This confidence is justified. But one of the consequences of the resilience of the system in the face of past shocks is a higher degree of confidence in a benign and stable future. And this confidence itself can increase the risk of future instability. It is critically important, then, that we continue to strengthen our financial system. The most important dimension of this challenge is to ensure that the size and the quality of the cushions maintained by financial institutions against the risk of adverse outcomes are sufficiently strong. This is particularly important in the case of the relatively small number of bank-centered financial institutions that now play a much more central role in our financial system. Their extraordinary size and diversity diminishes their vulnerability to shocks. However, it also exposes them to a broader array of potential shocks, and magnifies the potential damage to the system should one of these institutions stumble or fail. We need to ensure that the level of insurance these core institutions maintain against risk – insurance in the form of their capital and liquidity cushions, their operational resilience, and the quality of their risk management and control systems – are calibrated to reflect their greater systemic significance and the greater complexity of the challenges they face in managing more diverse businesses. This is true not only for the largest banks, but also for GSEs like Fannie Mae and Freddie Mac, and also for those non-bank financial institutions that play a critical role in the wholesale financial markets.
Global growth is reasonably strong and broad-based. Underlying inflation is low. Estimates of structural productivity growth in the United States remain high. The global economy has weathered the oil price shock and other recent shocks quite well. Most of the major emerging market economies look stronger than they have in some time. Overall volatility in output and inflation has moderated significantly in the United States and, to a lesser extent, in other economies as well. These favorable fundamentals are reflected in low risk premia of many forms - low credit spreads, low and quite stable inflation expectations, and low actual and implied volatility. Market participants appear to believe that future macroeconomic shocks will be more moderate, less frequent, and less damaging than past shocks have been. To say this another way, the price of insurance against a less benign world is now quite low. We face a number of significant challenges that threaten this positive outlook. I want to touch on the two that appear to me most important. The first is the growing imbalances at the center of the global economy. Fiscal policy in most of the major economies is on a path towards rising debt-to-GDP ratios; this trajectory gets dramatically worse as demographic changes reduce the ratio of workers to retirees. At the same time, external imbalances have reached unprecedented levels, most dramatically in the case of the U.S. current account deficit, which is on a path to exceed six percent of GDP. These imbalances – fiscal and external – cannot be sustained indefinitely.