November 12, 2007	Monday	Ziqa’ad 01, 1428

The financial crisis that erupted on August 9 was an accident waiting to happen. Credit spreads across all global asset classes had become compressed to clearly unsustainable levels. If the crisis had not been triggered by a mispricing of securitised US sub-prime mortgages, it would have eventually erupted in some other sector or market.

Candidate of many analysts in recent years has been a dramatic and abrupt unwinding of America’s huge current account deficit, with all sorts of extraordinary aftermaths as a consequence. To date this has not happened. But fear-laden concerns put that deficit on the agenda of virtually every international gathering I attended as Fed Chairman and since.

Unless protectionist forces drain the flexibility of the international financial system, I do not view the ultimate unwinding of America’s current account deficit, amounting to six per cent of our GDP, as a cause for undue alarm.

Apprehensions about the US external deficit are certainly not groundless. At some point, foreign investors will balk at increasing the share of dollar-denominated assets in the portfolios they hold. There obviously is a limit to the extent that US financial obligations to foreigners can reach. And perhaps the recent decline in the US dollar and shrinkage of the current account deficit is an indication that America is approaching that limit.

In 2006, the financing of the deficit siphoned off almost three-fifths of all the cross-border savings of the 67 countries that ran current account surpluses in that year.

Developing countries, which accounted for nearly half the value of those surpluses, were apparently unable to find sufficiently profitable investments at home that overcame market and political risk. The United States a decade ago likely could not have run up today’s near– $800 billion annual deficit for the simple reason that we could not have attracted the foreign savings to finance it. In 1995, for example, total cross-border saving was less than $300 billion.

But the reason I conclude that the persistently growing US current account deficit does not have seriously negative consequences for the US economy is that those deficits are a small part of a far-larger but less-threatening, ever-expanding specialisation and division of labour that is irreversibly evolving in our increasingly complex global environment.

Pulling together the pieces of evidence — anecdotal, circumstantial, and statistical — strongly suggests, to me at least, that the current account deficit is best viewed as a segment of a broader set of rising deficits and offsetting surpluses that reflect transactions of US economic entities—households, businesses, and governments—mostly within the borders of the United States.

The long-term up-drift in this broader swath of unconsolidated deficits and mostly offsetting surpluses of economic entities has been persistent but gradual for decades. However, the component of that broad set that captures only the net foreign financing of the imbalances of the individual US economic entities, our current account deficit, increased from negligible in the early 1990s to 6.2 per cent of our GDP by 2006.

What data we have suggest that the rise in America’s current account deficit as a percentage of GDP since early this decade is, to a large extent, the result of American business and government’s turning to foreign sources of deficit funding in place of domestic funding, and not predominantly the result of an acceleration in the secular uptrend in economically stressful company or government imbalances. Household borrowing, incidentally, from abroad to finance shortfalls in cash flow have always been negligible.

In my judgment, policymakers have been focusing too narrowly on foreign claims on US residents rather than on all claims, both foreign and domestic, that influence economic behaviour and can be a cause of systemic concern. It is the level of debt, not the source of its financing, that should engage us.

National borders, of course, do matter, at least to some extent. Debt service payments on foreign loans ultimately must be funded from exports of tradable goods and services or from capital inflows, whereas domestic debt has a broader base from which it can be serviced. For a business, cross-border transactions can be complicated by legal risks and a volatile exchange rate, but generally these are difficulties not outside most normal business risk.

It is true that the market adjustment process seems to be less effective or transparent across national borders than within them. Thus, cross-border current account imbalances impart a degree of economic stress that is likely greater than that stemming from domestic imbalances only.

I do not deny that nation-defined current account imbalances do have important implications for exchange rates and terms of trade. But I suspect the measure is too often used to signify some more-generic malaise, especially in the context of the so-called twin American deficits, with reference to our politically determined federal budget deficit, which has quite different roots and policy requirements than those of the market-determined current account balance.

To me the most persuasive explanations are a major decline in home bias and a concurrent significant acceleration in US productivity growth. When people are familiar with an investment environment, they harbour less uncertainty and hence, less risk, than they do for objectively comparable investments in distant, less-accessible environs.

A decline in home bias is reflected in savers’ increasingly reaching across national borders to invest in foreign assets. This engenders a marked rise in current account surpluses among some countries and an offsetting rise in deficits of others. For the world as a whole, exports must equal imports, savings must equal investment, and the world consolidated current account balance is always zero.

Gross domestic income rose significantly across the developing world. Consumption, inhibited in part by unresponsive financial infrastructures, lagged, propelling the developing world’s saving rate to 33 percent of GDP in 2006, up from 22 percent in 1992. Investment opportunities in the developing world, however, evidently were not adequate to absorb the new surge in saving, and hence investors, now less daunted by the uncertainties of distance, sought investments in the developed world, especially in the United States.

In short, vast improvements in information and communications technologies and rule of law and the enhanced protection of foreigners’ property rights have greatly extended investors’ geographic horizons, rendering foreign investment less risky than it appeared in earlier decades. Doubtless, the worldwide decline in credit-risk spreads was also a factor.

To get a sense of how widely cross-border current account balances have dispersed, I calculated the absolute sum of all countries’ current account imbalances as a percentage of world nominal GDP. That ratio hovered between two and three per cent between 1980 and 1996. By 2006, it had risen to almost six per cent.

Decreasing home bias is the major determinant of wider global surpluses and deficits. But differences in risk-adjusted rates of return, reflecting different rates of productivity growth, seem to have been a contributor as well.

A far more important question, however, is whether the seemingly inevitable adjustment of the US external accounts will be benign or, as many fear, entail an international financial crisis compounded by a dramatic fall in the dollar. I am far more inclined toward a more-benign, market-determined outcome in which financial factors — exchange rates, interest rates, and the prices of assets — change but the real economy — economic activity and employment — is sustained.

In short, the expansion of our current account deficits during the past decade appears to largely reflect the shift in trade and financing from within the borders of the United States to cross-border trade and finance. If so, does this matter? Does it matter importantly, for example, whether a US resident corporation finances its capital outlays from foreign rather than domestic sources? With some qualifications, the stress on US economic entities has arguably increased little with the shift in the source of their financing. The rise in the ratio of imbalances—the absolute sum of foreign and domestic—to GDP is a much more modest and less threatening trend over the past decade than that exhibited by its foreign component, the current account only.

Decisions to finance domestic US capital investment by borrowing from US or foreign lenders are often a matter of convenience and can usually be reversed at small cost. It is almost always the level of debt of economic entities, not the geographic location of the lender, that creates stress.

The trend toward intra-country dispersion of financial imbalances is occurring not only in the United States, but in other countries as well. A rising debt-to-income ratio for households or of total non-financial debt to GDP is not, in itself, a measure of stress. It is largely a reflection of dispersion of growing financial imbalance of economic entities that, in turn, reflects the irreversible up-drift in division of labour and specialisation.

It is difficult to judge how problematic this long-term increase in leverage is. Since risk aversion is presumably innate and unchanging, the willingness to take on increased leverage over the generations likely reflects an improved financial flexibility that enables leverage to increase without increased objective risk, at least up to a point.

American commercial bankers in the immediate post–Civil War years perceived the necessity to back two-fifths of their assets with equity. Less was considered too risky. Today’s bankers are comfortable with a tenth. Nonetheless, bankruptcy is less prevalent today than 140 years ago.

The same trends hold for households and businesses. Rising leverage appears, in large part, the result of massive improvements in technology and infrastructure, not significantly more risk-inclined humans or arguably objective risk. Obviously, a surge of debt leverage above what the newer technologies can support invites crises, as many analysts now currently fear. I am not sure where the tipping point is, but we can be sure there is one. For example, our sub-prime mortgage market was clearly seen as overleveraged, as home price inflation came to a halt in the United States.

Globalisation is changing many of our economic guideposts. It is probably reasonable to assume that the ratio of worldwide dispersion of the financial balances of unconsolidated economic entities to world nominal GDP will continue to rise as increasing specialistion and division of labour, and ever more sophisticated finance and capital-deepening, spread globally.

Whether the component reflecting dispersion of world current account balances continues to increase as well is a more-open question. Such an increase would imply a further decline in home bias. But in a world of nation-states, home bias can decline only so far. Thus, the degree of global current account dispersion would also stabilise, as indeed it may have already done.

Extracts from the Per Jacobsson lecture