Remarks by Chairman Alan Greenspan Cato Institute

["Gary Santos" <garysantos@xxxxxxxxxxxx>]

Remarks by Chairman Alan Greenspan
At the 21st Annual Monetary Conference, Cosponsored by the Cato Institute
and The Economist, Washington, D.C.
November 20, 2003
http://www.federalreserve.gov/boarddocs/speeches/2003/20031120/default.htm

Among the major forces that will help shape the euro's future as a world
currency will be the international evolution of the euro area's key
financial counterparty, the United States. I will leave the important
interplay between the euro and the dollar--and particularly forecasts of the
dollar-euro exchange rate--to more venturesome analysts. My experience is
that exchange markets have become so efficient that virtually all relevant
information is embedded almost instantaneously in exchange rates to the
point that anticipating movements in major currencies is rarely possible.1
I plan this morning to head in what I hope will be a more fruitful direction
by addressing the evolving international payments imbalance of the United
States and its effect on Europe and the rest of the world. I intend to focus
on the eventual resolution of that current account imbalance in the context
of accompanying balance-sheet changes.

I conclude that spreading globalization has fostered a degree of
international flexibility that has raised the probability of a benign
resolution to the U.S. current account imbalance. Such a resolution has been
the general experience of developed countries over the past two decades.
Moreover, history suggests that greater flexibility allows economies to
adjust more smoothly to changing economic circumstances and with less risk
of destabilizing outcomes.

Indeed, the example of the fifty states of the United States suggests that,
with full flexibility in the movement of labor and capital, adjustments to
cross-border imbalances can occur even without an exchange rate adjustment.
In closing, I raise the necessity of containing the forces of protectionism
to ensure the flexibility needed for a benign outcome of our international
imbalances.

* * *

The current account deficit of the United States, essentially net exports of
goods and services, has continued to widen over the past couple of years.
The external deficit receded modestly during our mild recession of 2001 only
to rebound to a record 5 percent of gross domestic product earlier this
year. Our persistent current account deficit is a growing concern because it
adds to the stock of outstanding external debt that could become
increasingly more difficult to finance.

These developments raise the question of whether the record imbalance will
benignly defuse, as it largely did after its previous peak of about 3-1/2
percent of GDP in 1986, or whether the resolution will be more troublesome.

* * *

Current account balances are determined mainly by countries' relative
incomes, by product and asset prices including exchange rates, and by
comparative advantage. To pay for the internationally traded goods and
services that underlie that balance, there is a wholly separate market in
financial instruments the magnitudes of which are determined by the same set
of asset prices that affects trade in goods and services. In the end, it is
the balancing of trade and financing that sets international product and
asset prices and global current account balances.

The buildup or reduction in financial claims among trading countries--that
is, capital flows--are hence exact mirrors of the current account balances.
And just as net trade and current accounts for the world as a whole
necessarily sum to zero, so do net capital flows. Because for any country
the change in net claims against all foreigners cumulates to its current
account balance (abstracting from valuation adjustments), that balance must
also equal the country's domestic saving less its domestic investment.

* * *

In as much as the balance of goods and services is brought into equality
with the associated capital flows through adjustments in prices, interest
rates, and exchange rates, how do we tell whether trade determines capital
flows or whether capital flows determine trade? Answering this question is
difficult because the balancing process is simultaneous rather than
sequential, so that there is no simple unidirectional causality between
trade and capital flows. For example, increased demand for dollar assets may
lower interest rates and equity premiums in the United States and thus
engender increased demand for imports. But the need for import financing may
raise domestic interest rates and thereby attract the required additional
capital inflows to the United States.

Nonetheless, as the U.S. current account deficit rose from 1995 to early
2002, so too did the dollar's effective exchange rate. Evidently, upward
pressure on the dollar was spurred by rising expected rates of return that
resulted in private capital investments from abroad that chronically
exceeded the current account deficit. The pickup in U.S. productivity growth
in the mid-1990s--the likely proximate cause of foreigners' perception of
increased rates of return on capital in the United States--boosted
investment spending, stock prices, wealth, and assessments of future income.
Those favorable developments led, in turn, to greater consumer spending and
lower saving rates.

The resulting widening gap between domestic investment and domestic saving
from 1995 to 2000 was held partly in check by higher government saving as
rising stock prices drove up taxable income. When, in 2002, that effect
reversed and the federal budget slipped back into deficit, and as the U.S.
economy emerged from its downturn, the gap in the current account balance
widened further. After contracting in the aftermath of the U.S. stock market
decline of 2000, private capital from abroad was apparently again drawn to
the United States in substantial quantities by renewed perceptions of
relatively high rates of return. In addition, during the past year or so the
financing of our external deficit was assisted by large accumulations of
dollars by foreign central banks.

* * *

Even before the productivity surge of the late 1990s, the United States had
become particularly prone to current account deficits and rising external
net debt because of the historical tendency on the part of U.S. residents to
import, relative to income, at a significantly higher rate than our trading
partners, at least for U.S. goods and services.2 If all economies were to
grow at the same rate, such differential propensities would produce an
ever-widening trade deficit for the United States and a corresponding
surplus for our trading partners, failing offsetting adjustments in relative
prices.

In the 1960s or 1970s, because our trading partners were growing far faster
than we were, a trade gap did not surface. When, in the 1980s, the
difference in growth rates narrowed while the dollar rose, our trade and the
associated current account deficits widened dramatically. By the late 1980s,
we had become a net debtor nation, ending seven decades as a net creditor.
While most recent data reaffirm our above-average propensity to import,
there is evidence to suggest that its magnitude has diminished.

* * *

There is no simple measure by which to judge the sustainability of either a
string of current account deficits or their consequence, a significant
buildup in external claims that need to be serviced. Financing comes from
receipts from exports, earnings on assets, and, if available, funds borrowed
from foreigners. In the end, it will likely be the reluctance of foreign
country residents to accumulate additional debt and equity claims against
U.S. residents that will serve as the restraint on the size of tolerable
U.S. imbalances in the global arena.

Unlike the financing of payments from export and income receipts, reliance
on borrowed funds may not be sustainable. By the end of September 2003, net
external claims on U.S. residents had risen to an estimated 25 percent of a
year's GDP, still far less than claims on many of our trading partners but
rising at the equivalent of 5 percentage points of GDP annually. However,
without some notion of our capacity for raising cross-border debt, the
sustainability of the current account deficit is difficult to estimate. That
capacity is evidently, in part, a function of globalization since the
apparent increase in our debt-raising capacity appears to be related to the
reduced cost and increasing reach of international financial intermediation.

The significant reduction in global trade barriers over the past half
century has contributed to a marked rise in the ratio of world trade to GDP
and, accordingly, a rise in the ratio of imports to domestic demand. But
also evident is that the funding of trade has required, or at least has been
associated with, an even faster rise in external finance. Between 1980 and
2002, for example, the nominal dollar value of world imports rose 5-1/2
percent annually, while gross external liabilities, largely financial
claims, also expressed in dollars, apparently rose considerably faster.3

This observation does not reflect solely the sharp rise in the external
liabilities of the United States that has occurred since 1995. For other
OECD economies, imports rose about 2 percent annually from 1995 to 2002;
external liabilities increased 8 percent. Less-comprehensive data suggest
that the ratio of global debt and equity claims to trade has been rising
since at least the beginning of the post-World War II period.4

>From an accounting perspective, part of the increase in finance relative to
trade in recent years reflects the continued marked rise in tradable foreign
currencies held by private firms as well as a very significant buildup of
international currency reserves of monetary authorities. Rising global
wealth has apparently led to increased demand for diversification of
portfolios by including greater shares of foreign currencies.

More generally, technological advance and the spread of global financial
deregulation has fostered a broadening array of specialized financial
products and institutions. The associated increased layers of intermediation
in our financial system make it easier to diversify and manage risk, thereby
facilitating an ever-rising ratio of domestic liabilities (and assets) to
GDP, and gross external liabilities to trade.5 These trends seem unlikely to
reverse, or even to slow materially, short of an improbable end to the
expansion of financial intermediation that is being driven by cost-reducing
technology.

Uptrends in the ratios of external liabilities or assets to trade, and
therefore to GDP, can be shown to have been associated with a widening
dispersion in countries' ratios of trade and current account balances to
GDP.6 A measure of that dispersion, the sum of the absolute values of the
current account balances estimated from each country's gross domestic saving
less gross domestic investment (the current account's algebraic equivalent),
has been rising as a ratio to GDP at an average annual rate of about 2
percent since 1970 for the OECD countries, which constitute four-fifths of
world GDP.

The long-term increase in intermediation, by facilitating the financing of
ever-wider current account deficits and surpluses, has created an
ever-larger class of investors who might be willing to hold cross-border
claims. To create liabilities, of course, implies a willingness of some
private investors and governments to hold the equivalent increase in claims
at market-determined asset prices. Indeed, were it otherwise, the funding of
liabilities would not be possible.

With the seeming willingness of foreigners to hold progressively greater
amounts of cross-border claims against U.S. residents, at what point do net
claims (that is, gross claims less gross liabilities) against us become
unsustainable and deficits decline? Presumably, a U.S. current account
deficit of 5 percent or more of GDP would not have been readily fundable a
half-century ago or perhaps even a couple of decades ago.7 The ability to
move that much of world saving to the United States in response to relative
rates of return would have been hindered by a far lower degree of
international financial intermediation. Endeavoring to transfer the
equivalent of 5 percent of U.S. GDP from foreign financial institutions and
persons to the United States would presumably have induced changes in the
prices of assets that would have proved inhibiting.

* * *

There is, for the moment, little evidence of stress in funding U.S. current
account deficits. To be sure, the real exchange rate for the dollar has, on
balance, declined more than 10 percent broadly and roughly 20 percent
against the major foreign currencies since early 2002. Yet inflation, the
typical symptom of a weak currency, appears quiescent. Indeed, inflation
premiums embedded in long-term interest rates apparently have fluctuated in
a relatively narrow range since early 2002. More generally, the vast savings
transfer has occurred without measurable disruption to the balance of
international finance. In fact, in recent months credit risk spreads have
fallen and equity prices have risen throughout much of the global economy.

* * *

To date, the widening to record levels of the U.S. ratio of current account
deficit to GDP has been seemingly uneventful. But I have little doubt that,
should it continue, at some point in the future adjustments will be set in
motion that will eventually slow and presumably reverse the rate of
accumulation of net claims on U.S. residents. How much further can
international financial intermediation stretch the capacity of world finance
to move national savings across borders?

A major inhibitor appears to be what economists call "home bias." Virtually
all our trading partners share our inclination to invest a disproportionate
percentage of domestic savings in domestic capital assets, irrespective of
the differential rates of return.

People seem to prefer to invest in familiar local businesses even where
currency and country risks do not exist. For the United States, studies have
shown that individual investors and even professional money managers have a
slight preference for investments in their own communities and states.
Trust, so crucial an aspect of investing, is most likely to be fostered by
the familiarity of local communities.

As a consequence, home bias will likely continue to constrain the movement
of world savings into its optimum use as capital investment, thus limiting
the internationalization of financial intermediation and hence the growth of
external assets and liabilities.8

Nonetheless, during the past decade, home bias has apparently declined
significantly. For most of the earlier postwar era, the correlation between
domestic saving rates and domestic investment rates across the world's major
trading partners, a conventional measure of home bias, was exceptionally
high.9 For OECD countries, the GDP-weighted correlation coefficient was 0.97
in 1970. However, it fell from 0.96 in 1992 to less than 0.8 in 2002. For
OECD countries excluding the United States, the recent decline is even more
pronounced. These declines, not surprisingly, mirror the rise in the
differences between saving and investment or, equivalently, of the
dispersion of current account balances over the same years.

The decline in home bias probably reflects an increased international
tendency for financial systems to be more transparent, open, and supportive
of strong investor protection.10 Moreover, vast improvements in information
and communication technologies have broadened investors' scope to the point
that foreign investment appears less nd risky. Accordingly, the trend of
declining home bias and expanding international financial intermediation
will likely continue as globalization proceeds.

* * *

It is unclear whether debt-servicing restraints or the rising weight of U.S.
assets in global portfolios will impose the greater restraint on current
account dispersion over the longer term. Either way, when that point
arrives, what do we know about whether the process of reining in our current
account deficit will be benign to the economies of the United States and the
world?

According to a Federal Reserve staff study, current account deficits that
emerged among developed countries since 1980 have risen as high as
double-digit percentages of GDP before markets enforced a reversal.11 The
median high has been about 5 percent of GDP.

Complicating the evaluation of the timing of a turnaround is that deficit
countries, both developed and emerging, borrow in international markets
largely in dollars rather than in their domestic currency. The United States
has been rare in its ability to finance its external deficit in a reserve
currency.12 This ability has presumably enlarged the capability of the
United States relative to most of our trading partners to incur foreign
debt.

* * *

Besides experiences with the current account deficits of other countries,
there are few useful guideposts of how high our country's net foreign
liabilities can mount. The foreign accumulation of U.S. assets would likely
slow if dollar assets, irrespective of their competitive return, came to
occupy too large a share of the world's portfolio of store of value assets.
In these circumstances, investors would seek greater diversification in
non-dollar assets. At the end of 2002, U.S. dollars accounted for about 65
percent of central bank foreign exchange reserves, with the euro second at
15 percent. Approximately half of private cross-border holdings were
denominated in dollars, with one-third in euros.

More important than the way that the adjustment of the U.S. current account
deficit will be initiated is the effect of the adjustment on both our
economy and the economies of our trading partners. The history of such
adjustments has been mixed. According to the aforementioned Federal Reserve
study of current account corrections in developed countries, although the
large majority of episodes were characterized by some significant slowing of
economic growth, most economies managed the adjustment without crisis. The
institutional strengths of many of these developed economies--rule of law,
transparency, and investor and property protection--likely helped to
minimize disruptions associated with current account adjustments. The United
Kingdom, however, had significant adjustment difficulties in its early
postwar years, as did, more recently, Mexico, Thailand, Korea, Russia,
Brazil, and Argentina, to name just a few.

Can market forces incrementally defuse a worrisome buildup in a nation's
current account deficit and net external debt before a crisis more abruptly
does so? The answer seems to lie with the degree of flexibility in both
domestic and international markets. In domestic economies that approach full
flexibility, imbalances are likely to be adjusted well before they become
potentially destabilizing. In a similarly flexible world economy, as debt
projections rise, product and equity prices, interest rates, and exchange
rates could change, presumably to reestablish global balance.

The experience over the past two centuries of trade and finance among the
individual states that make up the United States comes close to that
paradigm of flexibility even though exchange rates among the states have
been fixed. Although we have scant data on cross-border transactions among
the separate states, anecdotal evidence suggests that over the decades
significant apparent imbalances have been resolved without precipitating
interstate balance-of-payments crises. The dispersion of unemployment rates
among the states, one measure of imbalances, spikes during periods of
economic stress but rapidly returns to modest levels, reflecting a high
degree of adjustment flexibility. That flexibility is even more apparent in
regional money markets, where interest rates that presumably reflect
differential imbalances in states' current accounts and hence cross-border
borrowing requirements have, in recent years, exhibited very little
interstate dispersion. This observation suggests either negligible
cross-state-border imbalances, an unlikely occurrence given the pattern of
state unemployment dispersion, or more likely very rapid financial
adjustments.

* * *

We may not be able to usefully determine at what point foreign accumulation
of net claims on the United States will slow or even reverse, but it is
evident that the greater the degree of international flexibility, the less
the risk of a crisis.13 The experience of the United States over the past
three years is illustrative. The apparent ability of our economy to
withstand a number of severe shocks since mid-2000, with only a small
decline in real GDP, attests to the marked increase in our economy's
flexibility over the past quarter century.14

* * *

In evaluating the nature of the adjustment process, we need to ask whether
there is something special in the dollar being the world's primary reserve
currency. With so few historical examples of dominant world reserve
currencies, we are understandably inclined to look to the experiences of the
dollar's immediate predecessor. At the height of sterling's role as the
world's currency more than a century ago, Great Britain had net external
assets amounting to some 150 percent of its annual GDP, most of which were
lost in World Wars I and II. Early post-World War II Britain was hobbled
with periodic sterling crises as much of the remnants of Empire endeavored
to disengage themselves from heavy reliance on holding sterling assets as
central bank reserves and private stores of value. The experience of
Britain's then extensively regulated economy, harboring many wartime
controls well beyond the end of hostilities, provides testimony to the costs
of structural rigidity in times of crisis.

* * *

Should globalization be allowed to proceed and thereby create an ever more
flexible international financial system, history suggests that current
imbalances will be defused with little disruption. And if other currencies,
such as the euro, emerge to share the dollar's role as a global reserve
currency, that process, too, is likely to be benign.

I say this with one major caveat. Some clouds of emerging protectionism have
become increasingly visible on today's horizon. Over the years, protected
interests have often endeavored to stop in its tracks the process of
unsettling economic change. Pitted against the powerful forces of market
competition, virtually all such efforts have failed. The costs of any new
such protectionist initiatives, in the context of wide current account
imbalances, could significantly erode the flexibility of the global economy.
Consequently, it is imperative that creeping protectionism be thwarted and
reversed.



----------------------------------------------------------------------------
----
Footnotes
1. The exceptions to this conclusion are those few cases of successful
speculation in which governments have tried and failed to support a
particular exchange rate. Nonetheless, despite extensive efforts on the part
of analysts, to my knowledge, no model projecting directional movements in
exchange rates is significantly superior to tossing a coin. I am aware that
of the thousands who try, some are quite successful. So are winners of
coin-tossing contests. The seeming ability of a number of banking
organizations to make consistent profits from foreign exchange trading
likely derives not from their insight into future rate changes but from
making markets and consistently being able to buy at the bid and sell at the
offering price, pocketing the spread.  Return to text

2. This anomaly was first identified more than three decades ago; see H.S.
Houthakker and Stephen P. Magee, "Income and Price Elasticities in World
Trade," The Review of Economics and Statistics vol. 51 (May 1969), 111-25.
Return to text

3. Gross liabilities include both debt and equity claims. Data on the levels
of gross liability have to be interpreted carefully because they reflect the
degree of consolidation of the economic entities they cover. Were each of
our fifty states considered as a separate economy, for example, interstate
claims would add to both U.S. and world totals without affecting U.S. or
world GDP. Accordingly, it is the change in the gross liabilities ratios
that is the more economically meaningful concept.  Return to text

4. For the United States, for example, the ratio of external liabilities to
imports of goods and services rose from nearly 1-1/2 in 1948 to close to 2
in 1980. The comparable ratios for the United Kingdom can be estimated to
have been in the neighborhood of 2-1/2 or lower in 1948 and about 3-3/4 in
1980.  Return to text

5. For the United States, for example, even excluding mortgage pools, the
ratio of domestic liabilities to GDP rose at an annual rate of 2 percent
between 1965 to 2002. For the United Kingdom, the ratio of debt liabilities
to GDP increased 4 percent at an annual rate during the more recent
1987-2002 period.  Return to text

6. If the rate of growth of external assets (and liabilities) exceeds, on
average, the growth rate of world GDP, under a broad range of circumstances
the dispersion of the change in net external claims of trading countries
must increase as a percent of world GDP. But the change in net claims on a
country, excluding currency valuation changes and capital gains and losses,
is essentially the current account balance. Of necessity, of course, the
consolidated world current account balance remains at zero.

Theoretically, if external assets and liabilities were always equal,
implying a current account in balance, the ratio of liabilities to GDP could
grow without limit. But in the complexities of the real world, if external
assets fall short of liabilities for some countries, net external
liabilities will grow until they can no longer be effectively serviced. Well
short of that point, market prices, interest rates, and exchange rates will
slow, and then end, the funding of liability growth.  Return to text

7. It is true that estimates of the ratios of the current account to GDP for
many countries in the nineteenth century are estimated to have been as large
as, or larger, than we have experienced in recent years. However, the
substantial net flows of capital financing for those earlier deficits were
likely motivated in large part by specific major development projects (for
example, railroads) bearing high expected rates of return. By contrast,
diversification appears to be a more salient motivation for today's large
net capital flows. Moreover, gross capital flows are believed to be
considerably greater relative to GDP in recent years than in the nineteenth
century. (See Alan M. Taylor, "A Century of Current Account Dynamics,"
Journal of International Money and Finance, 2002, 725-48, and Maurice
Obstfeld and Alan Taylor, "Globalization and Capital Markets," NBER Working
Paper 8846, March 2002.)  Return to text

8. Without home bias, the dispersion of world current account balances would
likely be substantially greater.  Return to text

9. See Martin Feldstein and Charles Horioka, "Domestic Saving and
International Capital Flows," The Economic Journal, June 1980, 314-29.
Return to text

10. Research indicates that home bias in investment toward a foreign country
is likely to be diminished to the extent that the country's financial system
offers transparency, accessibility, and investor safeguards. See Alan
Ahearne, William Griever, and Frank Warnock, "Information Costs and Home
Bias" Board of Governors of the Federal Reserve System, International
Finance Discussion Paper No. 691, December 2000.  Return to text

11. Caroline Freund, "Current Account Adjustment in Industrialized
Countries," Board of Governors of the Federal Reserve System, International
Finance Discussion Paper No. 692, December 2000.  Return to text

12. Less than 10 percent of aggregate U.S. foreign liabilities are currently
denominated in nondollar currencies. To have your currency chosen as a store
of value is both a blessing and a curse. Presumably, the buildup of dollar
holdings by foreigners has provided Americans with lower interest rates as a
consequence. But, as Great Britain learned, the liquidation of sterling
balances after World War II exerted severe pressure on its domestic economy.
Return to text

13. Although increased flexibility apparently promotes resolution of current
account imbalances without significant disruption, it may also allow larger
deficits to emerge before markets are required to address them.  Return to
text

14. See Alan Greenspan, remarks before a symposium sponsored by the Federal
Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 30, 2002.  Return
to text




Gary Santos
250 West 27th Street, 6F
New York, NY 10001
(212) 366-6909
garysantos@xxxxxxxxxxxx