Wall Street History
Greenspan on Deficits
[Wall Street History returns December 10]
Following are excerpts from an important speech given by
Federal Reserve Chairman Alan Greenspan to a banking
conference in Frankfurt, Germany on November 19, 2004.
U.S. markets moved sharply lower when details emerged, as the
chairman addressed the issue of soaring deficits and American
reliance on foreigners to finance it. While the overall theme
echoes sentiments long expressed by market and economic
strategists, coming as it did from Greenspan sent a clear signal
there is concern a monetary crisis could occur sooner than later.
“Foreign exchange trading volumes have grown rapidly, and the
magnitude of cross-border claims continues to increase at an
impressive rate. Although international trade in goods, services,
and assets rose markedly after World War II, a persistent
dispersion of current account balances across countries did not
emerge until recent years. But, as the U.S. deficit crossed 4
percent of GDP in 2000, financed with the current account
surpluses of other countries, the widening dispersion of current
account balances became more evident. Previous postwar
increases in trade relative to world GDP had represented a more
balanced grossing up of exports and imports without engendering
chronic large trade deficits in the United States, and surpluses
among many other countries.
“Home bias – the propensity of residents of a country to invest
their savings disproportionately in domestic assets – prevailed
for most of the post-World War II period .
“That bias, however, diminished rather dramatically over the past
ten years, arguably in large measure because of the acceleration
in productivity growth in the United States. The associated
elevation of expected real rates of return relative to those
available elsewhere increased investment opportunities in the
United States .
“Basic national income accounting implies that domestic saving
less domestic investment is equal to net foreign investment, a
close approximation of a nation’s current account balance. The
correlation coefficient between domestic saving and domestic
investment varies inversely over time with the dispersion of
current account balances across countries. Obviously, if the
correlation coefficient is 1.0, meaning that every country
allocates its domestic saving only to domestic investment, then
no country has a current account deficit, and the variance of
world current account balances is zero. As the correlation
coefficient falls, as it has over the past decade, one would expect
the near algebraic equivalent – the dispersion of current account
balances – to increase. And, of course, it has. Over the past ten
years, a large current account deficit has emerged in the United
States matched by current account surpluses in other countries .
“Current account imbalances, per se, need not be a problem, but
‘cumulative’ deficits, which result in a marked decline of a
country’s net international investment position – as is occurring
in the United States – raise more complex issues. The U.S.
current account deficit has risen to more than 5 percent of GDP.
Because the deficit is essentially the change in net claims against
U.S. residents, the U.S. net international investment position
excluding valuation adjustments must also be declining in dollar
terms at an annual pace equivalent to roughly 5 percent of U.S.
“The question now confronting us is how large a current account
deficit in the United States can be financed before resistance to
acquiring new claims against U.S. residents leads to adjustment.
Even considering heavy purchases by central banks of U.S.
Treasury and agency issues, we see only limited indications that
the large U.S. current account deficit is meeting financing
resistance. Yet, net claims against residents of the United States
cannot continue to increase forever in international portfolios at
their recent pace. Net debt service cost, though currently still
modest, would eventually become burdensome. At some point,
diversification considerations will slow and possibly limit the
desire of investors to add dollar claims to their portfolios.
“Resistance to financing, however, is likely to emerge well
before debt servicing becomes an issue, or before the economic
return on assets invested in the United States or in dollars more
generally starts to erode. Even if returns hold steady, a continued
buildup of dollar assets increases concentration risk.
“Net cross-border claims against U.S. residents now amount to
about one-fourth of annual U.S. GDP. A continued financing
even of today’s current account deficits as a percentage of GDP
doubtless will, at some future point, increase shares of dollar
claims in investor portfolios to levels that imply an unacceptable
amount of concentration risk.
“This situation suggests that international investors will
eventually adjust their accumulation of dollar assets or,
alternatively, seek higher dollar returns to offset concentration
risk, elevating the cost of financing of the U.S. current account
deficit and rendering it increasingly less tenable. If a net
importing country finds financing for its net deficit too
expensive, that country will, of necessity, import less.
“It seems persuasive that, given the size of the U.S. current
account deficit, a diminished appetite for adding to dollar
balances must occur at some point. But when, through what
channels, and from what level of the dollar? Regrettably, no
answer to those questions is convincing. This is a reason that
forecasting the exchange rate for the dollar and other major
currencies is problematic .
“U.S. policy initiatives can reinforce other factors in the global
economy and marketplace that foster external adjustment. Policy
success, of course, requires that domestic saving must rise
relative to domestic investment. Policy initiatives addressing
individual components of domestic saving in years past appear to
have had significant effects on total domestic saving, even
though changes in the individual components are not wholly
independent of one another.
“Reducing the federal budget deficit (or preferably moving it to
surplus) appears to be the most effective action that could be
taken to augment domestic saving. Significantly increasing
private saving in the United States – more particularly, finding
policies that would elevate the personal saving rate from its
current extraordinarily low level – of course would also be
helpful. Corporate saving in the United States has risen to its
highest rate in decades and is unlikely to increase materially.
Alternative approaches to reducing our current account
imbalance by reducing domestic investment or inducing
recession to suppress consumption obviously are not constructive
“It is of course possible that U.S. policy initiatives directed at
closing the gap between our domestic investment and domestic
saving, and hence narrowing our current account deficit, may not
suffice. But should such initiatives fall short, the marked
increase in the economic flexibility of the American economy
that has developed in recent years suggests that market forces
should over time restore, without crises, a sustainable U.S.
balance of payments. At least this is the experience of developed
countries, which since 1980, have managed and eliminated large
current account deficits, some in double digits, without major
“Although we have examples of the efficacy of flexibility in
selected markets and evidence that, among developed countries,
current account deficits, even large ones, have been defused
without significance consequences, we cannot become
complacent. History is not an infallible guide to the future. We
in the United States need to continue to increase our degree of
flexibility and resilience. Similar initiatives elsewhere will
enhance global resilience to shocks.
“Many steps have been taken in the euro area to facilitate the free
flow of labor and capital across national borders, and
considerable progress is being made to enhance competition in
product, labor, and financial markets. But more will need to be
done in Europe as well as in the United States to ensure that our
economies are sufficiently resilient to respond effectively to all
the shocks and adjustments that the future will surely bring.”
Wall Street History will return December 10.