Greenspan: Learn Lessons From The Fading Of The Pound Sterling

Monday, November 14, 2005

Federal Reserve chairman Alan Greenspan today told bankers at an event of the Bank of Mexico that although the role of the dollar as the world's reserve currency "is not to change anytime soon, there are, in my judgment, lessons to be learned from the experience of sterling as it faded as the world's dominant currency."
In his speech he said, "Sterling's status was at its height more than a century ago. Great Britain had net external assets amounting to some 150 percent of its annual GDP, most of which were lost in World Wars I and II."
While Greenspan views the basis for the US' huge external financing needs still intact, he cautioned that "at some point investors will balk at further financing."
Catalyst for such an event could be rising interest rates in other major economies in the world. Both the Eurozone and Japan are seen by analysts to have ended the long period of historically low interest rates. A reduction of the US budget deficit alone would not be enough to reduce the huge current account imbalance, he said further. The US current account deficit hovers at a record 6.5% percent of GDP and has been subject of multiple warnings by his predecessor Paul Volcker who navigated the US out the worst postwar recession by jumping on the rate-brake.
For the most important paragraphs of Greenspan's speech read on.
"To date, despite a current account deficit exceeding 6 percent of our gross domestic product (GDP), we - or more exactly, the economic entities that comprise the U.S. economy--are experiencing few difficulties in attracting the foreign saving required to finance it, as evidenced by the recent upward pressure on the dollar."
Deficits Cannot Persist Indefinitely
"Of course, deficits that cumulate to ever-increasing net external debt, with its attendant rise in servicing costs, cannot persist indefinitely. At some point investors will balk at further financing. Such a development would be particularly likely should risk-adjusted rates of return on assets outside the United States rise relative to investment opportunities in the United States. Even if such returns on U.S. assets stay high, the rise of concentration risks in foreign official and private portfolios could still induce investors to slow their accumulation of dollar claims and thereby delimit the size of the financeable U.S. current account deficit."
Foreigner Will Get Cold Feet At Some Point
"However, the adjustment of the U.S. external balance, when it comes, doubtless will be initiated by the actions both of foreign investors and of U.S. residents. Whatever the triggers for adjustment, the move toward current account balance, in addition to being driven by foreign investors altering their external portfolios, presumably would also reflect actions by U.S. residents to address domestic imbalances."
Greenspan went on to say that forex interventions would be of no help as investors would not accept artificial imbalances.
"A nation's current account balance thus is essentially a market phenomenon that is not readily subject to rebalance by targeting one or more policy variables such as the exchange rate. To be sure, if the exchange rate of the dollar, through intervention, is persistently pressed higher or lower, the whole set of previously noted relationships would shift accordingly. I doubt, however, whether, given the current size of global financial markets, locking together two major currencies such as the dollar and the euro is feasible any longer. Over time, the required large domestic adjustments would be quite unlikely to be accepted by the majority of residents of either the United States or those of the euro area."
Reducing the budget deficit alone is not much help either, Greenspan said.
"To be sure, policy initiatives to increase interest rates, which would elevate the propensity of households to save, would reduce the need for domestic investment to be financed by borrowed foreign saving. However, the additional inflow of capital arising from higher U.S. interest rates would boost the dollar's value and offset the narrowing of the imbalance. Alternatively, a discretionary reduction in our federal budget deficit would work toward narrowing the current account deficit but, if history is any judge, to an uncertain and possibly small extent."
Declining Home Bias Benefits The Debtor USA
The huge appetite of foreigners - mainly their central banks, who are the biggest buyers of US debt paper - was a result of a declining home bias, the Fed chairman said.
"The rise of our deficit and our ability to finance it appears to coincide with a pronounced new phase of globalization that has emerged in the past decade. This phase is characterized by a major acceleration in U.S. productivity growth and the decline in what economists call home bias, the parochial tendency to invest domestic savings in one's home country...
Home bias is a broadly visible tendency of markets. Lower required risk compensation is associated with geographically close investment opportunities; when investors are familiar with the environment, they perceive less risk than they do for objectively comparable investment opportunities in far distant, less familiar environments. There is evidence that even when choosing investment targets within the United States, investors hold assets that are disproportionately close to home."
Where Is The Limit?
The Fed chairman raised the question where the limit of this tendency might lie and sees that limit coming when US obligations are becoming heavily overweighted in foreign portfolios.
"Given that we have yet to experience difficulties in funding a current account deficit that exceeds 6 percent of our GDP, what are the limits to the foreign markets' absorption of claims on U.S. residents?
Home bias is deeply ingrained in economic decisions and evident in the geographical mix of peoples' investments, even within national boundaries.5 How much further home bias can decline is obviously conjectural, given the paucity of historical precedent. Federal Reserve staff studies indicate that, despite evidence of recent diversification, U.S. and foreign portfolios still exhibit marked home bias. Funding of our current account deficit likely will become more difficult when home bias approaches its practical minimum. Irrespective of how globalized our economy may become, other things equal, people will still accord nearby investments a lower risk premium.
Presumably, well before the practical lower limits of home bias are reached, effective constraints on deficit funding, and hence on the deficit itself, are likely to come from foreign investors' fear of portfolio concentrations of claims on the residents and government of the United States."
Lessons From The Decline Of The British Empire
After saying that the US dollar's role as the world's reserve currency is not in danger anytime soon, Greenspan said lessons can be learned from the demise of the former leading currency, the pound sterling. He said the US economy is far more flexible than the Brtish economy was then and that structural rigidity came at a huge price for the Queen's empire.
"Although I doubt that the U.S. dollar will lose its status as the world's reserve currency any time soon, there are, in my judgment, lessons to be learned from the experience of sterling as it faded as the world's dominant currency. Sterling's status was at its height more than a century ago. Great Britain had net external assets amounting to some 150 percent of its annual GDP, most of which were lost in World Wars I and II. Many wartime controls were maintained in the years immediately after World War II. Arguably these exacerbated the periodic sterling crises that hobbled Britain in those years as much of the remnants of its empire endeavored to reduce their heavy reliance on holding sterling assets as central bank reserves and private stores of value. The experience of Britain's then extensively regulated economy provides testimony to the costs of structural rigidity in times of crisis."
Any diminution of the reserve status of the dollar, should it occur, is likely to be readily absorbed by a far more flexible U.S. economy than existed in Britain immediately following World War II. This, of course, presupposes that we in the United States in the years ahead maintain and, I trust, enhance our economy's degree of flexibility and our involvement in the highly successful globalization of recent decades."
NOTE: For some historical context about the coming and going of economic superpowers read the posts "Imperial Struggles - No Fairy Tale", "Experience Shows That Man Never Learned From Experience" and "What Will Be The Next Big Reserve Currency?"
Greenspan also pointed out that governments in modern times have a far more active role than they had in the 19th century. But he sees economic stability independent from the actions of macroeconomic policymakers.
"Governments today, although still far more activist than in the nineteenth and early twentieth centuries, are rediscovering the benefits of competition and the resilience to economic shocks that it fosters. We are also beginning to recognize an international version of Smith's invisible hand in the globalization of economic forces.
Whether by intention or by happenstance, many, if not most, governments in recent decades have been relying more and more on the forces of the marketplace and reducing their intervention in market outcomes. We appear to be revisiting Adam Smith's notion that the more flexible an economy, the greater its ability to self-correct after inevitable, often unanticipated disturbances. That greater tendency toward self-correction has made the cyclical stability of an economy less dependent on the actions of macroeconomic policy makers, whose responses often have come too late or have been misguided."
As often before Greenspan ended his speech with the advice not to turn to protectionist measures.
"Protectionism in all its guises, both domestic and international, does not contribute to the welfare of workers. At best, it is a short-term fix for a few workers at a cost of lower standards of living for a nation as a whole. Increased education and training for those displaced by creative destruction is the answer, not a stifling of competition."
Greenspan herewith deviates from the later lessons one of his favorite economists, the liberal-turned-protectionist Austrian Joseph Schumpeter, who in his career oversaw Austria's aquaintment with triple-digit inflation before he foundes his own bank in the 1920's that went belly-up after a few months. Schumpeter than retreated to the academic world. Find more theses and background on Schumpeter in the second half of the post "Fed Pianalto Takes The Bridge From Conundrum To Creative Destruction."

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