current account adjustments. the united kingdom, however, had significant adjustment difficulties in its early postwar years, as did, more recently, mexico, thailand, korea, russia, brazil, and argentina, to name just a few. can market forces incrementally defuse a worrisome buildup in a nation's current account deficit and net external debt before a crisis more abruptly does so? the answer seems to lie with the degree of flexibility in both domestic and international markets. in domestic economies that approach full flexibility, imbalances are likely to be adjusted well before they become potentially destabilizing. in a similarly flexible world economy, as debt projections rise, product and equity prices, interest rates, and exchange rates could change, presumably to reestablish global balance. the experience over the past two centuries of trade and finance among the individual states that make up the united states comes close to that paradigm of flexibility even though exchange rates among the states have been fixed. although we have scant data on cross - border transactions among the separate states, anecdotal evidence suggests that over the decades significant apparent imbalances have been resolved without precipitating interstate balance of payments crises. the dispersion of unemployment rates among the states, one measure of imbalances, spikes during periods of economic stress but rapidly returns to modest levels, reflecting a high degree of adjustment flexibility. that flexibility is even more apparent in regional money markets, where interest rates that presumably reflect differential imbalances in states'current accounts and hence cross - border borrowing requirements have, in recent years, exhibited very little interstate dispersion. this observation suggests either negligible cross - state - border imbalances, an unlikely occurrence given the pattern of state unemployment dispersion, or more likely very rapid financial adjustments. * * * 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. 7 the experience of the united states over the past three years is caroline freund, “ current account adjustment in industrialized countries, ” board of governors of the federal reserve system, international finance discussion paper no. 692, december 2000. although increased flexibility apparently promotes resolution of current account imbalances without significant disruption, it may also allow larger deficits to emerge before markets are required to address them. illust

##ging is expensive. thus, although hedging may delay, and perhaps even smooth out, the adjustment, it cannot eliminate, without prohibitive cost, the consequences of exchange rate change. accordingly, the currency depreciation that we have experienced of late should eventually help to contain our current account deficit as foreign producers export less to the united states. on the other side of the ledger, the current account should improve as u. s. firms find the export market more receptive. but in the process, dollar prices of imports will surely rise. * * * when the temporary forestalling of the u. s. balance of payments adjustment process comes to an end, does that suggest a steepening of the decline in the dollar's exchange rate? that many exports even from europe are priced in dollars is a trading convention. it does not affect the costs in domestic currencies that exporters incur. as i pointed out in the beginning, the most sophisticated analytical techniques have been unable to profitably project the exchange rates of major currencies. yet, most commentators argue that because the current account deficit must eventually narrow, the price - adjusted value of the dollar must accordingly decline. but how can exchange rates and the current account be systematically related, if exchange rates are inherently unpredictable? the answer is that the point at which the u. s. current account deficit will be forced to narrow is itself inherently difficult to predict. the current account reflects the myriad forces that bring our transactions with foreign economies into balance at our borders, of which exchange rates are only one. but those forces that, in the end, are reflected in a current account surplus or deficit are both domestic and foreign. indeed, our current account balance can be shown to be exactly equal to the difference between domestic saving and domestic investment. in fact, it is often instructive in longer - term analysis to view our current account in terms of its domestic counterparts. as i pointed out in a speech last november, 3 virtually all of our trading partners share our inclination to invest a disproportionate percentage of domestic savings in domestic capital assets, irrespective of their differential rates of return. people seem to prefer to invest in familiar local businesses even where currency and country risks do not exist. for the united states, studies have shown that individual investors and even professional money managers have a slight preference for investments in their own communities and states. trust, so crucial an aspect of investing, is most likely to