Trade Deficits May Scare Off Foreign Cash

Federal Reserve Chairman Alan Greenspan cautioned Monday that foreign investors might sour on bankrolling America’s mammoth trade deficits, but he expressed confidence that the economy’s flexibility would cushion any fallout.

The huge trade deficits the U.S. has been running up each year “cannot persist indefinitely,” Greenspan warned in remarks delivered via video link to a conference in Mexico. “At some point, investors will balk at further financing.”

The Fed chief, who retires Jan. 31 after 18-plus years running the central bank, didn’t say when this might occur.

Greenspan’s comments were aimed at the “current account” deficit, which swelled to a record $668 billion last year. The shortfall is financed by foreign investors.

The current account deficit is considered the best measure of a country’s international economic standing because it tracks not only goods and services but also investment flows between countries.

Foreigners have been willing to lend the United States money to finance its current account imbalances. The worry is that at some point foreigners will lose their appetite for holding dollar-denominated investments. That could cause them to unload investments in U.S. stocks and bonds, which would send prices plunging and interest rates soaring.

The constraints on financing the current account deficit are likely to come from “foreign investors’ fears” of holding too large a share of their investment portfolios in U.S. stocks and bonds, Greenspan said.

This change in mind-set may already be underway, he suggested.

“Concentration and other risks in holding dollar balances seem to have become a consideration at least for some investors,” Greenspan said.

Of the more than $30 trillion in foreign investment tracked by the Bank for International Settlements in the first three months of 2005, 42.5% were in dollars and 39.3% were in euros, Greenspan noted.

The dollar’s share was down by 4 percentage points from about three years earlier, while the euro’s share was up by 5 percentage points, he pointed out.

The current account deficit this year has exceeded 6% of the total U.S. economy as measured by gross domestic product, an all-time high. In 1986, the deficit accounted for 3.5% of GDP.

The U.S. has been able to finance the yawning deficits as foreign investors have become more willing and comfortable investing outside of their respective countries, Greenspan said.

The United States also has benefited from being considered the world’s reserve currency, the currency foreigners turn to first when they want to hold investments outside of their country, Greenspan said. This foreign investment has helped to keep U.S. interest rates lower than they otherwise would be.

“Although I doubt that the U.S. dollar will lose its status as the world’s reserve currency anytime soon, there are in my judgment lessons to be learned from the experience of [Britain’s currency] as it faded as the world’s dominant currency,” Greenspan said.

Britain made the mistake of trying to impose extensive regulations in an effort to support its currency’s position on the world’s stage, which made Britain’s economy too rigid in times of financial crisis, he said.

For the U.S., the lesson to be learned from Britain is to maintain financial flexibility, Greenspan said.