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Meeting the tests of a new era.


From now on, our priorities will be economic and social. And at least one businessperson is convinced that the U.S. private sector can meet the challenge.

John S. Reed



With the end of the cold war, the economic lessons we have learned during the last 45 years may no longer be relevant.

At the end of World War II, the leaders of the free world established an economic structure that provides reasonably predictable exchange rates and increasingly free trade. Their aim was to rebuild our economies and maintain our strength in the ongoing confrontation with the communist world. Through a war in Korea, another war in Vietnam, and the unremitting cold war all around the globe, this confrontation was the glue that held Europe, America, and japan together, limiting the degree to which our countries could differ over fundamental economic issues. Now that that confrontation-that glue-is a thing of the past, we face the possibility that the world will split into groups of countries with different economic interests.

Although the European Community is coming together, the opening Lip of eastern Europe is turning the attention of some EC countries in that direction, tempting them to take more interest in the east than in GATT and other agreements for global trade. They have more flexibility-more options-than they did even three or four years ago.

Japan is asymmetrical in its trade relations with the rest of the world. While it is very important as an exporter, Japan is quite unimportant as an importer. Absent the glue of the cold war that necessitated the close cooperation of our two countries, the U.S. may well become increasingly protectionist with regard to Japan.

In the coming years we're going to face many new tests of our ability to maintain the free flow of goods and capital throughout the world. But we learned much in the postwar period, and no responsible political or financial leader wants to throw all that away. That's why I'm optimistic that we can prevail through these tests and hold this globally interconnected world of ours together.

Capital will be scarce

One of our principal challenges in holding the world together will be the shortage of capital. There will be too little capital to meet the global demand for development. About 800 million people in Japan, Europe, and North America benefit from the economic development the U.S. enjoys here. But now there are at least another 800 million other people who aspire to live like us-425 million in eastern Europe and the U.S.S.R., 225 million in Mexico and Brazil, not even counting the other Latin and South American countries, and 300 or 400 million in southeastern Asia.

Our way of life is made possible by the money we've spent on roads, hospitals, schools, manufacturing plants and equipment, homes, cars, and so on. In the U.S., we have between $50,000 and $55,000 of imbedded capital per person. To achieve the same level of economic development, these aspiring people will need the same infrastructure and facilities. Somehow these 800 million people will have to find $50,000 each, or $40 trillion of capital, in order to live like us.

Forty trillion dollars is seven years of the U.S. GNP, and three years of the entire developed world's GNP. Are we likely to export 10 percent of our GNP to meet the capital needs of these aspiring people? No. And even if we did, it would take 30 years to do the job. I'm not saying it's hopeless, only that the need is very large.

To provide capital, we in the U.S. will have to consume less and save more, thus bringing about enormous structural change in our economy. The U.S. distribution system, for example, has long been geared to distributing vast amounts of consumer goods. How would it adjust to distributing less? I don't know the answer, but I do have faith in our ability to adapt to new conditions and emerge from the transition better off than ever.

An asset-led downturn

We already have a capital shortage in the U.S. today, where real interest rates exceed real economic growth. This situation favors the growth of the service sector at the expense of the manufacturing sector, because services require less capital to produce. It inhibits the growth of all asset-intensive enterprises, because when these enterprises have to pay high interest rates in a low-growth economy, they're dangerously exposed. And it corrodes the value of assets throughout the economy.

Not surprisingly, therefore, we've plunged into an asset-led downturn. On the world's stock markets, securities lost $1.4 trillion in value in 1990, a 24-percent drop.

When the stock markets crashed in 1987, many observers feared that a "wealth effect" would ensue-that those who had lost wealth would modify their spending behavior in such a way as to lead to an economic recession. As you know, that didn't happen. The markets recovered and spending behavior changed very little.

Why didn't we escape the "wealth effect" again this time? Largely because real estate values dropped as much as the stock market, particularly in the northeastern and central regions of the U.S.

The role of the financial sector

Normally, the financial sector serves to absorb risk. in a downturn, some significant portion of the risk that society bears is shifted to the banks and insurance companies, which ride it out in anticipation of recovering on the other side of the cycle.

This is a deeply held value at the micro level. A banker in a rural community who takes over a farm just because crop prices are down doesn't exactly improve his social standing. There is no question about what people think of a bank that is quick to foreclose when a borrower runs into difficulty.

Socially what is expected of banks, and what I believe should be expected of them, is that they give their customers time. In fact, the commodity that banks deal with is time. We charge for it and we pay for it. The role of the financial sector as a whole is to provide time for society to adjust-to give farmers in difficulty, industries in difficulty, even municipalities in difficulty, time to get their books back in order.

To play this role, financial institutions must operate in an environment that enables them to absorb risk. The current proposal to mark our portfolios to market would make it impossible for us to perform this function. Supporters of the proposal argue that all reality is described by markets and the financial sector should recognize this "reality."

This proposal is a by-product, I believe, of the cross-border problems that we faced in the 1980s, remnants of which remain on our balance sheets today. The less-developed countries that got caught in the high interest rates of 1979 and 1980 lost their liquidity, if nothing else, and went through a very hard time. Some people feel that we were slow to recognize these realities. They think the regulators were too lax, and the accounting profession should have forced banks to mark those assets to market.

I disagree. By now, the banks have substantially provided for the risks they assumed, and the countries involved are better off for the adjustments these loans made possible. Some of them are making excellent progress, most of them are making at least some progress, and the few that have made no progress whatsoever have been fully written off. if we'd been tougher, all these countries might have put off the necessary adjustments indefinitely, and we would have propagated a global problem.

The condition of the financial sector

If the role of the financial sector both domestically and world wide is to absorb risk, especially during economic downturns, how able is the financial sector to fulfill that function in the early 1990s?

Citicorp's earnings for 1990 were only half as much as we'd expected. The shortfall came primarily from real estate writeoffs and carrying costs and necessary buildup of reserves. Yet we have only 6 percent of our balance sheet in real estate, whereas the average bank in the U.S. has between 25 and 35 percent. Under these conditions, banks naturally become reluctant to give their customers time.

The drop in securities values has also put pressure on financial institutions. In response, we've had to squeeze down on liquidity and lines of credit.

So capital is scarce and interest rates are high. But they're even higher in Germany and japan. Germany's high rates are largely due to the way the country is being unified. Such mergers are usually accomplished with considerable inflation, because this provides flexibility on asset values. But apparently the Germans want to do it without inflation, giving full value to the embodied savings of the East Germans. This implies that East Germany's assets are every bit as productive as West Germany's, which they obviously aren't. Basically, therefore, the merger is a transfer, which has the effect of raising the interest on the mark and lowering the value of the dollar vis-a-vis the mark. If you go shopping around the world, you'll see that exchange rates are not in line with purchasing power. The U.S. is a wonderfully cheap place, unless you happen to be paid in dollars.

As a result of all these factors, financial institutions don't want any risk in their portfolios. When a customer asks us to wait, we have to say that we can't. Liquidate out. Pay us back. We don't want your assets on our balance sheets.

In short, the financial sector today is propagating risk instead of absorbing it.

Accounting issues

The U.S. has the best accounting system in the world. No country has a more descriptive, more responsive language of economic reality. Thanks to this system, we who try to run enterprises here are able to get a clear grasp of our economic resources and results.

Nevertheless, we hear proposals for change, many of which are more a reflection of economic policy and social values than they are dissatisfaction with accounting issues. One such change is the proposal to mark assets to market. As I said earlier, I do not support this proposal, at least insofar as it would apply to the financial sector. To my mind, marking assets to market simply does not describe our business.

Another change that's been proposed would address the problem of our short-term business orientation. I think it's true that if we didn't publish quarterly reports, we could remedy this fixation on short-term results. Let's publish a report every two to three years, at the discretion of management. Again, this isn't an accounting issue, but the accounting profession's attitude toward it will be an important factor in the debate. The Business Roundtable has recommended that we decrease the frequency of reporting, a position which I hope the accounting profession and corporate financial executives will support.

On the broad front of harmonizing accounting systems around the world, we're developing the mechanisms for bringing about change. it's surely not in the interests of U.S. business or the accounting profession to allow glaring accounting discrepancies that can make a real and unfair difference in the conduct of an enterprise. The accounting system in this country must not penalize the U.S. corporation in the global marketplace. Take the recognition of post-retirement benefits. American business recognizes that we've incurred liabilities in promising these benefits. The problem is that some of our competitors abroad have an accounting system that doesn't require this recognition, so the cost of an employee looks much larger for us than it does for them. Regrettably, this can force a U.S. company to do some of its manufacturing in places where it doesn't have to recognize the liability for postretirement benefits.

On the other hand, harmonization shouldn't get us into lockstep. Accounting should reflect the realities of how we do business, and business is done differently in different countries. An accounting system that's too uniform throughout the world might fail to capture local realities.

For example, I don't believe that the recent agreement to set global standards for bank capital was a constructive step. By and large, this agreement forces American and japanese banks to account for capital as if they were European banks, which they aren't. But I'm a minority on that, bucking the tendency clearly shown by the SEC and the banking regulators.

In general, the accounting profession favors more compatibility among accounting systems around the world, and so do I-up to a point.

Another issue that reflects our social and economic values is the intergenerational transfer in wealth. This transfer of wealth has occurred not only through Medicare, Social Security, and other social programs, but also through high real interest rates, which have the effect of favoring older people at the expense of those who are in the household-formation stage of their lives. Over the last 10 years, we've witnessed the greatest transfer of wealth from the young to the old in our history.

This transfer is one reason for the lack of an honest federal budget in this country. The budget is an accounting embarrassment. Look at the flow of funds, which comes out quarterly from the Federal Reserve and shows how much the government actually borrows. Strange to say, the government always borrows more than the deficit it states. This suggests that the accounting for the deficit differs from the accounting for the borrowing requirement.

What burdens the economy, obviously. is not the deficit but the cash borrowing. This is definitely an accounting issue, something which the private sector will be caught up in sooner or later.

As you know, the city of New York went through similar difficulties about 10 years ago. One of the changes that emerged from that crisis was a more realistic grasp of the flow of funds, the true economics of the city and its government. I predict that the accounting profession is soon going to he drawn into the problem besetting the Federal government and society as a whole.

As we look into the 1990s and beyond, we clearly need to rethink our priorities. For 45 years, our priorities were based on ideology. From now on, they will be social and economic. But the U.S. has an infinitely responsive private sector. While life won't be perfect, we have the ability -the mechanisms-to bring about change.

This article is based on Mr. Reed's address before Financial Executives Institute's conference on current financial reporting issues in November.
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Title Annotation:economic policy
Author:Reed, John S.
Publication:Financial Executive
Date:Mar 1, 1991
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