Alan Greenspan: Stability and economic growth - the role of the central bank
Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve
System, before the Banco de Mexico's 80th Anniversary International Conference, Mexico City (via
videoconference), 14 November 2005.
* * *
International finance presents us with a number of intriguing anomalies, but the one that seems to
bedevil monetary policy makers the most as they seek stability and growth (the topic of this
conference) is the seemingly endless ability of the United States to finance its current account deficit.
To date, despite a current account deficit exceeding 6 percent of our gross domestic product (GDP),
we--or more exactly, the economic entities that comprise the U.S. economy--are experiencing few
difficulties in attracting the foreign saving required to finance it, as evidenced by the recent upward
pressure on the dollar. The markets are not behaving in the way that some, if not most, analysts
anticipated as the U.S. current account deficit rose above its previous high of 3-1/2 percent of GDP
recorded in 1986.
Of course, deficits that cumulate to ever-increasing net external debt, with its attendant rise in
servicing costs, cannot persist indefinitely. At some point investors will balk at further financing. Such a
development would be particularly likely should risk-adjusted rates of return on assets outside the
United States rise relative to investment opportunities in the United States. Even if such returns on
U.S. assets stay high, the rise of concentration risks in foreign official and private portfolios could still
induce investors to slow their accumulation of dollar claims and thereby delimit the size of the
financeable U.S. current account deficit.
However, the adjustment of the U.S. external balance, when it comes, doubtless will be initiated by the
actions both of foreign investors and of U.S. residents. Whatever the triggers for adjustment, the move
toward current account balance, in addition to being driven by foreign investors altering their external
portfolios, presumably would also reflect actions by U.S. residents to address domestic imbalances.
In all instances, a current account balance is essentially the product of a wide-ranging interactive
process that reflects the production and allocation of goods, services, and incomes among the
residents of a country and those of the rest of the world. The outcome encompasses the full array of
domestic and international product and asset prices, including interest rates. The array of bilateral
exchange rates between the dollar and foreign currencies appears to be particularly important to the
current account balance, although, of course, exchange rates, like all other prices, are determined
interactively and simultaneously. To the extent that an economy harbors elements of inflexibility, so
that prices and quantities are slow to respond to new developments, the deficit-adjustment process is
likely to adversely affect the levels of output and employment.
A nation's current account balance thus is essentially a market phenomenon that is not readily subject
to rebalance by targeting one or more policy variables such as the exchange rate. To be sure, if the
exchange rate of the dollar, through intervention, is persistently pressed higher or lower, the whole set
of previously noted relationships would shift accordingly. I doubt, however, whether, given the current
size of global financial markets, locking together two major currencies such as the dollar and the euro
is feasible any longer. Over time, the required large domestic adjustments would be quite unlikely to
be accepted by the majority of residents of either the United States or those of the euro area.
To be sure, policy initiatives to increase interest rates, which would elevate the propensity of
households to save, would reduce the need for domestic investment to be financed by borrowed
foreign saving. However, the additional inflow of capital arising from higher U.S. interest rates would
boost the dollar's value and offset the narrowing of the imbalance. Alternatively, a discretionary
reduction in our federal budget deficit would work toward narrowing the current account deficit but, if
history is any judge, to an uncertain and possibly small extent.
The rise of our deficit and our ability to finance it appears to coincide with a pronounced new phase of
globalization that has emerged in the past decade. This phase is characterized by a major
acceleration in U.S. productivity growth and the decline in what economists call home bias, the
parochial tendency to invest domestic savings in one's home country.
Output per hour of nonfarm business in the United States has risen at an annual rate of 3 percent over
the past ten years, compared with only 1.6 percent during the previous quarter century. The
acceleration reflects the synergies of computer, telecommunications and networking technologies,
which although applied worldwide, have had a particularly pronounced impact on the U.S. economy.
Greater rates of productivity growth in the United States, compared with still-subdued rates abroad,
have apparently engendered comparable differences in risk-adjusted expected rates of return and
hence in the demand for U.S.-based investment assets.
Home bias is a broadly visible tendency of markets. Lower required risk compensation is associated
with geographically close investment opportunities; when investors are familiar with the environment,
they perceive less risk than they do for objectively comparable investment opportunities in far distant,
less familiar environments. There is evidence that even when choosing investment targets within the
United States, investors hold assets that are disproportionately close to home.1
Home bias was very much in evidence for a half century following World War II. Domestic saving was
directed predominantly toward domestic investment. Because the difference between a nation's
domestic saving and domestic investment is the near-algebraic equivalent of that nation's current
account balance, imbalances were small.2 However, starting in the 1990s home bias began to decline
discernibly. The weighted correlation between national saving rates and domestic investment rates for
countries representing four-fifths of world GDP declined from a coefficient of around 0.97 in 1992,
where it had hovered since 1970, to an estimated low of 0.68 last year. Excluding the United States,
the coefficient declined from 0.96 in 1992 to 0.58 last year.
To be sure, international trade has been expanding as a share of world GDP since the end of World
War II. Yet, through the mid-1990s, the expansion was largely a grossing up of individual countries'
exports and imports. Only in the past decade has expanding trade been associated with the
emergence of ever-larger U.S. trade and current account deficits, matched by a corresponding
widening of the aggregate external surpluses of many of our trading partners. Indeed, the growing
dispersion of current account balances is closely tied to the shrinking degree of correlation of country
shares of saving and investment.3 Obviously, if domestic saving exactly equaled domestic investment
for every country, all current accounts would be in balance and the dispersion of such balances would
be zero.
Current account imbalances require that the correlation between domestic saving and
investment-which reflects the degree of home bias--to be less than 1.0. Home bias, the inclination of individuals to
prefer to invest in their own country, given comparable foreign opportunities, of course, is only one of
several decision-sets that determine how much a nation actually saves, as distinct from intended
saving, and what part of that saving, or of foreign saving, is attracted to fund domestic investment.
Aside from the ex ante average inclination of the residents of a country toward home bias, the
difference between domestic saving and domestic investment, that is, the current account balance, is
determined by the potential rate of return on foreign investments relative to domestic investments as
well as a nation's underlying propensity to save relative to that of other nations.
Indeed, all of these factors working simultaneously determine the extent to which domestic savers
successfully reach beyond their borders to, on net, invest in foreign assets and thereby create current
account surpluses and deficits. That ex post relationship, the correlation between actual--instead of
intended--domestic saving and domestic investment was the object of the seminal work by Feldstein
and Horioka a quarter century ago.4 Without the evident worldwide fall in home bias over the past
decade, noted earlier, the United States would not have been able to finance its recent current
account deficits, and, accordingly, these deficits would have been smaller.
The decline in home bias reflects a number of recent factors that have converged to lessen restraints
on cross-border financial flows as well as on trade in goods and services. In addition to the
dismantling of restrictions on capital flows, the advance of information and communication
technologies has effectively shrunk the time and distance that separate markets around the world. The
vast improvements in these new technologies have broadened investors' vision to the point that
foreign investment appears less risky. Combined with improvements in transportation networks, these
developments have expanded the range of tradable goods and services that can be brought to each
market and financed, and thereby enabled greater integration of the productive resources of national
economies.
Technological innovation and ongoing deregulation and tariff reductions have driven the globalization
process by tearing down the barriers that have separated economic agents and thereby lowering the
cost of transacting across borders. The effect of these developments has been to markedly increase
the willingness and ability of financial market participants to reach beyond their national borders to
invest in foreign countries, just as a century and more ago savings moved beyond local investment
opportunities to develop national markets.
As I noted, the movement of savings across national borders to fund investment has permitted the
significant increase in the dispersion of national current account balances. In recent years, the
negative tail of the distribution of current account balances has been, of course, dominated by the U.S.
deficit. The decline in home bias has clearly enlarged sources of finance for the United States. Indeed,
the fall in the correlation of domestic saving with domestic investment over the past decade reflected
an increase in the proportion of world saving invested cross border from 5 percent in the mid-1990s to
10 percent last year.
Given that we have yet to experience difficulties in funding a current account deficit that exceeds
6 percent of our GDP, what are the limits to the foreign markets' absorption of claims on U.S.
residents?
Home bias is deeply ingrained in economic decisions and evident in the geographical mix of peoples'
investments, even within national boundaries.5 How much further home bias can decline is obviously
conjectural, given the paucity of historical precedent. Federal Reserve staff studies indicate that,
despite evidence of recent diversification, U.S. and foreign portfolios still exhibit marked home bias.
Funding of our current account deficit likely will become more difficult when home bias approaches its
practical minimum. Irrespective of how globalized our economy may become, other things equal,
people will still accord nearby investments a lower risk premium.
Presumably, well before the practical lower limits of home bias are reached, effective constraints on
deficit funding, and hence on the deficit itself, are likely to come from foreign investors' fear of portfolio
concentrations of claims on the residents and government of the United States.
Concentration and other risks in holding dollar balances seem to have become a consideration at least
for some investors. Of the more than $30 trillion equivalents of cross-border banking and international
bond claims reported by the private sector to the Bank for International Settlements for the end of the
first quarter of 2005, 41.8 percent were in dollars and 39.8 percent were in euros. Adjusting for
exchange rate changes, the dollar's share was 4 percentage points less than three years earlier, and
the euro's share was more than 5 percentage points greater.6 Monetary authorities have been
somewhat more inclined to hold dollar obligations. At the end of the first quarter of 2005, of the
$3.8 trillion equivalents held as foreign exchange reserves, more than three-fifths were held in dollars
and approximately one-quarter in euros. Since early 2002, the dollar's share has been little changed
after adjusting for movements in exchange rates.
What could be the potential consequences should the dollar's status as the world's reserve currency
significantly diminish, especially if foreign investors reduce their rate of accumulation of claims on U.S.
residents? Most analysts would contend that U.S. interest rates were lowered by the world's
accumulation of dollars. Accordingly, in the event of a significant diminishing of the dollar's reserve
currency status, U.S. interest rates would presumably rise.
Although I doubt that the U.S. dollar will lose its status as the world's reserve currency any time soon,
there are, in my judgment, lessons to be learned from the experience of sterling as it faded as the
world's dominant currency. Sterling's status was at its height 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. Many wartime controls were maintained in the years immediately after World War
II. Arguably these exacerbated the periodic sterling crises that hobbled Britain in those years as much
of the remnants of its empire endeavored to reduce their heavy reliance on holding sterling assets as
central bank reserves and private stores of value. The experience of Britain's then extensively
regulated economy provides testimony to the costs of structural rigidity in times of crisis.
Any diminution of the reserve status of the dollar, should it occur, is likely to be readily absorbed by a
far more flexible U.S. economy than existed in Britain immediately following World War II. This, of
course, presupposes that we in the United States in the years ahead maintain and, I trust, enhance
our economy's degree of flexibility and our involvement in the highly successful globalization of recent
decades.
Governments today, although still far more activist than in the nineteenth and early twentieth
centuries, are rediscovering the benefits of competition and the resilience to economic shocks that it
fosters. We are also beginning to recognize an international version of Smith's invisible hand in the
globalization of economic forces.
Whether by intention or by happenstance, many, if not most, governments in recent decades have
been relying more and more on the forces of the marketplace and reducing their intervention in market
outcomes. We appear to be revisiting Adam Smith's notion that the more flexible an economy, the
greater its ability to self-correct after inevitable, often unanticipated disturbances. That greater
tendency toward self-correction has made the cyclical stability of an economy less dependent on the
actions of macroeconomic policy makers, whose responses often have come too late or have been
misguided.
Being able to rely on markets to do the heavy lifting of adjustment is an exceptionally valuable policy
asset. The impressive performance of the U.S. economy over the past couple of decades, despite
shocks that in the past would have surely produced marked economic disruption, offers the clearest
evidence of the benefits of increased market flexibility.
We weathered a decline on October 19, 1987, of a fifth of the market value of U.S. equities with little
evidence of subsequent macroeconomic stress--an episode that hinted at a change in adjustment
dynamics. The credit crunch of the early 1990s and the bursting of the stock market bubble in 2000
were absorbed with the shallowest recessions in the post-World War II period. And the economic
fallout from the tragic events of September 11, 2001, was moderated by market forces, with severe
economic weakness evident for only a few weeks. Most recently, the flexibility of our market-driven
economy has allowed us, thus far, to weather reasonably well the steep rise in spot and futures prices
for oil and natural gas that we have experienced over the past two years. The consequence of this
flexibility has been a far more stable economy.
Flexibility is most readily achieved by fostering an environment of maximum competition. A key
element in creating this environment is flexible labor markets. Many working people equate labor
promote
market flexibility with job insecurity. Despite that perception, flexible labor policies appear to
job creation. An increased capacity of management to discharge workers without excessive cost, for
example, apparently increases companies' willingness to hire without fear of unremediable mistakes.
The net effect, to the surprise of most, has been what appears to be a decline in the structural
unemployment rate in the United States over the past quarter century.
Protectionism in all its guises, both domestic and international, does not contribute to the welfare of
workers. At best, it is a short-term fix for a few workers at a cost of lower standards of living for a
nation as a whole. Increased education and training for those displaced by creative destruction is the
answer, not a stifling of competition.
As we move forward, I trust that we all have learned durable lessons about the benefits of fostering
and preserving a flexible economy. In the United States that flexibility has been the product of the
economic dynamism of our workers and firms that was unleashed, in part, by the efforts of
policymakers to remove rigidities and promote competition.
Although the business cycle has not disappeared, flexibility has made the United States and most of
the global economy more resilient to shocks and more stable overall during the past couple of
decades. To be sure, that stability has created some new challenges for policymakers. But more
fundamentally, an environment of greater economic stability has been key to the impressive growth in
the standards of living and economic welfare so evident in much of the competitive world.