...such concerns are the stability U.S. net external liabilities and the minimal net income payments made by the United States on these liabilities. We show that the stability of the external position reflects sizable capital gains stemming from strong foreign equity markets and a weaker dollar--conditions that could be reversed in the future. We also show that while minimal U.S. net income payments reflect a much higher measured rate of return on U.S. foreign direct investment (FDI) assets than on U.S. FDI liabilities, ongoing borrowing is likely to overwhelm this favorable rate of return, pushing the U.S. net income balance more deeply into deficit.

In addition, we review the argument that the United States holds large amounts of intangible assets not captured in the data--assets that would bring the true U.S. net investment position close to balance. We argue that intangible capital, while a relevant dimension of economic analysis, is unlikely to be substantial enough to alter the U.S. net liability position

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Years of large current account deficits have left the United State with the world's largest net liability position. By the end of 2005, net foreign claims on the United States amounted to $2.5 trillion, more than 20 percent of U.S. GDP. Moreover, the U.S. current account deficit continues to climb higher, both in dollar terms and as a share of U.S. GDP. In 2006, according to the IMF, the U.S. deficit is likely to reach almost $870 billion, some 6.6 percent of GDP, and up from 4.8 percent of GDP in 2003 and just 3.8 percent of GDP as recently as 2001.

These trends raise worries about the sustainability of the U.S. external position. After all, continued large current account deficits should result in a growing net international liability position and growing payments on those liabilities. It is no surprise, then, that the clear consensus among policymakers and economists is that the U.S. current account deficit will eventually need to narrow as a percentage of GDP if not in dollar terms. (1) And some argue that the United States faces a growing risk that current account adjustment will be sudden and disruptive, with potential consequences of a sharply weaker dollar and a contraction in U.S. consumption. (2)

However, other features of the data do not quite square with this disquieting view. First, the value of U.S. net external liabilities has been rising less rapidly in recent years than the amount of net financial inflows represented by the country's current account deficit. (3) Indeed, from the end of 2001 to the end of 2005, U.S. net liabilities rose by little more than $200 billion, despite cumulative current account deficits of more than $2,400 billion over the period. With the U.S. economy growing, this has meant a decline in U.S. net liabilities as a percentage of GDP. Second, the U.S. now bears only a minimal servicing burden on its net liability position. Indeed, the $3.4 billion in net payments the United States made during the first half of 2006 implies a servicing cost of less than 0.3 percent (annualized) on net liabilities. In previous years, the net income balance was positive.

Why have large, ongoing current account deficits recently failed to translate into a sizeable buildup in U.S. net liabilities? And how has the United States managed to make such small service payments on its large net debt position? Do these facts imply that the United States could continue to run large current accounts deficits indefinitely without facing significant economic consequences?

To start answering these questions, it is important to understand that increases in the dollar value of U.S. foreign assets due to asset prices changes and a weaker dollar have moderated the decline in U.S. net liabilities in recent years. The risk is that United States cannot continue to count on future capital gains to offset large net financial inflows into the United States. In particular, asset price movements can easily move in the opposite direction and increase rather than decrease U.S. net liabilities.

A second development that has worked to the advantage of the United States is that it makes minimal net payments on its net liabilities because the United States earns a substantially higher rate of return on foreign assets than it pays out on foreign liabilities. (4) Some analysts have cited this higher rate of return as evidence that U.S. foreign assets are higher than reported in the official data, reflecting unmeasured holdings of intangible capital in the form of specialized knowledge, management expertise, and brand name value (so called "dark matter" assets). (5) However, even generous assumptions as to the scale of intangible foreign assets would still leave the United States with a sizeable net foreign liability position. More important for current account adjustment, however, the scale of such intangible assets turns out to have no material implications for future net payments to the rest of the world. In particular, large ongoing current account deficits will steadily increase U.S. net payment over time.

Our analysis does not settle whether U.S. current account adjustment will be gradual and benign, as most now expect, or sudden and disruptive, as others argue. It does indicate that any eventual adjustment will be made more difficult by a growing net income deficit. The next section of the paper documents the role of capital gains in driving the U.S. international position, showing the increasing sensitivity of the U.S. position to movements in international asset prices. The role of intangible assets in the external position is then discussed, followed by concluding comments.

Valuation Effects: Financial Flows vs. Capital Gains

As an accounting identity, the U.S. current account deficit is equal to the shortfall of domestic saving relative to...

NOTE: All illustrations and photos have been removed from this article.



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