B R O O K I N G S PA P E R S O N William C. Brainard and George L. Perry, Editors 2005 Ryan D. Nunn, Statistical Associate Theodore Papageorgiou, Assistant to the Editors Michael Treadway, Editorial Associate Lindsey B. Wilson, Production Associate BROOKINGS INSTITUTION WASHINGTON, D.C. Copyright ©2005 by THE BROOKINGS INSTITUTION 1775 Massachusetts Avenue, N.W., Washington, D.C. 20036 ISSN 0007-2303 ISBN-10: 0-8157-1350-9 ISBN-13: 978-0-8157-1350-0 Authorization to photocopy items for internal or personal use or the internal or personal use of specific clients is granted by the Brookings Institution for libraries and other users registered with the Copyright Clearance Center Transactional Reporting Service, provided that the basic fee is paid to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA01923. For more information, please contact CCC at (508) 750-8400. 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Perry, Editors 2005 Editors’Summary ix Articles OLIVIERBLANCHARD, FRANCESCOGIAVAZZI, and FILIPASA International Investors, the U.S. Current Account, and the Dollar 1 Comments by Ben S. Bernanke and Hélène Rey 50 General Discussion 62 MAURICEOBSTFELDand KENNETHS. ROGOFF Global Current Account Imbalances and Exchange Rate Adjustments 67 Comments by Richard N. Cooper and T. N. Srinivasan 124 General Discussion 141 MICHAELDOOLEYand PETERGARBER Is It 1958 or 1968? Three Notes on the Longevity of the Revived Bretton Woods System 147 Comments by Barry Eichengreen and Jeffrey A. Frankel 188 General Discussion 204 SEBASTIANEDWARDS Is the U.S. Current Account Deficit Sustainable? If Not, How Costly Is Adjustment Likely to Be? 211 Comments by Kathryn M. E. Dominguez and Pierre-Olivier Gourinchas 272 General Discussion 282 DEANBAKER, J. BRADFORDDELONG, and PAULR. KRUGMAN Asset Returns and Economic Growth 289 Comments by N. Gregory Mankiw and William D. Nordhaus 316 General Discussion 325 Purpose Brookings Papers on Economic Activitycontains the articles, reports, and highlights of the discussions from conferences of the Brookings Panel on Economic Activity. The panel was formed to promote pro- fessional research and analysis of key developments in U.S. economic activity. Prosperity and price stability are its basic subjects. The expertise of the panel is concentrated on the “live” issues of economic performance that confront the maker of public policy and the executive in the private sector. Particular attention is devoted to recent and current economic developments that are directly relevant to the contemporary scene or especially challenging because they stretch our understanding of economic theory or previous empirical findings. Such issues are typically quantitative, and the research findings are often statistical. Nevertheless, in all the articles and reports, the rea- soning and the conclusions are developed in a form intelligible to the interested, informed nonspecialist as well as useful to the expert in macroeconomics. In short, the papers aim at several objectives: metic- ulous and incisive professional analysis, timeliness and relevance to current issues, and lucid presentation. Articles appear in this publication after presentation and discussion at a conference at Brookings. From the spirited discussions at the con- ference, the authors obtain new insights and helpful comments; they also receive searching criticism about various aspects of the papers. Some of these comments are reflected in the published summaries of discussion, some in the final versions of the papers themselves. But in all cases the papers are finally the product of the authors’thinking and do not imply any agreement by those attending the conference. Nor do the papers or any of the other materials in this issue necessarily rep- resent the views of the staff members, officers, or trustees of the Brookings Institution. Correspondence Correspondence regarding papers in this issue should be addressed to the authors. Manuscripts are not accepted for review because this jour- nal is devoted exclusively to invited contributions. Subscriptions For information on subscriptions, standing orders, and individual copies, contact Brookings Institution Press, P.O. Box 465, Hanover, PA17331- 0465. Or call 866-698-0010. E-mail [email protected]. Visit Brookings online at http://bookstore.brookings.edu. Brookings periodicals are available online through both Online Com- puter Library Center (contact OCLC subscriptions department at 800-848-5878, ext. 6251) and Project Muse (http://muse.jhu.edu). Panel Dean Baker Center for Economic and Policy Research members and Olivier Blanchard Massachusetts Institute of Technology staff: William C. Brainard Yale University J. Bradford DeLong University of California, Berkeley Michael Dooley University of California, Santa Cruz Sebastian Edwards University of California, Los Angeles Peter Garber Deutsche Bank Francesco Giavazzi Universitá Commerciale Luigi Bocconi Paul R. Krugman Princeton University Maurice Obstfeld University of California, Berkeley George L. Perry Brookings Institution Kenneth S. Rogoff Harvard University Filipa Sa Massachusetts Institute of Technology ________ Ryan D. Nunn Brookings Institution Theodore Papageorgiou Yale University Michael Treadway Brookings Institution Lindsey B. Wilson Brookings Institution Panel advisers Martin Neil Baily Institute for International Economics participating Richard N. Cooper Harvard University in the Benjamin A. Friedman Harvard University seventy-ninth Robert J. Gordon Northwestern University conference: N. Gregory Mankiw Harvard University William D. Nordhaus Yale University Edmund S. Phelps Columbia University Guests whose Henry J. Aaron Brookings Institution writings or Ben S. Bernanke Board of Governors of the Federal Reserve System comments Kathryn M. E. Dominguez University of Michigan appear in this Barry Eichengreen University of California, Berkeley issue: Jeffrey A. Frankel Harvard University Pierre-Olivier Gourinchas University of California, Berkeley Gian Maria Milesi-Ferretti International Monetary Fund Richard Portes London Business School Hélène Rey Princeton University T. N. Srinivasan Yale University Editors’Summary The brookings panel onEconomic Activity held its seventy-ninth con- ference in Washington, D.C., on March 31 and April 1, 2005. This issue of Brookings Papers on Economic Activity includes the papers and discussions presented at the conference. The first four articles address the position of the United States in the global economy, an increasingly controversial sub- ject in the research, financial, and policy communities. Since the early 1990s, U.S. current account deficits have grown almost without interrup- tion, reaching $666 billion, or about 6 percent of GDP, in 2004. The U.S. international investment position is now one of net indebtedness approach- ing 30 percent of GDP, and in recent years a substantial portion of the buildup in net debt has come in the form of additions to dollar reserves by foreign central banks. Some observers see the present situation as unsus- tainable and warn of an abrupt depreciation of the dollar, which could destabilize financial markets and disrupt the global economy. Others are more sanguine, arguing that the present situation reflects the relative strength of the U.S. economy, consumer and business preferences, and rational financial decisions, all of which could evolve so as to make any needed adjustments gradual. Each of the four articles takes a different approach to analyzing the sit- uation, focusing on issues that the authors see as key. The first article models portfolio choices and how they moderate the pace of adjustment in exchange rates and current accounts. The second stresses the relative price changes that will be needed, both in the United States and abroad, to move the U.S. current account toward balance. The third considers the motiva- tions of policymakers in China and elsewhere for accumulating dollar reserves. The fourth assesses the likelihood of an abrupt depreciation of the dollar and the economic instability that might result in the United States and abroad. The volume concludes with an article on the possible impact of slowing labor force growth on stock market returns. ix x Brookings Papers on Economic Activity, 1:2005 The u.s. international investmentposition is affected by develop- ments in both foreign trade and international capital flows—the market for imports and exports of goods and services and the market for foreign and domestic assets. The sustainability of the U.S. current account deficit and the consequences of reducing that deficit depend on features of both those markets. Most economic models that have been used to analyze the cur- rent account deficit assume imperfect substitutability between foreign and domestic goods and services but perfect substitutability between foreign and domestic assets. These assumptions carry strong implications for how the economy adjusts to new developments. In the first article in this volume, Olivier Blanchard, Francesco Giavazzi, and Filipa Sa provide a distinctive analysis that allows for imperfect substitutability between domestic and foreign assets and between domestic and foreign goods. With this feature, movements in exchange rates and asset prices have poten- tially important effects on the portfolios of international investors and strong implications for the speed with which exchange rates adjust to shocks. Compared with popular discussion and with earlier, simpler mod- els, this rich specification provides a better understanding of past develop- ments in the U.S. current account balance and the dollar exchange rate and a more realistic framework for assessing future prospects. In its simplest form the authors’model has just two regions—the United States and the rest of the world—each of which supplies interest-bearing assets. The wealth of each region is given by the value of domestic assets plus net claims on foreigners. Investors diversify their portfolios, holding both foreign and U.S. assets, but exhibit home bias: given equal expected returns, they place a larger fraction of their wealth in domestic than in for- eign assets. As a result, a shift in wealth to foreigners reduces the demand for U.S. assets, causing the dollar to depreciate. Similarly, an increase in private or government demand for dollar assets causes the dollar to appre- ciate. Because of imperfect substitutability, the relative returns on foreign and U.S. assets can vary with changes in relative supplies or shifts in the distribution of world wealth, and uncovered interest parity does not hold. In the model the effects of a depreciation on the path of the current account balance and changes in U.S. net foreign indebtedness are conven- tional. The current account balance is the sum of the trade balance and net interest earnings. Dollar depreciation improves both, immediately reducing the dollar value of net interest payments and eventually reducing the U.S. trade deficit. Changes in U.S. net foreign indebtedness reflect the sum of the