FROM THE OFFICE OF PUBLIC AFFAIRS

I am happy to have an opportunity to address this annual conference and to present a U.S. Treasury perspective on the global economic situation. As you know, about ten days ago the G-7 met in Bonn to discuss the world economic and financial outlook and to consider what improvements might be made in what has come to be called the world financial "architecture". Today I would like to review in a broad-brush way what has been going on in the world economy and financial system, including some thoughts on the recent introduction of the euro.

Overview

The global economy is currently experiencing one of the weaker periods of aggregate growth in several decades. The International Monetary Fund is projecting another year of world growth of around 2-1/4 percent. However, before we get too pessimistic, a little perspective is in order.

In the last thirty years or so, we have been through three previous periods of weakness which extended beyond a single year: 1974-75, 1981-82 and 1991-92. While the numbers should not be taken as exact, the worst was the period 1981-82, with world output rising only 1.6 percent in 1981 and only 0.4 percent in 1982, and the industrial countries as a group in recession in the latter year. Current forecasts put us now roughly on a par with 1991-92 -- not so long ago. So we should not let today's very serious growth concerns make us forget that we have successfully coped with periods of slow world growth before.

In comparing these periods of slow world growth, it is interesting to see what happened in various regions. In 1974-75, it was mainly the industrial countries that weakened, in reaction to the first oil price shock. Developing countries as a whole did well. In the early 1980s, growth was slow nearly everywhere except in Asia. You may recall that in 1982, U.S. GDP fell 2.2 percent, our worst postwar recession. In the early 1990s, strong growth in developing countries -- particularly in Asia -- served as a cushion for weakness in the industrial countries and the collapse of output in the former Soviet Union area. One key difference between the current period and the three previous periods of aggregate weakness is that recently the U.S. economy has grown substantially more rapidly than the rest of the world, and in the previous episodes our economy was in or close to recession.

If IMF projections turn out to be correct, the current two years (1998-1999) will see industrial country growth averaging a little more than 2 percent (with the U.S. economy continuing to expand at an above-average pace), the developing countries growing at 3 percent and countries in transition to democratic, market-based economic systems contracting by 1 percent. It is useful to take a closer look at prospects for some broad regions.

Outlook for Global Regions

Asia

Japan -- the world's second largest industrial country -- remains mired in a serious slump. In the last few years only 1996, with 5.0 percent growth, can be said to have seen satisfactory economic performance. Prospects for Japan look worse than they did a few months ago, with most forecasters expecting another year of negative growth in 1999, and both IMF and private forecasts projecting a decline in the price level. The same forecasters estimate that only minimal positive growth will be achieved in the year 2000.

The problems in Japan have been much discussed. At the G-7 meeting in Bonn, all recognized that an important evolution has taken place in Japan's approach to its situation. Moves to implement more ambitious plans for strengthening the financial sector have been particularly welcome.

It is now widely recognized that the overarching policy challenge in Japan today is the creation of strong domestic-demand-led growth. The main elements of policy to meet that challenge are three: supportive macroeconomic policy, financial sector reforms, and structural reforms and market opening.

1. Fiscal and Monetary Policy

Japan is now implementing two large simulative supplemental budgets, and will soon approve a more expansionary initial FY99 budget. These measures, assuming they are effectively implemented, should provide some cushion for domestic demand in this period of weak private sector confidence and negative private sector spending growth. In monetary policy, the Bank of Japan has also recently taken steps to stimulate growth. Going forward, it will be important to think creatively about the best use of all the tools of fiscal and monetary policy to establish confidence and a reasonable expectation of renewed growth.

2. Financial Stabilization

As we have all learned, for other growth policies to be effective it is necessary to remove the bottleneck presented by an economy that remains mired in debt. When Japan announced its Financial Stabilization Plan last July, four critical priorities were identified to address decisively the problems in the Japanese financial sector: strengthening the capital positions of the major banks, dealing with insolvent institutions, disposing of non-performing assets, and improving disclosure and supervision.

We have been encouraged to see that Japan has achieved progress on all four fronts. More needs to be done, however, since banks are still undercapitalized and very large amounts of bad assets still impair bank balance sheets, preventing banking institutions from playing their proper intermediation role.

3. Structural Reform and Market Opening

As Prime Minister Obuchi has recognized, a third component in laying a strong foundation for sustained domestic-demand-led growth in Japan is deregulating and liberalizing the Japanese economy. We have, thus, been glad to note, in recent months, the revived interest in deregulation in Japan.

These three key elements -- supportive macroeconomic policy, financial sector restructuring, and structural reform and market opening -- will be mutually reinforcing in their support for domestically driven growth in Japan. If they are convincingly implemented, the benefits for the Japanese economy and society as a whole will be greater than the sum of the parts.

The recovery of the Japanese economy is important most of all for Japan itself. Beyond this, Japanese recovery is vital for the Asian region in which it plays such an important part. Indeed, it is difficult to imagine a return to strong growth in the formerly rapidly growing Asian economies without the positive backdrop of a solid recovery in Japan.

As for other countries in Asia, I would note first that China, the largest of the developing countries in the region, is still growing -- although the strength of that growth is in doubt. The other major economies are not out of the woods yet. But a lot of progress was made last year. For the five most seriously affected countries (Korea, Indonesia, Malaysia, the Philippines and Thailand) there was a major swing in trade balances between 1996 and 1998-- estimated by the IMF at roughly $120 billion. Much of this external adjustment came in the form of import compression, as output declined sharply. But the volume of their exports also rose, although this was obscured in the value data by falling export prices.

While much remains to be done in terms of rebuilding financial systems in these countries, the worst may be over as far as recession and rising unemployment goes. This year is likely to see smaller declines for some countries, and the beginnings of upturns for others. While it may be some time before strong growth is fully restored, the overall result should be stronger growth in the emerging market economies of Asia.

Latin America

Growth in Latin America has slowed sharply since mid-1998 in the face of an external financing environment that has become more difficult, lower commodity prices and in most cases -- a tightening of domestic monetary and fiscal policies in response to downward pressures on their currencies.

Obviously, Brazil is the greatest concern in this region at the moment. The Brazilian authorities have taken important steps to reduce their fiscal deficit -- a root cause of Brazil's difficulties. In the context of a revised economic program supported by the IMF, the authorities must persevere with those fiscal efforts, order to restore investor confidence. Brazil also faces the challenge of establishing a new, credible, and transparent monetary regime to replace its more rigid exchange rate system. The new regime must restrain the pass-through from currency depreciation to domestic inflation. The Cardoso Administration is deeply committed to preserving the financial stability gained through the real plan. While I am optimistic about the outcome, it may be some time before markets are persuaded that Brazil has turned the corner. Patience, perseverance and perspective are called for on the part of all interested parties.

So far we have not seen severe signs of "contagion" to other Latin American countries. This is a positive development, as it indicates that markets may be somewhat more discerning about the situations of specific countries. It is clear, for example, that Brazil's external adjustment will have an impact on Argentina's substantial exports to Brazil. Yet markets appear to have recognized Argentina's fundamentally strong domestic and international financial position, and this should allow Argentina to blunt the kinds of stresses that have afflicted Brazil. Mexico has been able to deflect some pressures with its floating exchange rate, but it is not entirely immune to external disturbances.

Europe

After nearly 3 percent growth last year for the Euro-11 countries, growth may well be no more than 2 percent this year. The larger countries are likely to grow somewhat less than the smaller countries, with Ireland still leading the pack.

This growth prospect is disappointing, but we should not exaggerate. We are not yet talking about a European recession. Growth of around 2 percent will, however, keep unemployment rates from declining much, and may prevent these countries from making a real contribution to recovery in emerging market economies. Europe needs to achieve a strengthening of domestic demand both to grow faster and to provide better markets for the recovering emerging market economies.

Continental European countries also need to do more in the way of structural reform in their labor, product and capital markets. Strong investment performance and a reduction in unemployment over the medium term will depend on improving economic incentives to invest and to create jobs.

At this point let me make a few observations about the world's newest currency -- the euro. It is important neither to minimize nor exaggerate the significance of the establishment of the euro. On the one hand, its establishment and the creation of the European System of Central Banks are major achievements. It was a very difficult task, both technically and politically, and many thought it could never succeed. While there were a few "teething" problems with the target system in the first few weeks, these problems were relatively minor for such a major project.

Since the euro's start, it has fallen by about 5-1/2 percent against the dollar and 2-3/4 percent against the yen through the end of last week. If, two or three years ago, financial market participants had thought that the euro would behave this way at its inception, they might have taken it as a shocking prognosis. Indeed, a few analysts had forecasted a sharp decline of the dollar as markets rushed to place funds in the euro or run down no-longer-needed dollar balances.

My perspective is quite different. These moderate fluctuations in the euro's value suggest that it has taken its place as a "normal" currency, subject as are other important currencies to many forces pushing it up or down. In recent weeks the macroeconomic news from Europe -- GDP and the Ifo survey for Germany and reports on industrial production in several other economies has been on the whole disappointing. In contrast, markets have been surprised by greater than anticipated strength in the U.S. economy. In this environment, mild currency fluctuations are to be expected. We should likewise not be surprised to see the euro rise against the dollar and yen if developments occur that give rise to revised assessments of economic and financial prospects. Thus, the euro has been firmly established as a major currency, and full Economic and Monetary Union is functioning smoothly.

On the other hand, creation of the euro and the establishment of the European Central Bank are not panaceas. The system was set up to achieve a limited, although important, set of goals: a common currency, price stability and -- via the Maastricht criteria -- a more solid fiscal system. These are vital goals, and much has been achieved already. But other economic goals are important too. These include growth and employment. Here the new monetary arrangements in Europe can make only a partial contribution. As I indicated previously, structural reforms will be particularly important in providing the right set of incentives for investment and job creation.

By way of illustration, it seems likely that, both because of EMU and because of the process of globalization, major structural changes in European banking will continue. The ability granted by EC-92 reforms and reinforced by the birth of the common currency -- to operate easily throughout Europe is giving rise to consolidation and greater efficiency in the banking industry. Harmonization of rules and regulations is both necessary to put in place more effective prudential supervision of the evolving banking industry and desirable in the interests of the more efficient provision of banking services. Growth of bond markets as an alternative to bank financing, and the loss of revenue from currency exchanges, will provide greater pressures for the efficient operation of banks.

If these structural changes occur with minimal disruption, European institutions will become more formidable competitors to non-European banks. This will be good for consumers of financial services and should be welcomed.

In the area of banking as well as more broadly, the United States welcomes a successful euro and successful EMU. We have always said that their success is our success. The worst thing that could happen from the U.S. point of view would be an unsuccessful euro. A prosperous, growing Europe, with a firmly established monetary system and successful currency, will contribute to American prosperity.

Conclusion

This quick sketch of global economic developments, as I currently see them, suggests that we should remain ready to face some major global economic challenges. We also should not despair about the seriousness of these challenges. We, the G-7, and many others around the world are committed to working our way through them and to building a more robust international financial architecture.