November 12, 2008
HP-1276

Remarks by Treasury Under Secretary For International Affairs David H. McCormick
to the Barclays Asia Forum

"Our Economy, a Global Challenge"

Washington, DC – When I was first asked to speak at Barclay's Asia Forum, I imagined I would be able join you in Singapore.  I am sorry to deliver this speech via videoconference, but at least the title of my talk – "Our Economy, a Global Challenge," is more appropriate now than ever.  The turmoil that started in the United States has resulted in a fundamental reassessment of risk across the globe, creating credit and liquidity pressures not only in the United States and Europe, but also in markets that seemed relatively immune to the underlying vulnerabilities.  As a result, the global economy is rapidly slowing, and significant challenges and difficult policy choices lie ahead.

We should take confidence from the fact that countries around the world have responded with comprehensive actions to help stem the crisis.  The Group of Seven (G-7) industrialized countries announced and are implementing a coordinated action plan to stabilize financial markets, restore the flow of credit, and support global economic growth.  Others throughout Europe, Asia, and Latin America have adopted similar approaches. 

While we must confront the immediate challenges before us, this crisis is also an appropriate moment to consider the more systemic issues raised by recent developments in our global financial system.  It is with this in mind that President Bush chose to host the Summit on Financial Markets and the World Economy with the Group of 20 countries in Washington this weekend to determine a path forward for addressing the root causes of the turmoil.  We recognize that no single country can successfully combat these economic challenges alone, and we are committed to working hand-in-hand with countries around the world to reform our regulations and institutions.

Today, I would like to take a moment to outline the actions taken by the United States to stabilize our economy and to discuss some of the larger trends that leaders may consider as they come together this weekend to determine the first steps ahead on the path to reform.

A Comprehensive Policy Response

Since August last year, when the cracks in the global financial system began to appear, U.S. policymakers have responded in three phases.  In the first phase, recognizing the risk of the housing downturn, the U.S. government took a number of immediate steps, including implementing a $150 billion stimulus package and launching a number of other initiatives to help mitigate the impact on the real economy and help preserve home ownership.  

In the second phase – as instability in the financial services sector grew – we acted on a case-by-case basis, as, for example, when the Federal Reserve facilitated the sale of Bear Stearns.  These moves were intended to address the systemic risk to the financial system that would have resulted from a sudden collapse of these firms.  Fannie Mae and Freddie Mac were placed in conservatorship, or government control, so the regulator could put in place business changes to restore the capital of the enterprises and Treasury could provide a firm commitment to protect agency debt holders.  In each of these cases, policymakers attempted to strike a careful balance between promoting market discipline and mitigating systemic risk, holding investors and management teams accountable and protecting consumers from collateral damage.

Despite the hardening of the government's support for Fannie Mae and Freddie Mac and the decisive resolutions of destabilizing situations ranging from American International Group (AIG) to Wachovia, investors became increasingly concerned over the possibility of other failing financial institutions.  This resulted in a freezing of credit markets and an unwillingness of investors around the world to assume counterparty risk.  Given this fragile environment, U.S. authorities moved to a third phase of action, taking decisive and comprehensive steps to stabilize the markets and address the underlying sources of uncertainty.  Our actions in early October sought to achieve several goals:

First, authorities in the United States and abroad took steps to improve liquidity.  The Federal Reserve launched a Commercial Paper Funding Facility to further increase access to funding for businesses in all sectors of our economy, followed by a Money Market Investor Funding Facility to improve money market liquidity by allowing funds to pledge assets for liquidity.  To address U.S. dollar liquidity shortages, the Federal Reserve created swap lines with European central banks and later – as the effects of the crisis spread to other parts of the world – lines with Singapore, New Zealand, Korea, Mexico, and Brazil.  

Second, with the support of Treasury and the Federal Reserve, the Federal Deposit Insurance Company (FDIC) launched a program to guarantee newly issued senior debt of participating FDIC-insured institutions for up to three years, as well as deposits in non-interest bearing deposit transaction accounts.  These actions are specifically designed to unlock interbank lending by mitigating counterparty risk and have provided confidence to the banking system and averted destabilizing capital flows between banks in the United States.

Finally, and perhaps most important, Treasury is providing much-needed capital to address one of the root causes of the current stress in our financial system – the ongoing housing correction and the consequent buildup of illiquid mortgage-related assets.  These troubled assets remain frozen on the balance sheets of banks and other financial institutions, eating away at their capital and constraining the flow of new lending. 

Under its new Congressional authority, Treasury has carefully designed a capital injection plan through which nine major financial institutions, comprising more than 50 percent of U.S. deposits and assets, received a combined $125 billion of capital in return for granting the U.S. government minority stakes.  An additional $125 billion is available under the same terms to other banks approved by their regulators.  This program is a critical step to restoring confidence and liquidity, as we continue to explore ways to best leverage additional TARP resources. 

Together, these actions demonstrate that the United States is committed to doing whatever is necessary to unlock our credit markets, minimize the impact of the current instability on the U.S. economy, and restore the health of the global financial system.  Much of this action is being coordinated internationally, as the steps taken in the United States are consistent with the efforts undertaken by others around the world to provide liquidity, strengthen financial institutions, protect savers, enforce investor protections, and prevent bank failures that pose systemic risk. 

We see signs of progress.  Short term funding spreads have tightened, and funding maturities are extending.  Money markets and the commercial paper market are showing signs of improvement, and credit default swaps for many financial institutions have narrowed dramatically.  Yet, significant challenges remain.  Risk spreads remain high, and lending standards have grown more restrictive.  The U.S. and the global economies are slowing rapidly with every indication that coming quarters in the U.S., Europe, and many emerging markets will be weaker. 

Themes for the Global Economy

The Leaders' Summit in Washington this weekend will provide an unprecedented opportunity for leaders of developed and emerging economies to discuss the state of the global economy and set forth the outline of a roadmap for reform.  The G-20, established in the wake of the Asian Financial Crisis, offers an established channel for this international dialogue.  Leaders will discuss the responses to the global crisis that we have seen to date, agree on principles to guide reform efforts, and identify specific actions that can be taken immediately to reform the international financial system.  We expect this to be the first in a series of leaders meetings to be conducted in close consultation with other countries, financial centers, and international bodies.

While the Summit will focus on a wide-range of near term and longer term challenges, I'd like to reflect on several themes I suspect will not only frame discussions this weekend, but also the choices policymakers will face in the months and years ahead.  To begin, one maxim should shape our policy choices:  We are one global economy, and in many ways we must act more like it.  The myth of decoupling, at least in its most simplistic formulation, has been debunked.  What happens in the United States and Europe affects the rest of the world, and what happens in the emerging markets is critical to developed countries and overall global growth.  This acknowledgement brings both an opportunity and a challenge for policymakers as we consider reforms of the international financial system.

Sound Macroeconomic Policy

Policymakers have for years long lamented the buildup of global current account imbalances but their implications have now become clear.  The past five years has in many ways been a Goldilocks period for the global economy, with rapid growth, low inflation, and the near-absence of financial crises.  But it depended heavily – too heavily, in fact – on U.S. spending growth, rising current account surpluses in many regions, and a growing U.S. current account deficit.  The rapid growth of U.S. spending made up for expenditure shortfalls in the rest of the world.   Growing saving-investment gaps, which resulted in current account surpluses, opened up in much of Asia as investment rates fell short of pre-Asian crisis levels, allowing for a rapid rise in household savings.  The efforts of policymakers to resist currency appreciation and maintain export competitiveness led to large reserve buildups.  These reserves, along with those accumulated from Gulf countries, flowed back into U.S. financial markets, fueling investment in housing and spurring financial innovation to increase yields.

As a result of the turmoil, U.S. saving rates have already begun to increase, and emerging markets are taking steps to boost domestic demand.  Together these factors will significantly narrow global imbalances.  But the key challenge policymakers will face as the world economy recovers is how to prevent the re-emergence of imbalances that threaten the sustainability of global growth.  

For China, achieving better balance means strengthening the social safety net, providing a greater array of financial services to households, and increasing dividend payments by state-owned enterprises – all topics we have worked on in the US-China Strategic Economic Dialogue, a Cabinet-level forum to develop strategies to reach shared long-term objectives while managing short-term challenges in our economic relationship.

For Japan and many parts of Europe, it means regulatory reform to increase competition, spur entrepreneurial activity and investment to bring about stronger domestic-demand based growth.  For the United States, it means measures to boost domestic saving and reduce the government deficit.  In addition to these domestic policy actions, international steps to assure exchange rate flexibility play a critical role in allowing price changes – and not significant slowdowns in growth – to bring about needed current account adjustments.   

Regulatory Reform

A second area of focus is regulatory reform.  One of the lessons from the global financial market crisis was that policymakers, regulators, and supervisors, along with market participants, did not fully appreciate the risks that built up over the last few years in the search for yield and product innovation.  We have discovered the hard way, for example, that there was a significant breakdown in our underwriting standards for sub-prime mortgages, weaknesses in market discipline and risk management practices in our financial institutions, and complex, opaque instruments that were poorly understood by the market. 

Over the past year, we have had an intense effort to address the shortcomings in our national and international regulatory frameworks.  In the United States, the President's Working Group on Financial Markets – or PWG – released a policy statement in March that outlined an ambitious reform agenda.  Internationally, we coordinated our efforts closely with the Financial Stability Forum, or FSF.  Both the PWG and the FSF issued recommendations that called for stronger risk management and prudential oversight, greater transparency and disclosure, and improved market infrastructure. 

We've made tremendous progress in the last eights months to implement these recommendations, but more work must be done.  For example, firms operating in different countries are burdened by varied accounting and auditing standards.  Deposit insurance schemes are not consistent across countries.  Differing policies in some countries can have spillover effects, resulting in opportunities for regulatory arbitrage.  While financial markets are global, financial market regulation is largely national.  Therefore, it is critical that nations around the world work to converge our standards, when appropriate, and step up our international cooperation wherever possible.  Establishing multilateral supervisory groups for all the major financial institutions is a good step towards greater cooperation.

Regulatory Structures

We can also foster international cooperation by making it easier and more efficient for countries to interact across national regulatory regimes.  My international counterparts often remark to me that they find our system extraordinarily complex with its seven federal and over 100 state regulators in the banking, securities, and insurance sectors.  Recognizing the importance of having a financial regulatory structure that would be more appropriate for modern financial markets, Secretary Paulson released in March a Blueprint for a Modernized Financial Regulatory Structure.   The Blueprint proposed an optimal financial regulatory model that links the regulatory structure to the reasons why we regulate.  It proposed three regulators:  a market stability regulator; a prudential regulator; and a regulator focused on protecting consumers and investors.  Although Treasury began working on the Blueprint a year ago, current market conditions have provided a pertinent backdrop for this study's release and highlighted the need to examine and reform the U.S. regulatory structure.

Other countries, such as the UK, Germany, and France, are also re-examining their structures in light of the lessons learned from the current crisis, and some in the private sector have advocated closer collaboration among national market stability regulators.  As the crisis passes, policymakers will quickly need to turn their attention to this issue.

International Financial Institution Reform

Finally, our international institutions will also need to adapt their governance structures to represent the shifting weight of the dynamic emerging market economies and their missions to the changing needs of borrowing members at different stages of development.  In particular, the IFIs need to accelerate their governance reforms as they relate to representation of countries at their executive boards and their voting power.  The IMF quota reform agreement reached this year and the proposed voice and vote reform package at the World Bank are promising first steps, but to be meaningful must be furthered by continued voice and board reforms in both institutions.  

The IFIs also need to consider new tools and priorities for addressing the modern day  challenges of economic development and financial stability.  The World Bank's efforts to develop a climate change framework and establish mechanisms to address food and energy needs, for example, and the recently launched IMF facility to address liquidity shortages are excellent steps in this direction.  However, these innovations need to be balanced with the recognition that these institutions will best serve their members when they engage according to their comparative advantages.  Therefore, they must carefully align their activities with one another and other donors.  This will ensure that assistance is effectively targeted, used more efficiently, and that countries receive what they actually need, not what the donors wish to give them. 

Conclusion

At this time of unprecedented change, we should approach the notion of proposing definitive policy priorities for the future with humility and caution.  As I have tried to faithfully describe today, we have a challenging and difficult journey of reform ahead of us.  While the final contours of the path are far from clear, some important milestones are beginning to come into focus.  With this weeks Leaders' meeting, we take an important first step down the path of reform.  I am optimistic that we are headed in the right direction.

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