The evolving U.S. payments imbalance and its impact on Europe and the rest of the world.

• Author: Greenspan, Alan

Among the major forces that will help shape the euro's future as a world currency will be the international evolution of the euro area's key financial counterparty, the United States. I will leave the important interplay between the euro and the dollar--and particularly forecasts of the dollar-euro exchange rate--to more venturesome analysts. My experience is that exchange markets have become so efficient that virtually all relevant information is embedded almost instantaneously in exchange rates to the point that anticipating movements in major currencies is rarely possible. (1)

I plan to head in what I hope will be a more fruitful direction by addressing the evolving international payments imbalance of the United States and its effect on Europe and the rest of the world. I intend to focus on the eventual resolution of that current account imbalance in the context of accompanying balance-sheet changes.

I conclude that spreading globalization has fostered a degree of international flexibility that has raised the probability of a benign resolution to the U.S. current account imbalance. Such a resolution has been the general experience of developed countries over the past two decades. Moreover, history suggests that greater flexibility allows economies to adjust more smoothly to changing economic circumstances and with less risk of destabilizing outcomes.

Indeed, the example of the 50 states of the United States suggests that, with full flexibility in the movement of labor and capital, adjustments to cross-border imbalances can occur even without an exchange rate adjustment. In closing, I raise the necessity of containing the forces of protectionism to ensure the flexibility needed for a benign outcome of our international imbalances.

The U.S. Current Account Deficit

The current account deficit of the United States, essentially net imports of goods and services, has continued to widen over the past couple of years. The external deficit receded modestly during our mild recession of 2001 only to rebound to a record 5 percent of gross domestic product earlier this year. Our persistent current account deficit is a growing concern because it adds to the stock of outstanding external debt that could become increasingly more difficult to finance.

These developments raise the question of whether the record imbalance will benignly defuse, as it largely did after its previous peak of about 3.5 percent of GDP in 1986, or whether the resolution will be more troublesome.

Current account balances are determined mainly by countries' relative incomes, by product and asset prices including exchange rates, and by comparative advantage. To pay for the internationally traded goods and services that underlie that balance, there is a wholly separate market in financial instruments the magnitudes of which are determined by the same set of asset prices that affects trade in goods and services. In the end, it is the balancing of trade and financing that sets international product and asset prices and global current account balances.

The buildup or reduction in financial claims among trading countries--that is, capital flows--are hence exact mirrors of the current account balances. And just as net trade and current accounts for the world as a whole necessarily sum to zero, so do net capital flows. Because for any country the change in net claims against all foreigners cumulates to its current account balance (abstracting from valuation adjustments), that balance must also equal the country's domestic saving less its domestic investment.

In as much as the balance of goods and services is brought into equality with the associated capital flows through adjustments in prices, interest rates, and exchange rates, how do we tell whether trade determines capital flows or whether capital flows determine trade? Answering this question is difficult because the balancing process is simultaneous rather than sequential, so that there is no simple unidirectional causality between trade and capital flows. For example, increased demand for dollar assets may lower interest rates and equity premiums in the United States and thus engender increased demand for imports. But the need for import financing may raise domestic interest rates and thereby attract the required additional capital inflows to the United States.

Nonetheless, as the U.S. current account deficit rose from 1995 to early 2002, so too did the dollar's effective exchange rate. Evidently, upward pressure on the dollar was spurred by rising expected rates of return that resulted in private capital investments from abroad that chronically exceeded the current account deficit. The pickup in U.S. productivity growth in the mid-1990s--the likely proximate cause of foreigners' perception of increased rates of return on capital in the United States--boosted investment spending, stock prices, wealth, and assessments of future income. Those favorable developments led, in turn, to greater consumer spending and lower saving rates.

The resulting widening gap between domestic investment and domestic saving from 1995 to 2000 was held partly in check by higher government saving as rising stock prices drove up taxable income. When, in 2002, that effect reversed and the federal budget slipped back into deficit, and as the U.S. economy emerged from its downturn, the gap in the current account balance widened further. After contracting in the aftermath of the U.S. stock market decline of 2000, private capital from abroad was apparently again drawn to the United States in substantial quantities by renewed perceptions of relatively high rates of return. In addition, during the past year or so the financing of our external deficit was assisted by large accumulations of dollars by foreign central banks.

Even before the productivity surge of the late 1990s, the United States had become particularly prone to current account deficits and rising external net debt because of the historical tendency on the part of U.S. residents to...