Greenspan on Deficits
Brian Trumbore
President/Editor, StocksandNews.com

Following are excerpts from an important speech given by Federal Reserve Chairman Alan Greenspan to a banking conference in Frankfurt, Germany on November 19, 2004.

U.S. markets moved sharply lower when details emerged, as the chairman addressed the issue of soaring deficits and American reliance on foreigners to finance it. While the overall theme echoes sentiments long expressed by market and economic strategists, coming as it did from Greenspan sent a clear signal there is concern a monetary crisis could occur sooner than later.

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"Foreign exchange trading volumes have grown rapidly, and the magnitude of cross-border claims continues to increase at an impressive rate. Although international trade in goods, services, and assets rose markedly after World War II, a persistent dispersion of current account balances across countries did not emerge until recent years. But, as the U.S. deficit crossed 4 percent of GDP in 2000, financed with the current account surpluses of other countries, the widening dispersion of current account balances became more evident. Previous postwar increases in trade relative to world GDP had represented a more balanced grossing up of exports and imports without engendering chronic large trade deficits in the United States, and surpluses among many other countries.

"Home bias - the propensity of residents of a country to invest their savings disproportionately in domestic assets - prevailed for most of the post-World War II period?.

"That bias, however, diminished rather dramatically over the past ten years, arguably in large measure because of the acceleration in productivity growth in the United States. The associated elevation of expected real rates of return relative to those available elsewhere increased investment opportunities in the United States?.

"Basic national income accounting implies that domestic saving less domestic investment is equal to net foreign investment, a close approximation of a nation's current account balance. The correlation coefficient between domestic saving and domestic investment varies inversely over time with the dispersion of current account balances across countries. Obviously, if the correlation coefficient is 1.0, meaning that every country allocates its domestic saving only to domestic investment, then no country has a current account deficit, and the variance of world current account balances is zero. As the correlation coefficient falls, as it has over the past decade, one would expect the near algebraic equivalent - the dispersion of current account balances - to increase. And, of course, it has. Over the past ten years, a large current account deficit has emerged in the United States matched by current account surpluses in other countries?.

"Current account imbalances, per se, need not be a problem, but 'cumulative' deficits, which result in a marked decline of a country's net international investment position - as is occurring in the United States - raise more complex issues. The U.S. current account deficit has risen to more than 5 percent of GDP. Because the deficit is essentially the change in net claims against U.S. residents, the U.S. net international investment position excluding valuation adjustments must also be declining in dollar terms at an annual pace equivalent to roughly 5 percent of U.S. GDP.

"The question now confronting us is how large a current account deficit in the United States can be financed before resistance to acquiring new claims against U.S. residents leads to adjustment. Even considering heavy purchases by central banks of U.S. Treasury and agency issues, we see only limited indications that the large U.S. current account deficit is meeting financing resistance. Yet, net claims against residents of the United States cannot continue to increase forever in international portfolios at their recent pace. Net debt service cost, though currently still modest, would eventually become burdensome. At some point, diversification considerations will slow and possibly limit the desire of investors to add dollar claims to their portfolios.

"Resistance to financing, however, is likely to emerge well before debt servicing becomes an issue, or before the economic return on assets invested in the United States or in dollars more generally starts to erode. Even if returns hold steady, a continued buildup of dollar assets increases concentration risk.

"Net cross-border claims against U.S. residents now amount to about one-fourth of annual U.S. GDP. A continued financing even of today's current account deficits as a percentage of GDP doubtless will, at some future point, increase shares of dollar claims in investor portfolios to levels that imply an unacceptable amount of concentration risk.

"This situation suggests that international investors will eventually adjust their accumulation of dollar assets or, alternatively, seek higher dollar returns to offset concentration risk, elevating the cost of financing of the U.S. current account deficit and rendering it increasingly less tenable. If a net importing country finds financing for its net deficit too expensive, that country will, of necessity, import less.

"It seems persuasive that, given the size of the U.S. current account deficit, a diminished appetite for adding to dollar balances must occur at some point. But when, through what channels, and from what level of the dollar? Regrettably, no answer to those questions is convincing. This is a reason that forecasting the exchange rate for the dollar and other major currencies is problematic?.

"U.S. policy initiatives can reinforce other factors in the global economy and marketplace that foster external adjustment. Policy success, of course, requires that domestic saving must rise relative to domestic investment. Policy initiatives addressing individual components of domestic saving in years past appear to have had significant effects on total domestic saving, even though changes in the individual components are not wholly independent of one another.

"Reducing the federal budget deficit (or preferably moving it to surplus) appears to be the most effective action that could be taken to augment domestic saving. Significantly increasing private saving in the United States - more particularly, finding policies that would elevate the personal saving rate from its current extraordinarily low level - of course would also be helpful. Corporate saving in the United States has risen to its highest rate in decades and is unlikely to increase materially. Alternative approaches to reducing our current account imbalance by reducing domestic investment or inducing recession to suppress consumption obviously are not constructive long-term solutions.

"It is of course possible that U.S. policy initiatives directed at closing the gap between our domestic investment and domestic saving, and hence narrowing our current account deficit, may not suffice. But should such initiatives fall short, the marked increase in the economic flexibility of the American economy that has developed in recent years suggests that market forces should over time restore, without crises, a sustainable U.S. balance of payments. At least this is the experience of developed countries, which since 1980, have managed and eliminated large current account deficits, some in double digits, without major disruption?.

"Although we have examples of the efficacy of flexibility in selected markets and evidence that, among developed countries, current account deficits, even large ones, have been defused without significance consequences, we cannot become complacent. History is not an infallible guide to the future. We in the United States need to continue to increase our degree of flexibility and resilience. Similar initiatives elsewhere will enhance global resilience to shocks.

"Many steps have been taken in the euro area to facilitate the free flow of labor and capital across national borders, and considerable progress is being made to enhance competition in product, labor, and financial markets. But more will need to be done in Europe as well as in the United States to ensure that our economies are sufficiently resilient to respond effectively to all the shocks and adjustments that the future will surely bring."

Brian Trumbore