Commentary Type

A Revived Bretton Woods System? Implications for Europe and the United States

Edwin M. Truman (Former PIIE)

Speech at the conference "Revived Bretton Woods System: A New Paradigm for Asian Development?"
Federal Reserve Bank of San Francisco



The author thanks Morris Goldstein, Catherine Mann, Michael Mussa, John Williamson, and Anna Wong for comments on an earlier draft without implicating them in this final product.

This note addresses three topics: (1) Do the recent musings by Dooley, Folkerts-Landau, and Garber (DFG), in particular their argument that the world is operating under a revived Bretton Woods system (BW2), provide a useful framework for thinking about international economic and financial developments and prospects? (2) What does the DFG framework imply for the euro area, and are those implications reasonable? (3) What does the DFG framework imply for the United States, and are those implications reasonable?

It is useful to establish my point of departure with respect to the DFG framework before addressing the other two topics. The DFG view is that the US current account deficit and the de facto pegs of many currencies, especially in Asia, to the US dollar represent a revival of the Bretton Woods system, and that the system is sustainable for a decade and serves the mutual interests of all parties. My summary reaction is that this view is incorrect, and their framework does not provide a useful guide for analysis or policy.

On the second topic, DFG argue that countries maintaining dollar pegs are capturing the home and export markets of floating-rate countries, the euro area in particular, and that Europe will soon join BW2, using heavy intervention, if necessary, to arrest the appreciation of their currencies against the dollar. Meanwhile, the Europeans do not need to worry about diversification of international reserve holdings into euros, but in contrast they might want to think deeply about the implications of an emerging dual-reserve currency BW2 system. I argue that the central DFG implication that Euroland will soon embark on large-scale foreign exchange market intervention is highly unlikely.

On the third topic, DFG argue that the countries whose currencies are pegged to the dollar are prepared to take over the financing of the large, and by implication, ever larger US current account deficit for an indefinite period and blunt external and internal market forces toward correction while US monetary and fiscal policy continue to foster the rapid expansion of domestic demand. In this context, BW2 looks more like Alice in Wonderland, where the upside down is the right side up. I doubt that either the laws of physics or principles of political economy have been repealed.

The BW2 Framework

The DFG proposition is that countries whose currencies are essentially pegged to the US dollar, which in their view includes most of emerging Asia and in some papers Japan as well, have embarked on a development strategy of maintaining the undervaluation of their currencies against the dollar for a period of at least a decade. That strategy is also in the interests of the United States as the center country because it is able to finance its external and internal deficits for a similar extended period and profitably send large amounts of foreign direct investment (FDI) to the emerging-market economies with their pegged rates. Thus, BW2 is win-win for the United States, perhaps for a longer period than BW1.

The foundation of the DFG view of BW2 contains four reasonable, though debatable, observations. First, some countries, including large countries with considerable influence on global economic and financial developments have a preference for pegged bilateral exchange rates. The source of that preference is complex; it may be part of a development strategy, as DFG argue, or it may be merely a convenient parameter for policy planning.

Second, many of these countries, especially in Asia, have a preference for an undervalued exchange rate. That preference may derive from a conscious development strategy of export-led growth or from a desire to accumulate a war chest of international reserves to provide insurance in a world of volatile economic financial conditions. The latter rationale suggests that diminishing returns will set in at some point. That point may be close at hand as recent rates of reserve accumulation by some countries have been off the scale of historical experience. Four Asian economies (China, Korea, Malaysia, and Taiwan) added to their international reserves at average annual rates of more than 10 percent of GDP in 2003 and 2004, and a fifth (Korea) at an average annual rate of 5 percent, before recently throwing in the towel and letting the won appreciate.

Third, the global system includes a number of important countries and areas with floating exchange rates. This means that the effective exchange rates of countries with dollar pegs are also floating. It follows that if a particular path for the real exchange rate is associated with a particular optimal time path toward an equilibrium in which surplus labor is fully absorbed and the country can join the world of floaters, then the appropriate policy measure is the effective exchange rate, not a bilaterally pegged rate.1 Consequently, in the case of China and India, the only two de facto peggers with substantial surplus labor, the optimal path for their real dollar exchange rates when the dollar was appreciating on average cannot be the optimal path when the dollar is depreciating. Their currencies have been effectively devalued over the past three years. Therefore, according to DFG's own analysis, they should embrace a discrete revaluation to put them back on the optimal path.

Fourth, in today's monetary system as under BW1, the United States is both central and, most of the time, passive, as befits the country issuing the n-currency. However, the qualification "most of the time" implies that there will be exceptions, as some say should be the case right now.

Accepting these perceptive, if imperfect, observations, the arguments that DFG employ to support their BW2 construction also involve important flaws. First, their "trade account bloc," even if limited to non-Japan Asia is not a monolith. The countries are not all like China in terms of their stage of development, the availability of surplus labor, the development of their financial markets, and in particular the extent of their capital controls. Most of the 10 Asian economies with currencies included in the Federal Reserve Board's broad exchange rate index differ from China. For example, only Hong Kong and Malaysia also have hard pegs to the dollar. The remaining seven economies, since February 2002 through late January 2005, have experienced appreciations against the dollar ranging from 27 percent (Korea) to minus 9 percent (the Philippines). Through November 2004 on the JPMorgan index movements in their real effective exchange rates range from a real depreciation of 15 percent for Malaysia to a real appreciation of 9 percent for Korea.2 There is more to the international monetary system than China, the United States, and the euro area. An analysis that explains the policy choices of China vis-à-vis a passive United States and, perhaps, a nervous Euroland is substantially incomplete in terms of the economic, financial, and political forces involved.

Second, as Eichengreen (2004) has argued persuasively, DFG make a false analogy with the first Bretton Woods system. Today more countries are relevant to the working of the system, and they have a much greater variety of exchange rate regimes than under BW1 even at the end. Very few countries have extensive capital controls. Domestic financial systems have been liberalized, and the international financial system and global capital movements have been transformed. The United States is no longer a net saver recording trade and current account trade surpluses. Finally, the system is not linked to a fixed price of gold and a diminishing US gold stock. This means that the international monetary system is less brittle; it does not offer the opportunity to break the bank. However, a constraint remains in the form of global current account positions, their political-economic acceptability, and their financial sustainability, which depends on more than de facto bilateral exchange rate arrangements.

Third, the status quo as it existed in early 2002 is already unraveling as can been seen in the actions by the Japanese and Korean authorities to tolerate greater exchange rate appreciation and pressures from the G-7 (October 1, 2004, repeated February 5, 2005) to "emphasize that more flexibility in exchange rates is desirable for major countries or economic areas that lack such flexibility to promote widespread adjustments in the international financial system based on market mechanisms."

Finally, a continuation of a US current account deficit of 6 percent of GDP is neither economically, financially, nor politically sustainable. The large economies with more or less firm pegs to the dollar inevitably will have to be part of the adjustment process. They do have a choice: They can choose to start to participate in the process now, contributing to a smoother adjustment process, or they can hold out and live with economic and financial consequences which are likely to be more unpleasant for them as well as the system as a whole.

On balance, the DFG framework does not offer a useful guide for analysis or policy.

Implications for Europe

I now consider the implications of the DFG framework for " Europe," which might be taken as shorthand for all countries with essentially free-floating exchange rate regimes, other than the United States, or as the euro area. I choose the latter, simpler interpretation, but the same points apply to other industrial countries with floating exchange rates.

My reading of the collective DFG musings has uncovered four implications for the euro area. (1) Because of the substantial appreciation of the freely floating euro over the past three years, the "Asians" (countries with de facto dollar pegs) are positioned to take market share from the euro area not only in the United States but also in the economies of all countries whose currencies are more firmly pegged to the dollar than the euro (DFG 2003b). (2) The most likely consequence, according to DFG, is that the euro area will alter its position in BW2 and undertake massive exchange market intervention to resist further appreciation of the euro (DFG 2003b, 2004a, and 2004d). (3) At the same time, given that the euro has already appreciated substantially against the dollar, the incentive for central banks to diversify their foreign reserves into euros is much smaller than it was in early 2002 when it took less than US$0.90 to buy a euro (DFG 2004d). (4) In contrast, DFG hint at the prospective emergence of two reserve currencies and the replacement of the dollar by the euro (DFG 2003b). Let's consider each of these implications in turn.

First, no one would dispute that the tendency is for the euro area to lose its trade share in all markets relative to those countries whose real effective exchange rates have not appreciated over the past three years: in the United States, in Asian markets, and in home markets. The DFG argument that the euro area is able to ward off "Asian," mainly Chinese, penetration of its home markets via subtle or not so subtle protection is not supported by the data. Goldstein and Lardy (2005) report that Europe absorbed a quarter of Chinese total exports in 2003; in addition, Europe is eager to expand in the Chinese market and would not risk Chinese retaliation.

To date, the euro area has borne a large and disproportionate share of the actual (small) and potential (larger) adjustment of the US external position.3 So far the response of euro-area policy makers has taken two forms. They have made the sensible suggestion that other countries, whose bilateral dollar and effective exchange rates have not appreciated over the past three years, and in many cases have depreciated in effective terms, should allow their currencies to adjust.

They also have made the less sensible suggestion that the United States should cut its fiscal and external deficits without relying upon additional dollar depreciation. Here, they are at best fooling themselves; restraint on the growth of US domestic demand and an increase in the US total saving rate should be part of the adjustment process, but expenditure switching must also play a role. I take as my baseline that an adjustment of the US current account position on the order of 3 percent of US GDP is likely to occur over the next three to five years, and that the size of the overall real effective depreciation of the dollar accompanying that adjustment is likely to be twice as large as the 15 percent we have already seen. Moreover, the additional depreciation of the dollar is not all going to come from China and other countries whose currencies have appreciated less against the dollar than has the euro.

Second, the conclusion that policymakers in the euro area will respond to their dilemma by abandoning floating and engage in large-scale exchange market intervention to prevent further euro appreciation is politically and economically unconvincing. If they did not know it already, the Europeans have learned from the massive Japanese intervention at the end of 2003 and the first quarter of 2004 that such operations have extremely limited (in size and duration) effects in countries with open capital markets and high degrees of asset substitutability. Partly for that reason, large dollar purchases would raise serious questions about risk-taking and financial accountability in democratic societies. In other words, if the euro-area fiscal and monetary authorities make large financial bets with a very low probability of a positive payoff, their taxpayers will punish them.

Third, DFG are technically correct when they argue that from a narrow financial perspective it would have been cheaper for central banks and finance ministries to diversify into euro-denominated assets in 2002 when the euro was relatively weak than it does to do so when the euro necessarily is closer to its probable peak. On the other hand, they now face larger potential losses on their larger portfolios of dollar assets, valued in their own currencies. Moreover, one area of substantial inertia in the international financial system involves the reserve management practices of monetary authorities. Therefore, I expect that the marginal countries to step up the pace of their diversification, but the financial-market implications are psychologically rather than substantively important because the amounts are likely to be small. More broadly, DFG and other analysts focus too much on the actions of the monetary authorities with respect to their foreign exchange reserves. Most of the finance ministries and central banks are no different, aside from their inertia, from other managers of small international portfolios. They are just a few more actors in the arena of international finance. Moreover, private cross-border holdings of financial assets are at least ten times the foreign exchange holdings of the monetary authorities.

Fourth, the appreciation of the euro is more likely to slow down the development of a bipolar global financial system than to accelerate its development. The appropriate metric for judging the decline of the dollar as an international currency is not its share of international reserves but its share of international transactions among traders and investors who are not located in the United States or in Europe (Truman 2005). Two types of developments could boost those trends: adoption of irresponsible macroeconomic policies by the United States, which is a risk but not yet a reality, and acceleration of the development of euro-area financial markets. Ironically, the second trend is likely to be slowed in the face of euro appreciation because euro-area policy makers in the short run will not want to increase the attractiveness of the euro. The euro may yet become a rival to the dollar as an international currency, but not right away soon.

In conclusion, I see no basis for embracing the implications for Europe that DFG derive from their analysis of BW2. Rather than joining the club of countries with pegged exchange rates, Europe will persist to exert political and economic pressures to induce major countries with relatively hard pegs to the dollar to abandon or substantially to modify their exchange rate policies. That said, before the current cycle of external adjustment has run its course, I fully expect to see ECB purchases of dollar-denominated assets, but those purchases will be small in scale-a few tens of billions of dollars not hundreds of billions of dollars-and defensive in character. They will be "doing something" to make them feel better even though they will have little confidence about its effects on exchange rates.

Implications for the United States

Turning to the implications of the DFG framework for the United States and US policy, my reading of the collective DFG musings again uncovered four implications for the United States. (1) The constellation of global current account positions is stable and sustainable (DFG 2004b). (2) As long as other countries continue to purchase massive amounts of US Treasury securities, US interest rates will remain lower than normal and rates on treasuries will be disproportionately low (DFG 2004a). (3) The United States faces no pressure to adjust its external position (DFG 2004d). (4) However, down the road the euro may emerge as a rival for the dollar (DFG 2003b). As before, I will consider each of these implications in turn.

First, it should be noted that in some of their papers DFG have argued that their BW2 system is indefinitely stable and sustainable (DFG 2003b), implying that the system they describe can be sustained with US current account deficits of 6 percent of GDP or larger. In another paper (DFG 2004a), they describe a current account deficit of 3 percent of GDP as "manageable" with the implication that anything larger than that figure is unmanageable. There is insufficient precision in their writing for readers to know what they really think.

What I think is that a US current account deficit of 6 percent of GDP, which implies a negative net international investment position (NIIP) of 100 percent of GDP in the long run, is unsustainable.4 Global economic and financial forces have been unleashed to reduce it substantially, and they are not likely to be appeased until the current account deficit is convincingly headed for the territory of 3 percent of GDP. No amount of purchases of US assets by the monetary authorities of a limited number of countries has the force to short circuit that process. As a first approximation, as part of this adjustment process in which the dollar's real effective depreciation ultimately reaches twice what we have already seen, it is inconceivable that the share of the euro in the second leg of adjustment will be as large as its share in the first leg-i.e., a further 50 percent appreciation to € 2.60 per dollar. The real effective exchange rates of a broad range of Asia and Latin American economies will appreciate rather than depreciate, including substantial bilateral appreciation of the currencies of those major economies that have been more tightly linked to the dollar over the past three years.

To make the same point another way: Do we really think that "Asian" official purchases of US assets, principally US Treasury securities, can expand to fill the gap created by the slowdown in "European" private purchases? As noted above, satiation points may soon be reached; it appears that Korea has already. If not the DFG story, then what is the story we want to tell?

The story that I would tell is that private investors in Europe as well as the rest of the world have reached the conclusion that a US external deficit of 6 percent of GDP is unsustainable, and have adjusted their purchases of US dollar assets accordingly. They have not collectively sold dollar assets; they have only slowed their rate of purchases. Assuming that their "target" for a sustainable US current account deficit is 3 percent of GDP, then exchange rate and other adjustments will have to occur until something close to that appears to be in the cards. The implication is that there will be continuing downward pressure on the dollar against floating currencies until the overall adjustment is consistent with a lower US current account deficit. Such pressures on the dollar against floating currencies will be translated into political and market pressures on the "Asia" authorities to permit the revaluation of their currencies against the dollar. In the meantime, as long as those authorities resist, they will have to purchase increased amounts of dollar assets, but the US current account will be adjusting.

Second, the scope for increased capital inflows via a large and widening US current account deficit tends to offset upward pressures on dollar interest rates, compared with a situation in which the increased inflow and wider current account deficit does not occur.5 This tendency will persist regardless of the assets purchased by the foreign investors and regardless of whether those investors are from the private or official sector. The effects on US interest rates of net inflows of private savings from abroad are comparable to the effects of the US fiscal deficit on interest rates.6 Such estimates vary, but a representative recent study by Laubach (2003) found that the US long-term rate is reduced by about 25 basis points for each one-percent of GDP in reduction of the fiscal deficit. Thus, everything else equal, as a first approximation a reduction in the US current account deficit by 3 percent of GDP would boost expected US long-term interest rates by 75 basis points.

On the other hand, if the US current account deficit is unchanged as a ratio to GDP, the level of US dollar interest rates should be unchanged, regardless of the composition of the counterpart financing of the deficit. The composition of net capital inflows should not affect the level of US interest rates or the spread between rates on different assets for three reasons. First, foreign official assets, as of the end of 2003, accounted for only 14.0 percent of all foreign assets in the United States (18.2 percent excluding foreign direct investment). Second, US financial liabilities-official and private-are highly substitutable in most portfolios. By way of illustration, note that over the twelve months through November 2004 gross foreign transactions in US long-term securities (notes, bonds, and equities) were almost $30 trillion and gross US transactions in foreign securities were more than $6 trillion, but those gross magnitudes produced a net inflow of only $828 billion. Third, there is no evidence of which I am aware of changes in spreads relative to treasuries, for example, between the first quarter of 2004 when recorded foreign official purchases of US government securities were $115 billion (78 percent of the current account deficit) and the third quarter of 2004 when recorded official purchases of US government securities declined to $52 billion (31 percent of the current account deficit).

It does not matter which foreign investors, public or private, in which countries do or do not buy which assets, as long as the total amount of net purchases is unchanged. This leads to the question of what would happen if the People's Bank of China (PBC) stopped purchasing US Treasuries, and also did not purchase other dollar assets, such as shares of IBM. Under current circumstances, one would expect that such a decision would accompany, or require, a decision to revalue the yuan by a significant amount, or a floating of the currency; in other words, the PBC would stop intervening to resist yuan appreciation, and the yuan would appreciate or would have been revalued.

What would be the likely financial-market consequences? Given the lags in the effects of exchange rate adjustments, as a first approximation the US current account deficit would be unchanged. It is possible that the Chinese decision would trigger similar decisions by other countries that have been resisting the appreciation of their currencies, and the market might also push up floating currencies against the dollar in a rush to anticipate global current account adjustment. Thus, there could be a significant real depreciation of the dollar in a short period of time.

However, for the next 6 to 12 months there would be no effect on the US current account position (perhaps even a J-curve effect temporarily enlarging the deficit) or on the size of net capital inflows to the United States.7 It is an open question whether market interest rates on dollar assets would rise or fall in the meantime. DFG might argue that US interest rates would rise sharply; their implicit view is that (a) it matters how the US current account is financed and (b) it matters whether residents of each country with the counterpart trade surpluses in effect provide bilateral financing. I have already argued that the first point is wrong, and I think that the second is a particularly misleading characterization of the functioning of global financial markets today. The counterpart of the Canadian bilateral surplus with the United States may be disproportionately invested, net, in US assets, but the same does not necessarily hold for the Venezuelan surplus, which may not even be invested in dollars, and almost certainly, for political reasons, is not directly invested in the United States. What matters is not bilateral deficits and bilateral financial flows but rather aggregate deficits and aggregate flows along with expectations about how that balance will be struck.

Third, is the United States under pressure to adjust its external position? Clearly yes. Those pressures take several forms.

The US dollar continues to be under intermittent market pressure to depreciate. The US economy also is coming under pressure to slow the rate of growth of domestic demand (gross domestic purchases or GDP less net exports) relative to the rate of growth of domestic production (GDP). For the decade from 1993 to 2003, the former growth rate was 3.3 percent, and the latter growth rate was 3.7 percent, real net exports of goods and services declined by $466 in chained 2000 dollars, and the US current account deficit widened by $465 current dollars. We have been living beyond our means.8 Over the decade ending in 2013, those relative growth rates will have to be roughly reversed if the US current account deficit is to shrink by 3 percent of GDP. Given developments in 2004 and in prospect for 2005, the gap between the growth rates will have to be even larger than four-tenths for the remaining eight years of the hypothetical adjustment period.9 It follows that US fiscal and monetary policy will come under pressure, even if those pressures have not already been felt, to help restrain the growth of domestic demand relative to the growth of output. Less restraint exerted on the fiscal side implies that more will have to be accomplished on the monetary side. In addition if, instead of narrowing over the next three to five years, the US current account deficit stalls out at 6 percent of GDP or continues to widen, then we can expect increased protectionist pressures in the United States . Policymakers and economies in other countries of the world are feeling similar economic and political pressures in varying degrees, but with opposite signs.

In summary, the notion implicit in the writings of DFG that global macroeconomic conditions are ideal and that the status quo can be maintained indefinitely is not one on which I would be willing to bet a lot of money.

Fourth and finally is the issue of whether down the road the euro may emerge as a rival for the dollar. I discussed this DFG conjecture under the heading of implications for Europe. I do not see it as a major issue for US or global policymakers in the current context unless US economic policies and performance are decidedly inferior to what I expect over the next ten years.

US policymakers will have to be sensitive to charges of benign neglect of their currency and of the world economy as the global adjustment process plays out over the next three to five years. It is for that reason that I am confident that before the US dollar reaches its lows against the euro and yen, the US monetary authorities will be buying dollars. They will do so not because they think there is a high probability that they can arrest the dollar's slide, but because they think the dollar may have moved too far too fast, and they are under pressure to "do something." However, I suspect that we are a long way from that trigger point.


The DFG arguments that the Bretton Woods system has been revived are thought provoking. The major thoughts that the DFG framework provokes for me are three: (1) The DFG framework is unconvincing as a description of today's international monetary or financial system. (2) Euroland or other major industrial countries with floating exchange rates are unlikely to alter their policies in the direction of managing their currencies via large-scale foreign exchange operations. (3) DFG do not establish a plausible case for the sustainability of the US current account deficit at its current rate of 6 percent of GDP or a case for China or other countries whose currencies have been more tightly linked to the dollar not participating in the global adjustment process.


DFG (Dooley, Michael, David Folkerts-Landau, and Peter Garber). 2003a. "Dollars and Deficits: Where Do We Go From Here?" Deutsche Bank (June 18).

DFG (Dooley, Michael, David Folkerts-Landau, and Peter Garber). 2003b. An Essay on the Revived Bretton Woods System . NBER Working Paper 9971. Cambridge, MA : National Bureau of Economic Research.

DFG (Dooley, Michael, David Folkerts-Landau, and Peter Garber). 2004a. The Revived Bretton Woods System: The Effects of Periphery Intervention and Reserve Management on Interest Rates and Exchange Rates in Center Countries. NBER Working Paper 10332. Cambridge, MA : National Bureau of Economic Research.

DFG (Dooley, Michael, David Folkerts-Landau, and Peter Garber). 2004b. Direct Investment, Rising Real Wages and the Absorption of Excess Labor in the Periphery. NBER Working Paper 10626. Cambridge, MA : National Bureau of Economic Research.

DFG (Dooley, Michael, David Folkerts-Landau, and Peter Garber). 2004c. The U.S. Current Account Deficit and Economic Development: Collateral for a Total Return Swap. NBER Working Paper 10727. Cambridge, MA : National Bureau of Economic Research.

DFG (Dooley, Michael, David Folkerts-Landau, and Peter Garber). 2004d. "The Revived Bretton Woods System: Alive and Well." Deutsche Bank (December).

Eichengreen, Barry. 2004. Global Imbalances and the Lessons of Bretton Woods. NBER Working Paper 10497. Cambridge, MA: National Bureau of Economic Research.

Goldstein, Morris and Nicholas Lardy. 2005. "China 's Role in the Revived Bretton Woods System: A Case of Mistaken Identity." Paper prepared for Federal Reserve Bank of San Francisco Conference on Revived Bretton Woods System: A New Paradigm for Asian Development? (February 4).

Laubach, Thomas. 2003. New Evidence on the Interest Rate Effects of Budget Deficits and Debt. Finance and Economics Discussion Series 2003-12. Washington: Board of Governors of the Federal Reserve System.

Macroeconomic Advisors. 2003. "Long-Term Economic Outlook: Forecast through 2013." December.

Truman, Edwin M. 2005. The Euro and Prospects for Policy Coordination. In The Euro at Five: Ready for a Global Role? ed., Adam Posen. Washington: Institute for International Economics (forthcoming).


1. I do not accept the DFG (2004b) argument that an undervalued exchange rate along with massive purchases of US Treasury instruments with a negative expected yield in Chinese yuan is in China 's developmental interest. I am merely pointing out that their argument is inconsistent with China 's maintaining a fixed dollar peg for the past three years.

2. On this basis, China 's real effective depreciation is 10 percent. The real effective appreciation of the Korean won is larger than that for the currencies of Japan (1 percent), the United Kingdom (-1 percent), Switzerland (5 percent), and Sweden (6 percent). The real effective appreciation of the euro is 23 percent.

3. To those who say that there has been no US adjustment, the appropriate counterfactual is to consider what the US external position would be if the US dollar had not depreciated by an effective 15 percent or so in real terms since early 2002.

4. The estimated equilibrium level of the US NIIP is derived from the simple relationship that stability requires that the current account deficit, which is the annual addition to the stock of debt, as a share of GDP must equal the nominal growth rate of the economy multiplied by the existing stock of net debt (NIIP) as a share of GDP. A reasonable assumption for the nominal growth rate of the US economy is 6 percent, which produces 100 percent of GDP as the equilibrium NIIP. Note that to achieve a stable current account deficit as a share of GDP, the trade deficit as a share of GDP most likely will have to be narrowing as the net income cost of previous deficits accumulate.

5. The strength of this tendency depends on the nature of the shock or disturbance causing the widening of the current account deficit. The tendency is likely to be more pronounced when the dollar is rising, reflecting an excess ex ante demand for dollar assets, than when the dollar is depreciating, reflecting an excess ex ante supply.

6. The adjustment of interest rates to achieve the flow equilibrium between savings and investment should be qualitatively similar whether one is considering about foreign saving or domestic (public or private) saving. Comparing the cases of an increase in US government debt and an increase in US net international debt, one would expect the stock effects on interest rates would differ. The latter is more comparable to an increase in private debt, which nets out against an increase in real assets. On the other hand, the stock of international debt may influence the willingness of foreigners to invest in the United States.

7. I am excluding the possibility that a large depreciation of the dollar over a short period of time would unleash macroeconomic forces that would quickly produce a substantial narrowing of the US current account deficit along the lines observed in some emerging market economies experiencing external financial crises.

8. Based upon the preliminary national income accounts data released for the fourth quarter of 2004, over the past four quarters the gap between the growth rate of real gross domestic purchases (4.5 percent) and real gross domestic product (3.7 percent) was double the average gap from 1993 to 2003.

9. These calculations are based on Macroeconomic Advisors, "Long-Term Economic Outlook: Forecast through 2013," December 2004. That forecast envisages a US current account deficit in 2013 of 2.2 percent of GDP, but it fails to take account of the fact that share of that the non-trade current account items will be expanding in line with the expansion of US net liabilities and the increase in US interest rates over the period. Therefore, I interpret their forecast to be more consistent with a current account deficit closer to 3 percent of GDP.

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