by Edwin M. Truman, Peterson Institute for International Economics
Speech at the Institute for International Economics
January 31, 2001
© Peterson Institute for International Economics
I want to thank Fred Bergsten for arranging this little "coming out party" for Martin, Robert, and myself. This occasion reminds me, first, that I am not really "retired" and, second, that especially when it comes to the IIE there is no such thing as a free lunch—nor should there be at an institution with economics at its core. It is characteristic of Fred that he has managed to bring Martin, Robert, and me together today to sing for our meals before any of us has gone on the Institute's payroll.
I am operating at a disadvantage relative to Martin and Robert in that I have not done extensive research on the topic of "The New Economy," published a 250-page book on the subject, or delivered a scholarly paper on it at the recent AEA meetings.
First, let me declare myself. I am predisposed to believe in evolution rather than revolution, including when it comes to economics and the New Economy.
Second, I am comfortable with the Goldman-Sachs view of the New Economy as characterized by (1) greater stability in growth and inflation, (2) lower structural unemployment and (3) a rise in underlying productivity growth.1 This characterization does not differ substantially from that offered in the Economic Report of the President, which "defines the New Economy by the extraordinary gains in performance-including rapid productivity growth, rising incomes, low unemployment, and moderate inflation- that have resulted from this combination of mutually reinforcing advances in technologies, business practices and economic policies."2 An important element of this phenomenon, which Martin Baily and Robert Lawrence have emphasized in the case of the United States, is the "substantial structural acceleration of total factor productivity (TFP) outside of the computer sector."3
Third, I think an important, interesting, and incompletely answered question is the extent to which this is principally a US phenomenon, especially with respect to the acceleration of productivity, or will it eventually spread more substantially to the rest of the world. To date, researchers at Goldman Sachs (noted earlier) as well as at the OECD and Federal Reserve appear to have been unable to detect a generalized, global trend.4 I will revert to this issue at the end of my remarks.
Fourth, I have been left to my own devices in preparing my remarks for this occasion. I have drawn on a certain amount of experience and talked with generous colleagues at various institutions over the past month or so while winding down my government career. I was able to devote time to my preparation because by an accident of history California is not a foreign country, and, therefore, the economic and financial crisis in California is classified as a domestic not an international matter.
With these caveats, I offer as food for thought six sets of conjectures, speculations, hypotheses, comments, and observations in three pairs. With respect to financial markets, I will comment on instruments and institutions. With respect to the global financial system, I will touch on a few architecture issues and exchange rate regimes. Finally, on exchange rates per se, feeling that Fred would require nothing less, I have some thoughts on possible implications of the New Economy for exchange-rate developments in the short run and longer run.
The first place to look for the implications of the New Economy for domestic and international financial markets is in those markets themselves and, in particular, in the instruments employed there. Doing so, we are reminded that technology has dramatically affected the way participants in financial markets go about their businesses. It has facilitated the unbundling of risks and, potentially, the better management of risks. As in the case of much technical change, rapid-fire development of new financial products has spawned much debate about the net benefit to the system as a whole. Have the availability of increasingly sophisticated derivative products, the more widespread use of less sophisticated derivative products, the growth of specialized financial entities (for example, hedge funds), and so forth contributed to the advancement of global income per capita?
I will not attempt to answer this cosmic question, though if forced to do I would line up with the cautious optimists. I do think that technological change affecting financial instruments—the heady wine New Economy in the old bottle of financial markets—raises some important policy questions: issues of leverage, liquidity, volatility, stability, and the behavior of financial markets. These are not new issues requiring a new economics for their analysis, but they are serious issues that require us to reexamine what we thought we knew about the behavior of markets and their institutions. It is important that these issues are effectively addressed, domestically and internationally. The New Economy has not won a universal embrace in our domestic economic and political discourse. Internationally, the financial instruments and financial entities that are associated with the New Economy are greeted, at best, with suspicion.
Just as the New Economy has affected the instruments of financial markets, so likewise the New Economy has affected and, more important, been affected by financial institutions and their evolution.
One salient issue is the evolution of the roles of bank versus nonbank financial institutions, in particular the institutions in the so-called private equity market such as the venture capital market, which are credited with facilitating the financing of much of the investment in the New Economy. For policymakers in countries that may want either to encourage or resist the inroads of the New Economy, an interesting question is whether the private equity market can or should be encouraged or discouraged. I suspect that discouraging such developments may, at least in the short run, be easier than encouraging them because it is difficult to force the adoption of technical change through legislation or regulation. In the longer run, the interaction of financial incentives and modern science—another name for technical change—is likely to take over. Traditional banking functions, for example, in the area of techniques of credit analysis, are becoming increasingly sophisticated and automated, further diminishing the informational advantages of relationship banking. Similarly, the increasing sophistication of financial markets allows nonfinancial entities to by-pass conventional banks when they need to collect large or small volumes of financial resources.
As an American (maybe I should say Anglo-Saxon), I am inclined to believe, perhaps incorrectly, that such increased reliance on arm's length financing helps to explain the more efficient use of capital in the US economy. However, I would also point out that the greater efficiency in the use of capital in the Unites States and, thus, the associated maintenance of our very high standard of living despite our persistently low savings rate has been a feature of the international economic scene since at least the end of World War II.
On the other hand, the ongoing transformation of financial markets and their institutions raises issues of optimal supervision and regulation, including the operation and extent of a financial sector safety net in a world where banks are becoming increasingly less special. Many of these issues have not yet been fully confronted. As a result, the interaction of the New Economy and financial institutions is likely to lead to accidents that, almost by definition, are unanticipated.
An interesting issue is the uncertain link between the financial environment and innovation: does the closer monitoring of investments made possible by a more "robust financial environment" facilitate the more productive use of capital or stifle innovation? Research at the OECD suggests the former and also suggests that transparency and the enforcement regime are more important in this regard than statutory shareholder and creditor rights.5 In the context of the New Economy, however, the issue is not what has worked best in the past but what will work best in the future. Incentive structures are changing for investors, employers, and employees; witness the explosive use of stock options and other devices that effectively alter the character of traditional financial contracts.
Innovation should be welcomed, but spectacular accidents or financial failures are likely to lead to pressures that discourage or even close off important avenues of future development—see the fallout from California's power crisis. The New Economy has not brought with it the end of the business cycle, nor has it ended debates about the optimal structure of supervision and regulation in terms of the extent to which investors and creditors should be protected from their larger mistakes (or the larger mistakes of borrowers) or, perhaps more important, the extent to which the society or system as a whole should be protected from the broader economic and financial consequences of such disasters.
The Global Financial System
III. Architecture Issues
The New Economy acting both in and through national financial systems raises a number of important issues in the area of the international financial architecture. Regardless of whether one thinks of the ERM crisis of 1992, the Mexican crisis of 1994-95, the Asian crisis of 1997-98, or the Russian crisis of 1998 as the first international financial crisis of the new global financial system or the Japanese financial crisis of the 1990s as the last crisis of an old national financial system, many of the same forces that have been associated with technical changes in financial markets as well as institutional changes in the conduct of national monetary and financial policies are at work in the global financial system. Moreover, as I noted earlier, many are not comfortable with change or these particular changes, including the actual and potential opponents of globalization. The New Economy has implications for domestic, or national, financial markets, but by its nature the spillover effects on the structure and functioning of international financial markets are substantial and consequential as well.
With respect to structure, the central issues involve the rules of the game and who should write them. The first challenge is to recognize the increased need for a more homogeneous set of rules of the game governing such areas as accounting, transparency, disclosure, regulation, legal regimes (including bankruptcy regimes), competition policies, and constraints on governmental intervention in the economy and the financial system. Although considerable progress has been made in this area over the past dozen years and, in particular, the past half-dozen years, in most jurisdictions the standards and codes collected in the compendium of the Financial Stability Forum are viewed not as a blueprint for full participation in the New Economy on a global basis, but rather as unfortunate distractions in the conduct of business as usual. Implementation lags far behind articulation! Part of the challenge in moving forward involves the issue of who should write the standards and codes—matters of legitimacy and governance—but part of the challenge is also to convince a broad set of financial market participants and national authorities that the benefits of technical change in financial markets are worth the costs. Globally, the issue can be framed in terms of a clash between relationship finance and arm's length finance, a clash that has to be resolved if the system as a whole is to survive and prosper without frequent major global economic and financial catastrophes. If major catastrophes become too frequent, there is the risk that strong political coalitions will form to try to reverse the technical changes and developments in global financial markets on which much of the actual and potential success of the New Economy rests. History suggests that such forces might just succeed. 6
IV. Exchange Rate Regimes
I am sorry to say this, Fred, but nowhere is the New Economy's writing on the wall of the international financial system clearer than when it comes to exchange rate regimes: exchange rate regimes that are based on maintenance of rigidity, including any but the most suggestive and broad target-zone arrangements, are destined in the environment of the New Economy to collapse—spectacularly! Let me be a bit less dogmatic: the choice of any exchange rate regime involves risks. With the advent of the New Economy and the associated technical change in the operation of financial markets and cultural change in views about the appropriate role of governments, the risks associated with rigid exchange rate regimes have increased dramatically. Market participants have many more ways to assume, as well as guard against, financial risk. Market participants have much more information about government policies—often instantaneously. Holding an exchange rate peg against the combined force of international financial markets or in the face of obviously misguided or poorly calibrated macroeconomic policies has become difficult, if not impossible.
Because I continue to believe that the exchange rate is an important economic variable, the conclusion that I draw from this implication of the New Economy for the operation of the global financial system is not to say that policymakers should forget about exchange rates and let them float freely. Instead, I view them as endogenous variables in the macroeconomic and financial system and would seek to strengthen these systems accordingly.
V. Potential Short-Run Developments
Now that we are agreed that exchange rates should most appropriately be viewed as endogenous variables, let's think a bit about what the near-term future might have in store for exchange rates in general and the US dollar in particular in a New Economy context. Having tried to stiff Fred on the issue of target zones, and in the interests of drawing a paycheck come April, I have to include some material on the topic of potential exchange rate developments.
It is easy to hypothesize that an end of the boom in US equity markets, slower growth of the US economy, and a diminution of merger-mania with regard to foreign takeovers of US entities in order to gain expensive footholds in the New Economy (locus the United States) should bring about downward pressure on the US dollar. Such a hypothesis would merely involve reversing the signs in the conventional story about the dollar's strength over the past six years: that strength has been driven by unexpectedly rapid growth in the US economy associated with macroeconomic stability, rapid change in high-tech sectors, and an acceleration of total factor productivity for the economy as a whole. The problem is that we could have told a story about dollar reversal with equal conviction twelve months ago or six months ago, and some of us may have, but the dollar has not weakened. According to the Federal Reserve Board staff's broad dollar index, by June 2000, when our growth cycle appears to have peaked, the dollar had appreciated 2 percent from its average level in 1999, and almost 3 percent against the major currencies. As of November, when it was pretty clear that US growth was slowing, the dollar had appreciated a further 4 percent according to the broad index and a further 6 percent against major currencies. More recently, the dollar has given up essentially none of its strength on the broad index and only a couple of percentage points against the major currencies on average.
What explains the failure of the dollar dog to bark? One possibility is that financial markets are reacting with a lag, but such an explanation is difficult to square with the proposition that financial markets, especially in the New Economy, are anticipatory. A second possibility is that merger mania has not run its course, and the evidence is that it has not entirely done so, but certainly the near-term attractiveness of acquiring US-based assets has diminished somewhat. A third possibility is that the attractiveness of dollar assets has less to do with the behavior of the US economy and more to do with global considerations, after all not all dollar-denominated assets are claims on the United States. This explanation has a bit in common with the argument in the Goldman Sachs piece on the New Economy in the United Kingdom; the authors argue that financial markets have anticipated gains in the New World Economy which has boosted demand for UK business and financial services because of London's prominent position in world financial markets, notwithstanding the fact that sterling-denominated financial assets are essentially irrelevant today in global financial markets and UK-chartered institutions play an equally marginal role in London's financial markets. Demand for the goods and services supplied in London may tend to boost sterling regardless of developments in the overall UK economy; similarly the demand for the services provided by the US dollar and dollar-based institutions may boost the demand for dollar-denominated assets regardless of what is going on in the US economy as a whole.
VI. Potential Longer-Run Developments
Turning to the longer-run outlook for the dollar, and abstracting for the moment from the US current account position and what fiscal policy might do to our national saving, a major consideration is the extent to which the New Economy phenomenon, including an acceleration in total factor productivity, is eventually replicated in the other major industrial countries. If it is, growth abroad will accelerate and the demand for US goods and services along with it, perhaps, requiring little in the way of relative price adjustments. If it is not, and the New Economy phenomenon persists in the United States, perhaps after a lull, then one might reasonably ask how we are going to dispose of the enlarged supply of goods and services our economy is producing. The economist's normal answer would be through lower prices, which could either take place through declines, or smaller increases, in prices of the relevant US goods and services, compared with the rest of the world, or through exchange rate adjustment.
With respect to all of these issues, we can be sure that this is not the last session sponsored by the Institute for International Economics on the New Economy or its implications for domestic and international financial markets.