Remarks: Amb. Richard McCormack at AS/COA's Annual Mexico City Conference

We were honored today by the brilliant presentation of President Calderón. It was full of insights and we Americans will be carrying these messages back to Washington when we return. Some months ago, President Calderón spoke to the Economic Club of New York. When he finished his address to nearly 1,000 of America’s business and financial leaders, the room erupted into a thunderous standing ovation. In the fifteen years I have attended the Club’s events, I have never heard such an ovation. It is a measure of the respect America feels for President Calderon’s vision and courage.

It is both an honor and a pleasure to be with you today to consider the implications of the global financial crisis for both the United States and Mexico.

As I was driving to my hotel, after arriving at the magnificent new terminal in Mexico City, I reflected on the enormous progress that Mexico has undergone since the early 1980s when I came here often as part of the Reagan Administration’s financial crisis management team.

Since then, vast and increasing investments in infrastructure and human capital are transforming this country. While Mexico, like the United States, and all other countries faces problems from the latest financial crisis, Mexico can take great pride in the results of its vision and statesmanship during the past quarter of a century of progress. The partnership that we formed during those early years has endured and brought benefits to both societies.

I remember the weekend meeting at the Treasury Department with Minister Silva Herzog and his able team during the first days of the financial crisis in 1982. The best brains from both our countries were deployed to contain the crisis so that we would both emerge from it stronger.

We in the United States rejected the protectionist solution to the crisis of that era. Instead of constructing a lifeboat for America, we consulted with our friends and allies, including our able Mexican colleagues, on how to construct an ark that would enable all of us to survive the financial and economic flood. The results of these efforts speak for themselves. They also point to a solution to our current challenges.

It is important for Americans that we now listen carefully again to our friends and allies around the world on possible solutions to the current financial crisis, which is even more complicated and dangerous than the problems we overcame together in the mid 1980s. The opportunity to listen to our friends in Mexico was one of the reasons why I gladly accepted the invitation to visit Mexico at this moment.

We now have a new Administration in Washington, whose election campaign I supported, believing that new thinking was needed both in the economic and foreign policy field. President Obama has assembled an able team which has considerable experience in managing the affairs of our country.  

The first 90 days of any Administration are, of course, always the most challenging for a new president. He must sort out which of the ideas from his campaign require modification in the face of new and challenging circumstances. This is not an easy task.

President Reagan cut taxes too severely in the first days of his presidency and was forced to retract some of them a year or two later in the face of mounting deficits. Presidents Carter, Ford, and Kennedy made other mistakes during the first 90 days of their presidencies. President Obama is determined to avoid repeating those errors, but he faces the most complicated economic situation of any American president in 80 years.

Since August 2007, more than 50 trillion dollars have vaporized from financial markets around the world. And over 11 trillion dollars worth of U.S. federal subsidies, stimulus, guarantees, and support have been deployed or pledged to contain the damage. These are titanic sums of money, but these numbers are an indicator of the scale of the challenge and the proposed response. Part of this program is controversial. But one thing is clear to me: after the financial earthquake we have already undergone, and where it is clear that economic aftershocks are a certainty, Obama’s administration deserves the benefit of the doubt for the scale on which it is seeking to act.  

Looking Forward

It is easy to point fingers at the long list of mistakes that were made by regulators, monetary authorities, Wall Street leaders, trade strategists, and indebted consumers. Too much money was printed. Risk was not priced into credit. There was a disconnect between those lending the money and those ultimately holding the risk. Derivatives were carelessly managed. Regulators’ complacency caused everybody else to underestimate the systemic risk brought about by the collective result of individual decisions. Dangers of global imbalances were widely underestimated.

The crucial question now is how to avoid having the results of all these lapses melt down the global economy and trigger unemployment on a scale that would produce political extremism, as happened in the 1930s.

This is a real danger.

Ambassador Jones and I attended a major presentation in New York on March 6th by William Dudley, President of the Federal Reserve Bank of New York on the American response thus far to the financial crisis. I commend Dudley’s analysis to all of you. It is available on the website of the Federal Reserve Bank of New York. It goes into greater detail than we have time for this morning. I do, however, want to make some general observations.

It is important to recognize that there are two distinct elements to this crisis:

1. A multifaceted macro economic problem.

2. An even more multifaceted set of micro economic complexities that must also be overcome.

The Macro Economic Challenge

Losses of financial wealth on the scale that we have endured since 2007 – the 50 trillion dollar problem – tremendously impacts global wealth and purchasing power. Furthermore, because housing prices in the U.S. rose 130 percent between 2000 and 2006, while wages remained stagnant or even weakened in real terms, it would not be surprising if there were additional losses in the real estate sector going forward that will add to the 50 trillion dollar number.

Secondly, because of the earlier availability of superabundant credit and low interest rates throughout the world, and widespread belief that global growth and consumer demand would continue indefinitely, there was a vast overexpansion of global production capacity and real estate construction.

This resulted in too many automobile factories in Japan and elsewhere. Too much expensive real estate built in America and elsewhere. Too many textile and electronic factories in China and elsewhere.

In effect, excess capital investment during credit bubbles borrows growth from the future. Supply gradually exceeds demand. This undermines pricing power, profits, equity markets, and banks.

Eventually bankruptcies occur which liquidate excess capacity. More than 600,000 small, medium and large Chinese factories have closed within the past year because of overcapacity.  Tens of millions of Chinese are today unemployed as a result. This creates a potential issue of political stability for China.

Sometimes, however, this rebalancing of supply and demand can take years, since banks are weakened in the process and excess houses do not just disappear. Factories struggle to survive often with government support to preserve employment, hoping that their competitors will fail before they do.

It took more than a decade before the excess farm capacity that was created in the United States during World War I was finally brought under control. It also took years for the excess factories that were financed during the credit bubble of the 1920s were able to get traction again. Eventually only World War II resolved the problem of excess production capacity and allowed a new investment cycle to begin.  

This situation was one of the drivers of the Great Depression that is often underestimated, but it has great macro economic relevance worldwide today.

When credit bubbles burst, the wealth effect implodes, and consumers are impacted and are forced to retrench, further reducing demand and growth.

So quite apart from the evils of the subprime housing problems and trillions of dollars of derivatives connected to them, which have to be addressed, there is a deeper underlying macro economic problem that also must be resolved before normal growth can resume.

Excess capacity must be liquidated, new demand must be generated, or there must be some combination of the two.

Macro Economic Lessons from the Japanese Bubble

There is much that can be learned from the lessons of the Japanese bubble which burst in 1990 and required more than a decade from which to recover.

Fortunately, our real estate problem is not as severe as the Japanese one, where commercial real estate fell by 87 percent before it was over.

Richard Koo, the chief economist from Nomura research in Tokyo, has written an interesting book about the macro economic lessons from the Japanese experience.

He points out that, for years, Japan underwent a poorly understood balance sheet recession, where frightened and indebted consumers and companies frantically began paying down debt after the crash. There was no domestic market for loans even when banks were eventually reorganized and recapitalized via government actions. What company wanted to build new factories in Japan when the market was already saturated? All individuals wanted to do was pay back debt from their stock market and real estate losses.

Confidence was totally lost. Confidence in the political system, confidence in the bureaucratic elite that had run Japan for decades, confidence in the banks that had urged people to borrow money on the inflated value of their real estate holdings and invest in the stock market. And the Japanese people for a time lost confidence in themselves.

The stock market collapsed by 80 percent, from nearly 40,000 to the present 7,000 level. This caused millions of Japanese to walk away from the stock market for a generation, much as the American people did after 1929. The Japanese stock market became dependent upon foreigners’ investments.

Too much yen was saved rather than spent, eventually creating a giant hoard of ten trillion dollars of savings, much of it in the government-owned postal savings bank. Much of the yen earned by company profits was used to pay back their own stock market speculation. This speculation occurred when, due to overcapacity, Japanese companies became unprofitable, borrowed money, and began speculating on everything from stocks to real estate. This is exactly what has happened in China in the past two years.

Since there was no market in Japan for private borrowings, the government began large-scale borrowing to stimulate growth. It did stabilize the economy, but it also created a titanic long-term Japanese public debt, probable in excess of 200 percent of GNP.

But Koo is undoubtedly correct that major countercyclical efforts must now be undertaken in the U.S. and elsewhere to mitigate the macro economic problem.

Yet macro economic medicine must be taken with care. Too little medicine and we are certain to experience the greatest recession since the 1930s. Too much medicine and we could create long-term debt, as well as fiscal, dollar, and inflation problems that could lead to an even more dangerous financial crisis several years from now.

This is what happened when the Carter Administration overdid the monetary stimulus at the beginning of its term in office in reaction to the weak economic growth of the period. This directly led to inflation, the commodity bubble, and other problems that eventually resulted in the disastrous crisis of the 1980s.

How to strike the right balance is now at the center of debate in Washington and at the G20 meeting.

If you watch the price of gold going forward, you will have a pretty good feel for whether this debate is moving in the right direction.

Conclusions

As we move forward to address this complex crisis, it is important to remember that there  are at least five distinct elements that must be addressed simultaneously.

1. We must make sure we do not repeat the uncontrolled Creditanstalt Bank collapse that so badly worsened the Depression in the 1930s. The Lehman Brothers crisis mismanagement was another example of what cannot be allowed to happen again.

Weakened banks must be closed, merged, or recapitalized in an orderly way.

We will also need to find a way to isolate temporarily illiquid and underpriced derivatives that are a mortal threat to bank balance sheets and financial stability.

2. We must find a way to make the financial system safer, without so crippling it with overregulation that we revert to the 1930s situation, where only those who did not need to borrow were allowed access to bank loans.

The timing of monetary policy changes is also critical to avoid another round of inflation. That is a tricky business because of the lags in impact of monetary policies. It is necessary to anticipate what the economy will look like a year ahead.

Paul Volcker’s Group of 30 has identified a number of potentially useful regulatory reforms.  Jean-Claude Trichet has generated his own list. We will need to adopt many of these proposals after careful examination of possible unintended consequences.  

3. We must find ways to fill at least part of the huge hole in global net demand that has been created. The stimulus package is a beginning.

4. We must focus more heavily on the housing default rate since housing mortgages are the small base on which the titanic inverted pyramid of problematic derivatives was erected.

The stabilization effort becomes more difficult and expensive the higher on the inverted pyramid of derivatives at which the government seeks to intervene.

5. We must make sure that the global trading system does not generate another round of imbalances. That will involve prudent demand management in both surplus and deficit countries.

6. America needs a modified economic model that relies less heavily on financial services, important through they are, and creates a strategy which revives our manufacturing and industrial section. We must eventually produce and sell more tradable goods on global and domestic markets.

The global economy itself must be rebalanced, and family and individual balance sheets repaired. This will take time.

The Investors Perspective

It is important for investors to understand that, as governments intervene to slow and buffer the correction of asset bubbles, one should not exaggerate the ability of governments to cure overvalued assets without price adjustments.

Bear traps for investors proliferate here. The Japanese tried to influence their stock market with price keeping operations.  But all they accomplished was to create speed bumps on the long fall of the Nikkei from 40,000 to 7,000.

So while it is true that stock markets are leading rather than lagging indicators, and the stock market will recover before the economy itself, one should be selective when contemplating stock purchases.

Remember Buffett’s slogan:  When others are greedy, I become fearful, when others are fearful, I become greedy.

My advice today is to be selectively greedy, but beware of bear trips in the broader market.

Final Word

No one who has lived through the last 50 years should feel anything other than hopeful about the future of the global economy.

The worldwide growth that we have seen in the past half century has transformed the lives of billions of people.  This is a productivity and technology driven process in a globalized world.  Billions of new people are now educated and are inventing new businesses, products, and advances in science that spill out into the global economy.

During the 1980s, when we were groping with the Rust Belt problems, no one had ever heard of Microsoft. Yet it subsequently helped lift the U.S. economy out of the recession of the early 1990s.

We cannot say exactly what the new inventions will be, but we know that they will happen.  Presumably they will involve such things as renewable energy; water related purification, desalinization, and utilization processes; nanotechnologies; huge leaps in the application of technology to address the bloated costs of medical diagnosis and treatment; and on and on.  Where there is a need, human ingenuity will create solutions.

As far as the United States is concerned, we have a long track record of overcoming problems, as do many other countries. I see no reason why the current complex of problems should be beyond our abilities to solve.  

We have just elected a new president, overcoming decades of prejudice and creating a new social healing for our country. This is a tremendously hopeful sign for our country and the world.

So my conclusion today is, do not expect short-term miracles for the global economy, but we all have every reason to feel hopeful about the mid-term future for our nation and the world.  But to find solutions to the current crisis, we must once again consult broadly with our friends and allies to seek ideas and mutually beneficial strategies to expedite the process.

Thank you.