Some observers have concluded, first, that the United States is able to borrow on highly advantageous terms to finance its external deficits and, second, that the United States receives a much higher return on its foreign investments than other countries receive on their investments in the United States. Some novel theories have been developed to support these interpretations. Recent work by Federal Reserve staff, however, has shown that one need not resort to such exotic explanations to understand the behavior of the international accounts. Instead, a careful look at the published data reveals that differences in the three characteristics of U.S. claims and liabilities that I just discussed--returns, composition, and size--contain the key to understanding these apparently anomalous results and, hence, that the United States faces a “reality” similar to that of other countries.

My view is the following: Global economic integration has progressed in recent years to the point that a slowdown in the United States will unquestionably be felt, but not as severely as imagined by some. Domestic growth momentum in many emerging economies will attenuate the influence of U.S. weakness. And the accumulation of foreign currency reserves by these countries—the result of trade surpluses—provides an accessible resource to stimulate their own domestic growth to offset weaker exports, should that weakness materialize.

Kohn also addressed the question of sovereign wealth funds and the risks associated with their investments. 

In general, he said, the U.S. benefits from the "recycling" of U.S. dollars back into the U.S. economy, through these funds and other mechanisms. However, the process would benefit from more transparency, he said, adding that the U.S. Treasury and the International Monetary Fund are studying the issue. 

"We should welcome that recycling," Kohn said.

From audience Q&A as reported by Market News International

I always thought that decoupling was a myth.

As reported by Bloomberg News

I think concerns about sovereign wealth funds can be overwrought. To the extent that trade and capital-account imbalances are the source of potential instability, the answer is to address the fundamental causes.

Exports are likely to remain a source of strength next year, however, as a weaker dollar and continuing growth abroad support demand for U.S. goods and services. Accordingly, I expect the trade deficit to continue to narrow, providing modest support to real GDP growth.

Since I discussed these issues in March 2005, real interest rates have reversed some of their previous declines.  For example, in the United States, real yields on inflation-indexed government debt averaged 2.3 percent in 2006 as compared with 1.85 percent in 2004.  In the past few weeks, that yield has averaged about 2.4 percent.  Inflation-adjusted yields in other industrial countries have also started to move back up after falling in 2005.⁸      

How does this all fit together?  My reading of recent developments is that although some of the details have changed, the fundamental elements of the global saving glut remain in place. ..

Further increases in net capital flows from the developing economies, all else being equal, should have further depressed real interest rates around the world.  But as I have noted, in the past few years, real interest rates have moved up a bit.  This increase does not imply that the global saving glut has dissipated.  However, it does suggest that, at the margin, desired investment net of desired saving must have risen in the industrial countries enough to offset any increase in desired saving by emerging-market countries...

Once again, however, I do not want to rely exclusively on this line of explanation for the behavior of long-term real interest rates, as other factors have no doubt been relevant.  In particular, term premiums appear recently to have risen from what may have been unsustainably low levels, in part because of the greater recent volatility in financial markets and investors' demands for increased compensation for risk-taking.

Within recent years, a significant anti-trade sentiment seems to have emerged in the developed world.  As policymakers, it is incumbent upon us to maintain a commitment to free and open trade, while helping those who experience losses from it find new opportunities.  In doing so, we hope to ensure continued increases in our standard of living and persuade greater numbers of people that trade can be beneficial for everyone. 

I agree with your premise that it's important that the Chinese begin to appreciate further. 

Let me just raise a couple of issues which I guess I would call tactical issues, without addressing any specific legislative proposal.

The first is that the currency, while an important issue, is probably in itself not going to solve the trade imbalance problem. There are fundamental saving/investment imbalances, both in the United States and abroad, which need to be changed in order to make real progress on the trade balance.

And in particular we have emphasized with the Chinese the importance of structural changes in their economy, such as increased safety net and improved financial system, that would increase the share of their output going to consumers and being consumed at home. And the combination of currency appreciation and this other set of measures is really what's needed to begin to move things in the right direction.

So I would urge you to broaden your focus just a bit, beyond the currency, to talk about the savings and investment balances that need to be adjusted in both the United States and in China.

Let's begin by getting some sense of the size, source, and composition of the net capital flows that are moving from developing to industrial countries.  One reasonable measure of the size of these flows is the combined current account balance of the developing economies.  According to estimates by the International Monetary Fund (IMF), the developing economies as a group had a current account surplus of $640 billion last year (IMF, 2007a).³  Because the financial counterpart to this surplus is a deficit on the financial accounts, it represents the net capital outflow to the industrial economies.  $640 billion is a big number and stands in sharp contrast to the situation preceding the Asia crisis.  For example, in 1996 the combined current account balance of the developing economies was a deficit of $80 billion, representing a capital inflow of that amount from the industrial world.

The sources of the $640 billion in net capital flow out of the developing economies are remarkably concentrated.  Of those developing economies running current account surpluses, a mere seventeen of them--China, four other Asian economies, Russia, and eleven members of the Organization of Petroleum Exporting Countries--accounted for a combined surplus of $710 billion.  And about half of that was generated by the major oil-exporting countries in the Middle East and by Russia, whose surpluses ballooned in the past several years as oil prices soared.  Thus, the other 131 developing economies in our data had a combined current account deficit, or net capital inflow, of $70 billion.  This is not to say that things have not changed for these 131 countries in the past decade:  In 1996, their combined current account deficit was twice as large as it was last year.

I especially want to highlight my unease with using the term “imbalances” to characterize the current situation. That term almost begs for a policy response—how can policymakers allow imbalances to persist? Unfortunately, policy responses could well involve damaging protectionist measures. I will argue that, to a large extent, the current situation is not fundamentally an imbalance but rather a condition that is conducive to coping with the major demographic changes that are occurring throughout the world.

Along with the evolving pattern of cross-border flows, we’ve also seen profound increases in the absolute size of current account balances in both industrial economies and emerging market economies. The average absolute value of current account balances as a share of GDP is higher today than it was three decades ago, with much of the run-up occurring in the past decade, and there is less dispersion around the average. Net external positions as a share of GDP have increased over time for both industrial and emerging market economies.

Some declines in residential investment could be large, and could contribute to some volatile numbers for overall GDP growth on a quarter-by-quarter basis. But currently we do not see the slowing in housing markets spilling over into a more prolonged period of weakness in the overall economy. So on balance, we expect GDP growth to average somewhat below potential over the next year or so...

But we cannot forget the plus side of the ledger. Outside of housing, there do not appear to be any imbalances that would foreshadow large adjustments in spending in other sectors. And, as I noted earlier, income growth and spending should be supported by the trends in productivity, recent oil price declines, and improved growth prospects for many of our trading partners.

However, from a current account perspective, if we look forward five or 10 years, at the rate we're going, there will be increasing reluctance of foreigners to hold USD -- that will have effects on our economy. We need to address that.

Although private and government demands for dollar assets have allowed the U.S. current account deficit and foreign surpluses to persist, these imbalances are not sustainable indefinitely. In the United States, both public and private saving will need to rise to meet the oncoming needs of an aging population. At some point, risk-adjusted returns on investments in the rest of the world will begin to look favorable relative to holding dollar assets. Dollar assets are becoming an increasing proportion of non-U.S. portfolios; this can continue for a time, but not forever. At some point, the United States is going to need to finance its imports with the proceeds of its exports, not with foreign saving.