It is interesting that, just a few years ago, strong countercyclical policy actions of the type taken by Korea would not have been recommended for an emerging market country during a period of crisis, and might not even have been feasible. In earlier crises, foreign investors were not inclined to give emerging market policymakers the benefit of the doubt when they promised low inflation and sustainable fiscal policies. Attempts to support economic activity through conventional expansionary policies thus risked a vicious circle of capital flight, exchange rate depreciation, higher inflation, a worsening balance of payments, and more capital flight. As a result, monetary policymakers in emerging markets often reacted to crises--such as the Asian financial crisis of the late 1990s--by raising rather than lowering policy rates, in order to defend the value of the currency, slow capital flight, and bolster the credibility of monetary policy. Likewise, the scope for fiscal expansion was severely limited by concerns about medium-term fiscal sustainability.

Why was this crisis different? In particular, why was the Bank of Korea able to respond in a countercyclical manner this time, reducing rather than raising the policy rate in response to the downturn? One important difference, of course, was that this crisis originated in advanced economies, not in the emerging market economies. Financial institutions in Korea and other emerging market economies had little direct exposure to structured credit products and other troubled securities and entered the crisis in relatively sound condition.

In addition, following the Asian financial crisis in the late 1990s, Korea and a number of other countries in Asia, Latin America, and elsewhere took decisive steps to strengthen their macroeconomic frameworks and financial systems... 

Improvements in the Bank of Korea's monetary framework served the country well during the crisis and are likely to provide additional benefits in the future. Over the past decade, many emerging market economies, including Korea, have reoriented monetary policy toward domestic price stability and away from a focus on stabilizing exchange rates. The Bank of Korea, indeed, adopted a formal inflation targeting regime in 1998. Since then, the exchange value of the won has become more flexible, inflation has declined to an average of about 3 percent, and--as I have discussed today--the ability of the Bank to conduct appropriate countercyclical monetary policies has increased.

As a final thought, I counsel policymakers and market participants alike to remember that no two crises are the same.  Recall that the Asian crisis of 1997-98 actually manifested itself differently across Asian countries, with each country having its own set of problems and needing to find its own solutions.  In other words, there is never a single remedy to each crisis and each brings its own surprises and risks.  Clearly, we can all learn a lot from past crises--which is the value in holding conferences like this one.  But we should not assume that past remedies will fully solve the next set of problems or address all future risks.  The key is to take lessons from the past and tailor them appropriately to future situations of potential distress.

Faced with the challenges of managing policy in an increasingly integrated world economy, the dominant instinct of officials is often to try to shield the economy from volatility.  But the crises of the 1990s helped demonstrate why this approach can be both futile and counterproductive...The more promising approach is to invest in the complement of institutions and policies that enable an economy to live more comfortably with openness.  Focusing on those measures that will enable an economy to be more flexible and to adapt more quickly to change ultimately will be a more effective policy strategy.  It is politically more difficult, but economically more effective than those solutions that seem to offer protection from competition and volatility.

For example, let's recall what happened with U.S. monetary policy beginning in the latter half of 1998. At this time, we were well into the turmoil that began in Southeast Asian economies the summer before. In September 1998, the Federal Open Market Committee informally convened via telephone for an unusual pre-FOMC meeting discussion regarding the unsettled nature of financial markets. At the formal FOMC meeting soon afterward, the Committee cut the federal funds rate target, followed by two additional cuts in October and November. In each case, the record makes clear that the Committee's decisions were greatly influenced by the unusual strains in financial markets.

Today, despite China’s recent successes, it still shares some of the vulnerabilities faced by the Asia crisis countries in the 1990s. For example, although it has made significant progress in reforming its banking sector through reducing nonperforming loans, the government still has a degree of influence in Chinese bank lending decisions, and some have expressed continuing concern over the health of the banking sector.

While China has increased the flexibility of the renminbi, permitting it to appreciate by 6.5 percent against the dollar since it was officially unpegged in July 2005, it is still much less flexible than the currencies of the Asia crisis countries. The central bank has resisted pressures for more rapid appreciation of the renminbi by intervening in the foreign exchange market and building up its holdings of foreign reserves. Limiting appreciation of the currency in this manner complicates the use of monetary policy to produce an orderly slowdown in China’s currently booming economy.

As an emerging leader within the region, China could also play a major role in promoting regional exchange rate flexibility. For example, Thailand’s Finance Minister recently argued that his nation’s economic conditions would be helped by a faster pace of renminbi revaluation. If China were to move more quickly, it could well encourage even greater exchange rate flexibility among the East Asian fledgling inflation-targeters, as they would be able to pursue their goal of reaching price stability without losing export competitiveness.

It is hard to look at this record and find support for the argument that the financial resources deployed by the IMF and the major economies in the crises [in the 1990s] produced a damaging degree of moral hazard—moral hazard in the form either of governments more prone to profligacy or investors prone to excess risk-taking in lending to banks and sovereign in emerging markets because of the expectation of financial resources from the IMF. Of course, those interventions must have produced some increase in moral hazard, but the effect on incentives does not seem to have been powerful relative to the countervailing effect of the economic and financial losses incurred in the crises.

We are approaching the 10-year anniversary of the financial crises of 1997-99. Those crises were remarkable both in the scope of countries and markets they affected, and for their speed and severity. The circumstances leading up to the crises varied across countries and regions, as did the magnitude of the resulting damage to the real economy. But each of these events had one dynamic in common—the confluence of a sharp increase in risk perception, and the subsequent actions taken by financial institutions and investors to limit their exposure to future losses.

Thus, the question emerges; can the Federal Reserve respond to "financial crises" in the same way that it responded to "banking crises" in the past?

My own view is that the Federal Reserve now has less flexibility in responding to crises as this relates to its operation of the discount window. Historically, the discount window has been the Federal Reserve’s principal facility for providing liquidity in times of crisis. Indeed, going back to the 1980s and early 1990s, the Federal Reserve provided extensive lending through its extended credit program to banks experiencing prolonged liquidity problems. Going forward, however, the discount window is less likely to be used for several reasons.

First, use of the window is now circumscribed by the provisions of FDICIA designed to minimize FDIC exposure if the Federal Reserve lends to institutions that ultimately fail. Second, banks have become reluctant to use the window in normal times and so may not be willing to approach the window in difficult times for fear of signaling changes in their condition. Third, to the extent that crises now originate outside the banking system, nonbank institutions do not have direct access to the discount window to meet their liquidity needs.

In the current circumstances, we need to be aware that monetary policy tightening actions in the United States could have outsized effects on very sensitive financial markets in Asia, a development that could have substantial adverse repercussions on U.S. financial markets and, over time, on our own economy. But while we must take account of such foreign interactions, we must be careful that our responses ultimately are consistent with a monetary policy aimed at optimal performance of the U.S. economy.

Should the situation abroad remain unsettled, these factors would probably continue to contribute to good price performance in the United States in the period ahead. But it is important to recognize that the damping influence of these factors on inflation is mostly temporary. At some point, the dollar will stop rising, foreign demand will begin to recover, and oil and other commodity prices will stop falling and could even back up some. Indeed, a brisk snap-back in foreign economic activity, should that occur, would add, at least temporarily, to price pressures in the United States.

Another theme that emerges is liquidity risk. A fundamental assumption of many risk management procedures is the ability to get out of a position or to hedge it. Events in Asia demonstrated once again that assumptions about liquidity in normal markets rarely hold in more volatile ones. This argues both for a reassessment of the assumptions themselves and for more careful and fundamental thinking about liquidity risk in risk management procedures.

The key question going forward is whether the restraint building from the turmoil in Asia will be sufficient to check inflationary tendencies that might otherwise result from the strength of domestic spending and tightening labor markets. The depth of the adjustment abroad will depend on the extent of weakness in the financial sectors of Asian economies and the speed with which structural inefficiencies in the financial and nonfinancial sectors of those economies are corrected.