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The National Interest
Surveying the Global Economy
A conversation with Carla Hills and Martin Feldstein
A few weeks ago in New York City, Carla Hills and Martin Feldstein sat with TNI editor Adam Garfinkle to discuss various aspects of the world economy. Here follows a transcription of that conversation.
The National Interest: May I begin, please, by asking each of you your view of what has happened, or not happened, since this past September 11 that may be described as out of line with the early post-attack expectations of economic analysts?
Martin Feldstein: After September 11 of last year, you will recall that stock markets collapsed, and the reason was obvious: People were afraid. Consumers worried that the U.S. economy would go into a tailspin, and businessmen worried that such expectations would create a self-fulfilling prophecy. In fact, the economy did very well. It has since slowed down, but this is part of a normal cyclical pattern. I don't think we can attribute very much to September 11 insofar as broad economic effects are concerned, and I think this does run contrary to many expectations at the time.
Carla Hills: Anticipations of damage may have been excessive, but security concerns continue to be a drag on the market. Companies are spending for protection, an expense they had no idea would be needed before last September 11. The congestion at our borders, north and south, has had an adverse effect on some sectors, too. Many believe—indeed, the administration has said explicitly that it believes—that another strike is highly likely. This makes the market quite jittery, and this is not about to go away.
TNI: Let me ask this as an addendum: Had the war in Afghanistan not gone as swiftly and successfully as it did, do you think it would have made any difference? In other words, would a general lack of confidence in the conduct of the war against terrorism have translated psychologically into a greater lack of confidence in the economy?
MF: Good question, but it's very hard to say.
CH: It is, indeed, hard to say, but I think we need to keep in mind that the war on terrorism is not over with the campaign in Afghanistan. Clearly, large numbers of bright and thinking people are concerned about the road ahead. Their concerns enter into how the government plans its budget, and into the planning of both companies and individuals. It affects the countries that they will invest in and a host of other decisions. So, yes, there is a link between how people perceive the war on terrorism to be going and their economic decisions on a range of issues and levels. But as Marty suggests, tying down the details of the relationship is very difficult.
East Asian Prospects
TNI: Let's tour the world, shall we? Japan is still, I believe, the world's second-largest economy—unless one counts Europe's euro zone as a single economy (which I, as a Euroskeptic, do not—at least not yet). And the Japanese are having great difficulties getting out of their protracted recession. Why has it proven so difficult for them to shake their problems?
MF: The Japanese lack the political ability to tackle the restructuring that they need to undertake. They lack the political wherewithal to put funds into a restructured banking system—if indeed they could summon the courage to restructure it. And many large non-financial companies, especially in construction and retailing, also need to be foreclosed or restructured. At the same time, the Bank of Japan is trying unsuccessfully to provide stimulus to the system. It has driven interest rates down; indeed, short-term interest rates are down to virtually zero and the longer-term rate is just one percent. But the banks aren't lending because they are afraid to take the risk, as they see it, of lending additional money while the economy is at a standstill and many businesses are insolvent. In sum, then, the Japanese can't deal with their long-term restructuring problems, and they can't achieve the short-term cyclical turnaround that they need to stop prices from falling and to start creating more jobs.
CH: I don't disagree.
TNI: Let me press a little further on the particulars of the political aspects of this problem. Banks will be banks, and consumer psychology, as ever, remains something of a mystery, and that explains, as you suggest, some of Japan's problems - especially its shorter-term ones. But how much of the seeming structural paralysis has to do with the relationship between the ruling LDP (Liberal Democratic Party), the large industries and the ministries that deal with them, and the banks?
MF: Yes, ultimately, there are a lot of industries that are very well connected with the LDP—and the politicians, who benefit in many ways from these connections, are unwilling to force bankruptcies upon those industries. That, in turn, contributes a lot to the problems that the banks have, and it helps explain why stimulus policies emanating from the Bank of Japan do not have the impact they otherwise might. Moreover, if Japanese policymakers took the right kinds of fiscal actions, by reshaping the tax system, they could stimulate the economy. That would make it possible to deal with the long-term problems—so we should not separate sharply what we call short-term and long-term problems.
TNI: Let's move on to China. China has acceded to the WTO and now faces a series of adjustments, some easy and some that pose very difficult dilemmas for them. They have a schedule against which to make those adjustments. How are they doing in the early going, and what would you project would be their course?
CH: China has made enormous progress in recent months. They've enacted thousands of new laws and regulations, and published many of them. This may not seem to some like a major event, but this makes China as a WTO member very different from the China that existed before the WTO. They have a great deal more to do. As you say, the challenges before them are tremendous. Their banking system is carrying huge amounts of non-performing loans that have been made to state-owned enterprises. Some state-owned enterprises have been privatized but many are still getting loans that will never be repaid in order to make products that are neither wanted nor needed. That is because state-owned enterprises continue to provide employment to people who otherwise would be left out of China's continuing surge of economic growth. China needs to create about 30 million jobs to absorb the unemployment that will be caused by the restructuring that the government has promised. If that does not sound daunting enough, consider that about 10 million Chinese enter the workforce every year. So they have a huge challenge before them.
Moreover, the Chinese have not yet developed a safety net to provide pensions and protections for those who are laid off; that is another reason why it is so difficult and potentially so unsettling politically to privatize the state-owned enterprises rapidly. These enterprises have traditionally supplied what social safety net that does exist. But reforming too slowly has adverse implications, too - not least for a banking system that, as I just said, suffers from too many politically-directed loans to economically deficient enterprises.
China also faces an enormous problem with rural unemployment and poverty, which is truly grinding. The rural sector is not only growing at a much slower rate than the urban sector, it is actually declining. That is why China has an estimated floating population of about 150 million - people who have left farms in search of work in the cities - and it is why the urban-rural gap is growing rapidly. It is in the countryside then, not surprisingly, where we are seeing a rising tide of protests and uprisings against local authorities.
So China has an enormous challenge before it, but it has made tremendous progress, and it is clearly a different country than it was a decade ago. Changes on such a scale take time; we need to continue to work with China, in my view—patiently and for as long as necessary—because these changes, whatever their temporary side effects, are as positive for the United States as they are for China and East Asia.
TNI: Let's talk for a moment about the impact of these changes in China on the rest of Asia, especially Southeast Asia. As I understand it, the huge size of China's poor population suggests that China will maintain a competitive labor wage advantage for a long time. This worries countries such as Indonesia, Malaysia, Thailand and others; they fear that there is no bottom to China's capacity to be a production platform—to make things cheaper than everybody else—and, hence, to capture export markets more effectively than everybody else.1 Are these worries justified?
MF: There are really two issues here. First, not only is the size of China not a handicap—after all, China has been growing at about 6-8 percent a year for the past many years—but the potential of China as a market is a major factor. Foreign businesses value their positions in China not just because wages are low, but because the market is enormous.
Now, with respect to the fears of their neighbors, I also hear that a lot when I am in Asia. And it is true, the Chinese will end up making some things now being made in Thailand or Korea; but they're not going to make everything, and the Thais, Indonesians, Malaysians and others have their own relative advantage. They will remain major exporters.
CH: We should remember, too, that China's economy is not static. In those sectors where they are competitive, as they grow and become more productive, there will be an increase in wages. You see that already in the coastal regions, which are becoming, relatively speaking, quite wealthy. The seemingly endless supply of low-wage workers is, in large measure, in the interior of the country; but what is being produced there is not in competition with, for example, what is made by a comparable factory in South Korea. South Korea's industry is way up the value-added chain from that.
I tell my friends in Southeast Asia that, were they to band together in an effective ASEAN Free Trade Agreement, they would do themselves a big favor. With 500 million people, they would be a much more attractive target for investment and a much more efficient region for combined production—both for regional markets and for export beyond. The point is that they should not just stand still and whine about China; they should take positive action to enhance their competitive edge.
Atlantic Static
TNI: I've been talking lately with a lot of Europeans, and every time we discuss American policy, they raise the steel tariffs and the farm bill and commence to lecture me, as their token captive-audience American, about the specter of American protectionism. I find these chidings a little odd, for two reasons. First, because I remember reading an article by Mickey Kantor—one of your Democratic successors, Carla—just after the steel tariffs were announced saying that the tariffs were a good idea, and that worried me. Second, in terms of protectionism aimed against poorer countries, aren't the EU-member states worse than the United States in many respects?
CH: I take your point. I have trouble defending the decision on steel—and the farm bill, too—on economic grounds. But politically, I understand the tremendous pressure put by Congress on the administration to do something about steel. You know, it's remarkable that after we declared that we would take a safeguard action—which is provided for in the rules of the World Trade Organization—we actually ran into short supply for our own users. So, it hasn't worked to our nation's overall economic interests.
The good news is that a safeguard is temporary—three years maximum. And, we will be forced to explain our rationale in a case that is being brought to the WTO by a number of countries. Were a panel to set it aside then, of course, we would abide by the ruling. Then the administration could say to the steel industry that it tried.
TNI: Do you think the administration expects an adverse WTO ruling?
CH: Well, let's just say that there are many trade experts who have written on this subject, and they are not confident that we will prevail.
TNI: I see. Well, let's not leave the Europeans quite yet. Of the many substantive deficiencies of journal editors in this field, economic literacy seems to be prominent among them. I certainly include myself. I cannot understand how the euro zone will work in the future. If there are such significant differences among the countries that are part of the euro zone, how can a single interest rate and a homogenous monetary policy make sense?
MF: Adam, you may not be an economist, but your difficulty in this respect is widely shared. There will be essentially one interest rate in the euro zone, since there is only one currency. There will be only one monetary policy. There will also be, therefore, only one exchange rate. And especially as the number of countries in the EU increases, it becomes more and more difficult to see how the same policy can be appropriate for all of them.
My European friends immediately reply: "You Americans have fifty states with economies as different as Alaska and Florida, and yet you have a single currency; so why can't we, with a smaller number of states, have a single currency, too?" To them, I say that the U.S. economy is very different from the European economy. One of the things we have going for us is that we all speak the same language, so that when demands slump in my own home state of Massachusetts, for example, people stop coming to Massachusetts, and people in Massachusetts start moving to places where the jobs are plentiful. But Europeans will not as readily move from Portugal to Germany, even if the Germans were willing to let them come. So, that's a major difference that is a real handicap for them.
A second difference is that our labor market is much more flexible than the European market. When a region in the United States sees a slump in demand for its product, instead of a large rise of unemployment locally, we see wages adjusting in that part of the country relative to what they are elsewhere. That provides a basis for employers to stay in production in that area.
And there's a third factor, which is that we have a centralized fiscal system. What that means in practice is that if demand falls and incomes fall in Massachusetts, say, then the taxes that flow from Massachusetts to Washington go down and the benefits that come from Washington to Massachusetts go up. As it happens, it's about forty cents on the dollar; that is to say, if the GDP in Massachusetts declines by a dollar, the net transfer to Washington declines by forty cents. That's a big stimulus to the Massachusetts economy. There's nothing like such a system at this point in Europe.
So while they have at least as much of a potential problem with a "one-size-fits-all" monetary policy as we do, they lack these three advantages that we have to help us cope: a common language; flexible wage-adjustment capabilities; and a centralized redistributive fiscal system. So, I think, as you do, that at some point they will get into trouble. At a minimum they will see more cyclical unemployment than would otherwise be the case. I suspect also that the European Central Bank, in the long run, will have a different attitude about inflation than the Bundesbank. The creation of the euro zone may have been good politically for moving forward with the European Union ...
TNI: ... and they did derive some one-time advantages from it, I think.
MF: That's right; but from a strictly economic point of view, they are liable to run into some fairly serious problems ahead.
CH: Yes, and I think it's worth pointing out that each country also gave up, to a certain extent, its own independent fiscal policy. Take Germany. Not only did it give up its independent monetary policy, but as it bumps up against the three percent EU deficit limit, it cannot use fiscal measures to stimulate growth. Usually, a country uses either monetary or fiscal policy to stimulate flagging economic growth. Moreover, the countries that need the stimulation usually have a debt burden that works as an additional inhibitor. So national governments in Euroland are pretty much without a tried and true economic policy to help them through rough waters.
TNI: Marty, you mentioned the fact of a single exchange rate. This also baffled me. Obviously, some economies in Europe are more export-dependent than others. A relatively weak euro would tend to help exporters, while a relatively strong euro would make imports cheaper and help consumers. The exchange rate, then, has a certain political quotient. So it matters who gets to decide the rate, doesn't it?
MF: I don't think any particular country is going to get control of the rate. The market will set the exchange rate between the euro and the dollar and the yen. But it's still true that fluctuations in that exchange rate are going to be more significant in some countries than in others, and that does have political implications. Countries in Europe that have extensive trade outside the euro zone will be much more affected than countries that trade mostly within Europe.
Dollarization and the Western Hemisphere
TNI: Since we're speaking of a new currency bloc, let's turn now to our own hemisphere where the question of dollarization has been much discussed in recent years. Given what's happened in Argentina lately, these formerly theoretical discussions seem to have been reshaped by events. How would you characterize the problems in Buenos Aires, and what connection do they have to the dollarization debate?
MF: Argentina is really an example of a country that fixed its exchange rate relative to the dollar, but without actually adopting the dollar as its currency. That was also a problem in Southeast Asia in 1997-98; it contributed fundamentally to the Thai problem and to a certain extent to Korea's problem. But those countries wised up and shifted to a floating exchange rate, as has Brazil, as has Mexico. By 2001, therefore, Argentina was odd man out in sticking to a policy that was very helpful a decade ago in bringing inflation under control, but it lacked an exit strategy back to a floating exchange rate - which they probably should have done five years ago when things were going well.
True dollarization, which they have not done, would mean not simply making the peso convertible to a dollar on a one-to-one basis, but eliminating completely the peso so that the Argentine people and businesses use the dollar as currency. And that makes no sense at all for an economy whose main trading partners are Brazil and Europe. It means that if the dollar strengthens relative to the euro, Argentina is in trouble. If the Brazilian real devalues relative to the dollar, Argentina is in trouble, too. So, it doesn't make sense for them, and that was why the debate to which you have referred ended as it did.
TNI: What, then, was the rationale for those proposals in the first place? Just to control inflation, or was there some other rationale?
CH: It is more than just inflation control. Ecuador also has adopted the dollar. Ecuador was under terrible financial stress and, by doing that, I think it offered them a new beginning, a new chapter in their economic story.
TNI: Agreed, but how do you get out of it once you no longer need the confidence that dollarization brings? How does Ecuador in future avoid the mess that the Argentines got themselves into?
MF: If a country has literally adopted the dollar, it is a problem. But it's a limited problem; sovereign nations need only a printing press to introduce a new currency. So Ecuador could in principle bring back its own currency at some time in the future.
The Russian Front
TNI: Let's talk about Russia for a minute or two. China is in the WTO, but Russia still isn't, and one of the items on the agenda of U.S.-Russian policy today is a cluster of economic issues: from the importation of chicken parts to declaring Russia a market economy to the rescinding of the Jackson-Vanik amendment. Also, when I was in Russia recently, I was struck by the contradiction between the Russians telling us, on the one hand, that they want more American and other foreign direct investment, especially in their energy sector, and, on the other, their inability to establish legal and business structures, not to mention a debt market, that would make more investment possible. When this contradiction is raised, many Russians point to the Duma and, as often as not, throw up their hands and shake their heads. You said earlier that China is headed in the right direction; is Russia as well?
CH: We should be encouraged by the reforms that President Putin has put in place. Both Europe and the United States have now designated Russia as a market economy. The benefit of doing this is that it puts pressure on a government to move in the right direction, and that's important because the cycle you mentioned is absolutely true: business people go to climates that are predictable and hospitable, and the more they go there and create a constituency, the more predictable and hospitable the climates tend to become.
You laugh when you describe Russians who are frustrated with the Duma, their legislative branch. But how often do many of us wish that our Congress would pass laws that we think are needed with alacrity and with intelligence?
Reforming the WTO
TNI: Yes, well said. Let's move on to a functional issue. We have discussed the implications of China's joining the WTO, and U.S.-European Union conflict in that arena as well. We know that off to the side of those matters there have been pressures brought to bear concerning the operation of the WTO itself. The anti-globalization crowd, but others as well, have raised the question of the WTO's decision-making transparency. Is there a need for reform of the WTO's modus operandi, and if so, at which sort of model should we be looking? Some have suggested, for example, that the WTO might function a bit like the U.S. Supreme Court, accepting representations from friends of the court, but still conducting its deliberations in private.
CH: Let me start with the value of the WTO. I think that the Dispute Settlement System is the jewel of the trading regime. If we didn't have a mechanism for resolving our disputes, we would be plunged into the economic version of the law of the jungle. Every complaint we register about a trading partner withdrawing trade benefits and raising tariffs because they have won a case before the WTO casts a negative light on the institution. But we need to understand that if we didn't have the WTO, our trading partners could do that and much more to harm American commercial interests. So, it's a huge benefit to us, as it is.
Can any institution be improved? Absolutely. And, of course, that includes the World Trade Organization. You speak of transparency. This is a legitimate issue, but it would not be wise to permit wholesale the presentation of amicus briefs. That would bog things down and allow an excessive politicization of the proceedings. But we could and should have rules governing the filing of briefs from those that have a demonstrated interest. These could help the WTO make its determinations. If the WTO's proceedings were open to everyone, regardless of pertinent interest, the organization simply could not function. The Supreme Court of the United States does not permit outsiders to sit in on its Friday afternoon deliberations. So, yes, there can and should be more transparency, but we should be very, very happy that we have the WTO. We should also remember that the United States is the most frequent user of the WTO and the most frequent winner - and although there are some high-visibility decisions that have disappointed us, we would be very, very much worse off without the WTO dispute settlement mechanism.
TNI: Somebody once told me that just the travel budget of the World Bank exceeds the entire budget of the WTO.
CH: Yes, that's right. The WTO is grossly under-funded for what it contributes.
TNI: How much of a budget boost might be required to have the WTO run at an optimal level?
CH: Well, any institution as underfunded as the WTO would be helped by any increase. But it's not the absolute amount that is so important, and it's not only about travel vouchers for its staff. One of the problems for the developing world is that many of these countries lack the technical capacity to deal with some trade issues—either to frame them during negotiations or to deal with differences that arise with their trading partners. It would be extremely helpful to the global economy if the WTO were to have a capacity to provide such assistance to the poorest nations.
The Doha Round, Development and the Virtuous Circle
TNI: Let's talk about trade policy more generally. I read recently of various estimates of how another round of trade liberalization—it's called the Doha round, is it not?...
CH: ...sometimes the Doha round, sometimes the Development round or the Millennium round....
TNI: Right. That there are so many names probably points to how inchoate it all is at this point. Anyway, there are figures being bandied about concerning how much of an increase in global GDP we might see from new advances in trade liberalization, especially liberalization that would affect the developing world's ability to export foodstuffs and textiles and shoes and things like that? Are these just guesses? What estimates are credible?
CH: Well, those figures aren't just guesses. There are several groups—one in Australia, for example—that have analyzed the economic effects of the Uruguay Round (the last, eighth round of talks), and other groups are making projections now. The benefits are in the billions of dollars. Of course, to get good estimates we have to specify what we are liberalizing. But your reference to the developing world is to the point. The developing world is badly hurt, and the least developed nations are the worst hurt, by the trade restrictions imposed on them by the industrialized countries. Certainly, in agriculture and in textiles, particularly at the lower end, we have very high protections in our country, as do the Europeans, the Japanese and the Koreans. This is heavily detrimental to the world economy as a whole.
You see particular examples of this harm done to Latin America today, and our national interests as well as theirs are adversely affected. We don't want Latin American countries to send us cocaine, but we won't buy their roses or their orange juice or their agricultural products or their textiles. By insisting on the maintenance of such restrictions, we force their farmers into the production of illicit items that cause us great harm.
We need to do a better job of informing the world and our own public as to the benefits of trade. It is true that when we remove our trade barriers to low-wage countries, the least-developed countries, they do sell us more products. But it is also true that with the currency they earn, they buy more from us. This creates a virtuous circle that benefits our economy tremendously. But this is not readily understood. All that seems to be recognized is that when we lower our barriers, these countries sell more to us, which affects our balance of trade and threatens some American jobs, and we forget the enormous benefits we receive.
TNI: Isn't it also true that when people worry about the loss of relatively low-skill jobs in the United States, they're really worrying overly much, because those jobs have left us a long time ago. Isn't it so that what we have seen in recent years is the displacement of one overseas country for another, rather than a massive loss of more jobs in the United States?
CH: That's a macro-analysis, and it is correct as far as it goes. But if you are the person who holds one of the remaining low-skills jobs on a micro level, you're very unhappy when a more competitive foreign product displaces you. Those who are directly affected are very unhappy and nervous about the next wave of change. So there's a high degree of anxiety in our country with respect to trade, globalization and open markets for capital, goods, and services. I think we have to do a better job not only in explaining the benefits of trade to the economy as a whole, but also do a better job trying to figure out how to raise the skill levels of those who are displaced so that they can move into sectors that provide higher pay, better benefits and greater security. The benefits of trade are great. Trade is truly the bedrock of our prosperity. But if we don't find a way to bring along those who may be displaced, we'll lose the national consensus that supports our nation's leadership in opening markets.
Energy Prices
TNI: If trade liberalization can help the global economy, we should also mention a factor that might harm it: an energy crunch. I have seen lately several projections of what oil prices might be over the next few years, out to a decade. Many people in the oil industry argue something like this: We have been living for the past decade or so on wells that were developed in the 1960s and the 1970s, while in most of the 1980s and the 1990s the industry was investing at something like 20 percent of the rate of the 1960s and 1970s. The reason is that prices were mostly soft and the investment climate in geologically promising areas has not been hospitable. As a result of this dearth of investment, they say, the rough balance of supply and demand we have witnessed in the 1990s will give way to shortages and price increases. Many industry analysts believe that prices will rise fairly substantially in the next few years, and that if substantial new investment is not forthcoming soon, high prices will predominate for a long time. That, of course, would put a whole different spin on the prospects for global economic growth. Since such projections have been made in the past and have been proven wrong, what do you make of these new analyses?
CH: The oil companies must go where the oil is located, and that very often is not a hospitable climate. They also have a five- to eight-year capital outlay before they achieve a return, and they cannot know exactly what the politics and investment climate will be in the future. But as you say, in the mid-1970s, our intelligence agencies were telling us that we were going to run out of oil by the 1990s. Frankly, there are markets opening up all the time. We are integrating Russia into the world economy and newly found reserves are being announced regularly. Also, new technologies are being developed, and we will have mechanisms for producing energy that did not exist in the past.
MF: That's a very important point: thanks to technological advances, we're getting a lot more oil out of the same wells than we did before. I think we will see Mexico become a larger supplier and, with any luck at all, as Carla said, Russia will become a very major supplier as well.
I think we also have to give credence to market signs. Certainly, there's nothing in the futures market for oil that suggests that people who are investing in those markets believe that there will be major increases in the benchmark price anytime soon. Moreover, if energy experts really believed that - if the consensus really was that the price was going to go to, say, $30 to $35 per barrel - the producers would pull back on their production now in order to get that higher price in the future, and the price would go up now. So the fact that the price is where it is today is in itself, to some extent, a forecast about the future.
TNI: Let me pose a related question: Is it ever appropriate for the United States government to try to insure or in some other way protect investments in the energy sector from risky projects in politically unstable places? The Baku-Ceyhan pipeline is a great example of such a case. Many people have wanted that pipeline built for a variety of political and strategic reasons, but the United States government has until now turned away from the idea of subsidizing it. And since the people who build pipelines and do other things in the energy business have pretty sharp pencils, they will only build it if they think it is financially viable. So far, they don't think it can be. Should the U.S. government ever distort the market, as it were, for national security reasons?
CH: No. Having a reliable energy source is in our national interest, and so the government should craft an energy policy that maximizes the possibilities of creating that reliability. Providing a subsidy is a different thing, however. One of the reasons why some pipelines are not developed is because they're not needed now.
TNI: They're not economically viable, in other words.
CH: Yes. They don't provide adequate returns to cover the risk. But if they are needed, the returns will go up, and at a certain point the incentives will become sufficient to cause the line to be built.
The Corporate Governance Crisis
TNI: There has been much comment in recent weeks about what has been called the crisis of corporate governance in the United States. From the examples of Enron, Adelphi, WorldCom and other apparent cases of a lack of integrity in high business places, media pundits (and some others) have declared a crisis, some claiming that dishonest high-rollers have done more harm to the American economy than that ever done by terrorists. How serious is all this, really? What are the implications, if any, for the world economy?
MF: The problem of inadequate corporate governance and improper accounting is certainly serious but not comparable to the effects of terrorism and potential future terrorism. Our economy depends on a healthy capital market and capital markets can only function well where investors have confidence in the data that are reported by firms. Corporate accounting in America has been regarded as better than accounting in other countries. This has given the American economy the advantage of a lower cost of funds. The recent discussion about the problems of U.S. corporate profit reporting now weakens American markets relative to those of other countries. That is hurting the dollar and U.S. equity markets. In my judgment, the weakness of American corporate reporting is exaggerated on the basis of a few egregious cases. With time, accounting standards and governance procedures will be stronger for all.
CH: I agree that, without question, there has been real harm. The cases cited in your question, Adam, and others, have indeed caused investors to lose confidence in our corporate governance system, and yes it has adversely affected our stock market and contributed to the weakening of the dollar. While ours is still the most respected capitalist system in the world, we must recognize that there are aspects of it in need of overhaul. I believe that we can build on what we have, making it even stronger. For example, I believe that the audit function must be substantially strengthened. The recent spate of problems show audit partners yielding to management pressures to inflate earnings. To improve the quality of audits, independent directors must have and must exercise much greater authority over the audit. Audit committees (not management) should have the power to hire and fire the auditors. They should insulate outside auditors from pressures from management. The New York Stock Exchange could require as a condition of listing that audit committees make a serious evaluation of the external auditors at regular intervals, say every four years. At such evaluations, independent expertise could be used to assist the committee in judging the competence and the independence of the auditors' work. Committee members could ask whether the audit partner has in fact exercised judgment as to whether the company's financial statements present the company's financial position in the fairest fashion and determine, where appropriate, whether the audit partner has explained to the audit committee any alternative ways in which estimates or assumptions could be made. Under this proposal, the audit committee would have an affirmative obligation to determine whether it was in the shareholders' interest to renew the external auditor contract.
I believe this approach is far superior to the mandatory rotation of outside auditors that some have suggested. Mandatory rotation gives the new audit firm a pass for the first two years because, under most circumstances, no one can tell how good or bad the audit is until well into the second cycle. And for the last two years of the audit firm's engagement, the fact that replacement will occur no matter what reduces incentives for the audit firm to be candid and careful, and for the audit committee to press for a replacement that will occur shortly in any event. Thus, mandatory rotation would have the perverse effects of immunizing the audit firm from being replaced and reducing the authority of the audit committee over the external auditors, whereas a four year evaluation system would maintain appropriate incentives for both.
TNI: I have one final question for you, Carla. Do you talk much these days with Bob Zoellick? What do you talk about?
CH: I have talked to Bob, yes. He's very bright and very strategic in the way he thinks about trade. I think he's doing a very good job under very difficult circumstances. Do we talk daily on policy? No. He doesn't begin to have the time, nor do I. But on issues like trying to ensure that the administration gets fast track authority, yes, we have talked. And I've talked to other people in the agency, where I think I can be helpful.
TNI: That's good to know; I'm sure you have been helpful. You certainly have helped me improve my grasp of these issues, and so have you, Marty. I thank you both.