Articles on America’s Current Account Imbalance

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Here is a recent speech by Alan Greenspan, the now-outgoing Chairman of the US Federal Reserve (Central Bank).

Greenspan notes that international trade has been expanding since WWII, but that for most of this period that expansion involved exports and imports (i.e., EX and IM, respectively) both rising the same amount across countries. This means that current accounts are essentially zero, so that S = I, approximately, across countries (S and I denote national saving and investment, respectively). A statistical measure of the association between S and I across countries is given by the correlation between the two. If in countries where I is high, S is high too, and where I is low S is low, then the correlation is nearly unity. On the other hand, if I and S are not closely related across countries, that is, countries with high I don’t necessarily have high S, then the correlation is substantially less than unity. Greenspan makes a remark based on a study of a large number of countries (their combined output is 4/5 of world GNP), which finds the correlation was a high 0.96 in 1992, and fell to 0.80 in 2004. He refers to this fall as indication that the world is more efficient at carrying out international finance.

To understand why Greenspan concludes this, it’s good to think about what it means, concretely, when S and I aren’t closely related. Consider, for example, a country in which S < I so that the current account is negative. This country experiences a capital inflow: the domestic currency that foreigners are accumulating is being returned by them to the domestic economy in exchange for financial assets, like stocks and bonds. The flip side of S < I in the domestic economy is that all the foreign economies combined must have S > I by the same amount. So, when S and I aren’t highly correlated across countries, this is an indication that people are acquiring financial claims on the residents of other countries – that is, international finance is operating. Greenspan is saying that over the past 15 years this is happening to an increasing extent, reaching levels that have not been seen since the 19^th century, which is sometimes referred to as the ‘golden age’ of international finance.

Greenspan speculates about why international finance is expanding. He speculates that improvements in information technology are an important factor. The notion is that in the (recent) past, people have been reluctant to hold financial claims on assets that are far away because the distance prevented them from monitoring the underlying businesses. In effect, information technology shrinks the size of the world, allowing people to ‘see’ what is going on on the other side of the earth just as quickly as they can see what is happening on the other side of the street. Greenspan speculates that another factor underlying the expansion of international finance is the deregulation of financial markets that began in earnest in the 1980s.

Greenspan notes that the US data play an important role in the finding that the correlation between S and I across countries has fallen. He thinks there is a special factor driving the growing disconnect between S and I in the US. In particular, he thinks the inflow of capital from the rest of the world is driven by the fact that productivity growth in the US is high relative to what it is elsewhere. Foreigners are anxious to acquire US assets because they generate a higher return.

The remainder of Greenspan’s speech (i.e., the part after page 1) is relevant to other parts of the course, and will not be reviewed here.

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A speech by Otmar Issing (member of the executive board of the European Central Bank), ‘Addressing Global Imbalances: the Role of Macroeconomic Policy’. Below, I review the first 12 pages of this speech.

By global imbalances, Issing means the big trade deficits of some countries, principally the US, and the corresponding surpluses of other countries, mainly Asia and oil exporters. Capital inflows have to exactly match the trade deficit, by accounting identity. Issing suggests that the big capital inflows into the US (the negative US current account) are necessary in order to allow the US to finance its big trade deficit. The implicit idea is that the trade deficit is causing the capital inflow: the US went on a spending spree and foreigners are enabling this by lending the necessary cash. This is Issing’s first paragraph.

In the second and third paragraphs, Issing raises basic questions: are the global imbalances due to economic policy, or are they the world’s response to fundamental forces? If the latter, perhaps they are benign and not to worry about. After all, there is no reason for a negative current account per se to signal trouble ahead. Indeed, it could be quite the opposite. Consider, for example, a new town that is under development. Capital flows in from all over to finance the building of homes and businesses, and the current account of the town is very negative, at least during the initial building phases. Later, the inflow of capital has to be paid for by an outflow of payments. But, that’s not a problem, to the extent that the investment in the town turns out to be profitable. And, even if it is not profitable, to the extent that the capital inflows are associated with equity finance, both the borrowers (i.e., the town’s citizens) and the lenders share in the loss.

What Issing is worried about, in the bottom paragraph of page 1, is this. In the US, we have S < I now. He worries that such a situation cannot long persist. Eventually, the normal balance between S and I will be restored. From this perspective, S must go up, or I go down, or some combination of the two. The trouble is that either of these two adjustments has a recessionary impact on the US by depressing demand (recall Econ 311). Moreover, if the US goes into a recession, then US demand for the output of the rest of the world will go down, dragging the rest of the world into recession too. Issing is worried that an adjustment is inevitable and that when it does occur it might be abrupt and damaging. It’s like a geologist who picks up signals of stress in the earth’s crust, and knows that a big shift must occur soon, a shift that may turn out to be sudden and wrenching. Issing is concerned that the more out of balance are S and I, the greater the inevitable adjustment will be. From this perspective, he suspects that a monetary and/or fiscal policy aimed at preventing S and I from getting too far out of line might be a good idea. Moreover, he thinks policy makers should get ready for the day when the adjustment does occur, so that they can soften the impact on the world economy.

In Charts 1 and 2, Issing provides some measures of the ‘imbalances’. In Chart 1 he shows that the main source of negative current accounts is the US. The main source of positive current accounts is Asia and the oil producers. The Euro area is neutral, as it has a current account nearly equal to zero. So, capital is flowing from Asia and the oil producers to the US. Chart 2 indicates what sort of financial assets they are accumulating: primarily bonds and ‘notes’. Relatively little equity is being accumulated.

Issing explores why it is that private saving fell. He suggests that this may be because US equity markets soared. Figure 3 in Kraay and Ventura (NBER working paper 11543), shows how US equity markets boomed much more than did equity markets around the world.

Chart 5 in Issing’s paper is interesting. It is consistent with the notion that US private saving declined in response to the rise in the US equity markets. (Note that what is reported is the minus of the value of US equity). Thus, as equity markets soared, savings rates dropped. The reason, presumably, is that when people felt wealthier from the high equity values, they asked themselves, ‘do I really need to save so much for my retirement, now that my equity holdings have turned out to be such a nice nest egg?’ Note how at the very end, there is a crash in the stock market, and yet saving remains low, in apparent contradiction to the notion that high equity values had previously been driving low saving. According to Issing, this may not be a contradiction at all. At the time of the stock market collapse, housing prices started to take off. Housing is a huge component of household wealth, and this would also make people feel better off. So, it’s possible that the low US saving rate is due to the rise in wealth that occurred since the 1990s, and the recent experience may not be an embarrassment to that view at all. However, it does seem like it may be an embarrassment to the view that foreign interest in US assets is the basic fuel driving up US wealth and causing low US saving. It is hard to see how foreign interest in US assets could trigger a housing price boom.

Charts 6 and 7 provide information about Asia’s current account surplus. Interestingly, the national saving rate is nearly double what it is in the US (see Figure 2 in lecture 1). Naturally, given the positive current account, the savings rates are higher than the investment rates. This is of course not a ‘problem’. If people want to save, in principle that should be great for everyone.

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The article by Dooley, Folkerts-Landau and Garber (‘Savings Glust and Interest Rates: The Missing Link to Europe’, NBER Working Paper 11520) argues that there has not been a general rise in world saving. Instead, a rise in saving in Asian and Middle Eastern economies has been roughly offset by a fall in saving in the US. They argue that this increase in saving comes to the US because returns to saving in the rest of the world are lower.

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Here is a New York Times article summarizing Bernanke’s ‘Global Saving’s Glut’ hypothesis about the current account. The idea is that foreigners have decided to increase their saving, and the US is the place to put it. This has driven up US asset prices and reduced interest rates. The author expresses some skepticism about the hypothesis at the end of the article. One source of skepticism is evidence (not documented in the article) that global saving has in fact been falling. Actually, Bernanke’s hypothesis does not require that saving rise globally anyway. It could be that foreigners have in recent years decided that the US was a more attractive place to place their saving than before. This could be for the reasons Greenspan laid out (information technology improvements, deregulation). In addition, there is the related argument by Dooley, Folkerts-Landau and Garber summarized above.

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Here is an interesting and very influential paper on the current account. It argues that the current account just can’t be as negative as government statistical agencies say it is, because otherwise net investment income earned by the US would have to be a lot more negative than it is. The authors coined a theory of what they call Dark Matter. They argue that US holdings of assets abroad must be massively underestimated, and that the assets that are not counted (‘Dark Matter’) continue to accumulate rapidly. So much so, that the US actually does not have a current account deficit at all. The uncounted foreign assets are called Dark Matter, because – as their namesake in astronomy – they are real things that are not visible by ordinary means. They can only be detected by indirect methods, such as by the investment income that shows up in the balance of payments. For a critical review of the Dark Matter theory, see. For another critical review, see the following blog.

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Here is a discussion of an article by Mike Kouparitsas about the change in the net export of goods and services that will be required to service the U.S. net foreign liabilities (i.e., after subtracting off assets). Surprisingly, the U.S. can continue to import more goods and services than it exports, even though its net foreign assets are positive. This is because the U.S. earns more on its investments abroad than it does on its investments in the U.S.

Inverted Yield Curve

The time over which different assets pay a return is different. Ten year government bonds make payments for 10 years. A 3-month government bond (it’s actually called a ‘bill’) comes due in only three months. Different assets with different maturities have different interest rates. Generally, the longer-term assets have a higher return. Presumably, this is in part because they are riskier. At the time you buy a long-term asset, you have to worry about the possibility that you may want to sell it before it has matured, and perhaps its price won’t be very high then.

A graph with the amount of time a bond pays off on the horizontal axis and its return on the vertical axis is call a ‘yield curve’. Typically, the yield curve is upward-sloped: bonds with longer maturity pay more than bonds with lower maturity.

Sometimes the yield curve becomes ‘inverted’. This means that short term bonds have a lower yield than longer-term bonds. The attached article reports that the yield curve in the US today is inverted.

We can use our model to think about the yield curve. Recall that when the Fed implements a permanent increase in the money stock, the interest rate rises for a while, and then returns to its pre-shock level in the long run. The yield on a long-term bond is roughly the average of the yield on a current short run bond (the R in our model) and the future interest rate on such bonds. The reason for this is simple. Suppose the short term rate is 2 percent now, and is expected to be 5 percent next year. So, over the two-year period the interest rate is 7 percent, or 3.5 percent at an annual rate. Now, suppose the return on two-year bonds were 6 percent per year. Many people and companies needed to borrow over a two year period, would be tempted to borrow now for one year, and then borrow again next year at 5 percent. The supply of long-term bonds (coming from borrowers) would fall and their price would rise, producing a fall in their yield. In this way, we’d expect the long-term interest rate to roughly correspond to the average of current and expected future short-term rates.

So, we can think of the long-term rate in our model as the average of the one that is determined in the short run equilibrium, and the one determined in long run equilibrium. Perhaps we’d want to add something above this, to take into account the greater riskiness of long-term bonds.

This reasoning suggests that our model will produce an inverted yield curve if the Fed tightens monetary policy significantly. The puzzle about the current yield curve is that this is not a time of especially tight monetary policy. It’s true that the Fed has been raising the interest rate recently. However, it is thought that it is simply returning monetary policy to a neutral position, after having worked aggressively to bring the economy out of the 2001 recession.