A big puzzle debated among economists today is why the United States' gluttonous trade imbalance with foreigners (technically referred to as the current account deficit) has not yet squashed the value of the dollar.

Lucky for them, hero and idol Alan Greenspan has come to save the day. (Yet again.)

Before we get into the big solution, let’s first talk about why this puzzle is a puzzle at all. Why is the value of the dollar expected to decline when the current account deficit is high?

Think about it. What do foreigners do with all the dollars that they receive in payment for the stuff they're selling to the U.S.? A Frenchman can't really go and take a greenback and buy a baguette with it.

No, in the simplest case, the Frenchman has two alternatives. The first option is to exchange his dollars for Euros to make local purchases. This leads to a bigger and bigger pile of dollars sitting in the banks' coffers. Just like for tangible products, supply and demand works for currencies too. Too many dollars, and their price (denominated in Euros, for example) will decline.

The second alternative is for the Frenchman to buy U.S.-denominated assets like U.S. Treasuries. But, according to many traditional economists, as more foreigners buy these instruments, the debt of the U.S. compared to its savings increases to a point where it becomes vulnerable in the eyes of the lender. Pretty soon lenders (foreigners) will see the U.S. as too debt-ridden and therefore too risky of an investment for the returns that it might be offering. So, this option can only be viable up to a point.

Because option #1 would lead to a decline in the dollar in all cases, option #2 must be the option of choice of most foreigners today. Indeed, the fact that foreign acquisitions of assets in the United States were a record $1,440.1 billion in 2004, up from $889.0 billion in 2003 is evidence of this.

So why haven’t we reached the point where foreigners think we’re borrowing too much?

Greenspan’s speech lifts us out of the nitty-gritty numbers and takes us to the 30,000-foot view of the state of the world.

[From Federal Reserve Board Chairman Greenspan's December 2, 2005 speech before the Advancing Enterprise Conference. London, England]

"This afternoon, I should like to raise the hypothesis that the reason the historically large U.S. current account deficit has not been placing persistent pressure on the exchange rate of the U.S. dollar, at least to date, is that the deficit is a reflection of a far broader and long-standing financial development in the United States and elsewhere..."

In about 3,500 words, Greenspan basically states that the deficit hasn't been that big of a deal because foreigners have money to spend (partially due to all these payments for their exports), and they're becoming more and more willing to spend it outside their borders.

To make his point, Greenspan explains that in the modern world of finance, the walls that once distinguished foreign investments vs. domestic investments have come down around the globe. He uses the term “home bias”, which is the tendency for investors to stick to their own turf even though an investment opportunity across the Atlantic might be just as good (or better) as one next door. Spewing a load of statistics, Greenspan demonstrates with absolute clarity that globalization has clearly hit with a bang and that home bias is becoming a thing of the past.

In essence, the amount of resources available to American people and companies extends beyond its borders. Foreigners who have current account surpluses have extra cash and, because their home bias goggles have been removed, a U.S. investment with a given risk factor looks just as good as that same investment in their own country. So, to understand whether America is using foreigners’ money to get itself into “too much debt”, Greenspan essentially says that you have to look not at U.S. debt compared with U.S. savings (usually measured by the current account balance), but, rather U.S. debt compared with global savings.

"To make the best judgment... would require current account measures obtained at the level of detail at which economic decisions are made: individual households, businesses, and governments. That level is where [economic] stress is experienced and hence where actions that may destabilize economies could originate. Debts usually represent individual obligations that are not guaranteed by other parties. Consolidated national balance sheets, by aggregating together net debtors and net creditors, accordingly can mask individual stress as well as individual strength."

If there are tons of pools of savings from which to borrow, and those lenders are just as willing to lend to the US as they are to their own nations, then Treasuries win over baguettes, the dollar stays strong and everybody’s happy.

Three cheers to Greenspan for solving another one of economics’ great mysteries. One more reason that his step-down in January will come all too soon.

UPDATE: Nouriel Roubini's blog post has great commentary on the US dollar exchange rate's relationship to our current account. Read more here.

Posted by Michelle Smith on December 9, 2005 07:49 AM