Greenspan's Delphic message on US deficit
Monday 07 February 2005
That Mr Greenspan chose to spend a whole speech talking about current accounts is, in itself, a rather interesting result. After all, it wasn't long ago that many Americans claimed that the US current account deficit really didn't matter. So, if Mr Greenspan decides to confront the issue, it may mean that current account deficits matter after all.
One of Mr Greenspan's main themes was the introduction of new technologies that had "broadened investors' vision to the point that foreign investment appears less exotic and risky". That, I think, is an entirely fair point: we know a lot more about what's going on in different parts of the world and, as a result, it's easier for us to gauge the risk associated with investing in one country rather than another. Mr Greenspan likened this process to the events of "a century and more ago", when "savings moved beyond local investment opportunities to develop national markets".
He also returned to the productivity theme, arguing that "the dramatic rise in underlying growth of US productivity over the past decade lifted real rates of return on dollar investments". In other words, he believes that at least part of the growth in external imbalances reflects, first, better economic performance of the US economy relative to its peers and, second, a global capital market that, through technological change, is better able to take advantage of these differences in economic performance.
All of this is a useful summary of the beliefs that dominated financial markets in the late 1990s, but it sits less easily with the events of more recent years. In particular, the decline in the dollar over this period of time might suggest that foreign investors now have more doubts about America's continued economic outperformance. Although it is true that productivity gains have continued to outstrip those in, say, Europe or Japan, it may just be that foreign investors are beginning to recognise that recent US borrowings have been used for consumption or military spending, not for additions to productive capacity over the longer term.
Mr Greenspan thinks that the dollar's decline will eventually have an impact on the size of America's current account deficit. He pointed to two factors that had delayed the effects of the dollar's fall so far. The first was the reaction of European exporters who, up until now, had absorbed the effects of a stronger euro through price cuts in euro terms to maintain constant dollar prices. This had led to a loss of profits for European exporters but, so far, not much in the way of a rise in US import prices, thereby leaving US consumers reasonably able to carry on spending.
Clearly, Mr Greenspan thinks this episode is now drawing to a close: "we may be approaching a point, if we are not already there, at which exporters to the United States ... would no longer choose to absorb a further reduction in profit margins". In other words, there is now a bigger danger of a rise in US import price inflation, which will either hit real incomes domestically or force up domestic inflation. All in all, Mr Greenspan expects the US to begin to feel the full effects of currency depreciation this year.
The second, related, factor is associated with hedging strategies. European companies may successfully have hedged themselves against the short-term effects of dollar weakness, but Mr Greenspan pointed out that "long-term hedging is expensive and, therefore, most currency futures contracts are short-term". An obvious point, perhaps, but one that suggests there are lags between initial currency movements and their full effect on economic activity.
Despite all this, Mr Greenspan seems doubtful that the current account deficit will fall very far from current levels unless further policy changes come through. Household leverage, boosted by continued increases in house prices, had contributed to higher demand for imports (an argument, one would think, to suggest that interest rates have been too low in recent years). US imports are now so much larger than exports that "exports must grow half again as quickly as imports just to keep the trade deficit from widening". The income elasticity of demand for imports into the US was significantly higher than the foreign income elasticity for US exports (a conclusion that seems odd given the supposed US productivity miracle).
Hope of a more sustained reversal of current account trends rests with other things. Mr Greenspan gave a gentle nudge to US political leaders, encouraging them to go the extra mile on budget deficit reduction. Yet unless the Bush administration chooses to reverse earlier tax cuts - an unlikely event - it is going to be very hard work indeed to reduce the deficit very far: no one enjoys spending cuts.
But why should Mr Greenspan even want the current account deficit to come down? Why should he be suggesting that the deficit needs to fall? After all, the opening section of his speech embraced the joys of unencumbered capital flows, arguing that larger external imbalances were a good thing because they demonstrated a healthier allocation of global capital. The explanation, I think, is that Mr Greenspan recognises that global capital allocation currently is perhaps a little less than healthy. He is suggesting that either the markets have got it wrong or, because of distortions imposed by governments and central banks, the markets have not been allowed to get it right.
So what are these problems? The most obvious is the type of capital inflow. In the late-1990s, most of the inflows into the US were from private investors who believed in the "new paradigm". Now, a lot of the inflows come from central banks who don't want to see their currencies rising too far against the dollar: these inflows are a consequence of other objectives, not a sign that foreign investors believe US returns are higher than elsewhere - but they leave the US with too low a cost of capital through surging foreign purchases of US treasuries (see chart), which encourages housing bubbles and excessive consumer borrowing.
Then there is the issue of ageing populations. Ideally, capital should be flowing from those countries with populations fast heading towards retirement towards those countries with young populations. Within a G7 context, the US should get capital from Germany and Japan. But the world economy is no longer a G7 economy - China, India, other Asian economies, Latin America and Russia all have a role to play yet, for the most part, are either unable or unwilling to accept capital from elsewhere. In truth, too much money is flowing into a US economy whose population is consuming today rather than investing for the world tomorrow. If you don't believe me, think about the limited geographical dispersion of capital flows today compared with a century ago: back then, countries with low GDP per capita did a lot better than they do today.
And finally, there is the issue of sustainability. Mr Greenspan chose not to talk about this on Friday but he has certainly raised the issue before. In November, he said that "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." We might not have reached that point yet, but Mr Greenspan knows it is coming. Better, then, to act now before the US economy - and, for that matter, the world economy - ends up in another fine mess.
Stephen King is managing director of economics at HSBC
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