My name is William Dudley. I am the chief U.S. economist for Goldman, Sachs & Co. It is my pleasure to have the opportunity to testify before the Subcommittee on Economic Policy of the Senate Banking Committee. The views expressed in my statement are my own and do not necessarily reflect the positions or views of Goldman Sachs.
The United States has a large current account deficit, which has grown sharply in recent years. To date, it has not proved problematic for the US economy or US financial markets. But this imbalance does create a risk. If foreign investors' appetite for dollar-denominated assets were to diminish, the result could be a sharp plunge in the value of the dollar and the potential for havoc in the US bond and equity markets.
So how to minimize this risk? I would suggest three approaches:
Before I discuss in greater detail what should be done in response to the large US current account deficit, let me start with my assessment of the causes and likely sustainability of this imbalance.
In my opinion, the large current account deficit evident for the United States mainly reflects the disparity between the low supply of domestic saving and high demand for investment both in business plant and equipment and in housing. This imbalance has developed primarily for four reasons.
First, household saving has been depressed as a consequence of the long bull market in US equities. The rise in the US equity market generated a huge increase in household net worth. This caused households to save less out of their current income. The result has been a sharp fall in the personal saving rate to the lowest level since the Great Depression.
Second, investment spending on plant and equipment surged as a consequence of technological change, which lifted productivity growth, and the buoyant equity market, which reduced the cost of capital. Investment spending also probably got a boost from a bit of irrational exuberance as investors mistook profits generated from the boom for profits that were sustainable on a long-term basis.
Third, the buoyant economy stimulated household formation and the demand for housing, which also increased the demand for capital.
Fourth, the willingness of foreign investors to supply capital to the US also exacerbated this imbalance. The appetite of foreign investors for US assets kept the dollar strong and inflation low. This helped to foster a more robust stock market and encouraged greater investment.
Up to this point, the rise in the dependence of the United States on foreign capital has not created any great difficulties. That is mainly because foreign businesses have been eager to increase their direct investment in the United States and foreign investors to increase their portfolio holdings of dollar-denominated financial assets. In fact, the desire by foreign investors to increase their holdings of dollar-denominated assets has been so great that it has caused the US dollar to appreciate significantly since 1995. The strength of the dollar, in turn, has helped to sustain the economic expansion by helping to keep inflation in check.
In general, the desire by foreign investors to increase their investment in the United States should be viewed for what it has been: A mark of the US economy's success. Capital is flowing here readily because the US economic system has been performing well. Many factors including credible fiscal, monetary, and trade policies, deregulation, a flexible financial system, and a transparent corporate governance and accounting framework have helped to generate high productivity growth and a healthy return on capital in the United States. These factors have helped to encourage the flow of foreign funds to the United States.
However, the dependence of the United States on foreign capital inflows does create a vulnerability that needs to be acknowledged. In particular, if the performance of the US economy were to falter on a sustained basis, the appetite for dollar-denominated assets could decline sharply. The result would be a sharp decline in the dollar and the risk of havoc for US financial markets. The consequence could be a vicious circle in which dollar weakness contributed to poorer economic performance, which, in turn, reinforced the dollar's slide.
There are three major reasons for concern. First, the US current account deficit is already very large, expected to reach nearly $450 billion in 2001. This is big relative to both GDP (about 4%) and relative to the dollar value of US exports (about 11% of GDP).
Second, the upward trajectory of the US current account deficit evident in recent years must prove to be unsustainable at some point. To see this, consider that a rising current account deficit leads to greater net foreign indebtedness. Because the interest on this debt must be paid, the increase in debt will lead, over time, to a sharp deterioration in the net investment income balance. Without trade improvement, that implies an even wider current account deficit. The result is a vicious circle of climbing debt and interest expense that ultimately is untenable.
Third, the risk that foreign investors lose their appetite for dollar-denominated assets has already increased because the performance of the US economy has deteriorated sharply over the past year. In particular, the growth rate of economic activity and productivity has faltered and corporate profits are contracting as the investment boom in technology has gone bust. The budget surplus is shrinking. Put simply, the notion of a "New Economy" is being called into question. If the economic rebound anticipated for 2002 disappoints, then the demand for US assets is likely to lessen.
Up to now, prospects elsewhere have also diminished. However, if the gap in economic performance between the United States and the rest of the world narrows in the future, then it will become more difficult for the United States to obtain the same huge sums of foreign capital on favorable terms, i.e., at low interest rates and a high dollar exchange rate.
Danger signs for the dollar are already visible in the shift in the composition of foreign capital inflows. The proportion of capital inflows consisting of direct investment, which is not easily reversed, has diminished sharply this year. In contrast, portfolio inflows, especially into corporate and agency bonds, have increased.
For example, in the first quarter of 2001, the rate of foreign direct investment into the United States fell to $41.6 billion, less than half the pace of the prior three quarters. Conversely, investment in private-sector equities and bonds increased to $147 billion, an all-time record.
The composition of these capital inflows is important. In contrast to direct investment, exit from publicly-traded securities is easy. Liquidation can occur quickly, with potentially destabilizing consequences to the dollar and financial markets.
So what should be done to forestall such an outcome?
The goal should be to pursue policies that encourage a gradual path of adjustment--a smaller current account deficit and an increase in the national saving rate. Three major policy adjustments are appropriate.
First, the time has probably come to scrap the so-called "strong dollar" policy. To fail to do so now, when the demand for dollars is still strong, heightens the risk of a sharper adjustment later. It would not be pleasant if US policymakers were forced to jettison the "strong dollar" policy under duress. The loss of credibility would tend to drive up the risk premium on dollar-denominated assets, necessitating a more painful economic adjustment.
A "strong dollar" policy made sense during the investment boom when the main risk was that the US economy might overheat. After all, during the boom, a strong dollar helped to keep inflation in check. Now that the boom is over, the rationale for a "strong dollar" has lessened, especially as the dollar's strength is undermining the effectiveness of US monetary policy and undercutting US international trade competitiveness.
However, rather than call for a weaker dollar, which might provoke a sharp, destabilizing adjustment, I would shift the emphasis away from the dollar altogether towards the importance of having a strong and healthy economy. If the US economy performs well, then foreign capital will flow here readily and the dollar will take care of itself.
Second, policies should be pursued that would act gradually to raise the pool of domestic saving. This can be accomplished in two ways. Continued discipline in terms of fiscal policy is important. The fact is that the dependence of the United States on foreign capital would be much greater currently if the US budget balance had not shifted sharply from deficit to surplus over the past decade. The improvement in the budget balance has enabled the national saving rate to remain generally stable in recent years, despite a sharp fall in the personal saving rate. Not only would slippage here reduce the pool of domestic saving, but it also might worry foreign investors that have invested large amounts of capital in the United States, in part, because of the improvement in the US fiscal outlook.
Although the long-term fiscal outlook for the United States remains challenging given the impending retirement of the baby-boom generation and the increase in life expectancy, it pales in comparison to the challenges faced by Japan and Europe, which have less favorable demographic trends and bigger unfunded pension obligations. It is important that the United States not squander its advantage in this area.
In addition, the tax code could be changed in ways that encouraged greater domestic private saving. This might include additional incentives to save or a more radical revamping of the tax code to a consumption-based tax system.
Policies that raise the national saving rate would gradually reduce the dependence of the United States on foreign capital. Over time, this would reduce the risks of a sharp reversal in the appetite of foreign investors for US assets.
Third, policies should be pursued that ensure the United States remains an attractive market in which to invest. This includes lowering trade barriers, investing in education in order to raise the quality of the US labor force, and taking steps to make the US capital markets more transparent and efficient. By creating a good environment for foreign investment--either direct or in financial assets, this would help to ensure that the flow of capital from abroad persists on favorable terms to the United States.
To sum up, the large US trade imbalance is worrisome. A sharp shift in perceptions among foreign investors could lead to a collapse in the dollar that could conceivably destabilize the US economy and global financial markets. The best way to deal with this risk is to keep the US economy healthy thorough the application of prudent economic policies. If the US economy remains more productive than its rivals and the US capital markets remain deeper and more liquid, then the flow of foreign monies to the United States should continue relatively smoothly and easily. The current account deficit probably would ultimately shrink, but in an orderly way that would not disrupt the ability of the US economy to grow and the nation to prosper.
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