Editors' Summary

The Brookings panel on Economic Activity held its seventy-ninth conference in Washington, D.C., on March 31 and April 1, 2005. This issue of Brookings Papers on Economic Activity includes the papers and discussions presented at the conference. The first four articles address the position of the United States in the global economy, an increasingly controversial subject in the research, financial, and policy communities. Since the early 1990s, U.S. current account deficits have grown almost without interruption, reaching $666 billion, or about 6 percent of GDP, in 2004. The U.S. international investment position is now one of net indebtedness approaching 30 percent of GDP, and in recent years a substantial portion of the buildup in net debt has come in the form of additions to dollar reserves by foreign central banks. Some observers see the present situation as unsustainable and warn of an abrupt depreciation of the dollar, which could destabilize financial markets and disrupt the global economy. Others are more sanguine, arguing that the present situation reflects the relative strength of the U.S. economy, consumer and business preferences, and rational financial decisions, all of which could evolve so as to make any needed adjustments gradual.

Each of the four articles takes a different approach to analyzing the situation, focusing on issues that the authors see as key. The first article models portfolio choices and how they moderate the pace of adjustment in exchange rates and current accounts. The second stresses the relative price changes that will be needed, both in the United States and abroad, to move the U.S. current account toward balance. The third considers the motivations of policymakers in China and elsewhere for accumulating dollar reserves. The fourth assesses the likelihood of an abrupt depreciation of the dollar and the economic instability that might result in the United States and abroad. The volume concludes with an article on the possible impact of slowing labor force growth on stock market returns.

The U.S. international investment position is affected by developments in both foreign trade and international capital flows—the market for imports and exports of goods and services and the market for foreign and domestic assets. The sustainability of the U.S. current account deficit and the consequences of reducing that deficit depend on features of both those markets. Most economic models that have been used to analyze the current account deficit assume imperfect substitutability between foreign and domestic goods and services but perfect substitutability between foreign and domestic assets. These assumptions carry strong implications for how the economy adjusts to new developments. In the first article in this volume, Olivier Blanchard, Francesco Giavazzi, and Filipa Sa provide a distinctive analysis that allows for imperfect substitutability between domestic and foreign assets and between domestic and foreign goods. With this feature, movements in exchange rates and asset prices have potentially important effects on the portfolios of international investors and strong implications for the speed with which exchange rates adjust to shocks. Compared with popular discussion and with earlier, simpler models, this rich specification provides a better understanding of past developments in the U.S. current account balance and the dollar exchange rate and a more realistic framework for assessing future prospects.

In its simplest form the authors' model has just two regions—the United States and the rest of the world—each of which supplies interest-bearing assets. The wealth of each region is given by the value of domestic assets plus net claims on foreigners. Investors diversify their portfolios, holding both foreign and U.S. assets, but exhibit home bias: given equal expected returns, they place a larger fraction of their wealth in domestic than in foreign assets. As a result, a shift in wealth to foreigners reduces the demand for U.S. assets, causing the dollar to depreciate. Similarly, an increase in private or government demand for dollar assets causes the dollar to appreciate. Because of imperfect substitutability, the relative returns on foreign and U.S. assets can vary with changes in relative supplies or shifts in the distribution of world wealth, and uncovered interest parity does not hold...