Introduction and summary
The U.S. deficit in international trade soared to new heights in 1998, again in 1999, and in all likelihood, will increase even further this year. Mirroring these deficits have been huge foreign capital inflows. In 1999, the U.S. current account deficit--that is, the difference between exports and imports of goods, services, receipts and payments of income from and to foreigners, and unilateral transfers--totaled $331 billion or 3.6 percent of nominal gross domestic product (GDP). This record deficit compares with the previous record of $217 billion (2.5 percent of GDP) in 1998 and $141 billion (1.7 percent of GDP) in 1997. The magnitude of the recent year-to-year increases in this deficit, as well as its absolute dollar size, has raised considerable concern among many public and private observers of the U.S. economy. Not since 1987, when the current account deficit peaked at a then record $161 billion, has the condition of the U.S. international accounts so captured the attention of economists, policymakers, and the popular press.
Further compounding uneasiness about the current situation is the expectation by many economists that the magnitude of the trade deficit will show a further increase this year and that only a modest reduction, if any, is likely in 2001. Indeed, trade developments thus far in 2000 indicate that at least the first half of that expectation (that is, an increase in the year-to-year size of the deficit during 2000) will be borne out. There are also fears surrounding an eventual economic adjustment--"the current account gap ... is the single biggest threat to the current expansion of the economy." 
There is nothing inherently "bad" (or "good") about a current account deficit--or for that matter, a current account surplus. However, the concern about the deficit that has drawn the attention of reasonable observers centers on a specific issue: Does the deficit in the U.S. international accounts represent a risk to our economic well-being in the near term or in the longer term? To answer this question, we need to identify the underlying cause of the deficit. What developments during the past two or three years--in the domestic economy and in the rest of the world--have led the U.S. to purchase dramatically more goods and services from abroad than it sold abroad? Furthermore, can the U.S. economy maintain a deficit of this magnitude? And, if not, what are the likely implications of an adjustment for the U.S. economy?
Three rationales are commonly used to explain the sudden and dramatic increase in the U.S. current account deficit. The first rationale contends that U.S. consumers have shifted their preferences from saving for the future--witness the near zero personal savings rate--toward purchasing more consumption goods in the present.  This surge in demand for domestic consumption goods translates into a corresponding increase in imported consumption goods. We call this the consumption boom hypothesis. Certainly, trade in consumer-type goods has increased in recent years. Indeed, more than 60 percent ($52 billion) of the year-to-year increase in the goods trade deficit between 1998 and 1999 was accounted for by the year-to-year increase in consumer goods, foods and beverages, and automotive imports (most of which are broadly classed as consumer goods). If the consumption boom story is true, it implies that there has been excessive borrowing from abroad to finance a domestic consumption binge. And according to this a rgument, since this borrowing has not gone toward enhancing productivity, the economy will be forced to suffer a decline in consumption in the future as resources are diverted away from production for domestic use toward production to service the foreign debt.
A second hypothesis suggests that the financial/exchange rate crises in Asia, Russia, and Brazil from mid-1997 through early 1999 contributed to a "safe haven" inflow of short-term foreign capital into U. …