Greenspan delivers annual Per Jacobsson Lecture: "It is the level of debt, not the source of financing, that should engage us" (IMF photo)
PER JACOBSSON LECTURE
Greenspan, in an October 21 lecture sponsored by the Per Jacobsson Foundation—a regular event for more than 40 years at the World Bank-IMF Annual Meetings—noted that the unwinding of balance of payments imbalances may take some time and will likely not disrupt the real economy, but cautioned that protectionism and a drift toward fiscal instability in the U.S. and other countries could make the adjustment painful.
U.S. external current account deficit
Greenspan said that "unless protectionist forces drain the flexibility of the international financial system, I do not view the ultimate unwinding of America's current account deficit," about 6 percent of U.S. gross domestic product, "as a cause for undue alarm."
He said the rapid growth in the U.S. current account deficit in the last 10 to 15 years does not indicate a sudden, unhealthy shift in behavior by U.S. borrowers—households, businesses and governments. The U.S. deficit should not be viewed in isolation; it is the result of U.S. businesses and governments turning to "foreign sources of deficit funding" in place of domestic sources "and not predominantly the result of an acceleration in the secular uptrend in economically stressful company or government imbalances."
In other words, it represents a shift to foreign rather than domestic sources of funding at a time when foreigners were shedding their "home bias" toward investing locally and saw better opportunities in the U.S. than elsewhere, mainly because of rapid U.S. productivity growth. These two developments in foreign investor behavior are were the most "persuasive" explanation for the outsized U.S. current account deficit.
Domestic investments
Until the mid-1990s domestic savings around the world were almost all directed at domestic investments, and global external imbalances were negligible. Investors used to invest locally because they knew little of foreign opportunities, which made them seem risky.
The former central banker said improvements in information and communications technologies, rule of law, and enhanced protection of foreigners' property rights made investments seem less risky at the same time that restrictions on cross border capital flows were being dismantled. He said developing countries were the source of about half of the world's current account surplus last year, an indication that they could not find "sufficiently profitable investments at home that overcame market and political risk."
"What is special about the past decade is that the global decline in real long-term interest rates that resulted in significant capital gains on homes and other assets had fostered a large increase in U.S. residents' purchases of foreign goods and services willingly financed net by foreign investors," said Greenspan, who stepped down as Federal Reserve chairman last year.
A decade ago, the United States could not have run up "today's near $800 billion annual deficit for the simple reason that we could not have attracted the foreign savings to finance it." In 1995, for example, cross border savings were less than $300 billion, about a quarter of today's level.
Level of debt key
However, there has been a long-term updrift in debt and leverage among U.S. borrowers that has the potential to be disruptive, he said. "It is the level of debt, not the source of financing, that should engage us."
He acknowledged that at some point, and it may have been reached, "foreigners will balk" at accumulating more U.S. debt, which last year absorbed 60 percent of the cross-border savings of the 67 countries that ran current account surpluses. But instead of an "international financial crisis compounded by a dramatic fall in the dollar" Greenspan sees a more likely scenario with "a benign market-determined outcome in which financial factors—exchange rates, interest rates and prices of assets—change but the real economy, economic activity and employment," remains largely unharmed. He noted that the recent decline in the dollar and the narrowing of the U.S. current account deficit may be an indication that the process has begun.
`Pernicious drift'
Greenspan warned that his belief in a benign unwinding would change if "the pernicious drift toward fiscal instability in the United States and elsewhere is not arrested and is compounded by a protectionist reversal of globalization," that undermines the flexibility of the international system and internal economies. In that case, he said, moments after the applause died down at the conclusion of his formal lecture, "the current account adjustment process could be quite painful for the United States and our trading partners."
Greenspan, who was chairman of President Gerald R. Ford's Council of Economic Advisers from 1974 to 1977, occasionally donned a political cap in his analytical lecture. In response to a question, he cited both Social Security and Medicare, the pension and health entitlement programs for the elderly, as major threats to U.S. fiscal health if the political system does not find ways to hold down their growth. Democrats and Republicans are in agreement about how to tackle that politically difficult issue, he said. "They have agreed to do nothing."
He also urged policymakers and others in the international economic arena to fight the global surge of protectionism which, if it reverses the globalization process would be "a major blow to world economic prosperity, especially in the emerging nations."
Tipping point
Even if the growth of the current account deficit is not an indication of acceleration in the long-standing updrift in debt accumulation and leverage, there is a "tipping point" at which the level of debt relative to assets will not be sustainable. The ability to accumulate larger amounts of debt relative to assets over generations "appears to be the result of massive improvements in technology and infrastructure," not a significant increase in human inclination to risk-taking. But leverage cannot increase indefinitely. "I am not sure where that tipping point is, but we can be sure there is one," he said.
Greenspan said the subprime mortgage market in the United States, which collapsed and triggered turmoil in world financial markets "was clearly seen to be overleveraged as home inflation came to a halt in the United States." He said the global disruption was "an accident waiting to happen. Credit spreads ... had been compressed to clearly unsustainable levels. Something had to give. If the crisis had not been triggered by a mispricing of U.S. securitized subprime mortgages, then it would have eventually erupted in some other sector of the credit market."
Sovereign wealth funds
In response to a question from the audience about sovereign wealth funds, Greenspan said that in the long run these funds—which are used to invest part of the reserves accumulated by some of the countries with current account surpluses—will not be the disruptive force in international finance that many fear them to be. The worry is that many of these funds will invest their rapidly growing dollar or euro reserves for political rather than economic reasons.
In the short run, he said, there may be some reason to worry, but the governments that are interested in earning more than the 3 to 4 percent a year available on safe investments such as U.S. Treasury bills will be disappointed to discover that, on a risk-adjusted basis, returns on higher-yield, higher risk investments are no better.
