The global economy is becoming ever more tightly knit, with
national economies increasingly drawn together through trade
and financial market transactions all facilitated by continuing
advances in telecommunications and related technologies. The
economic slowdown that the U.S. economy entered in 2001 was
shared by Europe, East Asia, and Latin America. Similarly, the revival
in growth that our economy has enjoyed since the middle of
last year has also shown up, to greater and lesser degrees, in other
parts of the world.
Although growth rates in different regions of the global economy
are somewhat synchronous, such shared movements in output do not ensure that
external deficits or surpluses will remain small.With the United States now running a
current account deficit equal to about five percent of the gross domestic product, the
rest of the world must run a correspondingly large net current account surplus. And
when the U.S. deficit starts to decline, then trade flows abroad will adjust as well,
reducing their overall surplus.
Because of its size and persistence, as
well as recent declines in the value of the
dollar, the U.S. current account balance
is receiving an extraordinary amount of
attention at present. Observers routinely
ask the following questions: Is the deficit
unusually, or even abnormally, large?
How long can it be sustained? How
might a correction of the deficit affect
the United States and its trading partners,
including Europe? One must always
be mindful of the possibility that the inevitable
adjustment process related to
global imbalances may be disorderly, but
the tone of these questions is often more
pessimistic than I think is warranted.
Nevertheless, these questions are important,
and I will devote the remainder of
this article to addressing them.
The economics profession has no
consensus model to tell us the appropriate
level of the current account balance
for a given economy. At best, economists
can agree on some general principles. I
will emphasize only two. First, current
account imbalances allow countries to
smooth consumption over time, for example,
in response to the ups and downs
of the world price of a major export.
Second, current account imbalances
which represent the difference between
domestic savings and domestic investment
allow savings to be allocated to
those parts of the world where they can
be invested most productively.
On the basis of these considerations,
some analysts have argued that industrial
countries should run current account
surpluses and invest their abundant
savings in developing countries,
which, being labor-rich and capital poor,
would offer higher rates of return.
Examples, however, of high or persistent
current account deficits abound among
industrialized economies, including
Canada (averaging 2.5 percent of GDP
from 1975 through 1998), the United
Kingdom (1.9 percent of GDP from
1984 through 2003) and Australia (4.1
percent of GDP from 1974 through
2003). Global investors have confidence
that in countries such as these as well as
in the United States they can safely seek
the highest possible return for their
funds.
Some of the factors that lie behind
such confidence are political stability, a
legal system that effectively protects
property rights and enforces commercial
contracts, economic policies that promote
and strengthen the role of markets,
a financial system that efficiently channels
resources to their most productive
uses, and an educational system that
produces highly skilled workers and supports
rapid technological development.
These elements are present in many mature
economies, including those of the
United States and Europe.
Rates of return on investments in
the United States have also been driven
by the rapid diffusion of technological
innovation. Labor productivity in the
United States accelerated to a rate of
about three percent in the period from
1996 to 2003. Over the same period,
smoothing through the recent cycle, the
value of U.S. equities rose about 80 percent,
compared with 60 percent for European
equities and a decline of 30
percent in Japan. These developments
attest to the expansion of favorable investment
opportunities in the United
States.
Thus, it is neither surprising nor abnormal
that, beginning in the mid-
1990s, capital flows to the United States
primarily in the form of direct investment
and equity inflows began to pick
up substantially, including, importantly,
investment flows from Europe. These
capital inflows exerted upward pressure
on the dollar and provided the financing
for our widening current account deficit.
To say that a current account deficit
is unsurprising or explainable is not to
say that it is sustainable in the long run.
With the net external debt of the United
States rising more rapidly than GDP,
some narrowing of the deficit is inevitable.
However, such shrinkage does
not mean that the current account
deficit will be eliminated. Moreover, to
say that the current account deficit cannot
stay large on a permanent basis is
not to say just when or how adjustment
will occur.
One can envision several developments
that could trigger adjustment,
many of which would be very positive
for the global economy. A pickup in perceived
rates of return abroad could divert
capital flows from the United States
to other countries and prompt adjustments
in external balances. In Europe,
for example, a considerable expansion in
the use of information technologies in
recent years has not, to date, appreciably
boosted growth rates of labor productivity.
It is conceivable that such high-tech
investments may finally lead to higher
productivity growth, further boosting
investment spending, and weakening
trade performance, as occurred in the
United States in the 1990s.
In Japan, corporate and financial
sector restructuring appears to be making
gains. In Latin America, improved
policies and more flexible exchange rates
may set the stage for renewed capital inflows.
And in Asia, a revival of domestic
demand could give the authorities confidence
that, if they allow capital inflows
to strengthen their currencies and narrow
their current account surpluses,
high rates of economic growth will be
maintained.
Even if rival sources of demand for
global capital do not emerge, another
factor that would induce adjustment of
the current account, if it were to occur,
would be a diminishing appetite for additional
U.S. assets and, therefore, a reduced
willingness to finance the deficit.
One cannot know whether or at what
point such concerns might become
pressing. By several measures, however,
the imprint of U.S. financing needs on
global capital markets has not been so
large as to be problematic. At roughly 25
percent of GDP, the net external debt of
the United States is still below that of
several other industrial economies, including
the Netherlands (30 percent),
Finland (40 percent), and Australia (60
percent).
Moreover, even though the United
States has been a net debtor since 1986,
the net income on the international investment
position has remained positive,
as the rate of return on U.S. investments
abroad continues to exceed that on foreign
investments in the United States.
From the standpoint of investor portfolios,
notwithstanding years of large current
account deficits, the share of U.S.
equities in global equities actually fell
from 49 percent in 1997 to 47 percent in
2002; the U.S. share in the global bond
market moved up only marginally during
the same period, from 42 percent to
44 percent.
Finally, current account adjustment
may be prompted by increases in U.S.
saving. Concerns about the expanding
budget deficit may prompt some reining
in of fiscal policy, leading to a reduction
of public sector dissaving. In the private
sector, personal saving rates remain extremely
low by historical standards and
thus may revert to earlier norms at some
point. Either of these developments
would boost total domestic savings and,
all else being equal, cut into the current
account deficit.
Although we cannot know the time
frame over which capital flows may
begin to shift or U.S. demand for imports
to lessen, so far there appears to
have been no loss of appetite for dollar denominated
assets. The dollar has declined
since early 2002, but net private
capital inflows have remained strong. In
the first two months of this year, net private
foreign purchases of U.S. securities,
which are admittedly volatile, averaged
about $60 billion, well above the $33 billion
monthly pace reached in 2001 and
2002, when the dollar was much higher.
Moreover, while I am not privy to their
plans, I note that foreign authorities,
who are increasingly large holders of
dollars, currently show few signs of substantially
adjusting the composition of
their balance sheets.
If a substantial current account adjustment
is required, how might it take
place, and what might be its effects on
the U.S. and global economies? As to the
first of these questions, three mechanisms
might induce a narrowing of the
current account deficit.
First, a fall of U.S. prices below foreign
prices could raise our competitiveness.
Prices have become relatively
stable, by historical standards, in the
United States and its trading partners,
however, and, it is not clear how much of
a dent this could put in the trade deficit.
A second possibility is that an increase of
foreign growth above U.S. growth could
boost our exports. Between 1970 and
1995, foreign GDP growth, weighted by
U.S. trade, exceeded U.S. growth by
nearly two thirds of a percentage point
annually; since then, U.S. growth has
exceeded foreign growth by a quarter
of a percentage point. Thus, there is
some potential for foreign growth to rise
relative to U.S. growth. Finally, price
adjustments through exchange rate
adjustment, by encouraging exports
and making imports more costly,
could play a role in current account
adjustment.
I must emphasize that, no matter
how the U.S. external imbalance is narrowed,
the level and composition of demand,
both in the United States and
abroad, would have to change. Such a
change, in turn, would require adjustments
of relative prices. In the United
States, to accommodate increases in exports
relative to imports, changes in relative
prices would be needed to shift
production toward internationally
traded goods and services and to shift
consumption toward non-traded goods
and services. By the same token, adjustment
by our trading partners to a reduction
in the U.S. current account deficit
would require both increased domestic
demand to maintain the overall level of
economic activity and an adjustment of
relative prices to raise the share of non traded
goods in production and of
traded goods in consumption.
The prospect of a correction in the
current account is often portrayed in
ominous tones, a dark storm cloud
looming on the economic horizon. Yet,
the economic adjustments I have just described
are both feasible and, properly
managed, need not lead to undue distress,
either in the United States or
abroad. After the dollar correction of the
mid-1980s, for example, economic activity
in the United States continued to expand
as the growth of domestic demand
eased but was replaced by strong contributions
from net exports. During that
period, analogous adjustments helped to
maintain economic performance among
our trading partners. The pace of GDP
growth in the foreign G7 economies,
weighted by U.S. exports, increased from
about 2.5 percent during 1982-84 to
nearly 4 percent in 1985-87 as greater
domestic demand growth compensated
for weaker performance in net exports.
U.S. current account adjustment
could, in fact, be associated with quite
favorable scenarios for the global economy.
For example, the rise in foreign
productivity growth that I touched on
earlier could work through several channels
to narrow the U.S. trade deficit as
funds were attracted abroad. Strong domestic
demand among our trading partners
would probably outweigh any drag
resulting from appreciation of their currencies,
while U.S. exports would benefit
from both a change in relative prices and
stronger foreign growth.
Of course, the financial press frequently
points to less favorable scenarios,
including the so-called disorderly
correction, that is, a rapid fall in the dollar
that engenders a steep falloff in U.S.
bond and equity prices and that perhaps
disrupts other national markets as well. I
have seen little evidence to suggest that
this scenario is likely, notwithstanding its
popularity. The fall in the dollar since
early 2002 has not disrupted financial
markets, nor did the dollar's previous
correction in the 1980s. Moreover, most
U.S. external debt is in dollars, so currency
depreciation is unlikely to lead to
the balance-sheet problems that arise
during financial crises in developing
countries, although obviously some parties
that have not taken precautions
would take losses.
That said, central bankers are paid to
be prudent and watchful, and we will
obviously continue to monitor closely
international financial markets and their
effects on the U.S. economy. Looking
ahead, I see no obvious indications that
the external sector poses significant concerns
for growth or stability. Not only
has the decline in the dollar to date failed
to disrupt U.S. financial markets, but
most would judge that, on balance, it has
had only modest effects on inflation.
Consumer spending is continuing to
rise strongly and, although activity in
housing markets has eased a bit, on balance,
from the brisk pace of late last year,
both sales and construction remain at
high levels. In the business sector, spending
on equipment and software appears
to be increasing quite strongly, although
outlays for nonresidential structures
have remained weak. In addition, employers
have been adding significantly to
their payrolls in the latest few months, a
sign that they have become more confident
about the sustainability of the economic
expansion.
Going forward, policy makers will
have to determine whether the improvements
evident in the recent labor market
measures indicate that the economy is
on a path to closing the pool of underutilized
resources. The strong productivity
gains of recent years, which probably
depressed job creation for a time, are a
positive for the economy's long-run outlook
and the creation of wealth. Partly
owing to these same increases in productivity,
inflationary pressures have generally
been muted. Now the process of
disinflation appears to have ceased, and
inflation has apparently stabilized. However,
we cannot be complacent regarding
inflation and inflation expectations.
Should the Federal Reserve conclude
that the maintenance of price stability is
in jeopardy, I am confident that it will
act appropriately.
To conclude, a change in the tone of
international financial markets that required
a substantial adjustment of the
U.S. current account would obviously
have important implications for spending
and economic activity, both here and
abroad. However, such an adjustment,
properly handled, need not derail the
global economy nor cloud the bright
prospects shared by the United States
and Europe, which are linked by myriad
ties of commerce, communications, culture,
and political tradition.
Roger W. Ferguson, Jr. is Vice Chairman of the Board of Governors of the
Federal Reserve System, currently serving a second four-year term ending October
28, 2007. While on the Board of Governors,
he has served as Chairman of the Joint Year 2000 Council; Chairman of the Group
of Ten Working Party on Financial Sector Consolidation, examining the causes
of consolidation in the financial
sector and its potential effects; Chairman of the Committee on the Global Financial
System (CGFS); and Chairman of the Financial Stability Forum (FSF), which promotes
international financial stability through information exchange and international
cooperation in
financial supervision and surveillance. He was previously a partner at McKinsey & Company, Inc.,
an international management consulting firm.
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