Greenspan on the US’s External Imbalances

Today Alan Greenspan gave an address to a central bankers’ conference in Frankfurt — at the end of a week that has seen the dollar plumb new depths of weakness against the euro. In his speech Greenspan reveals his latest thinking about the US’s external imbalances.

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.

Interestingly, Greenspan argues that the factor that will end the seemingly infinite appetite for US dollar securities around the world is the desire of foreign investors to diversify their portfolios. This seems a peculiar supposition, since most of the demand seems to be coming from central banks, not individuals, and it is well-known that central banks have very different objectives from individuals. In particular, Japan’s central bank (the Bank of Japan, or BoJ) almost certainly cares a lot more about keeping the dollar above some critical level against the yen than it cares about being properly diversified.

The chart below illustrates how closely the BoJ’s purchases of dollar-denominated assets are related to the yen/dollar exchange rate. The chart shows monthly net purchases of foreign currency reserves by the Japanese central bank since the middle of 2003, with the yen/dollar exchange rate superimposed. As I’ve pointed out before, the BoJ seems to have drawn a line in the sand at right around 105 ¥/$, below which it won’t allow the exchange rate to fall, for reasons having to do with the balance sheets of Japanese firms.

We don’t have data on BoJ purchases of dollars for October or November yet, but the pattern still seems quite clear: whenever the exchange rate starts moving down toward 105, the BoJ buys dollars, and whenever it starts rising away from 105 it stops buying them. So I just don’t buy Greenspan’s suggestion that portfolio diversification considerations are going to bring this pattern to an end.

I do agree, however, with the obvious point that Greenspan made in his speech that nothing lasts forever, including Asian central banks’ demand for US dollar assets:

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.

So we don’t know why foreign appetite for US securities will diminish, but we can agree that it will. So what can be done about the problem? Greenspan’s answer:

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.

…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 long-term solutions.

Hmmm. So it seems that, unless we can balance the federal budget (which, given our current president and Congress, is about as likely as my swimming across the Atlantic) there is no good policy solution to the problem. Luckily, Greenspan tells us that it doesn’t matter; even if none of these remedies does the trick, the “flexibility” of the US economy will magically make everything turn out okay anyway:

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.

No, we don’t exactly know how the US economy’s “flexibility” will make everything okay… but don’t worry. Everything will still be just fine.


UPDATE: I’ve fixed the error in the graph to reflect the fact that it measures purchases of all reserve assets by the BoJ, not just US Treasuries.