Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Committee on Banking and Financial Services, U.S. House of Representatives, January 30, 1998

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Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Committee on Banking and Financial Services, US. House of Representatives, January 30, 1998

The global financial system has been evolving rapidly in recent years. New technology has radically reduced the costs of borrowing and lending across traditional national borders, facilitating the development of new instruments and drawing in new players. One result has been a massive increase in capital flows. Information is transmitted instantaneously around the world, and huge shifts in the supply and demand for funds naturally follow.

This burgeoning global system has been demonstrated to be a highly efficient structure that has significantly facilitated cross-border trade in goods and services and, accordingly, has made a substantial contribution to standards of living worldwide. Its efficiency exposes and punishes underlying economic weakness swiftly and decisively. Regrettably, it also appears to have facilitated the transmission of financial disturbances far more effectively than ever before.

As I testified before this committee three years ago, the then-emerging Mexican crisis was the first such episode associated with our new high tech international financial system. The current Asian crisis is the second.

We do not as yet fully understand the new system's dynamics. We are learning fast and need to update and modify our institutions and practices to reduce the risks inherent in the new regime. Meanwhile, we have to confront the current crisis with the institutions and techniques we have.

Many argue that the current crisis should be allowed to run its course without support from the International Monetary Fund (IMF) or the bilateral financial backing of other nations. They assert that allowing this crisis to play out, while doubtless having additional negative effects on growth in Asia, and engendering greater spillovers onto the rest of the world, is not likely to have a large or lasting impact on the United States and the world economy.

They may well be correct in their judgment. There is, however, a small but not negligible probability that the upset in East Asia could have unexpectedly negative effects on Japan, Latin America, and eastern and central Europe that, in turn, could have repercussions elsewhere, including the United States. Thus, while the probability of such an outcome may be small, its consequences, in my judgment, should not be left solely to chance. We have observed that global financial markets, as currently organized, do not always achieve an appropriate equilibrium or at least require time to stabilize.

Opponents of IMF support also argue that the substantial financial backing, by cushioning the losses of imprudent investors, could exacerbate moral hazard. Moral hazard arises when someone can reap the rewards from one's actions when things go well but does not suffer the full consequences when things go badly. Such a reward structure, obviously, could encourage excessive risk-taking. To be sure, this is a problem, though with respect to Asia some investors have to date suffered substantial losses. Asian equity losses, excluding Japan, since June 1997 worldwide are estimated to have exceeded $700 billion, of which more than $30 billion has been lost by U.S. investors. Substantial further losses have been recorded in bonds and real estate.

Moreover, the policy conditionality associated principally with IMF lending, which dictates economic and financial discipline and structural change, helps to mitigate some of the moral hazard concerns. Such conditionality is also critical to the success of the overall stabilization effort. As I will be discussing in a moment, at the root of the problems is poor public policy that has resulted in misguided investments and very weak financial sectors. Convincing a sovereign nation to alter destructive policies that impair its own performance and threaten contagion to its neighbors is best handled by an international financial institution, such as the IMF. …