points. In other words, large accumulations or liquidations of U.S. treasuries can be made with
only modest effects on interest rates. The same holds true for exchange rates. The Japanese monetary
authorities purchased $20 billion in a single day a number of years ago, without evidence
of a significant impact on the yen's exchange rate. Months later, not being adequately aware of
the political sensitivity of such operations, I mentioned the ineffectual purchase publicly. My
Japanese friends were not amused. Again, in March 2004, the Japanese abruptly ended a long
period of very aggressive intervention against the yen. The exchange rate barely responded.
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monetary authorities might close out their dollar positions suddenly and
en masse by converting reserves to; say, euros or yen. I will address this concern
in chapter 25.
The most compelling explanation for the historic rise in the U.S. current
account deficit is that it stems from a broad set offerees. This does not
have the attraction of a single, "smoking-gun" explanation such as our federal
budget deficit, but it is more consonant with the reality of international
finance. The rise appears to have coincided with a pronounced new
phase of globalization. The key contributors, as I see it, have been a major
decline in what economists call "home bias" and a significant acceleration
in U.S. productivity growth.
Home bias is the parochial tendency of investors to invest their savings
in their home country, even though this means passing up more profitable
foreign opportunities. When people are familiar with an investment environment,
they perceive less risk than they do for objectively comparable
investments in distant, less familiar environs. A decline in home bias is reflected
in savers increasingly reaching across national borders to invest in
foreign assets. Such a shift causes a rise in current account surpluses of
some countries and an offsetting rise in deficits of others. For the world as
a whole, of course, exports must equal imports, and the world consolidated
current account balance is always zero.
Home bias was very much in evidence globally for the half century following
World War II. Domestic saving was directed almost wholly toward
domestic investment, that is, plant, equipment, inventories, and housing
within investors' sovereign borders. In a world with exceptionally strong
home bias, external imbalances were small.
However, starting in the 1990s, home bias began to decline perceptibly,
the consequence of a dismantling of restrictions on cross-border capital
flows that more or less coincided with the boost to competitive capitalism
from the demise of central planning. Private ownership and cross-border
investment rose significantly. Moreover, the advance of information and
communication technologies has effectively shrunk the time and distance
that separate markets around the world. In short, vast improvements in
technology and governance have expanded investors' geographic horizons,
rendering foreign investment less risky than it appeared in earlier decades.
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The increasing evidence of the protection of foreigners' property rights
with the fall of central planning has decreased risk still further.
Accordingly the weighted correlation between national saving rates and
domestic investment rates for countries or regions representing virtually all
of the world's gross domestic product, a measure of the degree of home
bias, declined from a coefficient of around 0.95 in 1992, where it had hovered
since 1970, to an estimated 0.74 in 2005. (If in every country saving
equaled investment—that is, if there were 100 percent home bias—the
correlation coefficient would be 1.0. On the other hand, if there were no
home bias, and the amount of domestic saving bore no relationship to the
amount and location of investments, the coefficient would be 0.)*
Only in the past decade has expanding trade been associated with the
emergence of ever-larger U.S. trade and current account deficits, matched
by a corresponding widening of the aggregate external surpluses of many of
our trading partners, most recently including China. By 2006, large current
account surpluses had emerged: China ($239 billion), Japan ($170 billion),
Germany ($146 billion), and Saudi Arabia ($96 billion), all record high
surpluses. Deficits in addition to that of the United States ($857 billion)
included those of Spain ($108 billion), the United Kingdom ($68 billion),
and France ($46 billion). To get a sense of how wide the dispersion (the extent
to which saving-minus-investment imbalances of individual countries
diverge from zero) has become, I calculated the absolute sum of countries'
current account imbalances (irrespective of sign) as a percentage of world
GDP. That ratio hovered between 2 and 3 percent between 1980 and 1996.
By 2006, it had risen to almost 6 percent.
Decreasing home bias is the major determinant of wider surpluses and
deficits, but differences of risk-adjusted rates of return may have been a
contributor as well.1" And certainly relative risk-adjusted rates of return are
*Obviously, if domestic saving exactly equaled domestic investment for every country, all current
accounts would be in balance, and there would be no dispersion of such balances. Thus,
the existence of current account imbalances requires the correlation between domestic saving
and domestic investment—which reflects the degree of home bias—to be less than 1.0.
t"Risk-adjusted" is a term economists use to recognize that risky investments, if investors
are to be induced to make them, require a higher rate of return to compensate for potential
losses. The risk adjustment is an estimate of how much of the return on an asset is merely that
extra compensation.
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THE AGE OF TURBULENCE
a key factor in determining to which countries excess savings are directed
for investment.
Since 1995, the greater rates of productivity growth in the United
States (compared with still-subdued rates abroad) apparently produced
correspondingly higher risk-adjusted expected rates of return that fostered
a disproportionate rise in the global demand for U.S.-based assets. This goes
a long way toward explaining why such a large percentage of cross-border
savings has been directed to the United States.*
I expect that the disputes over the causes of the recent sharp rise in the
U.S. current account deficit will continue. The far more important question,
however, is whether the seemingly inevitable external adjustment will be benign
or, as many fear, will entail an international financial crisis as the dollar
crashes. As I noted, I am far more inclined toward the more benign outcome.
Of greatest concern is what happens when foreigners begin to resist
further increasing the share in their investment portfolios of net claims
against U.S. residents, which is implied in current trends in external balances.
Current account deficits have been cumulating as an ever-rising net
negative international investment position of U.S. residents (nearly $2.5
trillion at the end of 2005), with an attendant rise in servicing costs. This
trend cannot persist indefinitely. At some point, even if rates of return on
investments in the United States remain competitively high, foreign investors
will balk at the growing concentration in their investment portfolios.
The well-established principle of not putting all your eggs in one basket
holds for global finance as well as for the private household. If and when
foreigners' appetite for U.S. assets slackens, it will be reflected in lessened
demand for U.S. currency and thus a lower foreign-exchange value of the
dollar.+ A lower dollar, of course, will discourage importers and encourage
*To facilitate comparisons, all nondollar currencies are converted to dollars on the basis of market
exchange rates. Purchasing power parities (PPPs), the major alternative means of converting, are
ill-suited for dealing with cross-border flows of saving and investment. For the world as a whole,
saving must equal investment, irrespective of the currency of record. For the years 2003—2005, the
absolute value of the statistical discrepancy between world saving and investment was $330 billion
annually converting with PPPs, but only $66 billion employing market exchange rates,
tl am disregarding the fact that not all claims against U.S. residents are in dollars, and not all
dollar claims, such as Eurodollars, are against U.S. residents. The overlap between claims in dollars
and those against U.S. residents is sufficiently large that these differences can be ignored.
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CURRENT ACCOUNTS AND DEBT
exporters. Thus, foreign resistance to financing the U.S. external deficit will
in itself reduce the deficit. Diversification of the reserves of the world's
monetary authorities, and, even more relevant, the international reserves of
private investors, has consequences.
Analysts worry that in order to service rising U.S. net debt to foreigners,
our trade deficit will eventually have to be sharply reduced (or returned to
surplus) and/or foreigners' willingness to invest in U.S. assets will have to
rise enough to supply the funds to meet the servicing requirements of U.S.
debtors.* That is not yet a problem, because the rate of return on our more
than $2 trillion of U.S. direct investments abroad was 11 percent in 2005,
much higher than current interest rates paid to foreigners on U.S. debt. The
result is that our debt service and dividend payments to foreigners are still
ahead of our receipts from foreigners of such income. But with the inexorable
net rise in debt (the equal of the current account deficit adjusted
for capital gains and losses), much larger net income payments to foreigners
loom.
The reason I suspect that the persistently large U.S. current account
deficits through 2006 did not have seriously negative consequences for the
U.S. economy is that the deficits are a manifestation, in large part, of an
ever-expanding specialization and division of labor that is evolving in a
wholly new high-tech global environment. Pulling together all the evidence—
anecdotal, circumstantial, and statistical—strongly suggests, to me at least,
that the record current account deficit of the United States is part of a
broader set of rising deficits and offsetting surpluses reflecting transactions
of U.S. economic entities—households, businesses, and governments—
mostly within the borders of the United States. These deficits and surpluses
have arguably been growing for decades, possibly generations. The
long-term up-drift in this broader swath of deficits has been persistent, but
*I am often asked why this is a problem, given that nearly all U.S. assets are denominated in
dollars. Won't foreigners accept payments in U.S. dollars? Yes, they usually will. But if trade
creditors decide to hold the dollar payments, they will have increased their investments in U.S.
assets. If, however, they sell the dollars to a third party (in exchange for their own currency),
that third party would be investing in US. assets. If no one wants to hold more U.S. assets at
current prices, the dollars must eventually be sold at a discount on the foreign-exchange market,
exerting downward pressure on the exchange value of the dollar.
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gradual. However, the component of that broad set that captures only the
net foreign financing of the imbalances of the individual U.S. economic
entities—our current account deficit—increased from negligible in the
early 1990s to 6.5 percent of our GDP by 2006.
From my perspective, policymakers have been focusing too narrowly
on foreign claims on U.S. residents rather than on all claims, both foreign
and domestic, that influence economic behavior and can be a cause of systemic
concern. Current account balances refer only to transactions that
cross sovereign borders. Our tabulations are loosely rooted in the obsession
of the mercantilists of the early eighteenth century to achieve a surplus in
their balance of payments that brought gold, then the measure of the
wealth of a nation, into the country.
Were we to measure financial net balances of much smaller geographic
divisions, such as the individual American states or Canadian provinces
(which we don't), or of much larger groupings of nations, such as South
America or Asia, the trends in these measures and their seeming implications
could be quite different from those extracted solely from the conventional
sovereignty-delineated national measure: the current account balance.
The choice of the appropriate geographical unit for measurement
should depend on what we are trying to find out. I presume that in most
instances, at least in a policy setting, we seek to judge the degree of economic
stress that could augur significantly adverse economic outcomes. Making
the best judgment in that case would require data on financial balances
at the level of detail at which economic decisions are made: individual
households, businesses, and governments. That is where stress is experienced
and hence is where actions and trends that may destabilize economies
would originate.
When a household spends more than its income on consumption and
investments such as a house*—that is, more cash going out than coming
in—it is designated by economists as a financial deficit household. It is a
net borrower, or liquidator, of financial assets. A household that saves
investments can, of course, be negative: for example, a sale of an existing house or inventory
liquidation.
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through accumulation of financial assets or through a reduction in debt is
called a financial surplus household, reflecting its positive cash flow. Similar
designations are applied to businesses and governments—federal, state,
and local. When we consolidate these deficits and surpluses for all U.S. residents,
