on September 11, 2001, the US has declared war against terrorism, has entered and begun to recover from a recession, has been beset with the revelation of serious financial scandals, has suffered from exceptional gyrations in equity values, and has faced default by the world’s largest sovereign borrower.  Nonetheless, the US economy has shown impressive resiliency to these shocks, growing at a 3 percent average annual pace over the past year, following a shallow recession which began as President Bush assumed office.  However, the road to recovery has been bumpy, most notably with growth slowing in the second quarter of this year, and with an enhanced downside risk to future growth causing the Fed recently to cut interest rates 50 basis points.

The economy’s durability in the face of significant adverse shocks is derived from its sound and flexible structure as well as well-timed policy decisions made by the Administration and the Federal Reserve.  The tax cuts signed into law in June 2001 were well timed and have boosted household incomes, supporting consumption.  In March of this year, Congress finally passed and the President signed a bill providing companies with tax incentives to undertake investments in equipment.  As many have noted, a pick-up in investment is a key to supporting economic expansion.  The second-quarter increase of 3.3 percent in equipment and software investment, followed by an even stronger 6.5 percent jump in the third quarter, suggests that this rebound has indeed begun and that the tax incentives, which boost corporate cash flow, are helping to support recovery.  The third-quarter rise in E and S investment was more than enough to offset the ongoing contraction in investment in business structures, leading to the first increase in real business fixed investment in two years. 

Of course investment, both business and residential, has benefited from the timely and decisive monetary policy actions of the Federal Reserve, which cut short term interest rates throughout 2001 and also on November 6.  I note as well the important stabilizing role that long-term interest rates have played.  Both in late 2001 and this summer and fall, as volatility and uncertainty in the equity markets rose sharply, a portfolio shift to government and agency bonds lowered long-term interest rates to 40-year lows.  This in turn was passed through to the mortgage market, triggering a wave of refinancings that put billions of dollars into the hands of households, significantly cushioning the otherwise dampening effect of the stock market on consumption growth.
 
Flexibility of our labor markets also contributed to a smaller decline in employment than occurs in most recessions.  While the Administration will not be satisfied until full employment is restored, we are encouraged by signs that the labor market is stabilizing.  The unemployment rate has been hovering in the 5.7 percent range for the last three months through October, off from the April high of 6 percent.  Initial claims for unemployment have drifted a bit lower.  Progress on employment has been erratic and slower than we would like, as evidenced by some slippage in payrolls in September and October.  As the President said in a press conference earlier this month, he is ready to work with the new Congress to pass new growth and jobs packages until every American who wants a job can get one. 

Last month, Treasury announced a budget deficit of 159 billion dollars for FY 2002 just completed, as compared with a surplus of 127 billion dollars in FY 2001.  The main reason for the swing in the fiscal balance is that last year’s recession and stock market weakness took a heavy toll on Federal revenues, and non-withheld incomes and capital gains realizations were reduced substantially.  We estimate that the recession and stock market weakness accounted for nearly two-thirds of the swing from surplus to deficit.  Another 23 percent reduction was attributable to the tax cuts and stimulus package.  Of the remaining 14 percent, part was accounted for by the vital needs of homeland security and the war effort.  Even without the tax cuts and stimulus, the budget would still have been in deficit in FY 2002.  Of course, the US is part of the global economy and the global capital market.  I would now like to discuss several important global economic issues that I am working on at Treasury.

Current Account

The US current account deficit reached an annual rate of $520 billion in the second quarter of this year, or 5.0 percent of GDP.  The magnitude and persistence of the current account deficit has caused consternation in some quarters.  I believe that many of the concerns about the deficit are misplaced, and I think that we should devote some time to understanding what the US current account deficit actually means.

Much recent discussion has focused on the size and sustainability of the US current account deficit.  It is not meaningful to assess the size and sustainability of the current account deficit without first identifying its proximate cause.  In fact, it is clear from the evidence that the US current account reflects a deficit of growth and growth prospects in much of the rest of the world.
 Moreover, the present deficit in the US current account does not suggest that a change in current US economic policy is warranted, nor would it be welcome by the rest of the world at this time. 

As a matter of national income accounting, the US current account is just the difference between national saving and investment and is equal to the net accumulation of US assets (portfolio and direct) by foreign investors.  It provides backward-looking information, rather like a "sources and uses of funds statement" for a company provides information on the amount of internal and external finance drawn on to finance investment outlays during the previous year.  A deficit is not necessarily bad, nor a surplus good.  This is because the US has a floating exchange rate and is well integrated into the global capital market.  It can finance its current account deficit in this capital market by selling equities, private debts, and government bonds -- all denominated in dollars -- without having to draw down international reserves or to incur foreign currency obligations.

According to official estimates, as a result of the current account deficits in the 1980s, the US became a net foreign debtor in late 1988, and since that time has accumulated a stock of net foreign liabilities exceeding 2 trillion dollars, about 23 percent of US GDP.  Yet, according to the national income accounts, the net cost of servicing this debt this year is running at an annual rate of 7.8 billion dollars, less than 40 basis points on the outstanding balance.  How can this be?  The most commonly offered explanation derives from the fact that US direct investments abroad are consistently much more profitable than are foreign direct investments in the US.  For example, in 2001, the estimated market value of US direct investments abroad was 2.3 trillion dollars compared with the market value of foreign direct investment in the US of 2.5 trillion dollars.  Yet, the receipts of direct investment income from current production of foreign affiliates of US companies in that year was 126 billion dollars compared with payments to foreign owners of US located investments of only 23 billion dollars.

In the view of the US Treasury, the best way to interpret the present situation is as follows.  The current pool of portfolio capital in the world has fewer places to invest than several years ago, and that capital is seeking safety and acceptable returns in the US.  Portfolio capital is not flowing to emerging markets as in the mid 1990s.   Europe faces long-standing structural problems (high average unemployment, sluggish productivity growth), and Japan is entering its second decade of operation well below its potential.  Not surprisingly in this setting, capital has been flowing into the US.  This process has been reinforced by the strong productivity numbers in the US over the past two years.   Even during the second quarter and into the third as the stock market weakened, we did not see the flight from US securities that many anticipated but rather merely a shift from equities into fixed-income securities.

 We in the US government hope that over time imbalances in growth prospects will narrow, not because of any diminution in US fundamentals, but rather because of improvements in the relative performance of the rest of the world.  We would hope to see in Europe lower unemployment and faster growth approaching US rates.  We certainly hope that Japan will resolve its structural problems and resume strong economic growth and investment. 

We aim, working with the G7, to put in place a framework in the international capital markets that will make more emerging markets attractive destinations for portfolio capital flows.  All of these developments would be most welcome.  We understand that, were they to occur, the US would benefit significantly.  Exports would surge, some of the growing pool of world capital that would otherwise flow to the US would be attracted abroad, and the US current account deficit would narrow.   There is every reason to expect -- as US history suggests -- that this adjustment would be accomplished in the global capital markets in an orderly fashion. 

In sum, the US current account is caused, in large part, by a deficit in growth in the rest of the world.  The growth deficit is not desirable but, as long as it persists, foreign capital flows to the US will adjust to bring global saving and investment into balance.

Trade Promotion Authority

 An important step forward in improving trade flows and expanding US exports was taken by the renewal of the President’s Trade Promotion Authority by Congress in August.  This was a hard won victory, and will enable the Administration to provide the necessary energy and leadership to further open and expand international trade, through the Doha round and through free trade agreements with individual countries.  In this light, the US will soon conclude free trade agreements with both Singapore and Chile, and we have begun discussions on President Bush’s proposal for a hemisphere-wide Free Trade of the Americas Agreement.

Sovereign Debt Restructuring

In April, the G-7 finance ministers met in Washington and found unprecedented unity on the need to develop a predictable process for restructuring sovereign debt.  They released agreement on an Action Plan to guide their efforts toward this goal.  The G-7 agreed to work together with emerging market countries and their creditors to incorporate new clauses into debt contracts, specifying the actions to be taken in the event a restructuring were necessary.  The policy of the G-7 is that any country that issues debt in another sovereign jurisdiction should include collective action clauses.  Such clauses are featured in bonds issued under UK law, but for historical – not legal – reasons are not common in bonds issued under US law.  These clauses would specify a majority action provision for amending the financial terms of the bond, as well as an engagement clause specifying how bondholders be represented in a negotiation with a borrower.  The G7 emphasized that work on this contract based approach should proceed in parallel with the statutory approach being developed by the IMF.

It is important that both creditors and debtors themselves be included in the dialogue as we move forward on this approach.  I am pleased to report that this is taking place.  Secretary O’Neill has expressed his goal that emerging countries that borrow in the capital markets be rated investment grade.  By making the sovereign restructuring process more predictable and less uncertain, it is hoped that flows of portfolio capital to credit worthy countries can be restored. 

Strengthening Financial Systems in Emerging Economies

The Treasury has recently outlined an initiative to work with emerging market economies to strengthen their financial sectors, in part by allowing the provision of financial services by foreign owned firms, usually through FDI in the financial services sector itself.  We believe -- and a recent and growing body of empirical evidence shows (including some outstanding research by the World Bank) -- that a well-developed, competitive financial sector, open to foreign direct investment, can contribute to economic growth and stability over the long term.  We seek to strengthen the financial sectors of developing economies, and spur financial sector reform in those countries by encouraging greater financial sector openness, coupled with improvements in financial supervision and regulation.

Most investment in most countries is financed with domestic saving, not by importing capital through capital inflows.  The research that I alluded to shows that having a competitive financial sector that is open to foreign participants exposes local firms to the best practices of world class financial institutions and enables them to learn from those at the top of their game.  Moreover, FDI in financial services can substantially broaden the range of financial products that are available to local firms and households, allowing them to better diversify risk and profit from local investment opportunities. We seek to make progress in the WTO Financial Services talks and in other fora to insure that foreign-owned financial firms can invest and compete to provide financial services in a host nation on an equal footing with domestic firms.  Studies of the liberalizations of the last decade remind us all of the crucial importance of an independent, professional, and transparent system of regulation and supervision.

The goal of strengthening financial systems in developing economies is worthwhile for several reasons: more durable growth prospects as countries move away from an ‘export-led’ model; a more stable global capital market; improved access to international portfolio flows for those countries that desire them; enhanced efficiency as countries benefit from international best practices in the provision of financial services; and an expanded range of financial products that could not otherwise be provided efficiently by domestic firms alone.  In this manner, freer direct investment enables countries to make the most effective and efficient use of their scarce pool of domestic saving and allocates scarce capital to its best and most highly rewarded use -- enhancing productivity and allowing faster growth. 

We realize that a country’s decision as to the appropriate pace and means by which it opens its capital account to portfolio flows is a  related, but distinct decision from allowing FDI in financial services.  However, even those countries that choose to open their capital account to portfolio flows at a  slower pace  still stand to benefit substantially from allowing a foreign presence in banking, brokerage, asset management, investment banking, and insurance services.  That said, it is not US policy to encourage any country to maintain capital controls over the long term. After all, no developed country maintains them. 
 
We recognize that growing interdependence will make financial sector development a major challenge for emerging markets in this decade.  But we believe the record shows that, when policymakers understand the importance of openness and are firmly resolved to take the necessary steps, they can succeed in strengthening their economies.