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. It fell slightly in 2007 and 2008, and reached 3% of GDP in 2009 (see Figure 1 ). The 2009 CA relative to GDP still exceeded the share reached in most years before the 2000s. By accounting identity, the CA deficit is equal to net inflows of foreign capital to the United States and reflects the imbalance between domestic saving and investment. If the CA deficit continued its decline since 2007, it would soon reach a sustainable level. The decline may be attributed to cyclical causes that are short-lived, however. As a result of the recession and financial crisis, domestic saving is higher, domestic private investment is lower, and so the need to borrow from abroad has diminished. As the economy returns to normal, domestic saving may fall and domestic investment is expected to rebound, either of which would increase the reliance on foreign borrowing. Further, the large increase in the federal budget deficit since 2007 requires financing—if maintained—from foreign or domestic sources. Without fundamental changes in underlying saving and investment patterns, the decline in the CA deficit will only be temporary. Some observers have questioned whether the CA deficit is sustainable. It has not prevented the economy from generally attaining full employment—the United States has run large CA deficits since the mid-1990s, yet unemployment has remained low in most of those years. The CA deficit has both positive and negative effects on the economy. Production of exports and import-competing goods is arguably lower than it would be in the absence of a CA deficit, but interest rates are also lower than they would be in the absence of foreign capital inflows. As a result, interest-sensitive spending on capital investment, residential investment, and consumer durables (e.g., automobiles and appliances) is higher. 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. Basically, the CA deficit is sustainable as long as foreigners are willing to continue buying American assets. It is not enough for foreigners to reduce their demand for U.S. assets, since this would cause yields on U.S. assets to automatically rise until the market once again cleared. 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. For the U.S. to literally be unable to continue financing its current account deficit, foreign demand would have to fall so much that asset yields could not rise enough for foreigners to be willing to hold U.S. assets again. But what would make foreign investors change their minds about U.S. assets? Federal Reserve Chairman Ben Bernanke has argued that foreigners will continue to increase their holdings of U.S. assets as long as a "global savings glut" remains that leaves them with few other desirable investment alternatives. 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. As long as those investments yield a high enough rate of return to service the debt, borrowing should not reduce future domestic income in absolute terms. Some economists, however, doubt this interpretation and are concerned that the large CA deficit is symptomatic of wider economic imbalance. They argue that a country cannot persistently rely on foreign borrowing to finance its investment needs, so the United States must eventually raise its low saving rate. They maintain that by financing a large budget deficit and housing boom (until 2006), much of the foreign borrowing is being used in ways that do not expand the economy's productive capacity, and therefore such borrowing does not enhance our ability to service foreign debt. Because foreign borrowing is not sustainable, they argue, Americans will eventually be forced to significantly increase their saving (equivalently, to reduce their consumption) and reduce their investment rates, and the U.S. economy will slow. As a long-term solution, these economists prescribe policy measures to raise saving and reduce overall spending as the appropriate response to an excessively large CA deficit. This could be done through microeconomic policies, such as policies to encourage higher private saving, and macroeconomic policies, such as a tightening of monetary and fiscal policy, although this response would risk inducing the same recession that they fear the CA deficit may eventually cause (particularly if the economy were weak already). As a consequence of large CA deficits, a growing share of the U.S. capital stock is owned by foreigners and a rising fraction of U.S. income will need to be diverted overseas in the form of interest and dividends to foreigners. The process cannot continue indefinitely, or else foreigners would eventually hold a larger share of American assets in their portfolios than they desire. But though economists may feel confident that the CA deficit will decline in the long run, long run predictions do not offer much help in predicting short-term trends. Foreigners may wish to increase their holdings of American assets (in which case the CA deficit would persist) in the near term. One common assumption is that the CA deficit would, at most, continue until the share of American assets held in foreign portfolios equaled America's share of world output; by this measure, foreigners still hold too few American assets. For example, citizens of the euro area hold an estimated 53% of their wealth in euro-denominated assets and 19% in U.S. dollar-denominated assets, whereas the Japanese hold an estimated 63% of their wealth in yen-denominated assets and 4% in dollar-denominated assets. This is referred to as a "home bias" in saving because all countries hold more of their own assets, and fewer foreign assets, than optimal portfolio diversification would suggest. This bias is considered unlikely to disappear entirely, in which case CA deficits will ease before this benchmark is met. In any case, the reason why home bias would decline for foreigners but not Americans, as continuing CA deficits would imply, remains unclear. 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. One reason that U.S. imports cannot exceed exports indefinitely (and the dollar could eventually fall) is that today's CA deficits have a consequence for future trade balances. The accumulation of net debt that Americans owe to foreigners will need to be serviced in the future, and debt service will take the form of a payment from the United States. To offset the payment, the United States must export more or borrow more. But, all else equal, foreigners will only be induced to buy more exports if the dollar depreciates. Net investment income payments make up a small fraction of the CA deficit today, but economist Edwin Truman estimates that if CA deficits continued to equal 6% of GDP, net income payments would eventually reach 4.5% of GDP, leaving a trade deficit of only 1.5% of GDP. In other words, a constant trade deficit would imply a growing CA deficit because of growing net investment income payments. 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. What is surprising about these data is that the United States still consistently has positive net investment income despite its large net debt, and shows no long-term downward trend as the foreign debt grows. That is because U.S. holdings of foreign assets have earned a higher rate of return than U.S. debt owed to foreigners. Between 1981 and 2008, the United States earned an average estimated real rate of return of 3.1% more on its foreign assets than its foreign liabilities. This estimated rate of return differential has prevented foreign borrowing from becoming burdensome and suggest that the U.S. net foreign debt could become significantly larger before debt payments would become burdensome. Kouparitsas estimates that if these rate-of-return differentials were to continue, the United States could maintain a current account deficit of 0.9-1.3% of GDP indefinitely without any increase in its net foreign debt. However, this favorable rate-of-return differential may not continue in the future if foreigners believe that the dollar will depreciate and demand a higher rate of return on U.S. borrowing as compensation. If U.S. interest rates rose, the debt could become burdensome quickly. Although some reduction in the CA deficit is inevitable (although not necessarily in the near future), it need not be sudden. 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. In fact, a slow decline could have an expansionary effect on the economy, because the increase in net exports could have a more stimulative effect on aggregate demand in the short run than the decrease in investment and other interest-sensitive spending caused by lower capital inflows. More realistically, the trade deficit would not decline exogenously, but in response to a slowing of overall domestic demand. Therefore, a falling trade deficit may tend to coincide with slower economic growth in practice, but that does not indicate that a falling trade deficit has caused growth to slow.