Alan Greenspan: The evolving international payments imbalance of the United
States and its effect on Europe and the rest of the world
Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve
System, at the 21st Annual Monetary Conference, Cosponsored by the Cato Institute and The
Economist, Washington, DC, 20 November 2003.
* * *
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-
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.
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.
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.
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.
BIS Review 50/2003
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 exotic and 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.