	Introduction

America's current account (CA) (exports less imports plus net income payments and net unilateral transfers) has been in deficit every year but one since 1982. After a year in surplus in 1991, it steadily rose as a share of gross domestic product (GDP) to a record high of 6.1% of GDP in 2005 and 2006. Some observers have questioned whether the CA deficit is sustainable. Those expressing concern about the CA deficit typically define unsustainability to mean that the United States would have difficulty financing the CA deficit at some point in the near future, and the resulting adjustment process would harm the U.S. economy. But if the desirability of U.S. assets were to change rapidly (due to a loss in confidence in the U.S. economy, for example), foreign capital inflows and the value of the dollar could decline quickly; at a minimum, foreigners would require significantly higher interest rates than they do at present for inflows to continue. If both lender and borrower are rational, many economists believe that the CA deficit can be mutually beneficial—it allows the lender to enjoy a higher rate of return than could be enjoyed at home and allows the borrower to operate with a larger capital stock than could be financed from domestic saving. Some economists, however, doubt this interpretation and are concerned that the large CA deficit is symptomatic of wider economic imbalance. On the other hand, if the U.S. economy grows faster than the rest of the world in the future, then (small) CA deficits would be needed for foreigners to maintain U.S. asset holdings equal to the U.S. share of world GDP. But, all else equal, foreigners will only be induced to buy more exports if the dollar depreciates. In 2008, the United States had a net foreign debt of $3.5 trillion, but received net investment income of $126 billion from the rest of the world. That is because U.S. holdings of foreign assets have earned a higher rate of return than U.S. debt owed to foreigners. It should be emphasized that economic theory suggests that a slow decline in the CA deficit and dollar would not be troublesome for the overall economy. The initial effect could be a sudden and large depreciation in the value of the dollar, as the supply of dollars on the foreign exchange market increased, and a sudden and large increase in U.S. interest rates, as an important funding source for investment and the budget deficit was withdrawn from the financial markets. (Empirical evidence suggests that the full effects of a change in the exchange rate on traded goods takes time, so the dollar may have to "overshoot" its eventual depreciation level in order to achieve a significant adjustment in trade flows in the short run.) The financial crisis, beginning in August 2007 with the illiquidity of the U.S. subprime mortgage market and deepening in September 2008, would seem to be a good test case for how a large change in investor sentiment would affect the CA deficit. The crisis led to a large decline in private capital flows in 2008—both foreign purchases of U.S. assets and U.S. purchases of foreign assets that had countervailing effects on the CA balance. This trend was not new—the steady financing of the CA deficit has depended heavily on official capital inflows since 2002. First, the United States has a flexible exchange rate regime. However, not all cases of large CA deficits end in a reversal. Under his optimistic scenario, in which he assumes that the U.S. net debt will rise to 60% of GDP by 2010 and then remain constant, the CA deficit would peak at 7.3% of GDP in four years, before eventually declining to 3.2% of GDP (with most of the decline occurring in the first four years after the peak). This scenario (and the first scenario) is not sustainable in the long run because the net foreign debt would grow continuously. From 2002 to 2006, the dollar depreciated by 16% in inflation-adjusted terms. The CA deficit began declining in 2007, along with the continued decline in the dollar through 2008. While a sudden reduction in foreign capital inflows cannot be ruled out—it has happened to foreign countries—it seems highly unlikely.
America's current account (CA) deficit (the trade deficit plus net income payments and net unilateral transfers) rose as a share of gross domestic product (GDP) from 1991 to a record high of about 6% of GDP in 2006. It began falling in 2007, and reached 3% of GDP in 2009. The CA deficit is financed by foreign capital inflows. Many observers have questioned whether such large inflows are sustainable. Even at 3% of GDP, the deficit is probably still too large to be permanently sustained, and many economists fear that the decline is temporary and caused by the recession. Further, a large share of the capital inflows have come from foreign central banks in recent years, and some are concerned about the economic and political implications of this reliance. Some fear that a rapid decline in capital inflows would trigger a sharp drop in the value of the dollar and an increase in interest rates that could lower asset values and disrupt economic activity. However, economic theory and empirical evidence suggest that the most plausible scenario is a slow decline in the CA deficit, which would not greatly disrupt economic activity because production in the traded goods sector would be stimulated.
The financial crisis that worsened in September 2008 would seem to be a good test case of the type of event that could lead to the feared "sudden stop" in foreigners' willingness to finance the CA deficit. While the recession deepened following the crisis, it has not been via a sudden decline in the dollar or a sudden broad spike in U.S. interest rates. On the contrary, the dollar appreciated in value in the months after the crisis and foreign demand for U.S. Treasury bonds has risen since the crisis worsened. On the other hand, there was a large decline in private foreign capital inflows beginning in 2008; had it not been for foreign government purchases of U.S. securities, the CA would have been in surplus in 2009, all else equal.
One long-term consequence of large and chronic CA deficits has been the growing foreign ownership of the U.S. capital stock. A large CA deficit is not sustainable in the long run because it increases U.S. net debt owed to foreigners, which cannot rise without limit. A larger debt can be serviced only through more borrowing or higher net exports. For net exports to rise, all else equal, the value of the dollar must fall. This explains why many economists believe that both the dollar and the CA deficit will fall further at some point in the future. To date, debt service has not been burdensome. Because U.S. holdings of foreign assets have earned a higher rate of return than U.S. debt owed to foreigners, U.S. net investment income has remained positive, even though the United States is a net debtor nation.
Since 1980, most episodes of a declining CA deficit in industrialized countries have been associated with slow economic growth. Only two episodes were associated with a severe disruption in economic activity. Because most of the episodes involved small countries, these cases may differ in important ways from any corresponding episode in the United States. Historically, a few other countries have had a higher net foreign debt-to-GDP ratio than the United States has at present; however, if CA deficits continue at current levels, the U.S. net foreign debt could eventually be the highest ever recorded.
This report also reviews studies on the CA deficit's sustainability. Some of the studies suggest that a large dollar depreciation could eventually be required to restore sustainability. But the inflation-adjusted 25% depreciation of the dollar from 2002-2008 had little effect on the CA deficit, which kept growing until 2007. The CA deficit did not decline rapidly until after the financial crisis of September 2008—a period with little trend movement in the dollar.