I am deeply concerned about one possible fallout from the large and persistent U.S. current account deficit. This is the possibility of protectionist legislation in the U.S. Such barriers to the trade of goods and services and restrictions on international investment in the U.S. would result in a substantial welfare loss, both for the U.S. and for other countries as well.

Another risk to output growth is the current low savings rate in the United States. For the last three quarters of 2005, the personal savings rate was negative. That means that personal consumption spending exceeded disposable income. So while businesses have be en improving their balance sheets as a result of strong earnings growth, consumer debt has been increasing. The picture for government savings is not any better due to the current large federal budget deficit. Combined, strong consumer and government demand have caused imports to exceed exports, resulting over time in the large U.S. trade deficit, now approaching 7 percent of nominal GDP. To finance this trade deficit, foreigners have acquired large holdings of U.S. securities.  At some point, the domestic savings rate will need to increase to reduce this trade imbalance. Many economists expect that the transition to a higher savings rate will occur smoothly, but with an imbalance of this magnitude, there is a chance that a rapid transition could lead to a downturn in the economy through a sharp falloff in consumption.

Being the world's biggest debtor has its downsides. It puts us at risk that foreign investment desires may change, with potentially harmful effects on the stability of our financial markets. The best guess is that any such change would happen slowly given the reliance of other countries on U.S. imports for growth. But past experiences in other countries with large external deficits leaves one cautious about being too sanguine. Indeed, if our current account deficit continues to grow faster than GDP, there will be a continued deterioration in our net international investment position. That creates an obligation to pay increasing amounts to foreign owners of U.S. debts, and eats into our very ability to invest in our future.

We cannot continue to run a federal budget deficit that raises our debt-to-GDP ratio indefinitely, without diminishing private investment through higher interest rates, thereby reducing productivity and long term growth. The current account deficit is also not sustainable at its existing size and rate of growth. If the amount we must borrow from abroad to finance spending is rising faster than GDP, at some point paying our debts will eat into our standard of living.

Few if any of the paths to current account reduction are cost free since, again, by definition, a slower pace of import growth suggests a slower pace of U.S. output growth. Perhaps the closest to a “win-win” would entail stronger economic growth in our major trading partners, leading to an increase in demand for U.S. exports. Indeed, achieving parity in the growth rates of our major trading partners and ourselves could go a long way toward a gradual and orderly reduction of the U.S. external deficit. It would, however, require strong, self-sustaining domestic-led growth in our major trading partners, something that has proven elusive, at least for the Euro-zone and Japan.

The emergence of large US trade deficits and corresponding surpluses on the part of our trading partners is, to an important extent, the outcome of market forces.  Several factors, including lingering effects of financial crises in emerging market forces.  Several factors, including the lingering effects of financial crises in emerging market economies and concerns abou the outlook for growth in some industrial economies, have led savings abroad to exceed investment.  This excess saving has been attracted to the United States by our favorable investment climate, strong productivity growth, and deep financial markets.  Although the US net external debt has been growing as a consequence of these inflows, as a fraction of our nation's income it remains within international and historical norms.  Given the strength and flexibility of our economy, there is every reason to believe that, if changes in the foreign outlook or in the tone of financial markets were to cause a reduction in capital inflows and the trade deficit, economic activity and employment would stay strong.

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.

The other surprising feature of the current economic environment is the pattern of global imbalances, and the size and persistence of the U.S. current account deficit. As Alan Greenspan has explained, the greater dispersion in external imbalances can be seen as the inevitable result of fundamentally healthy changes in the world economy. As the world progresses toward increasingly integrated financial and goods markets, other things being equal, one might expect to see an increase in the number of countries with surpluses or deficits, and potentially larger surpluses and deficits, as flows of both financial assets and goods work to equalize desired saving and investment around the world.

If one were confident that observed imbalances simply reflected a more efficient allocation of the world’s stock of saving to its most productive uses, that relative prices adjust freely in response to changing fundamentals and that economies are flexible and agile in adapting to those changes, then we might also reasonably expect these imbalances to resolve themselves through smooth and gradual adjustments in relative prices and flows of goods and services. These conditions do not fully exist today. We do not yet live in a world of perfect capital mobility, one in which savings move across borders to their most productive use without constraint in the form of capital controls or without distortions affecting the behavior of private actors. Recognizing this is important to understanding both why the U.S. imbalance has grown as large as it has and, perhaps, more importantly why it has been financed with such apparent ease despite obvious concerns about its sustainability...The anomaly is that these imbalances have persisted on a seemingly unsustainable path with relatively low interest rates and very little evidence of rising risk premia.

The robust productivity outlook for the United States relative to the rest of the world is consistent with an increase in the U.S. current account deficit, such as we experienced in the late 1990s. If this gap in potential growth were sustained, the United States would be able to sustain a larger external imbalance than we might have thought historically would be the case. But the present magnitude of the U.S. external imbalance seems difficult to reconcile with plausible estimates of future productivity and potential output growth.

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.

We do not yet live in a world of perfect capital mobility, one in which savings move across borders to their most productive use without constraint in the form of capital controls or without distortions affecting the behavior of private actors. Recognizing this is important to understanding both why the U.S. imbalance has grown as large as it has and, perhaps, more importantly why it has been financed with such apparent ease despite obvious concerns about its sustainability.

Now, as I said, I think that we ought to work to reduce the current account deficit over time. I think that would reduce the possibility of an uncomfortable adjustment process. But again, as I said earlier...I don't think that the Chinese ownership of U.S. assets is so large as to put our country at risk economically.

From Q & A session

The widening deficits over a period of years will reduce national savings, will probably exacerbate the current account deficit, may raise interest rates and will probably inhibit the dynamism of the economy.

But over a long period of time, a combination of higher national savings in the United States, increased demand by our trading partners and greater exchange rate flexibility - those three factors taken together will allow the current account deficit to come down in a way that I hope would not be disruptive to our economy.