Our fiscal deficit...is in the zone of unsustainability. Our external imbalance—the current account deficit—is...[at] a level without precedent in U.S. economic experience. Each of these imbalances magnifies the risk in the other.

Together, however, these imbalances [in the federal budget and current account] raise the potential for higher risk premia on U.S. financial assets and more uncertainty about future returns on claims on the United States. This in turn could reduce expected future investment, productivity growth and U.S. growth potential. This could reduce the willingness of the world’s savers to put their capital to work in the United States. And this could mean lower growth outcomes and slower growth in future incomes.

Our current account deficit reflects in part the relative attractiveness of the United States as a place for the world to invest its apparently ample present supply of savings. It is true that much of the cause of our imbalance seems to lie in optimism about future U.S. economic performance reflected in the willingness of non-Americans to put their savings to work here rather than in their own countries or in Europe or Japan. In this sense, our external deficit may reflect relative strength, rather than weakness. This argument would be more reassuring if we were facing a lower and more sustainable current account deficit. And it would be more powerful if the capital inflows that are the counterpart of our current account imbalance were going to finance private rather than public investment, and if a larger share of those flows were private rather than official.

We don’t know how likely it is that those outside the United States are going to be willing to continue to acquire claims on the United States at the recent pace.

[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.

This mix of challenges in our fiscal and external positions deserve concern and attention. They may end up being diffused gradually and benignly, but they necessarily bring with them a greater risk of higher risk premia, a more adverse investment environment and poorer growth outcomes. Under some circumstances, this could undermine an important foundation of the environment for innovation that has delivered our productivity acceleration.

To mitigate the risks [resulting from large fiscal and current account deficits]...we can work to keep monetary policy credible, to preserve confidence we will act to keep inflation and inflation expectations stable at moderate levels.

The imbalances in our fiscal and external positions could be diffused gradually and smoothly. But the transitions to a more sustainable equilibrium could also bring greater volatility in asset prices, less stability in macroeconomic outcomes, slower growth and more uncertainty.

Unavoidable economic logic suggests that eventually this situation will prove unsustainable: our deficit and other countries’ surplus positions will come into better balance. The question is how...National savings need to grow. One way to increase savings is to cut the federal deficit...Another source of adjustment would be an increase in the personal savings rate...Rising productivity also could help us grow out of the problem...But it is likely wishful thinking to rely on faster productivity alone even if it is sustained at current levels...A strong case can be made to begin to address this issue sooner rather than later. And personally, I would start with the federal budget deficit.

We may not be able to usefully determine at what point foreign accumulation of net claims on the United States will slow or even reverse, but it is evident that the greater the degree of international flexibility, the less the risk of a crisis. Should globalization continue unfettered and thereby create an ever-more flexible international financial system, history suggests that current account imbalances will be defused with modest risk of disruption.

The resolution of our current account deficit and household debt burdens does not strike me as overly worrisome, but that is certainly not the case for our fiscal deficit, which...will rise significantly as the baby boomers start to retire in 2008. Our fiscal prospects are, in my judgment, a significant obstacle to long-term stability because the budget deficit is not readily subject to correction by market forces that stabilize other imbalances.

I will argue that over the past decade a combination of diverse forces has created a significant increase in the global supply of saving--a global saving glut--which helps to explain both the increase in the U.S. current account deficit and the relatively low level of long-term real interest rates in the world today...The global saving glut has been a remarkable reversal in the flows of credit to developing and emerging-market economies, a shift that has transformed those economies from borrowers on international capital markets to large net lenders.

As U.S. business investment has recently begun a cyclical recovery while residential investment has remained strong, the domestic saving shortfall has continued to widen, implying a rise in the current account deficit and increasing dependence of the United States on capital inflows.

The greater the extent to which capital inflows act to augment residential construction and especially current consumption spending, the greater the future economic burden of repaying the foreign debt is likely to be.

The growth in export-oriented sectors such as manufacturing has been restrained by the U.S. trade imbalance (although the recent decline in the dollar has alleviated that pressure somewhat), while sectors producing nontraded goods and services, such as home construction, have grown rapidly. To repay foreign creditors, as it must someday, the United States will need large and healthy export industries. The relative shrinkage in those industries in the presence of current account deficits--a shrinkage that may well have to be reversed in the future--imposes real costs of adjustment on firms and workers in those industries.