Alan Greenspan: Globalisation and innovation
Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve
System, at the Conference on Bank Structure and Competition, sponsored by the Federal Reserve
Bank of Chicago, Chicago, Illinois, (via satellite), 6 May 2004.
* * *
The United States economy appears to have been pressing a number of historic limits in recent years
without experiencing the types of financial disruption that almost surely would have arisen in decades
past. This observation raises some key questions about the longer-term stability of the U.S. and global
economies that bear significantly on future economic developments, including the future competitive
shape of banking.
Among the limits we have been pressing against are those in our external and budget balances. We in
the United States have been incurring ever larger trade deficits, with the broader current account
measure having reached 5 percent of our gross domestic product (GDP). Yet the dollar's real
exchange value, despite its recent decline, remains close to its average of the past two decades.
Meanwhile, we have lurched from a budget surplus in 2000 to a deficit that is projected by the
Congressional Budget Office to be 4-1/4 percent of GDP this year. In addition, we have legislated
commitments to our senior citizens that, given the inevitable retirement of our huge baby-boom
generation, will create significant fiscal challenges in the years ahead. Yet the yield on Treasury notes
maturing a decade from now remain at low levels. Nor are we experiencing inordinate household
financial pressures as a consequence of record high household debt as a percent of income.
* * *
Has something fundamental happened to the U.S. economy and, by extension, U.S. banking, that
enables us to disregard all the time-tested criteria of imbalance and economic danger? Regrettably,
the answer is no. The free lunch has still to be invented. We do, however, seem to be undergoing what
is likely, in the end, to be a one-time shift in the degree of globalization and innovation that has
temporarily altered the specific calibrations of those criteria. Recent evidence is consistent with such a
hypothesis of a transitional economic paradigm, a paradigm somewhat different from that which fit
much of our earlier post-World War II experience.
* * *
Globalization has altered the economic frameworks of both advanced and developing nations in ways
that are difficult to fully comprehend. Nonetheless, the largely unregulated global markets, with some
notable exceptions, appear to move effortlessly from one state of equilibrium to another. Adam Smith's
"invisible hand" remains at work on a global scale.
Because of a lowering of trade barriers, deregulation, and increased innovation, cross-border trade in
recent decades has been expanding at a far faster pace than GDP. As a result, domestic economies
are increasingly exposed to the rigors of international competition and comparative advantage. In the
process, lower prices for some goods and services produced by our trading partners have
competitively suppressed domestic price pressures.
Production of traded goods has expanded rapidly in economies with large, low-wage labor forces.
Most prominent are China and India, which over the past decade have partly opened up to market
capitalism, and the economies of central and eastern Europe that were freed from central planning by
the fall of the Soviet empire. The consequent significant additions to world production and trade have
clearly put downward pressure on domestic prices, though somewhat less so over the past year.
Moreover, the pronounced fall in inflation, virtually worldwide, over the past two decades has
doubtless been a key factor in the notable decline in world economic volatility.
In tandem with increasing globalization, monetary policy, to most observers, has become increasingly
effective in achieving the objective of price stability. But because we have not experienced a sufficient
number of economic turning points to judge the causal linkages among increased globalization,
improved monetary policy, significant disinflation, and greater economic stability, the structure of the
transitional paradigm is necessarily sketchy.
Nonetheless, a paradigm encompassing globalization and innovation, far more than in earlier
decades, appears to explain the events of the past ten years better than other conceptual constructs.
If this is indeed the case, because there are limits to how far globalization and the speed of innovation
can proceed, the current apparent rapid pace of structural shift cannot continue indefinitely. A couple
of weeks ago, I indicated in testimony to the Congress that the outlook for the next year or two has
materially brightened. But the outlook for the latter part of this decade remains opaque because it is
uncertain whether this transitional paradigm, if that is what it is, is already far advanced and about to
slow, or whether it remains in an early, still vibrant stage of evolution.
* * *
Globalization - the extension of the division of labor and specialization beyond national borders - is
patently a key to understanding much of our recent economic history. With a deepening of
specialization and a growing population free to take risks over a widening area, production has
become increasingly international.1
The pronounced structural shift over the past decade to a far more vigorous competitive world
economy than that which existed in earlier postwar decades apparently has been adding significant
stimulus to world economic activity. That stimulus, like that which resulted from similar structural
changes in the past, is likely a function of the rate of increase of globalization and not its level. If so,
such impetus would tend to peter out, as we approach the practical limits of globalization.
Full globalization, in which trade and finance are driven solely by risk-adjusted rates of return and risk
is indifferent to distance and national borders, will likely never be achieved. The inherent risk aversion
of people, and the home bias implied by that aversion, will limit how far globalization can proceed. But
because so much of our recent experience has little precedent, as I noted earlier, we cannot fully
determine how long the current globalization dynamic will take to play out.
* * *
The increasing globalization of the post-war world was fostered at its beginnings by the judgment that
burgeoning prewar protectionism was among the primary causes of the depth of the Great Depression
of the 1930s. As a consequence, trade barriers began to fall after the war. Globalization was
enhanced further when the inflation-ridden 1970s provoked a rethinking of the philosophy of economic
policy, the roots of which were still planted in the Depression era. In the United States, that rethinking
led to a wave of bipartisan deregulation of transportation, energy, and finance. At the same time, there
was a growing recognition that inflation impaired economic performance. Indeed, Group of Seven
world leaders at their 1977 Economic Summit identified inflation as a cause of unemployment.
Moreover, monetary policy tightening, and not increased regulation, came to be seen by the end of
that decade as the only viable solution to taming inflation.2 Of course, the startling recovery of
war-ravaged West Germany following Ludwig Erhard's postwar reforms, and Japan's embrace of
global trade, were early examples of the policy reevaluation process.
It has taken several decades of experience with markets and competition to foster an unwinding of
regulatory rigidities. Today, privatization and deregulation have become almost synonymous with
"reform."
* * *
By any number of measures, globalization has expanded markedly in recent decades. Not only has
the ratio of international trade in goods and services to world GDP risen inexorably over the past
half-century, but a related measure - the extent to which savers reach beyond their national borders to
invest in foreign assets - has also risen.
Through much of the post-World War II years, domestic saving for each country was invested
predominantly in its domestic capital assets, irrespective of the potential for superior risk-adjusted
returns to be available from abroad. Because a country's domestic saving less its domestic investment
is equal to its current account balance, such balances, positive or negative, with the exception of the
mid-1980s, were therefore generally modest. But in the early 1990s, "home bias" began to diminish
appreciably,3 and, hence, the dispersion of current account balances among countries has increased
markedly. The widening current account deficit in the United States has come to dominate the tail of
that distribution of external balances across countries.
Thus, the decline in home bias, or its equivalent, expanding globalization, has apparently enabled the
United States to finance and, hence, incur so large a current account deficit. As a result of these
capital flows, the ratio of foreign net claims against U.S. residents to our annual GDP has risen to
approximately one-fourth. While some other countries are far more in debt to foreigners, at least
relative to their GDPs, they do not face the scale of international financing that we require.
A U.S. current account deficit of 5 percent or more of GDP would probably not have been readily
fundable a half-century ago or perhaps even a couple of decades ago.4 The ability to move that much
of world saving to the United States in response to relative rates of return almost surely would have
been hindered by the far-lesser degree of both globalization and international financial flexibility that
existed at the time. Such large transfers would presumably have induced changes in the prices of
assets that would have proved inhibiting.
Nonetheless, we have little evidence that the economic forces that are fostering international
specialization, and hence cross-border trade and increasing dispersion of current account balances,
are as yet diminishing. At some point, however, international investors, private and official, faced with
a concentration of dollar assets in their portfolios, will seek diversification, irrespective of the
competitive returns on dollar assets. That shift, over time, would likely induce contractions in both the
U.S. current account deficit and the corresponding current account surpluses of other nations.
Can market forces incrementally defuse a 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 market
flexibility. In a world economy that is sufficiently flexible, as debt projections rise, product and equity
prices, interest rates, and exchange rates presumably would change to reestablish global balance.5
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.6
Should globalization continue unfettered and thereby create an ever more flexible international
financial system, history suggests that current account imbalances will be defused with modest risk of
3
The correlation coefficient between paired domestic saving and domestic investment, a conventional measure of the
propensity to invest at home for OECD countries constituting four-fifths of world GDP, fell from 0.96 in 1992 to less than 0.8
in 2002. With rare exceptions, a decline in the correlation of countries' paired domestic investment to domestic saving
implies an increased dispersion of current account balances.
4
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, pp. 725-48, and Maurice Obstfeld and Alan M. Taylor, "Globalization and
Capital Markets," NBER Working Paper 8846, March 2002.)
5
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, a pattern 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.
6
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. Moreover, the apparent ability of the
U.S. economy to withstand the stock market plunge of 2000, the terrorist attacks of 9/11, corporate governance scandals,
and wars in Afghanistan and Iraq indicates a greater degree of economic flexibility than was apparent in the 1970s and
earlier.
disruption. A Federal Reserve study of large current account adjustments in developed countries,7 the
results of which are presumably applicable to the United States, suggests that market forces are likely
to restore a more long-term sustainable current account balance here without measurable disruption.
Indeed, this was the case in the second half of the 1980s.
I say this with one major caveat. Protectionism, some signs of which have recently emerged, could
significantly erode global flexibility and, hence, undermine the global adjustment process. We are
already experiencing pressure to slow down the expansion of trade. The current Doha Round of trade
negotiations is in some difficulty owing largely to the fact that the low-hanging fruit of trade negotiation
has already been picked in the trade liberalizations that have occurred since the Kennedy Round.
* * *
Augmenting the dramatic effect of increased globalization on economic growth, and perhaps at some
times, fostering it, have been the remarkable technological advances of recent decades. In particular,
information and communication technologies have propelled the processing and transmission of data
and ideas to a level far beyond our capabilities of a decade or two ago.
The advent of real-time information systems has enabled managers to organize a workforce without
the redundancy required in earlier decades to ensure against the type of human error that technology
has now made far less prevalent. Real-time information, by eliminating much human intervention, has
markedly reduced scrappage rates on production lines, lead times on purchases, and errors in all
forms of recordkeeping. Much data transfer is now electronic and far more accurate than possible in
earlier times.
The long-term path of technology and growth is difficult to discern. Indeed, innovation, by definition, is
not forecastable. Nonetheless, the overall pace of productivity growth that has recently been near
5 percent at an annual rate is highly likely to slow because we have rarely exceeded 3 percent for any
protracted period. In the United States, we have always employed technologies at, or close to, the
cutting edge, and we have created much of our innovative technologies ourselves. The opportunities
of many developing economies to borrow innovation is not readily available to us. Thus, even though
the longer-term prospects for innovation and respectable productivity growth are encouraging, some
near-term slowing in the pace of advance to a rate closer to productivity's long-term average seems
likely.
* * *
We have, I believe, a reasonably good understanding of why Americans have been able to reach
farther into global markets, incur significant increases in debt, and yet fail to produce the disruptions so
often observed as a consequence. However, a widely held alternative view of the past decade cannot
readily be dismissed. That view holds that the postwar paradigm is still largely in place, and key
financial ratios, rather than suggesting a moving structure, reflect extreme values of a fixed structure
that must eventually adjust, perhaps abruptly.
To be sure, even with the increased flexibility implied in a paradigm of expanding globalization and
innovation, the combination of exceptionally low saving rates and historically high ratios of household
debt to income can be a concern if incomes unexpectedly fall. Indeed, there is little doubt that virtually
any debt burden becomes oppressive if incomes fall significantly.
But rising debt-to-income ratios can be somewhat misleading as an indicator of stress. Indeed the ratio
of household debt to income has been rising sporadically for more than a half-century, a trend that
partly reflects the increased capacity of ever-wealthier households to service debt. Moreover, a
significant part of the recent rise in the debt-to-income ratio also reflects the remarkable gain in
homeownership. Over the past decade, for example, the share of households that owns homes has
risen from 6 percent to 69 percent. During the decade a significant number of renters bought homes,
thus increasing the asset side of their balance sheets as well as increasing their debt. It can scarcely
be argued that the substitutions of debt service for rent materially impaired the financial state of the
new homeowner. Yet the process over the past decade added more than 10 percent to outstanding
mortgage debt and accounted for more than one-seventh of the increase in total household debt over
that period.8
Thus, short of a period of overall economic weakness, households, with the exception of some highly
leveraged subprime borrowers, do not appear to be faced with significant financial strain. With interest
rates low, debt service costs for households are average, or only marginally higher than average.
Adding other fixed charges such as rent, utilities, and auto-leasing costs does not materially alter the
change in the degree of burden.
Even should interest rates rise materially further, the effect on household expenses will be stretched
out because four-fifths of debt is fixed rate of varying maturities, and it will take time for debt to mature
and reflect the higher rates. Despite the almost two percentage point rise in mortgage rates on new
originations from mid-1999 to mid-2000, the average interest rate on outstanding mortgage debt rose
only slightly, as did debt service.
In a related concern, a number of analysts have conjectured that the extended period of low interest
rates is spawning a bubble in housing prices in the United States that will, at some point, implode.
Their concern is that, if this were to occur, highly leveraged homeowners will be forced to sharply
curtail their spending. To be sure, indexes of house prices based on repeat sales of existing homes
have outstripped increases in rents, suggesting at least the possibility of price misalignment in some
housing markets. A softening in housing markets would likely be one of many adjustments that would
occur in the wake of an increase in interest rates.
But a destabilizing contraction in nationwide house prices does not seem the most probable outcome.
Indeed, nominal house prices in the aggregate have rarely fallen and certainly not by very much.
Still, house prices, like those of many other assets, are difficult to predict, and movements in those
prices can be of macroeconomic significance. Moreover, because these transactions often involve
considerable leverage, they need to be monitored by those responsible for fostering financial stability.
There appears, at the moment, to be little concern about corporate financial imbalances.
Debt-to-equity ratios are well within historical ranges, and the recent prolonged period of low long-term
interest rates has enabled corporations to fund short-term liabilities and stretch out bond maturities.
Even the relatively narrow spreads on below-investment-grade corporate debt appear to reflect low
expected losses rather than an especially small aversion to risk.
The resolution of our current account deficit and household debt burdens does not strike me as overly
worrisome, but that is certainly not the case for our yawning fiscal deficit. Our fiscal prospects are, in
my judgment, a significant obstacle to long-term stability because the budget deficit is not readily
subject to correction by market forces that stabilize other imbalances.
One issue that concerns most analysts, especially in the context of a widening structural federal
deficit, is inadequate national saving. Fortunately, our meager domestic savings, and those attracted
from abroad, are being very effectively invested in domestic capital assets. The efficiency of our
capital stock thus has been an important offset to what, by any standard, has been an exceptionally
low domestic saving rate in the United States. Although saving is a necessary condition for financing
the capital investment required to engender productivity, it is not a sufficient condition. The very high
saving rates of the Soviet Union, of China, and of India in earlier decades, often did not foster
significant productivity growth in those countries. Saving squandered in financing inefficient
technologies does not advance living standards. It is thus difficult to judge how significant a problem
our relatively low gross domestic saving rate is to the future growth of an efficient capital stock. The
high productivity growth rate of the past decade does not suggest a problem. But our success in
attracting savings from abroad may be masking the full effect of deficient domestic saving.
* * *
Our day-by-day experiences with the effectiveness of flexible markets as they adjust to, and correct,
imbalances can readily lead us to the conclusion that once markets are purged of rigidities,
macroeconomic disturbances will become a historical relic. However, the penchant of humans for
quirky, often irrational, behavior gets in the way of this conclusion. A discontinuity in valuation
judgments, often the cause or consequence of a building and bursting of a bubble, can occasionally
destabilize even the most liquid and flexible of markets. I do not have much to add on this issue except
to reiterate our need to better understand it.
* * *
The last three decades have witnessed a significant coalescing of economic policy philosophies.
Central planning has been judged as ineffective and is now generally avoided. Market flexibility has
become the focus, albeit often hesitant focus, of reform in most countries. All policymakers are
struggling to understand global and technological changes that appear to have profoundly altered
world economic developments. For most economic participants, these changes appear to have had
positive effects on their economic well-being. But a significant minority, trapped on the adverse side of
creative destruction, are suffering. This is an issue that needs to be addressed if globalization is to
sustain the necessary public support.
* * *
The competitive state of banking, the subject of this conference, will be significantly affected by the
path of global financial and technological innovations. In my judgment, this will be among the most
significant developments affecting banking in the next decades.