*Chairman Greenspan attributes the gaping US current account deficit to three forces: (1) financial deepening, (2) reduced home bias among investors, and (3) stronger relative US productivity growth. His story implies that the US deficit might be sustainable for a long time, without necessarily putting much downward pressure on the dollar.
*We agree with Greenspan's first two points. These developments have increased the dispersion of global current account imbalances. Historical rules of thumb about how large the deficit can get are therefore becoming progressively less helpful to investors.
*But the facts do not support the relative productivity growth story as an explanation for why it is the United States, rather than another country, that is borrowing so much abroad. A better explanation is the dearth of global investment, relative to the available saving pool.
*As investment normalizes, global real interest rates are likely to rise. This could put significant downward pressure on the US dollar, especially against Asian currencies that now look substantially undervalued.
The Global Investment Dearth and the US Current Account
On Friday, Chairman Greenspan gave an important speech on the US current account deficit (see <http://federalreserve.gov/boarddocs/ speeches/2005/200512022/default.htm>). He notes that, so far, the deficit has put less stress on either the dollar or the US bond market than most policymakers or economists had expected. He attributes this to a combination of three basic forces that interact with one another.
First, deeper capital markets have allowed households and businesses to rely more heavily on outside financing (borrowing or equity issuance) and less on inside financing (household saving or cash-flow financed capital spending). Second, reduced home bias among investors has made it easier for US borrowers to tap foreign sources for this outside financing. Third, higher US productivity growth has attracted a greater share of the world's net capital flows to the United States.
Although Greenspan hedges his bets by noting that much remains unknown, his story implies that the US deficit is largely benign. The first and second point -- increased outside financing and reduced home bias -- explain why the dispersion of global current account balances should be increasing as financial markets mature. The third point -- higher US productivity growth -- explains why in practice this increasing dispersion has manifested itself in a rising US deficit. If increased structural productivity growth has boosted the return on capital in the United States compared with other nations, it makes sense for the United States to invest more heavily in plant and equipment, finance some of this investment via capital inflows, build up a stock of net external liabilities, and subsequently service the larger debt stock out of the resulting increased productive capacity.
We strongly agree with the first part of the story. It implies that simple rules of thumb about the sustainable current account deficit that are based on past experience are unlikely to be very useful for investors. In essence, financial globalization has reduced the 'liquidity risk' associated with large-scale reliance on net capital inflows.
But we are more skeptical with regard to the second part of Greenspan's story. Although the official data show a bigger pickup in underlying productivity growth in the United States than in most other developed nations, and our GSDEER model implies that productivity matters to the long-run sustainable level of the dollar, there are several reasons to doubt that the increased current account deficit is due to a productivity-led US investment boom.
First, of course, there is no investment boom. The capital inflows associated with the deficit have financed increased consumption and homebuilding, not productive business investment that might be driven by a productivity acceleration. The deficit began to explode in 1997. Since then, the current account deficit as a share of GDP has risen by 4-1/2 percentage points. Over the same period, the sum of personal consumption and residential investment as a share of GDP has risen by 5 percentage points. Meanwhile, business investment as a share of GDP has fallen by 1 percentage point -- the opposite of the pattern implied by Greenspan's story.
Second, US export performance remains significantly weaker than Greenspan's story would imply. The United States has lost market share in recent years, not just against China but also against other developed nations. This suggests that US productivity is either weaker than shown in the official numbers, or foreign productivity growth is stronger.
Third, real interest rates remain fairly low for this stage of the business cycle. This also conflicts with Greenspan's story of unusually high US returns on capital.
In our view, the US deficit is better explained by a shortfall of investment relative to the available saving pool, combined with a relatively greater interest rate sensitivity of US demand. This story is related to Ben Bernanke's 'global saving glut'. However, the IMF's latest data on global saving and investment show that both have been falling significantly in recent years. Thus, it may be more accurate to label the mismatch between intended saving and intended investment a global investment dearth rather than a global saving glut.
There is a significant practical difference between Greenspan's story and ours. Greenspan's story implies that the deficit could remain sustainably large as long as productivity grows faster in the United States than abroad. That could be a long time. In contrast, the investment dearth could reverse quickly for any number of reasons, including cyclical upward pressure on global wage growth, a pickup in energy infrastructure investment, or an end to the deleveraging process. A reversal would imply a rise in global real interest rates. The relatively greater interest rate sensitivity of US demand then would result in worse relative US economic performance. As a result, the dollar would probably weaken significantly in this environment, especially against Asian currencies that currently look substantially undervalued.
Jan Hatzius