The first deficit we face is the federal budget deficit (see fig. 1). In 2005 the unified federal budget deficit was around $318 billion or 2.6 percent of gross domestic product (GDP). This figure is an approximation of what the federal government absorbs from private saving. Although a single year’s federal deficit is not a cause for concern, persistent deficits are. Federal deficits reduce the amount of national saving available for investment. They also lead to growing federal debt, on which net interest payments must be made by current and future generations. A budget deficit represents dissaving by the government, but the U.S. suffers from an even broader national saving deficit. National saving is the sum of personal saving, corporate saving, and government saving. Last year, for the first time since 1934, net national saving declined to less than 1 percent of GDP and the personal saving rate was slightly negative (see fig. 2). Remarkably—and unfortunately—the United States has returned to saving levels not seen since the depths of the Great Depression. A negative saving rate means that, in the aggregate, households are spending more than their current income by drawing down past saving, selling existing assets, or borrowing. No one is sure why the personal saving rate has declined. One possible explanation is increases in household wealth, which surged in the late 1990s due to the stock market boom and more recently due to the run-up in housing prices. Household wealth relative to income increased from 4.7 in 1990 to 5.8 in 2005 (see fig. 3). If people feel wealthier, they may feel less need to save. Continued financial liberalization and innovation have made it easier for Americans to borrow, particularly against their real estate wealth, which may have lead to greater consumption. Clearly, as the Comptroller General has said, many Americans, like their government, are living beyond their means and are deeply in debt. This trend is particularly alarming in an aging society such as our own. Those Americans who choose to save more will certainly live better in retirement. Those Americans who choose to save less are rolling the dice on whether they will have adequate resources for a secure retirement. While Social Security provides a foundation for retirement income, Social Security benefits replace only about 40 percent of preretirement income for the average worker. As a result, Social Security benefits must be supplemented by private pensions, accumulated assets, or other resources in order for individuals to maintain a reasonable standard of living in retirement compared to their final working years. Though the aggregate wealth-to-income ratio remains relatively high, it is a misleading indicator of financial status of the typical household because wealth is highly concentrated among a few households. While the median net worth of all families was $93,100 in 2004, the top 10 percent of the families had a median net worth of over $1.4 million and the bottom quarter of the families had a median net worth of about $1,700. Moreover, measures of wealth are largely based on market values, which on occasion can exhibit substantial swings. This is illustrated by the sharp run-up in stock prices in the late 1990s and their subsequent decline beginning in 2000. The only components of national saving that have not shown a long-term decline are corporate and state and local saving. In fact, corporate saving is actually high by historical standards. After declines in corporate profits in 2000-2001, corporate saving has rebounded to almost 4 percent of GDP—a level not seen since the late 1960s. The state and local sector as a whole experienced a deficit from 2002 to 2004 but has since returned to a slight surplus. Now let me turn to the third deficit: our current account deficit. The current account deficit is the difference between domestic investment and national saving. That is, it is the amount of domestic investment financed by borrowing from abroad. Over most of the last 25 years, the United States has run a current account deficit, but in 2005 the current account deficit hit an all-time record—$782 billion, or over 6 percent of GDP (see fig.4). That is twice what it was only 6 years earlier. Funds from overseas have been pouring into the United States. One explanation for these inflows is that high productivity in the U.S. raised the perceived return on U.S. assets. Moreover rising federal budget deficits and declining personal saving rates have necessitated foreign borrowing to help finance domestic investment. Another possible explanation for persistent U.S. current account deficits may be the weakness of foreign demand and the efforts of some countries to support their exports by keeping their own currencies from strengthening. Also, other countries’ populations are aging more rapidly than the U.S. population and they may be investing in the U.S. in order to build up a stock of assets to prepare for their retirement spending. Whatever the reason for high current account deficits, policymakers should be aware of the implications these financial inflows have for the nation’s economic growth and for future living standards. While current account deficits support domestic investment and productivity growth, they also translate into a rising level of indebtedness to other countries. Figure 5 shows that the net foreign ownership of U.S. assets grew to more than 20 percent of GDP in 2005. The fact that our net indebtedness to other nations is rising more rapidly than our income raises concerns that the U.S. current account balance is on an unsustainable path. Despite the growth of foreign asset holdings in the United States in recent years, the United States earned more in interest, dividends, and other investment returns from other countries than it paid on U.S. assets held by foreigners. This may seem counterintuitive to the notion that U.S. assets, on average, pay a higher return than foreign assets and thus attract a large amount of foreign investment. The positive net income receipts reflect differences in the composition of foreign and U.S. investment and the higher rate of return that U.S. firms earn on their direct investments abroad compared to the earnings of foreign companies from their U.S. subsidiaries. A larger share of foreign-owned assets in the U.S. is held in portfolio investment, such as stocks, bonds, loans, and bank deposits, which pay a lower yield than U.S. direct investments abroad. A recent study by the Congressional Budget Office (CBO) attributed this to three factors. First, U.S. subsidiaries abroad have generally been in business longer than foreign-owned subsidiaries in the U.S., which contributes to greater profitability. Second, investors of U.S. subsidiaries abroad may require higher returns because they face greater political and economic risks than subsidiaries of foreign-owned corporations. Finally, some observers argue that U.S subsidiaries abroad may overstate their profits for tax reasons, while foreign-owned subsidiaries in the United States understate their profits. However, given the nation’s increasingly negative net international investment position, it is not clear how long the U.S. will continue to earn more on its foreign investment than it pays on foreign investment in the U.S. The effect of large foreign borrowing on our economy also depends in part on how the borrowed funds are used. To the extent that borrowing from abroad finances domestic investment, the foreign borrowing adds to the nation’s capital stock and boosts productive capacity. Thus, even though some of the income generated by the investment must be paid to foreign lenders, the investment—and hence the borrowing that financed it— augments future income. However, if the borrowing from abroad is used to finance consumption, this is not true. Short-term well-being is improved but the ability to repay the borrowing in the future is not. Both economists and policymakers are concerned about whether the United States can maintain its reliance on foreign capital inflows to sustain domestic investment. Investors generally try to achieve some balance in the allocation of their portfolios, and U.S. assets already represent a growing and significant share of foreign portfolios (see fig. 6). Although the United States accounts for 29 percent of global GDP, it received 70 percent of the net saving exported by countries with current account surpluses in 2004. Observers suggest that the United States’ favorable investment climate, including the potential for high rates of return, may explain why the U.S. absorbs such a large share of the world’s saving. However, it is probably not realistic to expect ever-increasing foreign investment in the United States. Imagine what would happen to the stock and bond markets if these foreign investors began to lose confidence and lowered their rates of accumulation, or worse yet, started to sell off their holdings. We would likely face some adverse effects in the form of higher interest rates, reduced investment, and more expensive imports. Economic growth in recent years has been high despite the fact that national saving was low by U.S. historical standards. This is because more and better investments were made. Each dollar saved bought more investment goods, and a greater share of saving was invested in highly productive information technology. Also, as discussed earlier, the United States was able to invest more than it saved by borrowing from abroad. However, we cannot let our recent good fortune lull us into complacency. While the U.S. has benefited from high levels of foreign investment in recent years, this is not a viable strategy for the long run. Many of the nations currently financing investment in the United States face aging populations and their own retirement financing challenges that may reduce foreign saving available for U.S. domestic investment. If the net inflow of foreign investment were to diminish, so too would domestic investment and potentially economic growth if that saving is not offset by saving here in the U.S. Also, our nation faces daunting fiscal and demographic challenges, which may be even more of a reason to address our nation’s low saving rates.