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World Economic Update -- May 25, 1999

May 25, 1999
Council on Foreign Relations

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Mr. DANIEL K. TARULLO (Linda J. Wachner Senior Fellow for U.S. Foreign Economic Policy, Council on Foreign Relations): ...(Joined in progress)

In the past World Economic Update sessions, we have not paid quite as much attention to Latin America, and in light of recent developments, it seems in need of some attention.

We are pleased to have with us this morning three distinguished panelists: to your far right, John Lipsky, the chief economist at Chase Manhattan; sitting next to me, Arturo Porzecanski, the managing director at ING Barings and the Americas chief economist; and then to your far left, Bruce Steinberg, chief economist at Merrill Lynch.

Let me begin by noting that there had been a widespread perception that when Bob Rubin eventually announced his resignation as Treasury secretary, he would do so in a way that almost signaled the end of the Asian financial crisis. There was a belief that Bob would not leave until he was reasonably confident that market turmoil had subsided and that he was not leaving a difficult situation which would be hard for his successor to manage. His announcement, when it was previewed a few days before he actually announced his departure, seemed to be coming just in that kind of circumstance. There had been a general upswing in optimism in a number of the Asian emerging markets, in Brazil, and although there were continued concerns about macro performance in both Europe and Japan, in general, things seemed to be about as calm as they had been in a couple of years.

Although we wouldn’t characterize that situation as fundamentally changed since Bob’s announcement, there have been a few things which have perhaps given people some pause. First, of course, the Fed has announced a change in its bias. It is now biased towards higher interest rates, although it has obviously not taken the step of raising interest rates. We’ve also seen more than a bit of retrenchment in equities in Latin America, and we have obviously seen just yesterday that one doesn’t want to place too much emphasis on anything that happens in one or two days in the stock market, but a bit of a correction in the U.S. stock market, which is apparently being followed in European stock markets today.

So in light of both Bob’s departure and these little ripples around it, let me begin by asking the panelists whether they think that the timing of Bob’s departure has, in fact, occurred in a period where the turmoil is over and we’ve just got individual problems left to be faced, or whether there’s a possibility that something a little more serious might return.

And, John, why don’t we start with you?

Mr. JOHN LIPSKY (Chief Economist, The Chase Manhattan Bank; Director of Research, Chase Global Bank): Obviously, we are at a period of calm that I think it would have been extremely optimistic to have predicted even four or six months ago in terms of economic and world markets. At the same time, it’s hard to say that what lies ahead is exquisite smooth sailing. In fact, there’s a sense, I think, that the next few months will be dominated by a sense of difficulties; not terrible ones, but I would expect that we’re going to have a sense that the hoped-for progress in Asia may have been oversold and that the idea of any quick bounce back, for example, in the Japanese economy is premature.

We have seen signs in two of the key core countries of Europe, Germany especially, and also Italy; very weak economic performance, unexpectedly weak economic performance from the point of view of the locals with little clarity about exactly how it is going to turn around and the strain that that could imply for Europe. At the same time, in Latin America, we’ve had sort of a—well, I’m sure we’ll talk about this more—but a sense that we’ve gone through the Brazilian devaluation, the institution of a new stabilization program that has gone better than most people have thought, but to assume that the problems in Latin America have thereby been solved by this step, I think, was laid bare. The falsity of that was laid bare by the kerfuffle, if you will, in markets in the last few days about developments in Argentina, where the economy there is in recession and there is at least market discussion about whether the Argentines are going to maintain their currency stability.

All in all—and here in the United States, of course, as Dan already mentioned, there is at least now priced in the market the expectation that the Federal Reserve will start raising interest rates for the first time since March 1997. In other words, there are a series of challenges coming forward that have the potential, at least, for creating both economic and market strains that I think Mr. Rubin is going to be happy to be reading about while he’s fly-fishing.

Mr. TARULLO: Bone-fishing.

Mr. LIPSKY: Oh, bone-fishing. Sorry.

Mr. TARULLO: OK. Arturo.

Mr. ARTURO PORZECANSKI (Managing Director and Americas Chief Economist, ING Barings): Well, on a personal note, I think we should just be very grateful that we had Bob Rubin all the years that we had him and that he accomplished everything that he did. And I think he’s going to be a very tough act to follow. But he had to leave at some point, and that point was as good as any. Maybe somebody could say he, too, got tired of waiting for the Japanese economy to recover.

But obviously, the challenges for Larry Summers and the rest of the economic team in the government are there. We continue to break new records in this country in terms of pushing the envelope; very low unemployment; until recently, anyway, very low inflation and very rapid growth. How sustainable is that? I’ve thrown away all my textbooks because they’ve stopped giving me guidance on what is really an unprecedented situation. And whether this comes to a sudden end or it doesn’t, I think it’s very much an open question for Larry Summers and the rest of us.

In terms of the international economy, can we enjoy the fruits of integration, goods markets, and capital markets integration, without the destructive forces of, you know, blind speculative runs and other, you know, waves of contagion and whatnot? That’s very much an open question, also. So I think that, you know, he left enough unanswered questions for Larry Summers to deal with, but, as I say, we’ve been very lucky to have him for the years that we had him.

Mr. TARULLO: Bruce, do you agree with the conventional wisdom that’s reflected in both White House talking points and the newspapers that Larry will essentially maintain continuity with the policies that have been pursued in the last several years? And whether or not you agree with that, what advice might you have for Secretary Designate Summers in light of some of the developments which John just mentioned?

Mr. BRUCE STEINBERG (Chief Economist, Merrill Lynch & Company): I do believe that Larry will maintain continuity. Obviously, Larry is not Bob, and in Bob Rubin, we had, really, one of the best Treasury secretaries of all time, someone who had just a very inherent sense of how financial markets work and how financial markets interact with economic policy and how to manage that. Now even Bob’s predecessors who came from Wall Street, did not have that touch, so he was a fairly—I won’t say unique, but a very unusual Treasury secretary, and that skill set is not likely to be seen again soon.

Now I think Larry has demonstrated a quick study, and as the global crisis has raged these last two years, it was usually Larry that was dispatched to the far corners of the world to be the firefighter, so he’s had some very intensive on-the-job training.

I do agree with, you know, the gist of what both John and Arturo just said, that it’s not going to be smooth sailing from here on out, but the contagion phase of this global crisis is over with. The part where you had a breakdown one place and it all of a sudden leapt to some other places and went around the world, that’s probably done with right now. And even the Fed’s move toward a tightening bias—I don’t actually think they’re going to end up tightening this year, but their move to a tightening bias is another demonstration that policymakers in Washington believe that the global crisis, if not over with, that the contagion part of it is over with and that other considerations can now play a bigger role in formulating U.S. economic policy.

But as John pointed out, other parts of the world are still somewhat fragile. There are recoveries taking place in Asia, other than Japan. They’re fragile recoveries, except in Korea, where it looks stronger. Japan, in all likelihood, will continue to contract this year and probably next. And Europe is pretty sluggish right now. So the world is not a safe place, but it’s a much safer place than it was six months ago.

Mr. TARULLO: Well, with respect—you just got back from Japan. With respect to Japan, what would you counsel the administration’s position, policies, and profile to be on Japan’s economic performance as Larry takes over the reins of Treasury?

Mr. STEINBERG: Well, I guess my impression is that the administration has given up on trying to pressure the Japanese because it really doesn’t lead anywhere. In Japan itself, I think after a decade of deep denial, finally there is a realization there, both in the public sector and, more importantly, in the corporate sector, that it’s just not a cyclical problem that Japan is going through, that it’s a deep structural problem that needs to be addressed. And in the corporate sector, they are finally, however grudgingly, beginning to address it by beginning to restructure operations and so on.

But this process is only at the very beginning, and when you restructure an economy that has the kind of deep imbalances that the Japanese economy has, the initial effects in terms of economic activity are negative ones, because you’ve got to cut back on capital spending, you have to cut back on employment. And we have a lower unemployment rate than Japan for the first time in history, but it’s kind of incredible that an economy that hasn’t grown in a decade has an unemployment rate of only 4.6 percent. And Japanese companies are incredibly overstaffed.

So things are hopefully going to look better in Japan over the next few years, but over the next year or two, further contraction, and there’s not much we can do about it.

Mr. TARULLO: John.

Mr. LIPSKY: Yeah, just to—Bruce, I don’t know if you discussed this while you were over there, but I’d say there are a couple of trends, although in the long term, I’m sure what you say is correct; in other words, structural change is going to be inevitable in the Japanese economy, etc. But in the near term, it appears to us that the Bank of Japan is once again allowing their balance sheet to shrink; in other words, that despite all this idea that they’ve got incredibly low nominal interest rates and are therefore very stimulative, from a technical point of view, it looks as though the Bank of Japan continues to act as a drag on Japanese growth in the near term, and Japanese officials continually talked about their policies in terms of how the yen is doing, which strikes me as—the conclusion you can draw from those two things, unless—and third and finally, once again, they’re talking about a large, new fiscal package, a supplementary budget, in a context in which nobody really thinks that’s very effective. In other words, it looks to me like Japanese policy is still condemning Japan to an extended period of little or no growth.

Mr. STEINBERG: Well, several things on that score. You know, no country has ever run as stimulative an economic policy as Japan: 0 percent money market rates and a budget deficit equal to 10 percent of GDP, and yet, the economy there is still contracting. Of course, that’s a commentary on what a pitiful thing it actually is.

On the yen, my impression is this: that because the crisis in the rest of Asia is abating, the Japanese are less resistant to the idea of yen depreciation. And I think that the yen will depreciate, actually, over the balance of the year, and the Japanese authorities will acquiesce to a depreciation.

On the issue of what the BOJ is up to, yeah, there will be a supplementary budget in the fall. The budget deficit will remain amiss. Now Japanese bond yields are only 1.2 percent in a country in which the government is increasing the national debt by an enormous amount, you know, every passing day. There will be a point later this year where I think the BOJ is finally going to have to basically monetize or begin to monetize the debt by buying bonds directly from the government, and at that point, monetary policy will become much more stimulative. And, of course, the yen is likely to weaken considerably when that happens.

Mr. TARULLO: And continuing with that line of inquiry, is any of you at all concerned about the relative stability of the dollar, particularly as our current account deficit goes up and as the rest of the world does not seem to be giving us any signs that they’re going to start to pull imports from the rest of the world?

Mr. LIPSKY: Well, you know, I think the worry about the current accounts is somewhat misplaced. The fact that we have this ever-widening trade imbalance is completely a function of the fact that our economy is strong and the rest of the world is extremely weak. Our current account deficit was stable until the Asian crisis began, and then it, you know, went into a very rapid deterioration. But in the meantime, the dollar is strong because where else will people put their assets? Capital inflows to the U.S. have dominated the current account deficit, hence the strong dollar, and that’s not likely to change in the next six to twelve months. There will be a point further out when the dollar may begin to weaken, when other countries begin to recover better, but, of course, at that point, the current account deficit of the U.S. will begin to shrink, because once there’s a revival of demand in the rest of the world, then our exports will accelerate.

Mr. TARULLO: I guess I’ve been struck by the fact that in the last several months, Rubin, Summers, and Greenspan have all alluded to the strength of the dollar and the relative stability of the current account deficit. That is something which you hadn’t seen any of them address, even obliquely, in years past. Do you think that it is something they’ve done because of the politics of the current account deficit? Rubin’s phrase is that the deficit is “politically and economically unsustainable.” Or has anything shifted in the last six months that would give any of you—I think Bruce’s answer is no, but the other two of you—any grounds for concern that there could be a more rapid rather than more gradual adjustment in the value of the dollar?

Mr. PORZECANSKI: The danger is clearly the protection of them. I think that that’s what concerns them, that if we go on like this and import penetration continues to increase, that then they could be fighting a rear-guard action to keep this market open. And so, in that sense, yes, I think that the constructive response is to push Europe and Japan and the rest of the world to grow and start buying from us for a change, rather than waiting for pressures to build, political pressures to build or, potentially, currency pressures to build. Because the link to your first question, of course: If Larry Summers should ever falter in his job or Alan Greenspan send the wrong signals and whatnot, I think that with this gigantic current account deficit, we are much more vulnerable to a sudden swing in currencies than we were before. So I think they’re just sending some cautionary signals, and they’re correct in doing so.

Mr. TARULLO: John.

Mr. LIPSKY: I think it’s important to note, we are getting to a point, we will reach a point this year, most likely, in which the current account deficit, both in nominal terms and relative as a percentage of GDP, is going to be the largest in history. It’s going to surpass the deficit that we ran in 1985. Now there’s an important difference. In 1985, the U.S. economy was pulling in imports at an extremely rapid pace, and the dollar was grotesquely overvalued on any kind of a reasonable basis. This time around, it’s not clear the dollar’s overvalued and, in fact, the widening of the deficit is not so much because of rapid import growth. It’s not particularly notable. It’s because of incredibly weak performance on the export side.

Nonetheless, it would be, I think, too much of a Pollyanna to say, `Therefore, there’s no problem.’ And I would endorse the idea that Arturo suggested. There will be a sense of—just be another element that creates a sense of uncertainty about whether stability can be sustained. And it would be best if we could have avoided this by better economic performance in our trade partners, but I think that the news suggests so far this year, our current deficit is widening faster than it did in 1998. So I think this is something ignored at our peril, and I would feel a lot better if I felt more upbeat about growth globally.

Mr. TARULLO: All right. Let’s turn to Latin America, specifically, for a couple of minutes. If, indeed, the global financial crisis is over and another round is not to come, history may well record that the contagion was contained in Latin America. Notwithstanding the problems that Brazil has gone through and the eventual devaluation of the real, it did not, in fact, lead to economic collapse and, contrary to many people’s expectations, Brazil’s problems, the real problems, although they had ripples through Argentina and other parts of Latin America, did not provoke financial crises in those countries. So in that sense, it seems as though Latin America had developed some antibodies to financial contagion, perhaps in the aftermath of the Tequila Crisis of 1994 and ’5.

On the other hand, the real economies in at least Argentina, Brazil, and Mexico, and probably Ecuador and Colombia and a couple of other countries as well, seem of uncertain prospects right now, and obviously, the big correction in the Brazilian stock market yesterday suggests that optimism is far from unalloyed. So, Arturo, let’s begin with you. How do you look at both the ability of most of Latin America to hold off financial crisis on the one hand, and on the other hand, how do you look at prospects for the real economy in the next twelve months?

Mr. PORZECANSKI: Well, to touch on one of your points, I think things are pretty fragile, still. Sure, we don’t have the buildup in leverage and the, you know, consequent willingness to take on risk, including foolish risk, that we had last year. But on the other hand, the fact that everybody is still very mindful—I mean, memories are short, but they’re not that short. So people are still very mindful of risk. Everybody’s managing their risk positions very close to the vest. And I think this means that when something happens, be it the bias to tighten on the part of the Fed or be it the rumor that Argentina might devalue against all odds, it’s actually amazing to see the contagion—I’ll call it that—the contagion that we’ve witnessed in the last week or 10 days. I mean, it’s not just yesterday. All emerging market and certainly all Latin American stocks and bonds and currencies for the past 10 days have been seriously affected.

So I think we’re still in a fragile state. Now I don’t believe that we have a crisis waiting to happen like we had in Russia, you know, last August. I think that the countries themselves, the investors, the intermediaries, all of them, by being so mindful, by being much more risk-averse, are contributing to a climate that, while it seems shaky in the short term, I think, is more salutary in the medium term. But I think things are still very fragile.

Now turning to fundamentals, remember this: First of all, Latin America is mostly a commodity-producing and exporting region, and until we have a broad-based recovery in commodity prices, I think that Latin American growth and investment and the business climate and so on is going to continue to limp along. Fortunately, we’ve had a recovery in oil prices, so some of the weakest members of the community, like Venezuela and Ecuador, have their head above water right now. But for most of the other countries that depend on the export of foodstuffs or metals or, you know, other commodity prices, things are very rough. Yes, most commodity prices are not declining, but, you know, that just means that they’re operating in the basement and they’re not, as I say, above water.

Secondly, access to capital is very important for Latin America. Latin America, unlike Asia, is a savings-deficient, consumption- and investment-heavy region, and so access to new issuance in the bond market and in the equity market and bank loans and so on is very important for the region. It’s very dependent. And yet, if we have now, like it looks like, kind of a closure of the capital markets, at least for a few weeks, that could help abort some of the recoveries that we have been expecting to take place in this second quarter.

So I think that as long as commodity prices don’t rally and as long as access to capital is constrained, limited, halting and so on, prospects for an economic recovery in Latin America are compromised.

Mr. TARULLO: Bruce, one of the disadvantages of doing these panels is, they’re actually transcribed, and so I can go back—and I do—and read the past comments we’ve made. Your comments on Brazil at the very first one of these that we did were particularly prescient, and some of the specific cautions that you pointed out at the time, I think, have been borne out in subsequent performance, including the unsustainability of the real at that time. Do you still have a very cautious outlook on Brazil, notwithstanding the apparent quick turnaround which Armenia has been able to effect with interest rates?

Mr. STEINBERG: I think one has to be cautious about Latin America, yet I don’t think one should be despondent about it. Even in looking at this market sell-off over the last few weeks, markets go up and markets go down, and not every market movement is to say that something profound is about to happen. Emerging markets in general have huge rallies in the first few months of the year because people began to believe, and I think rightfully so, that the global crisis was in the process of being resolved. And Brazil was part of that, because the worst didn’t happen there. Brazil did not have hyperinflation. Its problems were brought into some degree of control and so on.

But in terms of the equity market performance of these countries, it really got ahead of itself and these huge, huge increases, and now you’re having a correction. Well, that’s OK. It doesn’t mean that they’re going to be shut off from capital as we go forward. Brazil is the country that really has to do the most because, you know, why did it have its problems? Because it was running an irresponsible fiscal policy, an unsustainable fiscal policy, big budget deficits. And they’ve done a lot to address that, but there’s still a lot more on that. But, you know, compared to Asia, Latin problems are much easier to fix. They don’t involve overleveraging of the financial system, they don’t involve crony capitalism and all of these things. They’re really either, in the case of Brazil, a function of a bad economic policy that can be fixed pretty easily—well, not that easily politically speaking, but can be fixed—or the Latin countries are the innocent victims of the global crisis in the sense that commodity prices remain quite depressed.

So I think that you will see stabilization this year, and hopefully you will see some good growth in Latin America by next year.

Mr. TARULLO: John, would you agree with the proposition that one of the antibodies which South America, at least, did develop was a relatively better regulated and sounder financial system which helped to absorb rather than magnify shocks coming from the rest of the world?

Mr. LIPSKY: Yeah, absolutely. I think the easiest way to look at that is that Latin America actually learned some lessons from the debt crisis of the 1980s, and one of the lessons was to strengthen financial systems, and that occurred in almost every major country in Latin America. And that’s one reason why they have been able to avoid the catastrophic outcomes that have occurred elsewhere. At the same time, I also think that, certainly, the Russian debacle of last fall eliminated any kind of illusion that any investor might have that there was a viable international crisis management system that was going to solve problems through the application of large amounts of official funding.

In other words, if you hadn’t figured that out after last August, then you deserved whatever bad thing happened to you. And I think most people figured that out, and as a result, the Brazilian crisis, with the failure of the Brazilian first stabilization program, didn’t come as any great surprise, as anybody who’d been listening to a lot of talk about that beforehand would have noted. So I think it was that combination of ingredients.

Nonetheless, I think there is something important to say. In the last few months, there has been, in capital markets in general and emerging markets in particular, a kind of effect, in a sense, in which the outcomes were calmer than had been anticipated. A lot of investors, especially institutional investors, sensed an opportunity in buying into higher-risk securities like emerging-market securities. Result: They performed very well. There wasn’t underneath that, at least in my sense, a tremendous conviction about a big turnaround in the underlying fundamentals. It was a market deal. And now, especially with the turn with the Fed’s policy and other developments, a sense that that moment has passed.

So I suspect there is going to be a sense of greater pressure on Latin American countries because there’s going to be a sense of more capital market difficulties and more pressure. And one place to look for this is the issue of MERCOSUR and the weakness of the Argentine economy and the question about how can MERCOSUR go forward in a context in which Brazil has achieved a very large depreciation of its currency in real terms while the Argentine economy remains pegged to the dollar? I had the opportunity to ask that question of President Cardoso a few weeks ago when he spoke here in New York, and I thought the answer was rather unclear.

Mr. TARULLO: Well, that actually leads to another question I wanted to pose to the panel, and that’s the proposals to dollarize the Argentine economy, for sure; those are official proposals from the government of Argentina. There’s also been talk in other Latin American countries, even Mexico, about the possibility of dollarizing, which is to say, to completely substitute the dollar for the national currency of the country in question. I wonder whether—I’m interested in the panel’s views on this.

Let me try to set up the question a bit by suggesting that the commodity price difficulties to which Bruce and Arturo alluded are essentially beyond the control of the Latin American countries. They can’t do anything about low demand in Asia and Europe for the commodities they export. They are probably well aware of the fact that they can make changes in their own fundamentals only slowly, including the budget deficit, without very, very serious recessions, and so it may be that taking action on their currency, their foreign exchange regime, is something that looks to them like potential action—something they can actually do, make the change and, from their point of view, presumably insulate themselves against another financial crisis.

Arturo, let’s start with you. What is your view on the relative merits of dollarizing which, for Argentina, would really be going the next step? They already have a quasi-currency-board system right now, so they’ve effectively got the peso tied to the dollar. But this would sort of throw away the key, as one metaphor has put it. Are the costs and the uncertainties under current circumstances so high that this is a plan which should be pursued slowly, if at all? Is it simply a “let’s do something” response to a set of problems that’s more difficult than that, or do you think there’s merit in the proposal?

Mr. PORZECANSKI: First, I would differentiate between market-driven dollarization and dollarization by government fiat. Namely, in those countries, if there are any, where there is a banking crisis and the government loses control of public finances and inflation shoots up and the people don’t want to hold a national currency because it is not a stable vehicle for purchasing power, that is what I would call market-driven dollarization. And that’s how we’ve gotten to where we are. The countries that are heavily dollarized, be it Bolivia or Peru or Argentina, have been because previous governments failed in containing inflation, and so people went the route of the dollar.

Given the fact that most countries, with the possible exception of Ecuador, seem to have things more or less under control in terms of stability in the banking system, rules of engagement in terms of running the printing presses and the government finances, I think that market-driven dollarization is unlikely to happen unless we really have some, you know, major collapse in confidence in institutions and so on.

Now there is dollarization by government fiat, where the government says, “From now on, everything shall be denominated in U.S. dollars and we shall have no local currency anymore.” That obviously is a big decision, if for no other reasons than cultural nationalistic reasons. And I don’t see, certainly, Brazil doing that anytime soon. And, you know, maybe the next president of Mexico will contemplate it, but certainly the outgoing president of Argentina—we have elections there in October and a new president, other than Menem, is going to be in office in December. I think that in terms of Argentina, government-inspired dollarization is a non-issue for this year, in any case.

Now what about dollarization? As I alluded, I think that if you have a banking system that’s very weak, you have a central bank with no reputation, no track record, no ability to gain the confidence of the people, well, then, I think dollarization is a very good economical response to that. Give up the local currency, which you obviously haven’t been able to print with good judgment, and have the people use a store of value such as the dollar.

But in terms of solving what I would call the real economy problems, dollarization won’t help you. I mean, imagine yourself that Argentina today, which is two-thirds dollarized, becomes 100 percent dollarized. Would that improve its competitiveness? Of course not. Argentina is expensive in dollar terms. Wages are too high, land prices are too high, taxes are too high and so on. So the deflation that is necessary, the cut in costs that is necessary to have in Argentina, or the jump in competitiveness and efficiency that can offset the loss of competitiveness, that’s not, you know, by any means ameliorated by the shift from two-thirds to 100 percent dollarization.

So I think we must not lose sight that, while dollarization can help deal with some of the financial issues, certainly the ones that at one time were acute, it wouldn’t do anything in terms of lowering costs, such as in the case of Europe, of course. Just because you have the euro doesn’t mean that the structural problems of the European countries are getting any better.

Mr. STEINBERG: But I think pointing to the euro brings out an interesting thing, because now that they do have the euro, those structural problems are highlighted in bold relief, and they have no way out now other than to start to fix the structural problems of the European economy. And the countries which are underperforming the worst in Europe right now—that is, Germany and Italy—are the ones that have the biggest structural problems, and their underperformance is a reflection of that—the most rigid labor markets, the most bureaucratic rules and so on.

In terms of dollarization in Latin America, I mean, the one country for which it makes sense to dollarize isn’t likely to do it very soon. That’s Mexico. Eighty-five percent of its trade is with us. If they dollarize, interest rates in Mexico would be a lot lower than they’ve been in a very long time. An even more inward investment would come to Mexico as it integrated into the NAFTA market. So for Mexico, it may well make sense to dollarize, although nationalistically, I’m not looking for that to happen.

Argentina is the economy in which it’s easiest to dollarize, because it’s basically a dollarized economy already. And yet Argentina, of course, is not an optimal currency zone with the United States. Only I think it’s 9 percent or 10 percent of its exports go to the United States. And with Brazil now having such a big competitive advantage, that’s why Argentina is in a recession.

Yet it’s not enough to say these countries now have stable financial systems. Argentina, Brazil—these are countries with histories of hyperinflation. And if Argentina were to break its currency peg to the dollar, I think that there would be an enormous loss of confidence in them. So there’s a price to be paid for anything. There’s no optimal currency arrangement that there is. You’ve got to fix your structural problems one way or another; some ways are easier than others, but some of the easiest ways actually don’t cause you to fix those problems as rapidly as some of the more difficult ways. So, you know, whether Argentina dollarizes or not, whether this is good for them or not, it may be good. It may be good. They’re mostly there already, as Arturo pointed out. And they will be at a competitive disadvantage relative to Brazil. On the other hand, it does force the further efficiency deepening in their own economy if they’re ever going to be globally competitive, and the alternative for them to break the peg is really not an alternative for Argentina.

Mr. TARTULLO: John, before I go to questions, do you want a word on dollarization?

Mr. LIPSKY: Yeah, I do, actually. Yeah, I think there’s a point here that’s—I don’t disagree with anything that’s been said, but there’s another way to look at this that I think is important. Introduction: First of all, I think the United States made a dramatic, what would be seen as a historic, strategic error in failing to carry through the NAFTA negotiations or the opening of the free trade negotiations with Chile, which meant definitively that Latin America is now focused on creating MERCOSUR. And if Brazil stabilizes successfully, then the next order of business in Latin America is going to be the definition of the degree of integration through MERCOSUR.

And just as we found in Europe that the European authorities themselves felt that creation of a free trade agreement or customs agreement was not possible without some mechanisms to stabilize internal exchange rates, that’s what we’re going to find in Latin America as well, and that’s going to be a challenge for them, how to stabilize exchange rates within MERCOSUR. And that’s important within the context; again, if you listened to President Cardoso the other night here in New York, made very clear that the next order of business for MERCOSUR, its own vision, is to open trade negotiations not with the United States but with Europe. And the idea of creating a third trade block that would negotiate in a coherent sense with NAFTA on the one hand and with the Europeans on the other—this is a potentially profound change in the way global negotiations and economic relations and financial relations are going to take place. And I would say this is going to be the major challenge in Latin America of the next few years.

And parenthetically, as Bruce said, the country that dollarization makes sense for is Mexico, and you can write that larger and say in NAFTA, eventually, we’re going to face the issue of whether or not there ought to be or will be a single currency within the NAFTA zone.

Mr. TARULLO: All right. Thank you, John.

Now we’re going to turn to questions. I would ask that when I recognize you to pose a question you stand, identify yourself and your affiliation and try to keep your question as succinct as possible. OK, unless there are none, in which—yes, right over here. Yes, sir?

QUESTIONER: I wonder if you could give us an update on where we are with the sort of overleveraging in international capital markets we saw last fall, excessive pyramiding, hedge funds and so forth.

Mr. STEINBERG: You know, after the debacles of last summer and fall, first with the Russian default and then with the LTCM issue, the Street collectively has certainly taken down their highly leveraged positions a lot, and there is a lot less risk in the system now than there was. This is a major reason why contagion is much harder to accomplish now than it was before. And I think as Arturo said earlier, it’s not like people—people do forget, but they don’t forget this soon. And so for the time being, I think that our financial system is pretty sound, and you’re not going to have this kind of highly leveraged house of cards collapsing on us. We’ve gotten past that point. There was a near-death experience we had when LTCM almost went under, and that could have had very profoundly horrible consequences if that happened, but it didn’t happen, thanks to Greenspan, in large part. And I think we’re OK now. I don’t think it can be repeated, that particular event.

Mr. TARULLO: Do you want to get in?

Mr. LIPSKY: Yeah. I’ll just say that, look, what was the meaning of LTCM? LTCM, among other things, suggested that a lot of the assumptions underlying market transactions or market positions about the sustainability of market liquidity were simply wrong. I think there are a lot of participants who never dreamed that you could come to the position, as we did last fall, in which the U.S. Treasury bond market, theoretically the most liquid, most risk-free market in the world, had turned virtually illiquid. My trading colleagues told me they’d never seen anything like it in their careers.

I think that was a message that shouldn’t be overlooked. I don’t think we’ve resolved that in any way, shape or form. I don’t think we even clearly understand exactly what happened and why, and how we could come to such extremes on the one hand and how it could go apace so seemingly quickly on the other.

I’m, in fact, quite comforted that institutions like the Ball Committee and other official institutions are looking into and thinking about the issues that were implied, namely, have we built a superstructure based on assumptions of continuous liquidity that may not be entirely justified?

Mr. TARULLO: OK. Thank you. Yes, sir, in the back?

QUESTIONER: There was a great deal of comment last fall about the need for an intense international crisis management. And I wonder if you’d comment about what you see as the desirability of greater reform or initiatives in this era, and the likelihood of their occurring.

Mr. TARTULLO: Let me supplement—that’s a very good question. Let me supplement it to the panel. Michael Weinstein of The New York Times wrote a very interesting column at the time of the bank fund meetings suggesting that there was now something approaching a consensus on what to do but very little specificity on how to do it and how the plan and program was actually going to be implemented. What are all your reactions to reform of the architecture and the international financial management system? Arturo, you want to start?

Mr. PORZECANSKI: I’ll start. I mean, certainly, some things have been done. The IMF now has a contingent facility. Nobody has signed up for it yet. But, you know, some things have been done. I’m not sure they will forestall a crisis. Of all the discussions on the new financial architecture and so on, my biggest concern was that there would not be a clear statement on the desirable nature of currency regimes in the world. And lately, one of Rubin’s last things has been to say that the United States government now feels that it ought not to come to the rescue with, you know, zillions of dollars to countries with an artificially pegged currency regime, unless there are, you know, very special circumstances.

And that was the first time that I had some hope about the whole discussion of international financial architecture, because to me, at the core of all the crises has been a currency regime that is artificially managed by the government and that doesn’t reflect market realities. And I think that it’s amazing how the Washington consensus has answers to everything, but not to “What is the right currency regime that I should have?” And the answer, I guess, we’re now beginning to say to countries—and this is very important, because in Latin America and in eastern Europe and so on, we still have countries that, in my judgment, are prone to crises.