of our debt in terms of foreign currencies would then automatically decline, inducing foreign wealth - holders to make further portfolio shifts, perhaps even including increasing their stock of dollar - denominated debt. this ( september 17, 2003 ) and rudolph g. penner and c. eugene steuerle, budget crisis at the door ( the urban institute, october 2003 ). see, for example, peter hooper, karen johnson, and jaime marquez, “ trade elasticities for g - 7 countries ”, princeton studies in international economics, vol. 87, ( august 2000 ). even this claim may be overoptimistic. see, for example, thomas laubach, “ new evidence on the interest rate effects of budget deficits and debt, ” finance and economics discussion series working paper ( april 2003 ). among other things, laubach has an interesting way to remove cyclical effects from his dependent variables, interest rates. denomination effect would not permanently prevent any relative price adjustment, but it could lengthen the process. beyond that, for pragmatic reasons this conventional adjustment process could be extended or distorted even further. by way of illustration, asian central banks have now accumulated more than a trillion dollars of international currency reserves - largely in dollar - denominated assets - equal to roughly half of the outstanding net debt of the united states. these central banks are not traditional wealth - holders motivated by expected risks and returns. instead, they seem motivated more by the prospect of preserving low domestic currency values for their exporters. 10 to pursue this objective, they can print money to buy u. s. securities. this monetary expansion could generate domestic inflation unless it is sterilized with other open market sales of securities - and the mere scale of present and expected future debt stocks may make continued sterilization impossible. but if these central banks continue behaving this way, the so - called credibility range could be extended significantly. while trade deficits should ultimately correct themselves, perhaps after a long trek through the credibility range, there are really no natural self - corrective mechanisms for budget deficits. once the u. s. economy gets through the credibility range, interest rates on the increasing government debt will have to rise to induce people to hold the debt. this rise increases the interest burden and causes total deficits to rise further, all the time subtracting more and more funds from capital accumulation. once this process begins, market psychology may hasten the adjustment. 11 hence, while natural

conversely, suppose that expansionary fiscal policy resulted in a rise in budget deficits. if this expansion were totally financed by borrowing from foreigners, domestic interest rates would not change much, and domestic investment and private saving might not either. in this scenario, there could be a simultaneous dollar - per - dollar change in budget and trade deficits - the classic twin - deficit scenario. such a situation is most likely to occur in small economies fully open to international trade and capital flows, economies in which domestic interest rates are determined by world capital markets and are independent of domestic economic variables. but if domestic interest rates do change, as they likely would in either a closed economy or a large open economy, private investment and saving would also likely change, and any strict link between budget and trade deficits would be broken. one could spin any number of scenarios, but these are enough to make the basic point. because of the underlying relationship between saving and investment, budget and trade deficits could be strictly linked. but in a large open economy like the united states, it is easy to imagine plenty of scenarios in which they are imperfectly linked, and even some scenarios in which they move in opposite directions. budget and trade deficits should be viewed as linked, but not as twins. stability conditions although the economic implications and reactions of budget deficits and trade deficits differ, both are deficits. another elementary accounting identity says that last period ’ s debt level plus the current deficit equals the current period ’ s debt level. this identity is true whether we are talking about budget deficits building up the stock of outstanding government debt ( a liability of the government sector to the private sector ), or trade deficits building up the stock of external debt ( the net stock of accumulated foreign claims against the united states ). 2 economists have worried for years about optimal stocks of government and external debt. for government debt, the optimal stock turns out to be related to the optimal level of national saving, which can be defined as the level that maximizes the nation ’ s long - term path of consumption per worker. the optimal stock of net external debt can be determined in the same framework from an open economy perspective. while these models can be instructive, today i am going to focus on a weaker standard. whatever the long - term optimal level of government debt, and whatever the optimal level of external debt, one can separately ask whether either debt level is becoming a more, or less, important economic factor over time.