Donald L Kohn: Imbalances in the US economy
Remarks by Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve
System, at the 15th Annual Hyman P Minsky Conference, The Levy Economics Institute of Bard
College, Annandale-on-Hudson, New York, 22 April 2005.
* * *
I am pleased to be here today at this conference considering U.S. financial and macroeconomic
conditions and the economy's prospects, puzzles, and imbalances. You have considered a broad
range of issues of interest to us at the Federal Reserve, and I am sorry I could not be here for your
discussions. I thought it might be useful for me to close the conference by giving you my perspective
on some of the imbalances currently evident in the U.S. and global economies, how they might be
resolved, and their implications for policy - including monetary policy. I must emphasize that these
views are my own and not necessarily those of my colleagues on the Federal Open Market
Committee.1
The current state of the economy
The United States has been doing well over the past few years by most measures of overall economic
performance. Real gross domestic product growth has rebounded smartly from the 2001 recession,
and slack both in labor and product markets has eroded appreciably. After a substantial period of little
or no increase in employment, payroll gains have picked up to an average of 160,000 per month over
the past half year, and the unemployment rate has fallen to 5-1/4 percent, almost 1 percentage point
below where it was two years ago. Household spending on goods and services and housing has been
strong throughout the expansion, and, more recently, business investment in capital equipment has
surged. The increase in output has been accompanied by large increases in labor productivity that,
since 2002, have been in excess of even the elevated pace of the second half of the 1990s. To be
sure, the rise in energy prices seems to have taken a toll on consumer confidence and spending most
recently. But with financial conditions still accommodative, profits and cash flow still healthy, and
incomes continuing to increase, most forecasters expect growth to remain solid.
Excluding food and energy, the rate of inflation has fluctuated around 1-1/2 percent over the past few
years, measured by the chain-weighted price index for personal consumption expenditures. Core
inflation has been running somewhat faster more recently, in part because of the increases in the
prices of energy, commodities, and imports that began last year. Nevertheless, barring further sizable
increases in the prices of oil and natural gas, both core and headline inflation rates should moderate
later this year. Buttressing this view, long-run inflation expectations have been, on balance, fairly
stable in the face of these price gyrations.
Imbalances in the economy
Although the overall state of the economy is favorable, some aspects of the current situation might be
viewed as worrisome. In particular, beneath this placid surface are what appear to be a number of
spending imbalances and unusual asset-price configurations. At the most aggregated level, the
important imbalance is the large and growing discrepancy between what the United States spends
and what it produces. This imbalance, measured by the current account deficit, has risen to a record
level, both in absolute terms and as a ratio to GDP. Moreover, the cumulative value of past current
account deficits - the net foreign indebtedness of the United States - is also at a record high, again
both in absolute terms and as a ratio to GDP.
The growing current account deficit has been associated with a pronounced decline in the saving
proclivities of both the private and public sectors. Over the past year, households have saved only
about 1 percent of their after-tax income, compared with about 8 percent on average from 1950 to
2000. In the public sector, the federal-budget deficit has been larger in the past, at least relative to the
size of GDP, but the deterioration in the balance over recent years has been sizable, moving from a
surplus of $236 billion in fiscal year 2000 to a deficit of more than $400 billion last year. The resultant
overall decline in national saving contrasts with the pace of capital spending: Residential investment
as a share of GDP now stands at its highest level since the 1950s, while the share of GDP devoted to
investment in plant and equipment has recovered sufficiently from its recent slump to return to the
neighborhood of its long-run average.
One might have thought that, with probably limited economic slack remaining, such a pronounced
imbalance between national saving and domestic investment would have placed substantial upward
pressure on interest rates. One also might have expected real interest rates to be high at a time when
we are experiencing rapid productivity growth. But, as you know, nominal and real yields on both
short-term and long-term Treasury securities are low by historical standards. Moreover, although
premiums on private bonds relative to Treasury yields have risen somewhat of late, they are still at the
low end of their historical range, suggesting that investors are sanguine about default risk and other
types of uncertainty.
Low interest rates have, in turn, been a major force driving the phenomenal run-up in residential real
estate prices over the past few years, and the resultant boost to net worth must be one of the reasons
households have felt comfortable directing so little of their current income to saving. However, whether
low interest rates and other fundamental factors can fully explain the current lofty level of housing
prices is the subject of substantial debate.
This situation raises some difficult questions. Can the aforementioned spending imbalances and
possible asset-price anomalies continue without threatening macroeconomic stability? And if they
cannot be sustained, how will they unwind? Will the transition be relatively benign, or will it be a rocky
adjustment with deleterious effects on economic growth, inflation, and other factors? And finally, what
role will government policies play in influencing the path of adjustment?
Sustainability of current imbalances
On the question of sustainability, it is worth noting that these sorts of imbalances are not new. The
trade account has been persistently in deficit since the late 1970s, and the current account has been
in a similar state almost continuously since the early 1980s. The personal saving rate has been
declining since the mid 1980s. And the federal government has spent more than it has taken in every
year since 1970 except for a brief respite between 1998 and 2001. So these imbalances have been
around for a long time, and our economy is still churning out high rates of productivity and income
growth. But, the magnitude of these imbalances is increasingly moving into unfamiliar territory. I have
already noted the unprecedented level of the current account deficit and the depressed household
saving rate. As for the federal budget, the projected funding shortfall in Social Security and exploding
Medicare and Medicaid costs mean that without a reassertion of fiscal discipline, the long-run outlook
for the federal budget balance is for worse to come.
The sustainability of these large and growing imbalances has become especially suspect because it
would require behavior that appears to be inconsistent with reasonable assumptions about how
people spend and invest. For example, it seems unlikely that foreigners would be willing to continue to
indefinitely increase the proportion of their wealth held in dollars without upward movements in the
expected return on these assets. And if the government tried to honor its current long-run
commitments to future retirees without raising tax rates, it seems unlikely that it could borrow the
massive amounts needed without paying creditors higher returns - returns potentially so high over
coming decades as to be economically debilitating.
Similar considerations apply to the current low rate of household saving. Most theories of consumer
behavior emphasize the desire of households to save for retirement. However, given average life
expectancies and the typical number of working years, a sustained saving rate of less than 2 percent
is too low for households to accumulate enough wealth to maintain their standard of living after
retirement - unless, of course, those households are lucky enough to receive outsized capital gains on
their homes and other assets. Although many households have received such windfalls over the past
few years, such gains are not likely to be continually repeated in the future.
The current imbalances will ultimately give way to more sustainable configurations of income and
spending. But that leaves open the question of the nature of that adjustment. Ideally, the transition
would be made without disturbing the relatively tranquil macroeconomic environment that we now
enjoy. But the size and persistence of the current imbalances pose a risk that the transition may prove
more disruptive.
The underlying causes of the imbalances
Speculating on the adjustment path would be more fruitful if we understood how we got to where we
are today. Unfortunately, the situation is complicated and, even after the fact, not fully understood,
which is why we hold conferences like this one. Nevertheless, I think we can identify several factors
that have played an important role in the emergence of these imbalances, and in so doing gain some
insight into their likely resolution.2
A rise in the net supply of saving in other countries, the perception that dollar assets are a relatively
favorable vehicle in which to place that saving, and an increase in global financial integration that has
facilitated the transfer of savings have been important factors in our growing trade and current-account
imbalances. The increased desire to hold dollar assets resulted in part from the jump in the rate of
increase in productivity that materialized in the United States in the mid- to late-1990s and that, in turn,
raised the perceived rate of return on U.S. assets. At the same time, sluggish growth and recessions
in other developed countries and the Asian financial crisis of 1997 damped returns elsewhere.
Moreover, foreign governments - especially in Asia - took the lesson from the financial crisis that a
large war chest of reserves was needed to protect against the volatility of capital flows. Such a buildup
of dollar reserves was also consistent with an emphasis on stable exchange rates that fostered
exports as means to sustaining high growth rates in their countries. The resultant shift toward
dollardenominated assets was associated with capital inflows into the United States and a deterioration of
the current-account balance. In addition, the increased willingness of the rest of the world to hold U.S.
assets, along with the jump in our productivity growth, contributed to a sharp increase in U.S. equity
valuations. And the associated capital gains, in turn, caused the net worth of U.S. households to soar
relative to their income and induced a reduction in personal savings rates.
Then, in 2000 and 2001, global stock markets slumped and business investment was slashed. In the
United States and elsewhere, monetary and fiscal policies turned stimulative to bolster demand and to
stave off unwelcome disinflation. The size of the stimulus required to accomplish our macroeconomic
objectives in the United States was further increased by the sluggish economic growth of our trading
partners and by continued demand for dollar assets, which further exacerbated our trade imbalance.
In the aftermath of the recession in the United States, private aggregate demand, both here as well as
in Europe and Japan, has strengthened only gradually. This slow rebound has meant that many
central banks around the world have held real interest rates low to support real activity and keep
inflation stable. The climate of low interest rates has in turn bolstered asset markets in some countries,
especially residential real estate markets. The associated capital gains, coupled with financial market
innovations that make extracting housing equity easier in the United States, help to explain the
depressed level of the personal saving rate here; low interest rates themselves also have probably
boosted consumption relative to income by reducing the return to saving.
At the same time, demands for dollar-denominated assets have been sustained at a high level.
Returns on these assets have apparently continued to look reasonably attractive to private investors.
And some foreign governments have continued to accumulate dollar assets, adding to already high
levels of reserves. Their actions likely reflect in part a concern about the adequacy of their domestic
demand to support the advances in economic activity required for job creation.
This explanation has emphasized a favorable relative return on U.S. investment, coupled with
increased foreign willingness to hold dollar assets, as causal factors driving the United States' growing
current account deficit and low national saving rate. But causation may in part also have run from
structural influences that contributed to reduced U.S. saving. That is, a fiscal policy shift toward greater
deficits and innovations in financial markets and other structural changes that facilitated household
spending worked to lower national saving relative to domestic investment. The resultant upward
pressure on rates of return here relative to those abroad have helped to draw in capital and increase
the current account deficit.
Unwinding the imbalances
What can we say about the likely path by which these spending imbalances will resolve themselves
and about the effects those resolutions will have on the broader economy? Almost a year ago, the
Federal Reserve started a process of removing the unusual degree of policy accommodation, which
was outliving its usefulness as the economic expansion gathered strength and the possibility of
declines in inflation receded. We have not yet finished this task: The federal funds rate appears to be
below the level that we would expect to be consistent with the maintenance of stable inflation and full
employment over the medium run, and, if growth is sustained and inflation remains contained, we are
likely to raise rates further at a measured pace. By increasing the return to saving and by damping the
upward momentum in housing prices, rising interest rates should induce an increase in the personal
savings rate, and thereby lessen one of the significant spending imbalances we have noted.
Forecasting the path of the overall spending-production imbalance is more difficult. To a great extent,
continuation of the current account deficit depends on the willingness of investors to provide financing.
One factor that will influence their willingness is the rate at which U.S. dollar assets are increasing in
global portfolios relative to other assets. We can speculate that unless a persistently large current
account deficit in the United States is accompanied by further and continuous shifts in the world's
willingness to increase holdings of dollar-denominated assets in their total portfolios, investors will
ex ante
ultimately require higher rates of return on their U.S. assets relative to those available on
foreign assets. This presumably applies to foreign governments as well as private investors.
Governments will eventually see that returns from encouraging domestic investment will outstrip those
expected on their growing holdings of dollar reserves, or that more-flexible exchange rates are
required to exercise a stabilizing monetary policy. Over the past few years, we have seen a moderate
decline in the dollar, indicating that the demand for dollar-denominated assets is not infinitely elastic.
And, at some point, the current account deficit should start to narrow.
In addition, the process of narrowing deficits may be helped by an autonomous rise in domestic
saving. We do not understand all the reasons for recent low personal saving rates, and the rise in the
saving rate could exceed the increase that results from likely movements in interest rates and house
prices - especially as households contemplate the adequacy of their retirement income. And fiscal
policymakers do seem to be more aware of the need to change the medium-term trajectory of the
federal budget.
To the extent that current spending behavior is built on realistic expectations - in particular, for future
short-term interest rates, the exchange rate, rates of return on capital investments in the United States
relative to those abroad, and housing price appreciation - the transition should be relatively orderly:
Asset prices should adjust gradually to changing developments, as should the spending patterns of
households and firms. But if current expectations are badly distorted, then the way forward may not be
so smooth. Eventually, reality always asserts itself over wishful thinking, and such realignments are
sometimes abrupt, as illustrated by the collapse of the high-tech bubble a few years ago. In such
circumstances, asset prices can adjust sharply, and private spending may also respond quickly,
making it difficult for monetary and fiscal policy actions to provide a timely enough counterweight to
keep the economy continuously on track.
Are expectations substantially distorted? Because we seldom have direct and reliable readings, it is
hard to say. Still, some observations can be made. First, even after their recent increases, both
Treasury yields and risk premiums on private securities are low by historical standards. To a
considerable extent, Treasury yields reflect two factors: low actual and expected inflation; and the
market's belief that, with growth moderate and inflation contained, the federal funds rate will move up
only gradually as the expansion proceeds. In addition, with the macroeconomic climate expected to
remain calm, investors seem to require less compensation for the risks inherent in lending over a
longer term or of supplying credit to borrowers who usually have a greater chance of defaulting. In this
environment, the likelihood that major credit problems will develop would seem limited, and that limited
risk makes it not unreasonable for private bond premiums to be at the low end of their historical range.
Still, investors seem to expect short-term interest rates to remain on the low side of historical averages
for some time. These subdued expectations may reflect a belief that underlying global demand will
remain damped and that the world will continue to be willing to invest heavily in the United States.
A second observation concerns the housing market, which you have already discussed. A couple of
years ago I was fairly confident that the rise in real estate prices primarily reflected low interest rates,
good growth in disposable income, and favorable demographics. Prices have gone up far enough
since then relative to interest rates, rents, and incomes to raise questions; recent reports from
professionals in the housing market suggest an increasing volume of transactions by investors, who
(along with homeowners more generally) may be expecting the recent trend of price increases to
continue. Even so, such a distortion would most likely unwind through a slow erosion of real house
prices, rather than a sudden crash. Moreover, experience suggests that consumer spending would
respond only gradually to any loss in wealth - an important consideration because a gradual
adjustment in spending would give offsetting policy actions time to work. In any event, I take some
comfort from the continuing disagreement among close students of the market about whether houses
are overvalued, and, given the widespread press coverage of this issue, from my expectation that
people should now be aware of the risks in the real estate market.
Finally, there is the exchange rate. The inability of anyone to predict movement in the dollar accurately
and consistently has been evident. Presumably, the dollar's value is based partly on market
expectations about future interest rates, trade flows, and portfolio preferences, among other things.
There is no particular reason to think that these expectations are substantially distorted. Certainly no
investor out there buying dollar assets could be surprised to learn that the United States has a growing
current account deficit! And, I do not anticipate a marked and persistent downshift in U.S. productivity
growth that would greatly reduce the expected returns from holding dollar-denominated assets.
Governments who have been accumulating dollar assets also would seem to have no reason for
shifting their preferences suddenly and disruptively, even in the context of allowing greater exchange
rate flexibility.
Financial markets are flexible and increasingly integrated around the world, facilitating continuous and
gradual adaption of capital flows to changing circumstances. Markets for goods and services are also
becoming more integrated and flexible, though this trend has been, perhaps, more subject to
government actions to slow the process. In fact, the dollar has risen in 2005, reflecting the interplay of
portfolio preferences and shifting patterns of saving and investment in markets. In all likelihood,
adjustments toward reduced imbalances in the United States and globally will be handled well by
markets without, by themselves, disrupting the good, overall performance of the U.S. economy -
provided, of course, that the Federal Reserve reacts appropriately to foster price and economic
stability.
Still, complacency would be ill-advised. Although the odds seem favorable for an orderly adjustment,
the current imbalances are large and - importantly for gauging risks - unusual from a historical
perspective. Thus, we have little experience to call on in judging when and how they will be corrected.
In such circumstances, we cannot rule out sudden shifts in expectations, whether or not they are
unreasonable to begin with, and asset prices may change suddenly. Investors may recognize the
unsustainability of some flows and prices, but believe they can adjust in advance of the market - as
apparently many thought they could in the tech-stock bubble - and their reactions when prices move
could add to volatility. Moreover, we cannot rule out governments engaging in unwise policies -
policies that might undermine confidence or might hinder market adjustments and associated changes
in asset prices.
The role of policy
Sound public policies are essential to enhance the chances that any transition will be smooth. A
permanent correction to the spending imbalances must involve the restoration of fiscal discipline and
long-run solutions to the financing problems of Social Security, Medicare, and Medicaid. Achieving
these objectives are important in any event, but they take on added weight to the extent that we
cannot count on an ever-increasing flow of global savings coming to the United States. Without a
resolution of these fiscal problems, the balancing of aggregate production and spending would be
much more difficult and would result in intensified pressures on interest rates. Those pressures would
tend to hold down the growth of investment and productivity and they would exacerbate asset-price
movements and adjustment difficulties in other markets.
Adjustment of global current-account imbalances could also be aided by changes over time in the
policies of our trading partners. To some extent, it would seem appropriate for them to use their
macroeconomic policies to stimulate domestic spending. In many cases, however, the root cause of
deficient demand seems to be more structural than cyclical in nature, and would thus call for more
micro-oriented measures. Combined, these policy initiatives on the part of our trading partners should
yield higher productivity growth, generate more vigorous spending abroad, raise rates of return on
their capital investment, and ease their adjustment to smaller U.S. deficits. These changes, in turn,
would boost the demand for U.S. exports and could shift portfolio preferences away from
dollar-denominated assets.
Other public policies here and abroad can have an important influence on the transition process by
working with markets and facilitating adjustment. For example, governments should strive to maintain
and enhance the flexibility of markets. In particular, the United States and its trading partners should
vigorously protect the current degree of market openness and should aim to reduce trade barriers
further. Over time, increased exchange rate flexibility abroad would also be beneficial. These and
other types of market flexibility help facilitate needed shifts in spending and prices; without them,
rigidities might impede such stabilizing changes, causing adjustments to break out forcefully in other,
more disruptive ways.
Strong financial institutions are especially important at this time when asset prices could move by large
amounts unexpectedly. By ensuring that financial institutions are adequately capitalized and well
prepared in general to deal with major changes in asset prices, prudential regulation decreases the
risk that the actions of impaired financial institutions could disrupt the flow of credit and thereby
intensify what might already be difficult adjustments. In addition, strong institutions should be
positioned to weather any necessary changes in short-term interest rates as policy is adjusted.
Finally, there is the role that monetary policy plays in reacting to these imbalances and their inevitable
unwinding. The Federal Reserve's mandate is to keep inflation low and stable and to promote full
resource utilization, with the economy expanding at its maximum sustainable rate. Thus, anything that
has the potential to threaten the stability of output and prices is of concern to us. These imbalances
certainly affect the forces of supply and demand and have consequences for price stability.
Nevertheless, their direct influence on monetary policy is limited: They are important to us in so far as
they affect the macro economy, and in this regard they are just a few of the factors that the Federal
Open Market Committee considers in assessing the prospects for the stability of prices and output.
Hence, we should take into account the claim on resources implied by the federal budget, as we
should the effect that housing wealth has on consumer spending and the economy more broadly. We
should note the implications of changes in the exchange rate or borrowing rates by U.S. corporations
that result from shifts in global investor sentiment. But, in the same vein, we should not hesitate to
raise interest rates to contain inflation pressures just because it might set off a retrenchment in
housing prices, just as we were willing to keep rates unusually low as house prices rose rapidly. Nor
should we hesitate to raise rates because higher rates mean higher debt-servicing burdens for the
current account, the fiscal authority, or households. In my view, our role is to anticipate as best we can
the macroeconomic effects of imbalances and their correction and to respond to unexpected changes
in asset prices and spending propensities as they occur. It is through such actions that we aim to
achieve our objective of economic stability.