Cross-border flows of real and financial capital have also increased dramatically—a reflection of the recent notable reduction in the degree of home bias in capital markets.

The rise of the US current account deficit over the past decade appears to have coincided with a pronounced new phase of globalization that is characterized by a major acceleration in US productivity growth and the decline in what economists call home bias.

In the 1990s, home bias began to decline discernibly, the consequence of a dismantling of restrictions on capital flows and the advance of information and communication technologies that has effectively shrunk the time and distance that separate markets around the world.  The vast improvements in these technologies have broadened investors' vision to the point that foreign investment appears less risky than it did in earlier times.

I should like to raise the hypothesis that the reason the historically large US current account deficit has not been placing pressure on the exchange rate of the US 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.  An ever-growing proportion of US households, nonfinancial busineses, and governments, both national and local, fund their capital investments from external sources...What is special about the past decade is that the decline in home bias, along with the rise in IT productivity growth and the rise in the dollar, has engendered a large increase by US residents in purchases of goods and services from foreign producers.  The increased purchases have been willingly financed by foreign investors with implications that are not as yet clear.

How much further home bias can decline is obviously conjectural, given the paucity of historical precedent. Federal Reserve staff studies indicate that, despite evidence of recent diversification, U.S. and foreign portfolios still exhibit marked home bias. Funding of our current account deficit likely will become more difficult when home bias approaches its practical minimum. Irrespective of how globalized our economy may become, other things equal, people will still accord nearby investments a lower risk premium.

Capital flows are driven by a number of economic forces which are not fully understood, especially at a quantitative level. The “home bias” of investors, which has led them to invest in their home countries rather than seek optimal international diversification, has probably been diminishing and as a consequence investors everywhere are increasingly investing outside their home countries. Countries with rapidly aging populations, especially Japan and Western European ones, may be saving and investing in the United States against the day when their populations will be drawing down assets to support retired citizens. Because the United States economy has been growing at a faster pace than most high-income counties, investment returns from U.S. operations have tended to exceed those abroad, thus encouraging capital flows to the United States.

So, how much of the enlargement of the U.S. current account deficit can we attribute to improved international intermediation? This is difficult to answer because it is hard enough to measure a concept as amorphous as international financial intermediation, let alone to gauge its effect on the current account. As a step in this direction, however, we reasoned that any reduction in home bias by foreign investors toward the United States would show up as a decline in the risk premium these investors demand for holding U.S. assets. This decline in the risk premium, in turn, would lead to a greater demand for U.S. assets and a rise in the dollar.

Based on an estimate of the decline in the risk premium that occurred since the mid-1990s, our macroeconomic model suggests that the decline contributed importantly to the rise in the dollar, and, therefore, to the widening of the trade deficit. Assuming that the lower risk premium can be attributed to growing international intermediation, this latter development apparently exerted an important influence on the U.S. current account.

In line with this record, many authors have been predicting for some time that the combination of interest rates, income, prices, and exchange rates would adjust to end the U.S. trade deficits. But the deficits have not ended, and international economists are searching for reasons to explain the situation...[One] possibility is that the so-called "home bias" in international saving-investment choices is gradually eroding.10 In this view, globalization has generally reduced the barriers to international asset diversification, and we are witnessing a rebalancing of wealth portfolios which, in the transition, can lead to persisting current account deficits or surpluses.

A clear benefit of financial globalization is that, to the extent that it reduces home bias, savings will be better directed to the most promising investments in the world, increasing global economic growth and prosperity. However, so long as risk aversion exists and trust is enhanced by local familiarity, we cannot expect that home bias will fully dissipate.

Recent studies suggest that differing disclosure and corporate governance standards preserve home bias. Researchers have shown that, in most countries, holding a controlling interest in a firm yields significant benefits that do not accrue to minority shareholders, and that a substantial portion of home bias in those countries can be attributed to local holdings of closely held firms.7 Additionally, staff at the Federal Reserve Board and International Monetary Fund have shown that, for firms from emerging-market economies that meet U.S. standards for disclosure and protection of minority shareholder rights, U.S. residents hold the theoretically predicted proportion of company shares in their portfolios.8 Thus, it appears that an improvement in global reporting and corporate governance standards could significantly reduce global home bias.

Certainly, globalization does mean that changes in foreign demand conditions matter more for U.S. aggregate demand. And global financial markets and cross-border capital flows quickly transmit pressures abroad to U.S. markets. But neither has had much effect on our ability to control domestic monetary policy. The reason is that there’s still a substantial “home bias” in our demand for goods, services, and assets—that is, the bulk of the goods and services we consume and the assets we hold are produced or issued in the U.S.