As our net external debt rises, the cost of servicing that debt increasingly will subtract from US income.  Accordingly, it would be helpful to raise our domestic saving and reduce our trade deficit while maintaining an environment conducive to investment and growth.  Reducing the budget deficit would release resources for private investment and reduce the future burden of repaying the public debt, although studies indicate a relatively modest effect of budget-cutting on the trade deficit.  Pro-growth policies among our trade partners would also contribute to some adjustment of external imbalances.  Finally, more flexible exchange rate regimes in some countries would provide greater scope for market forces to reduce our trade deficit, and would be in the interests of the countries implementing these regimes as well.  Nevertheless, in the absence of a shift in market perceptions of the relative attractiveness of US and foreign assets, government policies would likely have only limited effects on the trade balance.

Even with the broad shift globally to more flexible exchange rates, a substantial part of the world economy now run monetary policy regimes targeted at limiting the variability in their exchange rate against the dollar, or a basket in which the dollar plays a substantial role. Sustaining that objective in the past several years has required a large accumulation of dollar assets...The significant rise in the earnings of the energy exporters, many of whom also run exchange rate regimes that seek to shadow the dollar, has also generated a substantial rise in investments in U.S. assets. A large share of the capital flows to the United States that have financed our current account imbalance come from these official sources. These flows add to other sources of private demand for U.S. assets. At the margin, they put downward pressure on U.S. interest rates and upward pressure on other asset prices. Through this effect, the monetary policy regimes that prevail in parts of the world help explain at least part of the persistence of these anomalies...Research at the Federal Reserve and outside suggests that the scale of foreign official accumulation of U.S. assets has put downward pressure on U.S. interest rates, with estimates of the effect ranging from small to quite significant.

For global growth to be sustained at a reasonably strong pace during this period of adjustment, the desirable increase in U.S. savings, and the necessary slowing in U.S. domestic demand growth relative to growth of U.S. output, would have to be complemented by stronger domestic demand growth outside the United States, absorbing a larger share of national savings. Exchange rate regimes, where they are currently closely tied to the dollar, will have to become more flexible, allowing exchange rates to adjust in response to changing fundamentals. Reforms to financial systems and to social safety nets over time would help reduce the need for exceptionally high levels of domestic saving we see in many countries. The global nature of these requirements does not imply that the United States can put the principal burden for adjustment on others

Although the business cycle has not disappeared, flexibility has made the United States and the United Kingdom, and much of the remainder of the global economy more resilient to shocks and more stable during the past couple of decades.  Nonetheless, the piling up of dollar claims against US residents is already leading to concerns about concentration risk.  Although foreign investors have not as yet significantly slowed their financing of US capital investments, since 2002, we have observed a decline in the value of the dollar and a reduction in the share of dollars in global cross-border portfolios

The impact of a reduction in the scale of official accumulation of dollar assets could be fully offset by increases in purchases by private investors. But even in the context of a continued high degree of confidence in the relative return on claims on the United States, it is hard to know with confidence how the preferences of private savers might respond to the process of gradual evolution in their nation’s exchange rate regimes now underway.

Some observers mistakenly believe that a marked increase in the exchange value of the renminbi relative to the US dollar would significantly increase manufacturing activity and jobs in the United States.  I am aware of no credible evidence that supports such a conclusion.

The sooner the Chinese, in their own self-interest, move to a more flexible currency regime, perhaps leading other Asian currencies to become more flexible as well, the better for all participants in the global trading system.

Now, it seems that investors are becoming less willing to channel so much of their savings into additional dollar-denominated instruments going forward. And some have suggested that they are beginning to diversify into other currencies, like the euro. This has caused the dollar to depreciate against other currencies.

[A] substantial part of the world economy...has an interest in shadowing the dollar closely, as they absorb excess capacity, and...these governments are likely to continue to want to acquire dollars to make that exchange rate objective possible.

The United States continues to be a desirable place to invest both in terms of equity returns and, increasingly, in terms of fixed income returns.

In general, I would say flexibility, which is an extraordinarily valuable asset to the world financial system, is clearly advanced by having, essentially, a free floating rate system, which is largely what we have.

The present [global exchange rate] system, where the major currencies adjust against each other, but many large emerging market economies tie their currencies to the dollar or shadow it closely, creates an awkward asymmetry. This system carries with it the seeds of future stress for the global economy.

Many [policy makers in Asia] are moving toward more flexibility in their exchange rate regimes. The challenge ahead is to help manage the transition to a monetary system that provides flexibility in the exchange rates of all the major economic areas, and this has to be handled with care...Bringing these imbalances down to a more sustainable level will take time. During this period of adjustment, despite our fundamental economic strengths, we will be vulnerable to an elevated risk of volatility in financial markets.

[The current global exchange rate regime] is not an ideal mix, either for the monetary system as a whole, or for those countries which permit very little variability in their real effective exchange rates, and it’s probably not sustainable over time...It creates the risk of larger moves in the major currencies than might otherwise be the case. In the national economies of those not yet prepared to allow more flexibility in their effective exchange rates, it creates the risk of growing distortions in the allocation of resources, conflict with domestic monetary policy objectives, and the risk of larger and more abrupt future movements in the exchange rate.

Policy makers in Asia are well aware of the complications and costs involved in sustaining their current regimes. Many are moving toward permitting more flexibility against the dollar, and even in their effective exchange rates. Few however are comfortable with the prospect of accepting large short-term volatility and large movements over time in their effective exchange rates.