Over the past 15 years, the U.S. current account has moved from a small surplus to a deficit that in 2005 was nearly $800 billion. The final tally for 2006 has not been completed, but preliminary data suggests the deficit will grow to near $900 billion. The current account deficit has increased also as a share of gross domestic product (GDP), climbing from near zero to a record 6.2% in 2005. Because a current account deficit is a reflection of a concurrent net inflow of borrowed funds from the rest of the world, the accumulation of debt from a long succession of large annual deficits has caused the United States to move from being a small net creditor to the rest of the world to being a large net debtor. The net accumulation of liabilities through 2005 is $2.7 trillion, which is equivalent to about 22% of U.S. GDP. There is, however, an apparent paradox in U.S. international transactions in this period. Despite the huge increase in U.S. external debt, the investment income component of the current account has remained in surplus. The size of this surplus has varied, hitting a low of $4 billion in 1998 and a high of $37 billion in 2003, but over the past 25 years, the surplus has remained between $15 billion and $30 billion. Since 2003, the surplus has fallen, reaching $28 billion in 2004 and $11 billion in 2005. The significance of this enduring surplus of investment income is that the United States, although a large net debtor, has been borrowing free of any economically meaningful debt service cost. The investment income balance is a tally of U.S. earnings on its foreign investments net of foreigners' earnings on their investments in the United States. It is reported as a component of the current account balance—the nation's most comprehensive measure of international transactions. A surplus in the investment income balance (the U.S. earns more than it pays) means that the United States, despite being a large net debtor on an accounting basis (value of foreign liabilities exceeds value of foreign assets), is on an economic basis a net creditor. An economically significant debt would generate net capital income payments to the rest of the world, that is, a debt burden in the form of real resources being transferred to the rest of the world. Because the United States is generating net capital income receipts suggests that it is an economic net creditor to the rest of the world and is bearing no debt service cost on its large external debt. This would also suggest that the large trade deficits generating that debt could be much less onerous than typically portrayed. Why is there this paradox? Does it suggest there is no reason for concern about U.S. international imbalances because its accumulated debt is economically costless? Several explanations have recently been put forward. A 2005 study by economist William Cline provides an explanation for the external debt paradox as well as an assessment of the need for concern about U.S. external imbalances by policy makers. It argues that two factors have worked to limit the impact of large current account deficits on the nation's economic debt service payments. First is the effect of valuation changes that have caused the magnitude of United States net indebtedness to grow much more slowly than the size of the current account deficits would indicate. Second is the effect of asymmetrical capital returns —the United States earns a higher rate of return on its foreign investments than foreigners earn on their U.S. investments. Over time, valuation effects have worked to increase the price of U.S. assets relative to the price of U.S. liabilities for two reasons. First, U.S. foreign assets have a higher incidence of equities (58%), such as foreign direct investment and portfolio investment, than do U.S. liabilities (37%). In contrast, U.S. liabilities have a higher incidence of debt obligations(51%), such as bonds and bank loans, than do U.S. assets (31%). The differential valuation effect occurs because equities appreciate with inflation and stock market booms, but debt obligations most often do not. Second, to a far greater degree than other countries, U.S. external liabilities are denominated in dollars, whereas U.S. external assets are heavily denominated in foreign currencies. Therefore, when the dollar depreciates against major currencies, the dollar value of U.S. foreign assets rises relative to the value of U.S. foreign liabilities. How significant have valuation changes been for the U.S. net asset position? Based on Bureau of Economic Analysis (BEA) data, Cline reports that from 1991 through 2004, the cumulative current deficits amounted to $3.6 trillion. The actual increase in the U.S. net asset position over this period was only $2.4 trillion. Therefore valuation effects erased $1.2 trillion or 53% of the U.S. current account deficits. This effect was found to be particularly strong in the 2002-2004 period when the dollar depreciated substantially, erasing seven-eights of the cumulative current account deficit's impact on the U.S. net asset position for this period. The United States has, on average, consistently earned higher returns on its foreign investments than foreign investors earned on their U.S. investments. This overall rate of return advantage has fluctuated narrowly but steadily between 1 to 2 percentage points. There is likely a structural bias in world capital markets that contributes to this outcome. Prudent investment portfolio management calls for holding a diversified collection of assets that strike a reasonable balance between risk and reward. That balance would entail holding some assets offering higher return but also higher risk and other assets offering a lower return, but also lower risk. In light of this, an argument can be made that the large and highly liquid U.S. asset market, with its transparency and legal safeguards, offers a bountiful array of low-yield and low-risk assets. U.S. Treasury securities are a particularly attractive element of this array of low-risk assets. For this reason, great numbers of foreign investors come to the U.S. asset market to fill out the low-risk tier of their investment portfolios. Currently, foreigners hold more than $2 trillion in U.S. Treasury securities or about 53% of all U.S. Treasury securities held by the public. Conversely, U.S. investors are more likely to buy foreign assets that offer high return and high risk. How significant this bias is in causing the asymmetric returns is not known. The United States' rate of return advantage on its foreign assets is not common to all types of foreign investments, however. It is almost exclusively an outcome associated with foreign direct investment (FDI) in the United States. The rate of return on U.S. FDI averages 7.1% and the rate of return on FDI in the United States averages only 2.5%. In contrast, rates of return on bank and non-bank claims and corporate bonds have been similar for both assets and liabilities. The rates of return on portfolio equities have shifted over the past 15 years, favoring U.S. equities in the early part of the period and in recent years favoring foreign equities. The advantage in this case is much smaller than the $128 billion net earnings on U.S. FDI in 2004, adding only $20 billion to U.S. investment income. The significance of the rate of return advantage of U.S. FDI for investment income is substantial. Cline estimates that if the rates of return on all foreign assets and liabilities were the same, the U.S. investment income balance in 2004 would not have been a surplus of $36 billion, but a deficit of $102 billion. Cline cannot give a conclusive reason or reasons why U.S. FDI earns a higher return than FDI in the United States. Clearly the burden of the massive external borrowing by the United States has been relatively painless to this point, but, as Cline argues, future prospects are unlikely to be as benign. The sheer size of prospective U.S. current account deficits will soon overtake the several mitigating forces and cause the real debt burden to grow substantially. The high incidence of fixed income obligations in U.S. foreign liabilities is a characteristic that could greatly accelerate the growth of that burden. Fixed income obligations, which include bank and non-bank claims as well as government and corporate bonds, tend to be sensitive to the level of interest rates. In the past, the extremely low interest rates have made this structural characteristic relatively benign. But global interest rates have now begun to rise and because the United States will have to sell new debt instruments as well as turn over a large share of existing debt, the total interest payments to foreigners holding these liabilities will increase. Cline estimates that an increase in interest rates of only 1 or 2 percentage points would increase U.S. net interest payments to foreigners by $30 billion to $70 billion. Added net interest payments of this size would soon swing the investment income balance from surplus to deficit and cause U.S. debt service costs to become very real. The United States was able to avoid this effect in 2005 because interest rate increases were in short-term yields that generated equally large increases in interest receipts and payments. If, however, long-term yields also begin to rise, the effect will be more one-sided because there will be substantial increases in payments on U.S. Treasury securities held abroad with no compensating increase in similar foreign payments. A more controversial interpretation of the paradox of the United States having large net external liabilities paired with an investment income surplus has been provided by economists Hausmann and Sturzenegger. They maintain that the official current account data have failed to record a large volume of service exports, so large that the United States has in truth remained a large net external creditor.