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Tuesday, November 15, 2005

The Grass is Always Greener at Home ... But I'm Biased

Federal Reserve Chair Alan Greenspan discusses the current account balance and the role that two factors, a decline in home bias and a relative increase in U.S. productivity, have played in allowing such a large deficit to persist. Noting that the growth in the deficit cannot persist indefinitely and adjustment will occur at some point, he believes the key to a smooth adjustment is economic flexibility. Economic flexibility, which requires a hands off approach from government, gives economies the best chance to withstand shocks and to provide the stability needed for economic growth:

Stability and Economic Growth: The Role of the Central Bank, by Fed Chair Alan Greenspan: International finance presents us with a number of intriguing anomalies, but the one that seems to bedevil monetary policy makers the most as they seek stability and growth ... is the seemingly endless ability of the United States to finance its current account deficit. To date, despite a current account deficit exceeding 6 percent of our gross domestic product (GDP), we ... are experiencing few difficulties in attracting the foreign saving required to finance it... Of course, deficits that cumulate to ever-increasing net external debt ... cannot persist indefinitely. At some point investors will balk at further financing. ...

In all instances, a current account balance is essentially the product of a wide-ranging interactive process ... To the extent that an economy harbors elements of inflexibility, so that prices and quantities are slow to respond to new developments, the deficit-adjustment process is likely to adversely affect the levels of output and employment. ... The rise of our deficit and our ability to finance it appears to coincide with ... 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. ...[S]tarting in the 1990s home bias began to decline discernibly. ... The decline in home bias reflects a number of recent factors that ... lessen restraints on cross-border financial flows as well as on trade in goods and services. ... [T]he advance of information and communication technologies has effectively shrunk the time and distance that separate markets around the world. ... Technological innovation and ongoing deregulation and tariff reductions have driven the globalization process by ... lowering the cost of transacting across borders. The effect of these developments has been to markedly increase the willingness and ability of financial market participants to reach beyond their national borders to invest in foreign countries...

The decline in home bias has clearly enlarged sources of finance for the United States. ...  How much further home bias can decline is obviously conjectural, ... Federal Reserve staff studies indicate that ... U.S. and foreign portfolios still exhibit marked home bias. ... 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. Concentration and other risks in holding dollar balances seem to have become a consideration at least for some investors. ... What could be the potential consequences should the dollar's status as the world's reserve currency significantly diminish...? Most analysts would contend that U.S. interest rates were lowered by the world's accumulation of dollars. Accordingly, in the event of a significant diminishing of the dollar's reserve currency status, U.S. interest rates would presumably rise. ...

[T]here are ... lessons to be learned from the experience of sterling as it faded as the world's dominant currency. ... Many wartime controls were maintained ... immediately after World War II. ... 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 ... is likely to be readily absorbed by a far more flexible U.S. economy than existed in Britain immediately following World War II. ... Governments today ... are rediscovering the benefits of competition and ... beginning to recognize an international version of Smith's invisible hand in the globalization of economic forces. ... 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. ... Being able to rely on markets to do the heavy lifting of adjustment is an exceptionally valuable policy asset. The impressive performance of the U.S. economy over the past couple of decades ... offers the clearest evidence of the benefits of increased market flexibility. ...

Flexibility is most readily achieved by fostering an environment of maximum competition. A key element in creating this environment is flexible labor markets. Many working people equate labor market flexibility with job insecurity. Despite that perception, flexible labor policies appear to promote job creation. An increased capacity of management to discharge workers without excessive cost, for example, apparently increases companies' willingness to hire without fear of unremediable mistakes. ... Protectionism in all its guises ... 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. ...

See Kash at Angry Bear for more comments. I would also add that sometimes government intervention is required to make markets work. Does anyone doubt that the protection of property rights by the government is necessary for markets to flourish? It's hard to bring goods to market if they are stolen along the way. Monopolies are easy to create if the most powerful can block the gates to the market. Governments and other institutions make markets work in both obvious and subtle ways, a lesson learned most recently by formerly socialist countries attempting to transform to market economies.  As we go down the path to less government regulation, a path justified in most cases, we should be careful not to undermine rather than promote competition.

    Posted by on Tuesday, November 15, 2005 at 12:15 AM in Economics, Fed Speeches, International Finance, Monetary Policy | Permalink  TrackBack (0)  Comments (4)


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