Alan Greenspan: Euro in wider circles
Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve
System, at the European Banking Congress 2004, Frankfurt, 19 November 2004.
* * *
I am pleased to join my central bank colleagues in appraising an increasingly important issue - the
globalization of trade and finance. I should emphasize that I speak for myself and not necessarily for
the Federal Reserve.
Among the many aspects of the euro addressed in today's discussion, we should include its role in the
ongoing globalization of economic activity. The euro ties together a sizable share of the world
economy with a single currency and, by doing so, lowers transaction costs associated with trade and
finance within the region.
More generally, globalization of trade in goods, services, and assets continues to move forward at an
impressive pace, despite some indications of increased resistance to that process and the evident
difficulties in completing the Doha Round. The volume of trade relative to world gross domestic
product has been rising for decades, largely because of decreasing transportation costs and lowered
trade barriers. The increasing shift of world GDP toward items with greater conceptual content has
further facilitated increased trade because ideas and services tend to move across borders with
greater ease and speed than goods.
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. Indeed, Feldstein and Horioka
found a remarkably high degree of home bias in their seminal 1980 study.1 Through most of the
postwar period up to the mid-1990s, the GDP-weighted correlation coefficient between domestic
saving and domestic investment across countries accounting for four-fifths of world GDP hovered
around 0.95.
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. The correlation coefficient accordingly fell from 0.95 in 1993 to less than 0.8 by
2002. When one excludes the United States, the correlation coefficient's decline was even more
pronounced. Preliminary estimates for a smaller sample of countries over the past two years indicate a
continued decline on net.
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.
* * *
How far can the decline in home bias and the increase in the variance of current account balances be
expected to proceed, and where will it lead?
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.
Our analytic difficulty is that the forces driving the current account deficit are more, perhaps far more,
visible than those determining the ex ante financing of the deficit. The former are captured by
reasonably reliable estimates of income- and price-driven trade imbalances and net interest income;
the latter by the considerably more amorphous assessments of international portfolio choices.
The inability to anticipate changes in supply and demand for a currency is at the root of the statistically
robust finding that forecasting exchange rates has a success rate no better than that of forecasting the
outcome of a coin toss.2
* * *
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.3
Flexibility, as history persuasively shows, enables an economic system to better absorb and rebound
from shocks. In the United States, for example, real output contracted very little during our most recent
cyclical episode despite having been subjected to a number of shocks: the bursting of the technology
bubble, the terrorist attack of September 2001, and the corporate governance scandals. Indeed, the
U.S. economy has exhibited a degree of resilience in the face of these adversities not evident in
previous decades. Presumably, the rise in product and labor market flexibility in the United States and
in a number of other countries over the past quarter-century is continuing to pay off. If such flexibility
can be achieved more fully on a global scale, adjustments to the future current account imbalances of
both developed and emerging economies could be rendered significantly less stressful than in the
past.
An admittedly exceptional example of how a flexible system adjusts even with fixed exchange rates is
seen at the state level in the United States. For more than two centuries, the United States has
experienced largely unencumbered interstate free trade. 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 - has tended to spike up during periods of economic stress but has then rapidly returned
to modest levels, reflecting a high degree of adjustment flexibility. That flexibility is even more
apparent in regional money markets. Interest rates, which presumably reflect differential imbalances in
states' current accounts, and hence cross-border borrowing requirements, have exhibited very little
interstate dispersion in recent years. 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.
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 significant
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.
Jean-Claude Trichet: Euro in wider circles
Speech by Mr Jean-Claude Trichet, President of the European Central Bank, at the Conference
"Goodbye Lisbon" organised by the European Banking Congress, Frankfurt, 19 November 2004.
* * *
Ladies and gentlemen,
It is a pleasure for me to share with you some thoughts on the euro in wider circles. Reflecting on what
the term "wider circles" means for the euro, I think of the EU Member States that still use their national
currencies and that aim to adopt the single currency in the future, and in particular the ten new
Member States that joined the EU earlier this year and their path towards the euro. Let me briefly say
a few words on this aspect.
The euro goes east
It is now 15 years ago that the Berlin Wall fell, giving rise to one of the most astonishing political and
economic transformations in European history. Who could have imagined 15 years ago that in May
2004, eight countries in central and eastern Europe, together with two countries in the Mediterranean,
would be members of the European Union? The perspective of joining the European Union and
eventually adopting a European single currency was out of sight for even the most imaginative minds.
In only 15 years, these countries managed to restore and entrench democratic institutions and market
economies, replacing the communist ones that were imposed there before.
The accession of ten new countries to the EU was an important milestone in a process that will lead to
the eventual adoption of the euro by these new Member States. The euro will go east and south and
the road to the adoption of the euro is embedded in a well-defined institutional framework. A crucial
phase before euro adoption is ERM II membership for at least two years. Although there are no formal
criteria to be met for entry into ERM II, successful participation in the mechanism requires that major
policy adjustments - for example relating to fiscal policy and price liberalisation - are undertaken before
joining the mechanism. Participation in ERM II is an important means to anchor exchange rate and
inflation expectations and to promote consistently sound policies. It helps to orient macroeconomic
policies to stability, while at the same time allowing for a degree of flexibility, if needed, through the
wide standard fluctuation band and the possibility of adjusting the central parity.
As you know, three new EU countries have in the meantime entered the ERM II: with effect from
28 June 2004, Estonia, Lithuania and Slovenia joined Denmark as participants in the mechanism. The
three new entrants joined with a standard fluctuation band of ±15% around their central rates against
the euro, while Estonia and Lithuania kept their currency boards as a unilateral commitment. In order
to ensure a smooth participation in ERM II, countries have firmly committed to take the necessary
measures to preserve macroeconomic and exchange rate stability. Participation in ERM II has been
smooth. The four currencies in the ERM II have traded continuously at or close to their central rates,
while short-term interest rate differentials vis-à-vis the euro area have been small.
Beyond ERM II membership lies the adoption of the euro, the crowning achievement of the monetary
integration process. In order to adopt the euro, non-participating EU Member States have to achieve a
high degree of sustainable economic and legal convergence. Every country will be assessed on its
own merits and its own particular situation, on the basis of a strict analysis of the performance relating
to the Maastricht convergence criteria. Let me stress that there is no pre-set timetable for the
enlargement of the euro area.
Economic challenges for the new Member States
How far are the new Member States on this road towards the euro? The countries that joined the EU
this year have shown impressive economic growth rates and have made great strides in reducing
inflation. They belong to the most dynamic economies in the EU, having gone through profound
structural changes. For example, they have taken thorough measures to reform their product and
labour markets, and some new Member States, in some respects, may be even more advanced than
other, existing EU countries. They have become more integrated with the euro area, with the major
part of their trade now occurring with the euro area and tight financial links: as a matter of fact, the
share of the new 10 Member States in the total external trade of the euro area stands around 11%,
compared with around 14% for the US and 3% for Japan. In addition, the transition process has
brought their economic structures closer to those of the euro area. At the same time, while remaining a
diverse group in many respects, the new Member States still display distinct economic characteristics
that differ from the euro area. Their income-per-capita and productivity levels are still low relative to
the euro area, which may have an impact on their inflation rates.
Let me mention two particularly important economic challenges that the new Member States are
confronted with on the road to the euro: price stability and fiscal policy. Price stability is an essential
requirement for a successful monetary integration process. Inflation rates in many new Member States
have picked up recently to an average of almost 5%, following increases in food and energy prices
and indirect tax changes. The challenge for the new Member States is to contain inflation and inflation
expectations in an environment of rapid catching-up. Besides solid macroeconomic policy frameworks
and prudent wage policies, progress in structural reforms is conducive to price stability by improving
the supply side of the economy and enhancing the growth potential.
This brings me to the second challenge that I want to mention: the need to achieve sound fiscal
positions. Fiscal deficits are on average high or even very high in a number of new Member States
and mostly despite very high economic growth. Their governments are confronted with competing
expenditure demands, including public investment in infrastructure and the need to strengthen the
effectiveness of public administration and the judicial systems. This, however, should not be seen as
an excuse to delay fiscal consolidation, but as an additional reason to design and implement a
credible consolidation path based on durable and growth-enhancing structural reforms. It is important
to bear in mind that fiscal consolidation in the new Member States becomes increasingly important in
the course of the monetary integration process and it is essential for a smooth participation in ERM II
and the eventual adoption of the euro.
Conclusion
Let me conclude. The historic enlargement of the EU is now six months ago and I think we can say
that is has been a genuine success. Following a remarkable transformation in the past 15 years, the
further integration of the new Member States into the European family has progressed smoothly and
without any disruptions. The new Member States have shown an impressive economic performance,
though various important challenges still remain to be fully tackled, including those relating to the
recent pick-up in inflation and to fiscal imbalances.