Jan 13, 2005

Geithner on Risk

The NY Fed President Geithner made these comments today.

In the financial markets, this broadly positive outlook has been accompanied by a dramatic reduction in risk premia, leaving the price of insurance unusually low against a less favorable or more volatile environment.

These developments imply a view among market participants that future macroeconomic shocks will be more moderate than in the past and more likely to be absorbed without broader damage to economic performance or the financial system. They reflect a general increase in confidence that monetary authorities here and in other countries can keep inflation stable at appropriately moderate levels. They reflect diminished uncertainty about the expected path of monetary policy in the United States. And they imply that the imbalances in the global economy will be diffused smoothly.

Of course, not much is certain in economics and finance. One cannot know with confidence whether future economic policies and outcomes will justify the confidence in the benign outlook now reflected in risk premia.

He also comments on external imbalances:
Alongside these fiscal challenges, the size and concentration of external imbalances in the system are at an unprecedented scale, between five to six percent of GDP in the case of the U.S. current account deficit. This imbalance is the result of a combination of a sharp decline in U.S. net national savings, driven by increased public sector borrowing and a large rise in household debt, and a sustained increase in the relative strength of U.S. demand growth compared with Europe and Japan.
And the sums it all up.

These four broad forces will have substantial implications for the macroeconomic performance of the world economy over the medium term.

This combination of fiscal sustainability problems, large external imbalances, and the tension in the existing exchange rate system creates the risk of unanticipated shocks to financial prices, even in a context where monetary policy credibility is strong. The probability of these shocks may be low, but it is higher than it has been, and higher than we should be comfortable with.

These shocks could be large enough to lower future growth outcomes. The world's economies have very different capacities to comfortably manage the inevitable adjustments.

Without policy action commensurate with the challenges, we face some risk, it may not be high, but it is material, of a world with somewhat lower growth performance and higher volatility.

Hard not to view the current low risk premiums in a reflexive way. The trend toward tighter spreads and cheaper borrowing has allowed marginal companies to borrow their way out of difficulties. Maybe the trend has farther to run but at this point the odds definitely favor a widening of risk spreads across the board.

Geithner's full speech is here.

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