Alan Greenspan: Current account
Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve
System, at the Advancing Enterprise 2005 Conference, London, England, 4 February 2005.
* * *
International trade has been expanding as a share of world gross domestic product since the end of
World War II. Yet through 1995, the expansion was essentially a balanced grossing up of cross-border
flows. Only in the past decade has expanding trade been associated with the emergence of
ever-larger U.S. current account deficits, lesser deficits elsewhere, matched by a corresponding
widening of external surpluses in a majority of trading nations.
The increased dispersion of these external imbalances is mirrored in a decline in the tight association
between national saving rates and domestic investment rates. The correlation between the two, for
countries representing four-fifths of world GDP, declined from a coefficient of around 0.96 in 1992,
where it had hovered for a half-century, to an estimated low of 0.8 last year.1 A number of factors have
recently converged to lessen restraints on cross-border financial flows as well as on trade in goods
and services.
The advance of information and communication technology has effectively shrunk the time and
distance that separate markets around the world. The vast improvements in these newer technologies
have broadened investors' vision to the point that foreign investment appears less exotic and 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 have enabled greater
integration of the productive resources of national economies.
Both deregulation and technological innovation have driven the globalization process by tearing down
the barriers that have separated economic agents, thus lowering costs. The effect of these
developments has been to markedly increase the willingness and ability of financial market
participants to reach beyond national borders to invest in foreign countries, just as a century and more
ago savings moved beyond local investment opportunities to develop national markets.
Implicit in the movement of savings across national borders to fund investment has been 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, as economists call the parochial tendency to invest domestic savings
at home, has clearly enlarged the capacity of the United States to fund deficits.
Arguably, however, it has been economic characteristics special to the United States that have
permitted our current account deficit to be driven ever higher, in an environment of greater
international capital mobility. In particular, the dramatic increase in underlying growth of U.S.
productivity over the past decade lifted real rates of return on dollar investments. These higher rates,
in turn, appeared to be the principal cause of the notable rise in the exchange rate of the U.S. dollar in
the late 1990s. As the dollar rose, gross operating profit margins of exporters to the United States
increased even as trade and current account deficits in the United States widened markedly.2 But
these deficits have continued to grow over the past three years despite a decline in the dollar, whose
broadly weighted real index is now much of the way back to its previous low in 1995.
Although the dollar's exchange rate has been declining since early 2002, increasingly tight competitive
conditions in the United States, as elsewhere, in 2002 and 2003 apparently induced exporters to the
United States to hold dollar prices to competitive levels to ensure their market share and foothold in
the world's largest economy. For example, from early 2002 to early 2004, the dollar's exchange rate
against the euro and sterling, on average, declined about 30 percent, yet dollar prices of imported
manufactured goods from the European Union rose by only 9 percent, slightly more than dollar prices
of U.S. manufactured goods during the same two years.
The consequence of the relatively small rise in the dollar price was a significant compression of gross
operating profit margins on European exports to the United States. In recent years, exporters, not only
in Europe but in many other trading partners of the United States as well, have tended to increasingly
absorb declines in prices denominated in their own currencies when their currencies rose and to fatten
profit margins when their currencies fell.
Unit labor costs in euros and sterling, for example, increased nearly 2 percent between the first quarter
of 2002 and the first quarter of 2004. So, given the average fall in euro and sterling prices of European
exports to the United States, gross operating profit margins on those sales must have declined more
than 20 percentage points.3 The margin squeeze, in effect, absorbed about three-quarters of the
decline in the dollar's exchange rate relative to the euro and the pound, on average, over the two
years. Export margins, as I indicated earlier, had apparently risen to high levels by early 2002,
following the roughly 40 percent increase in the value of the dollar in terms of euro and sterling from
1995 to 2002. Hence, margins in early 2004 might still have exceeded their levels of 1995.
However, with the strengthening of sterling and the euro that resumed in the last three quarters of
2004, exporters to the United States exhibited significant resistance to further lowering of euro and
sterling prices. Accordingly, dollar prices of imports from Europe picked up a bit. This pickup suggests
that profit margins were minimal at best a year ago and hence that exporters were willing to lose some
U.S. market share rather than compress margins still further. A noticeable downtrend in the share of
European exports in U.S. imports has been apparent over the past year.
***
Gains from increased currency hedging against the dollar since early 20024 may have enabled
European exporters to tolerate a fall in operating profit margins beyond what they otherwise would
have been able to tolerate. Hedging, however, can only partially and temporarily alter the impact of
exchange rates on export prices. To be sure, very long-dated contracts can transcend short-run
fluctuations in currencies. But, long-term hedging is expensive, and therefore, most currency futures
contracts are short-term. Once hedges expire, export revenues are no longer protected from past and
future changes in exchange rates, and any new hedges must reflect the new exchange rates. Thus,
successful currency hedges can at best delay but cannot prevent the ultimate effects of changes in
exchange rates on trade.
Many other exporters to the United States have exhibited pricing strategies similar to those of
European firms. Chinese exporters, of course, have not had to address this issue because China
continues to hold its renminbi at a fixed rate against the dollar.
U.S. exporters have also faced large exchange rate movements relative to many of their destination
markets. The ratio of U.S. merchandise export prices to manufacturing unit labor costs provides some
evidence of margin movements linked to exchange rates that is analogous to the effects I described
earlier for foreign exporters. Given the dollar's depreciation since 2002, U.S. exporters' profit margins
appear to be increasing, which bodes well for future U.S. exports and the adjustment process.
***
A consequence of the contraction in profit margins of exporters to the United States, and thus low
pass-through of dollar depreciation to U.S. import prices, has been minimal pressure on U.S.
consumer price inflation in recent years. A corollary is that the adjustment of U.S. real imports - that is,
the quantity of imported goods and services - has been negligible.
However, we may be approaching a point, if we are not already there, at which exporters to the United
States, should the dollar decline further, would no longer choose to absorb a further reduction in profit
margins.
Although the limited response, to date, of import prices to the dollar's decline has likely forestalled a
decline in U.S. real imports, the effect of the low pass-through of exchange rates into import prices on
the nominal dollar value of imports, and thus on the trade balance, is more complex. Increases in
import prices lower the quantity of imports but leave the resulting value of imports uncertain.
***
To understand why the nominal trade deficit - the nominal dollar value of imports minus exports - has
widened considerably since 2002, even as the dollar has declined, we must consider several
additional factors. First, partly as a legacy of the dollar's previous strength, the level of imports
exceeds that of exports by about 50 percent. Thus exports must grow half again as quickly as imports
just to keep the trade deficit from widening - a benchmark that has yet to be met. Second, as is
well-documented, the responsiveness of U.S. imports to U.S. income exceeds the responsiveness of
U.S. exports to foreign income; this difference leads to a tendency - even if the United States and
foreign economies are growing at about the same rate - for the growth of U.S. imports to exceed that
of our exports. Third, as of late, the growth of the U.S. economy has exceeded that of our trading
partners, further reinforcing the factors leading imports to outstrip exports. Finally, our import bill has
expanded significantly as oil prices have risen in recent years.
To be sure, the lower dollar has undoubtedly boosted the competitiveness of U.S. exports and the
profitability of U.S. exporters. These factors help explain the considerable increase in exports over the
past couple of years. Yet the positive effect of the dollar's decline on exports and on the trade balance
has been offset by the other aforementioned factors.
***
Besides market pressures, which appear poised to stabilize and over the longer run possibly to
decrease the U.S. current account deficit and its attendant financing requirements, some forces in the
domestic U.S. economy seem about to head in the same direction.
The voice of fiscal restraint, barely audible a year ago, has at least partially regained volume. If actions
are taken to reduce federal government dissaving, pressures to borrow from abroad will presumably
diminish.5
An increase in household saving should also act to diminish borrowing from abroad. The growth of
home mortgage debt has been the major contributor, at least in an accounting sense, to the decline in
the personal saving rate in the United States from almost 6 percent in 1993 to its current level of
1 percent. The fall in U.S. interest rates since the early 1980s has supported both home price
increases and, in recent years, an unprecedented rate of existing home turnover.
This combination has led to a significant increase in home mortgage debt. The rise in home prices
creates capital gains, which become realized with the subsequent sale of a home. The amount of debt
paid off by the seller of an existing home averages about three-fifths of the mortgage debt taken on by
the buyer, effectively converting to cash an amount of home equity close to the realized gain. This
cash payout is financed by the net increase in debt on the purchased home, and hence on total
mortgage debt outstanding.
Even after accounting for the down payments on any subsequent home purchase, sellers receive, net,
large amounts of cash, which they view as unencumbered. The counterpart of that cash, the increased
debt taken on by the homebuyers, is supported by the new home values enhanced by capital gains. In
addition, low mortgage interest rates have encouraged significant growth of home equity loan
advances and cash-out refinancings, which are another channel for the extraction of previously
unrealized capital gains on homes.
All told, home mortgage debt, driven largely by equity extraction, has grown much more rapidly in the
past five years than during the previous five years. Surveys suggest that approximately half of equity
extraction shows up in additional household expenditures, reducing savings commensurately and
thereby presumably contributing to the current account deficit.
Interestingly, the change in U.S. home mortgage debt over the past half-century correlates significantly
with our current account deficit.6 To be sure, correlation is not causation, and there have been many
influences on both mortgage debt and the current account. Nevertheless, over the past two decades,
major innovations in the United States have improved the availability and lowered the costs of home
mortgages. These developments likely spurred homeowners to tap increasing home equity to finance
consumer expenditures beyond home purchase. In contrast, mortgage debt is not so readily available
among our trading partners as a vehicle to finance consumption expenditures.
***
Because exporters to the United States are willing to countenance wide swings in profit margins, the
level of international trade may be less variable than under previous price-setting regimes when
exchange rate pass-through was greater. Arguably, this development has contributed to a higher level
of trade. Accordingly, the competitive benefits of globalization may be greater than if exporters allowed
exports rather than profit margins to swing widely with exchange rate changes, as they apparently did
earlier in the post-World War II period. Exports, of course, were a much smaller share of world GDP in
those years. And many, perhaps most, producers, as exchange rates moved in their favor, accordingly
chose to pick off only the low-hanging trade fruit, so to speak. Such opportunistic exports obviated
large up-front financial commitments to foreign markets. As trade barriers have been lowered over the
decades, much has changed, evidenced by the emergence of critical mass in many export markets,
the growing importance of multinational firms, and the rise of production processes that are integrated
across borders.
***
The interaction of a wide range of economic forces, which adjust at national borders to create what we
call the current account balance, has proved difficult to predict with any precision, primarily because of
the difficulty of forecasting exchange rates. These same forces have lessened our ability to anticipate
the consequences of a buildup of either a surplus or a deficit.
In addition, numerous issues that have arisen with respect to the adjustment of the U.S. current
account remain unresolved. One is the effect of Asian official purchases of dollars in support of their
currencies. Such intervention may be supporting the dollar and U.S. Treasury bond prices somewhat,
but the effect is difficult to pin down. Another issue is the influence of still-growing globalization,
arguably one of the key factors that has facilitated the financing of the U.S. current account deficit.
There is little evidence that the growth of globalization has yet slowed.
The dramatic advances over the past decade in virtually all measures of globalization have resulted in
an international economic environment with little relevant historical precedent.7 I have argued
elsewhere that the U.S. current account deficit cannot widen forever but that, fortunately, the
increased flexibility of the American economy will likely facilitate any adjustment without significant
consequences to aggregate economic activity.8 That argument will be tested, I suspect, by possibly
new twists and turns that will emerge in a seemingly ever-more complex international economic and
financial structure.