I think that the financial markets are really very deep and liquid for U.S. dollar assets. If you include not only U.S. government debt, GSE debt, but also highly rated corporate debt, for example, the size of the market for high-rated U.S. dollar credit instruments is perhaps $40 trillion or something along those lines - would mean that China is only holding a few percentage points of that debt...I think that realistic changes in China's portfolio are not going to have major impacts on U.S. asset prices or interest rates. 

The issue is not so much the change in China's portfolio; the issue really is the fact that we are consuming more than we are producing domestically. That means that foreign debt is increasing. And there may come a period or a time when foreigners are not willing to continue to add to their holdings of U.S. dollar assets. And that will, in turn, lead to perhaps an uncomfortable adjustment in the current account.

Those urging the United States to rein in its spending should be equally full-throated in prodding countries with excess savings and trade surpluses to create conditions for growing their domestic demand. If they fail to do so, and the U.S. suddenly becomes virtuous on its own, the global economy would sink into a deep funk.

The size and duration of these imbalances, perhaps the most visible of which is the U.S. current account deficit, present challenges—and risks—for the world economy.

If the deficit continues to run at a level close to 7 percent of GDP—and most forecasts assume it will for some time—the net international investment position of the United States will deteriorate sharply, U.S. net obligations to the rest of the world will rise to a very substantial share of GDP, and a growing share of U.S. income will have to go to service those obligations. This fact alone suggests that something will have to give eventually, and this raises the interesting question of how these imbalances have persisted on a path that seems unsustainable with so little evidence of rising risk premia.

Even if we could be confident that the world would be comfortable financing the United States on these terms for some time, that fact alone does not mean that it is prudent for the United States to continue borrowing on this scale, particularly given that doing so means that the net obligations of the United States to the rest of the world are likely to rise sharply relative to GDP.

The continuing buildup in liabilities should soon push U.S. net investment income balances into deficit, with progressively larger net transfers of income to the rest of the world. In that event, net income flows will begin to boost the nation's current account deficit instead of reducing it, reinforcing the deterioration in net liability position of the United States.

The arguments I have just described highlight factors that may improve the odds of a more protracted, gradual and benign scenario, but they do not really alter the general conclusion that these [current account] imbalances are unsustainable and that they will need to unwind at some point. Time does not necessarily help. The longer these gaps continue to build, the greater the ultimate adjustment required, and the greater the risks that accompany that process.

The United States needs to restore a reasonable cushion in its structural budget balance to help deal with future shocks. If we are unable to begin to generate more confidence in the capacity of the U.S. political system to produce these improvements, we would face a greater risk of future increases in risk premia. And even though substantial fiscal consolidation would not by itself bring the external imbalance down to a more sustainable level, it would improve the prospect for a smoother adjustment to that outcome.

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

Monetary policy itself cannot sensibly be directed at reducing imbalances, but the past and future evolution of global capital flows will of course matter for monetary policy by virtue of their impact on the outlook for output and inflation.

In the international sector, continued strong growth in the rest of the world will slow the growth of the trade deficit.  An expanding world economy is expected by many economists to generate increasing demand for U.S. exports.  Such growth, however, is also likely to further increase global demand for natural resources.  This implies that prices for commodities such as oil may remain at elevated levels for an extended period of time.

The United States continues to be a preferred destination for foreign capital, the most mobile of factors.  These flows of international capital have made it easier--or at least less painful--to finance our deficits at low interest rates.  Without capital from overseas, the growth of government spending might have crowded out the growth of household spending.

Most policy makers marvel at the seeming ease with which the United States continues to finance its current account deficit.

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.