(Archived Content)
The most important thing that the United States can do for the prosperity of all of the Americas is to return and sustain our economy on a path of steady non-inflationary growth. And nothing could be more predictable than a Treasury official and ex-central banker that wants to talk to you about something so self-evident. But I ask you to look beyond the truism and to see that we are at a turning point.
I want you to see the connection between our 25-year effort to reverse the inflationary mistakes of the 1970s and the volatility in our domestic credit markets in the last few years and the recent decline in contagion among emerging markets. I would like you to see much of the recent market turmoil as a transition to a world of more stable real and nominal interest rates and one in which the individual characteristics of both corporate and sovereign borrowers will be better recognized - a world where credit matters.
But first, let me remind you of the history of one country's experience.
The country abandoned its long-maintained currency peg, stunning the foreign exchange market. Lax monetary policy created the conditions for a subsequent acceleration of inflation just as fiscal deficits began to increase, together leading to a second wave of currency turmoil and depreciation. The high interest rates with which the central bank was forced to respond exposed weaknesses in the banking sector and in banking supervision, leading to government bailouts of financial institutions and further volatility in the exchange market.
I repeat this brief history of the United States in the 1970s and 1980s both to underscore the common experiences we have had across the hemisphere and to take you back to the extraordinary volatility in our economy - in both real output and in inflation and inflation expectations - that accompanied the great expansion of traded capital markets both here and around the world.
In such an environment, you make or lose money in credit markets by anticipating (or failing to anticipate) the rapid swings in real and nominal interest rates. Anticipating the big macro-economic events becomes relatively more important than the particular circumstances of individual corporate or sovereign borrowers.
Catching the turns from the negative real U.S. interest rates in the late 1970s, to the highly-volatile nominal and real rates of the 1980s, and to the low nominal rates of the early 1990s, proved to be more important for creditors than the finer points of deciding the particular spreads that individual borrowers should pay over comparable U.S. Treasury yields. In that environment, it was good enough for bond traders, investment bankers and credit officers to form a consensus on rough rules of thumb for credit spreads, for both corporate and sovereign debt, as long as you could hang on for the ride as the underlying interest rates gyrated.
In a period of more stable real and nominal interest rates, by definition, it becomes relatively less important to anticipate the changes in underlying rates and, therefore, relatively more important to assess accurately the credit standing of individual borrowers.
In the latter half of the 1990s we moved into such an environment, one of much more stability in real output, in real interest rates and in inflation expectations. Even in the last two years, in the recession and recovery now beginning, we have seen much less volatility in real output and in long-term interest rates than most observers expected. In this environment, bond traders who were once thought to be masters of the universe have discovered that credit matters, that it is a little bit less about macro-economics and little bit more about the particular conditions of the borrower.
In international financial circles this is referred to as the question of sustainability. In the somewhat blunter world of domestic finance, we say that it's about cash flow: it's about whether a borrower can meet its payment obligations.
In the summer of 1998, participants in global capital markets made a collective credit misjudgment. It was widely agreed that Russia was a better credit than Argentina that summer because Russia had missiles. Before that summer was over, it turned out that what mattered was cash flow.
More recently, in our domestic capital markets, we have learned that it is not enough to know what sector a company is in. You also need to know whether there is any real cash flow behind the corporate balance sheet.
The transition to world where credit matters has been an expensive learning process for some. The habits of the 1980s and early 1990s - of tracking indexes and trading off of rule-of-thumb spread relationships - have been hard to shed. Indeed, these habits can only prudently be shed if we keep our economy on the path of stable and sustainable growth and price stability.
A major benefit of our doing so will be greater stability and opportunity for developing economies. A world in which credit matters is a world with less contagion.
I am convinced that the relative lack of contagion from the current tragedy in Argentina, compared with the events in Mexico in 1994, is significantly a consequence of the greater expected stability of the U.S. economy and interest rates and also of our low and stable inflation expectations.
In 1994, financial markets had firmly in mind the then-recent spike in U.S. inflation up to 6 percent and the wide swings that our interest rates and exchange rates went through in the 1980s. While our interest rate markets did experience some heightened volatility late last year, they did so, in part, as they adjusted to the idea that our economy's performance would be much less volatile than had been feared: that real output would vary less than had been expected. Inflation expectations have also remained remarkably stable.
A world of more stable interest rates - and one of less divergence between real and nominal rates - is a world in which all borrowers will be judged on their own circumstances and not on the basis of the index that they are in or the language that they speak.
If at this important turning point we can get our economy back on a path of steady non-inflationary growth, and keep the trend of increasing convergence between our real and nominal interest rates, we will be able to keep training credit market participants to differentiate both corporate and sovereign borrowers on the basis of their fundamentals.
For both companies and countries, this will mean greater attention to their cash flow, to the question of whether they can sustain their debt service payments.
For countries this will also enable them to differentiate themselves more effectively on the basis of the environment they provide for economic growth, on their commitment to the rule of law, on the strength of their financial sector, on the competence of their administration and their commitment to fight corruption, and on their investments in human capital in education and health care.
In a world where credit matters, where we differentiate more carefully among borrowers, there will be fewer triple A companies here in the United States. And, in fact, we are now down to just eight.
In a world where credit matters, some countries may not be able to borrow at all in the traded capital markets. Some countries may fall out of investment grade status if their performance falls short. But other countries will be able to move up into investment grade status, as we have seen.
Credit markets that can effectively differentiate among borrowers will provide the strongest incentives for both the private sector and the public sector to pursue policies that will lead to prosperity throughout the Americas. And steady and sustainable real growth is truly the most important contribution that we can make to this process.