[House Hearing, 110 Congress]
[From the U.S. Government Printing Office]

                     FOREIGN HOLDINGS OF U.S. DEBT:
                       IS OUR ECONOMY VULNERABLE?



                               before the

                        COMMITTEE ON THE BUDGET
                        HOUSE OF REPRESENTATIVES

                       ONE HUNDRED TENTH CONGRESS

                             FIRST SESSION


             HEARING HELD IN WASHINGTON, DC, JUNE 26, 2007


                           Serial No. 110-13


           Printed for the use of the Committee on the Budget

                       Available on the Internet:

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                        COMMITTEE ON THE BUDGET

             JOHN M. SPRATT, Jr., South Carolina, Chairman
ROSA L. DeLAURO, Connecticut,        PAUL RYAN, Wisconsin,
CHET EDWARDS, Texas                    Ranking Minority Member
JIM COOPER, Tennessee                J. GRESHAM BARRETT, South Carolina
THOMAS H. ALLEN, Maine               JO BONNER, Alabama
ALLYSON Y. SCHWARTZ, Pennsylvania    SCOTT GARRETT, New Jersey
MARCY KAPTUR, Ohio                   MARIO DIAZ-BALART, Florida
XAVIER BECERRA, California           JEB HENSARLING, Texas
LLOYD DOGGETT, Texas                 DANIEL E. LUNGREN, California
EARL BLUMENAUER, Oregon              MICHAEL K. SIMPSON, Idaho
MARION BERRY, Arkansas               PATRICK T. McHENRY, North Carolina
ALLEN BOYD, Florida                  CONNIE MACK, Florida
JAMES P. McGOVERN, Massachusetts     K. MICHAEL CONAWAY, Texas
BETTY SUTTON, Ohio                   JOHN CAMPBELL, California
ROBERT C. ``BOBBY'' SCOTT, Virginia  JON C. PORTER, Nevada
BOB ETHERIDGE, North Carolina        RODNEY ALEXANDER, Louisiana
DARLENE HOOLEY, Oregon               ADRIAN SMITH, Nebraska
BRIAN BAIRD, Washington              [Vacancy]
GWEN MOORE, Wisconsin

                           Professional Staff

            Thomas S. Kahn, Staff Director and Chief Counsel
                James T. Bates, Minority Chief of Staff

                            C O N T E N T S

Hearing held in Washington, DC, June 26, 2007....................     1

Statement of:
    Hon. John M. Spratt, Jr., Chairman, House Committee on the 
      Budget.....................................................     1
    Hon. Paul Ryan, ranking minority member, House Committee on 
      the Budget.................................................     2
    Peter R. Orszag, Director, Congressional Budget Office (CBO).     5
        Prepared statement of....................................     7
    Robert D. Hormats, vice chairman, Goldman Sachs 
      (International)............................................    43
        Prepared statement of....................................    45
    Mickey D. Levy, chief economist, Bank of America.............    49
        Prepared statement of....................................    52
    Kenneth Rogoff, Thomas D. Cabot professor of public policy 
      and professor of economics, Harvard University, and 
      visiting fellow, Brookings Institution.....................    57
        Prepared statement of....................................    60
    Brad Setser, senior economist, Roubini Global Economics and 
      research associate, Global Economic Governance Programme, 
      University College, Oxford.................................    62
        Prepared statement of....................................    65

                     FOREIGN HOLDINGS OF U.S. DEBT:
                       IS OUR ECONOMY VULNERABLE?


                         TUESDAY, JUNE 26, 2007

                          House of Representatives,
                                   Committee on the Budget,
                                                    Washington, DC.
    The committee met, pursuant to call, at 2:04 p.m., in room 
210, Cannon House Office Building, Hon. John M. Spratt, Jr. 
[Chairman of the committee] presiding.
    Present: Representatives Spratt, Edwards, Cooper, Kaptur, 
Becerra, Doggett, Blumenauer, Berry, Sutton, Scott, Etheridge, 
Hooley, Ryan, Lungren, Simpson, Tiberi, Porter, Alexander, and 
    Chairman Spratt. I would like to open the hearing and thank 
everyone for their coming and attendance. And I have a brief 
opening statement. Then we will turn to Mr. Ryan and then to 
Mr. Orszag to begin our hearing today.
    We are here to talk for a change about the elephant in the 
room. Our subject is foreign holdings of U.S. debt and the 
question is our economy vulnerable? We touched on this issue 
last January when we held a hearing on why deficits matter. 
Today we explore the subject further.
    At our January hearing, we heard from Ed Gramlick and Ted 
Truman that budget deficits are part of a broader problem, low 
national savings, which diminishes the prospect of long-term 
growth and, in particular, the well-being of our children and 
    We heard that our entire economy, both public and private 
sectors, are relying to an unprecedented extent on foreign 
debt, foreign capital to fund current investment and 
consumption because other countries are much more diligent than 
we are at saving.
    We were reminded that national saving is the sum of public 
and private saving and that recent budget deficits are negative 
public saving and are driving down overall national savings 
which is already woefully inadequate.
    Our reliance on foreign capital to fund our budget deficits 
has grown tremendously since 2001. Foreign holdings of Treasury 
securities have more than doubled to a level of $2.2 trillion, 
accounting for nearly half of marketable Treasury debt.
    For every dollar of additional funds the federal government 
has borrowed since 2001, an estimated 80 cents is owed to 
foreign investors.
    Most economists now believe that perennially growing 
deficits are unsustainable, certainly that endless growing 
foreign debt is unsustainable, and that our worsening and 
deepening current account deficit is unsustainable.
    No one can predict exactly when our economy hits the wall 
or whether there will be a soft landing or a hard landing. We 
have asked today's witnesses to testify on this topic so that 
we can better understand the gravity of this problem, what the 
federal debt and deficit spending have to do with it, and what 
deficits policy role should be to mitigate the adverse economic 
    We are fortunate to have an impressive panel of witnesses 
today. First we will hear from Dr. Peter Orszag, the Director 
of the CBO. And then we will hear from a panel of very 
distinguished economists and foreign policy experts, Dr. Robert 
Hormats, Dr. Mickey Levy, Dr. Kenneth Rogoff, and Dr. Brad 
    We thank each one of you for coming, for agreeing to 
testify, and for the time you are taking. We look forward to 
your testimony and the answers to our questions that follow.
    Before turning to Dr. Orszag, however, let me turn to Mr. 
Ryan for any opening statement he would like to make.
    Mr. Ryan.
    Mr. Ryan. Thank you, Mr. Chairman. And first of all, I want 
to thank you for getting the hearings up and running here. I 
think we have a number of interesting hearings and I am looking 
forward to participating in those.
    Clearly members on both sides of the aisle share a concern 
about the effects of chronic deficit spending and the resulting 
accumulation of debt that we are discussing here today. So it 
is fitting we have this hearing.
    It is not simply enough to rail against deficits, to rail 
against debt, and then rail against the fact that foreigners 
are buying it up. Yes, we have a debt and, yes, we have chronic 
deficits and a considerable share of that debt is held by 
foreign investors. These are the facts that are before us 
    The question is, and I imagine the purpose of this hearing 
is, what are we going to do about it? First, we have got to 
understand why we have the deficits and why we have the debt 
    Clearly there are some political points that are going to 
be had by some who want to play the blame game, claiming the 
U.S. government would be rolling in money had, say, Republicans 
not squandered through our reckless tax cuts and spending the 
often quoted 2001 projected $5.6 trillion surplus.
    But, once again, if you go back and look at the facts, we 
never actually had that money. It was a projection of what our 
number crunchers thought we have if everything went according 
to their assumptions. Clearly it did not.
    Their assumptions did not foresee the bursting of the dot 
com bubble, the eruption of corporate scandals, or the economic 
slowdown and the recession that had already begun, and, of 
course, the forecasters did not foresee the attacks of 9/11 and 
ensuing War on Terror.
    Tax relief was not the problem. Well-timed tax relief not 
only helped buoy the economy out of recession, it also fostered 
investment leading the way to significant job creation and 
sustained economic growth that we continue to enjoy today.
    That growth has fueled double digit revenue growth and has 
been the key factor in not only dramatically driving down the 
deficit but also to getting within striking distance of 
balancing the budget.
    The cause of the deficit and debt is that Congress has and 
continues to spend too much money. I will be the first one here 
today to acknowledge that Republicans spent too much money when 
we were in the majority.
    After 9/11, we said largely in a bipartisan way whatever it 
takes and we deliberately spent enormous amounts and took on 
debt. But we also allowed pork barrel spending to explode and 
get out of control and we took far too long to get our act 
together to do anything about it.
    But we did not just throw up our hands and raise taxes to 
make up for all that spending. We finally slowed down the rate 
of nonsecurity appropriations spending and, more important, we 
took a critical first step to address our largest and least 
sustainable spending growth about reforming entitlements, 
albeit to a small degree.
    We set a plan to keep our economy growing strong and slow 
down our unsustainable spending growth and we made significant 
progress in the right direction. But we did not do nearly 
enough and we have still got major spending problems that we 
have to deal with.

    Mr. Ryan. And I would like to bring up chart one if I could 
at this time. We have been told time and time again that the 
unrestricted growth of our nation's largest entitlements is the 
chief threat to our nation's long-term fiscal health. With the 
coming retirement of 78 million baby boomers, this problem is 
going to get exponentially worse.
    Let us take a look at where we are heading. If we do 
nothing as the current budget resolution proposes, look at 
chart two.

    Mr. Ryan. This is the debt projection we have in front of 
us by doing nothing to restrain our entitlement programs. We 
see the levels of debt required to meet our spending 
obligations in the decades ahead will absolutely cripple this 
    And so this is where our conversation needs to go. We need 
to be constructive to look for solutions to this issue rather 
than just score political points or simply rail against the 
past. We need to start with addressing the problem and the 
problem is spending, and it is a problem which both Republicans 
and Democrats share in the blame and a problem that we must 
work together to fix.
    I also think it is important for today's conversation that 
we focus on another issue critical to this Committee and that 
is how our choices impact our nation's global economic standing 
and our ability to compete in the global marketplace.
    Traditionally we have been able to attract foreign capital 
and we are the world's top destination for foreign capital as 
evidenced by all this debt that is being bought by foreigners. 
Because we have a strong innovative economy with deep liquid 
capital markets, that is the case.
    But remaining attractive to investors is not simply a 
given. We have got to make choices that support the fundamental 
features of a successful economy, low tax burdens, strong 
growth potential, and favorable legal and regulatory 
environment, and prudent fiscal policies that deal with long-
term challenges.
    Actually choosing to put our nation on the path of ever-
higher spending chased by ever-higher taxes will not only 
severely threaten our economy at home, it sends a pretty dire 
message to the world about our likely economic future.
    And it is just not rhetoric. International economic data 
confirm the fact that economies and countries with bigger 
governments tend to have slower rates of real GDP growth. Let 
us just take a look at France. Total government receipts in 
France represent more than half of their economy, one of the 
highest shares in the OECD. Not surprisingly, France has just 
averaged 1.5 percent real GDP growth over the last five years.
    By comparison, U.S. combined federal and state local 
government receipts account for about one-third of the overall 
economy and we have averaged close to three percent GDP growth 
over the last five years, double the growth rate of France. 
That is not a coincidence. It is the direct result of choices 
we have made. It is the result of the choice that we have made 
to be a country of limited government, a country that rewards 
the entrepreneur and provides freedom for the individual.
    And as we move forward, it is vitally important that we 
continue to make these types of choices so we do not leave our 
children with an economy that is weighed down by enormous 
government debt, because right now with inaction, that is a 
very real possibility.
    This chart is not only a possibility, it is the projection 
and trajectory we are on right now. Entitlement programs 
continue to grow at unsustainable rates and are projected to 
double in size in the next 30 years. If we do nothing now to 
reform them and instead put off these tough choices as the 
current budget resolution does, our debt condition will be far 
worse than what we are talking about today and our tax burden 
will be twice as high.
    So I am glad we are having this hearing today. We need to 
have this conversation and we need to ensure that we are making 
the right choices now both for the next year and for the next 
generation so that our children can enjoy an America that 
continues to thrive, that continues to produce jobs, and 
continues to be the same attractive place in which to invest in 
as it is today.
    And with that, I yield, and I appreciate the Chairman for 
his indulgence.
    Chairman Spratt. Thank you, Mr. Ryan.
    At this point, let me say that all members without 
objection shall be allowed to submit for the record an opening 
statement at this point in the record.
    Let me say also to Dr. Orszag and to all of our witnesses 
that you may submit your statements for the record as well and 
summarize to the extent that you find necessary.
    Dr. Orszag, you are the lead witness. We are glad to have 
you. We look forward to your testimony.


    Mr. Orszag. Thank you very much.
    Chairman Spratt, Mr. Ryan, members of the Committee, thank 
you for having me back today to testify. My testimony makes 
four main points.
    The first is that as has already been noted foreign 
holdings of U.S. Treasury debt have been rising rapidly. 
Between 2003 and 2006, for example, such holdings rose by about 
50 percent and their increase accounted for almost three-
quarters of total federal borrowing over that period.
    Such holdings now exceed $2 trillion and account for more 
than 40 percent of Treasury debt held by the public. Although 
the estimates are imperfect, evidence suggests that East Asian 
countries are associated with a significant share of recent 
increases and at the end of last year, such countries accounted 
for almost two-thirds of foreign holdings of Treasury 
    In addition, the increases have been disproportionately 
tied to foreign official activity rather than private investor 
activity. At the end of 2006, foreign central banks owned 66 
percent of all federal debt held by foreign residents which is 
up several percentage points from 2003. And such foreign 
official purchases account for roughly or a little bit more 
than half of federal borrowing since 2003.
    My second point is that these increasing foreign holdings 
of U.S. government debt are related to a more fundamental issue 
which is the nation's substantial current account deficit. This 
current account deficit must be financed by increasing 
liabilities to and assets held by foreign investors.
    In particular, the current account deficit expanded from 
under two percent of GDP in 1997 as shown in my first chart to 
more than six percent last year.
    As a result of these ongoing current account deficits, the 
net international indebtedness of the United States, that is 
how much U.S. investors own abroad minus how much foreigners 
own here, deteriorated from about ten percent of GDP, which is 
shown in figure two, to about twenty percent in 2005. You see 
that decline that was occurring in the late 1990s and early 
    So why has the current account deficit increased? There are 
a variety of perspectives that can be brought to bear on that 
question, but one is to examine the difference between domestic 
investment and national saving.
    As figure three shows, net domestic investment climbed 
steadily throughout the 1990s and then declined on balance in 
the early 2000s. On average, it has been about seven percent of 
national income since 1990 and in the past four years. This net 
domestic investment must be financed either by net national 
saving or by increasing net foreign claims on U.S. assets.
    Since the late 1990s, it has been financed increasingly by 
foreign claims as the rate of net national saving also shown on 
this chart has declined from an average of more than four 
percent in the 1990s to an average of about one percent in the 
past four years.
    In other words, from this perspective, the increase in the 
current account deficit that has occurred reflects the decline 
in net national saving that you can see on that chart.
    So the question then becomes why has net national saving 
declined and one can in the next chart break the decline in the 
rate of national saving into its components, in particular 
federal and private net saving rates.
    As you may be able to see from the chart, the decline in 
the federal net saving rate from 2000 to 2003 accounts for much 
of the decline in net national saving over that period. After 
2003, however, the rate of net federal saving rose primarily 
tied to increases in corporate income tax revenue which I could 
discuss more during the question and answer period. But the net 
national saving rate was little changed because the net private 
saving rate fell.
    The bottom line is that the nation's rate of domestic 
investment of roughly seven percent of income or so is possible 
given our low level of domestic saving only because the nation 
is running a significant current account deficit and that in 
turn is possible only because foreign entities have been 
willing to invest significant sums in U.S. assets and 
securities, including U.S. Treasury securities.
    That observation leads me to my third point, which is that 
economists generally agree that the current account deficit is 
unsustainable because the nation's indebtedness to the rest of 
the world will grow faster than its income and foreign 
investors will not continue to be willing to purchase U.S. 
claims indefinitely as their portfolios become more and more 
concentrated in such assets.
    Views differ on whether the adjustment will occur gradually 
or suddenly, but there is little disagreement that some sort of 
adjustment is inevitable. As the CBO has pointed out in a 
recent issue brief, the more likely scenario appears to be a 
gradual adjustment without severe short-term economic 
consequences, but a sudden adjustment remains a risk and 
possibly a growing one as the nation's net indebtedness rises.
    And that leads me to my final point, which is that policy 
makers can help facilitate the necessary reduction in the 
current account deficit and reduce the risk of a severe 
economic disruption in foreign financing by taking actions to 
raise the rate of national saving.
    Focusing on government saving may be particularly important 
in light of the economic and budgetary outlook in the United 
States over the next few decades as Mr. Ryan highlighted.
    Figure five shows that most of the discussion that has 
surrounded our long-term fiscal challenge has been somewhat 
off. It is often described as being caused by aging and 
healthcare. It is primarily tied to the rate of growth in 
healthcare costs.
    In particular, if over the next four decades healthcare 
costs per beneficiary grow at the same rate relative to income 
per capita as they did over the past four decades, Medicare and 
Medicaid will rise from four and a half percent of the economy 
today to twenty percent of the economy by 2050 as the top line 
of that chart shows.
    The bottom line shows the pure effect of aging on those two 
programs and I think you can see that there is some impact 
there, but that that rise, the difference on the bottom dotted 
line between 2050 and today is much smaller than the difference 
in 2050 between the bottom dotted line and the top solid line.
    In any case, reducing government dis-saving, that is 
reducing the budget deficit both today and in the future, is 
perhaps one of the most reliable ways through which policy 
makers could boost national saving. Such national saving could 
also be increased through higher private saving, and my written 
testimony discusses some of the possible policy interventions 
that could produce that effect.
    However it is accomplished, higher national saving is 
fundamental to reducing the current account deficit which in 
turn will reduce the rate at which the nation is increasing 
liabilities to and assets held by foreign investors, including 
Treasury Securities.
    Thank you.
    [The prepared statement of Peter Orszag follows:]

            Prepared Statement of Peter R. Orszag, Director,
                   Congressional Budget Office (CBO)

    Chairman Spratt, Ranking Member Ryan, and Members of the Committee, 
thank you for inviting me to testify today. Foreign holdings of U.S. 
Treasury debt have grown rapidly in recent years and now are a 
significant percentage of such debt held by the public. A broader issue 
is the substantial deficit in the U.S. current account--which 
summarizes the country's current transactions with the rest of the 
world, including trade in goods and services, net income from 
international investments and the compensation of employees, and net 
unilateral transfers (such as gifts, pension payments, and foreign 
aid). The mirror image of the nation's large current-account deficit is 
foreign investors' increased holdings of a variety of claims on the 
United States, including U.S. government debt as well as private-sector 
securities and assets.
    My testimony today makes four main points:
     Foreign holdings of U.S. Treasury debt have risen rapidly. 
Between 2003 and 2006, for example, such holdings rose almost 50 
percent. They now exceed $2 trillion and account for more than 40 
percent of Treasury debt held by the public.
     Those increasing foreign holdings of U.S. government debt 
are part of a more fundamental issue: The nation is running a 
substantial current-account deficit, which is financed by increasing 
liabilities to and assets held by foreign investors. The current-
account deficit measures the excess of the country's spending over its 
income or, equivalently, of its domestic investment over its national 
saving. After the depreciation of physical capital is taken into 
account, the nation saved only 2 percent of its income last year, an 
unusually low level for the world's leading economy. At the same time, 
the nation's net domestic investment was 8 percent of its income. The 
difference, 6 percent of income, was financed by increases in net 
foreign claims on the United States and manifested itself in the 
current-account deficit.
     Economists generally agree that the nation's current-
account deficit cannot be sustained indefinitely at its current level 
relative to gross domestic product (GDP) because the nation's 
indebtedness to the rest of the world will grow faster than its income. 
Moreover, foreign investors will not continue to be willing to purchase 
U.S. claims at current rates of return indefinitely as their portfolios 
become more and more concentrated in such assets. To be sure, views 
differ on whether a future adjustment in the current-account deficit 
will occur gradually or suddenly--but there is little disagreement that 
some sort of adjustment is inevitable.
     The necessary adjustment of the current-account deficit, 
which requires slower growth of consumption in the future, could take 
place slowly or rapidly. The more likely scenario appears to be a 
gradual adjustment without severe short-term economic consequences, but 
a sudden adjustment remains a risk--and possibly a growing risk as 
foreign net holdings of claims on the United States rise as a 
percentage of GDP. Policymakers can help facilitate the necessary 
reduction in the current-account deficit and reduce the risk of a 
severe economic disruption in foreign financing by taking actions to 
raise the rate of national saving.
 estimated holdings of u.s. government securities by foreign investors
    Foreign holdings of U.S. Treasury securities have grown rapidly in 
recent years. In 2003, for example, U.S. Treasury securities held by 
foreign investors amounted to $1.45 trillion, and by 2006, those 
holdings rose to $2.13 trillion--an increase of 47 percent.\1\ As a 
percentage of total Treasury debt held by the public, foreign holdings 
rose from 37 percent to 44 percent over that span.\2\ The increase in 
foreign holdings accounted for about 86 percent of total federal 
borrowing last year and about 72 percent from 2003 to 2006.
    According to survey estimates, East Asian countries held a large 
share of foreign holdings of Treasury securities last year--about 63 
percent.\3\ The two East Asian countries with the largest holdings were 
Japan, which held an estimated 31 percent of all foreign-held Treasury 
securities, and mainland China, with 19 percent. In comparison, the 
European Union held an estimated 15 percent, and oil-exporting 
countries in the Middle East, about 5 percent.
    Foreign official institutions have played a significant role in the 
increase in foreign ownership of federal debt. Indeed, at the end of 
2006, foreign central banks owned 66 percent of all federal debt held 
by foreign residents, up from 63 percent at the end of 2005.
    The data on ownership by country and by type of foreign entity 
(official versus private) are imperfect.\4\ The surveys used to collect 
the data do not always capture the ultimate owner of the securities. If 
an owner entrusts securities with a custodian in a different country, 
for example, the ownership of the securities is attributed to the 
country of the custodian, not the owner. That ``custodial bias'' 
contributes to the large recorded foreign holdings of U.S. securities 
in major financial centers such as Belgium, the Caribbean banking 
centers, Luxembourg,
    Switzerland, and the United Kingdom.\5\ Similarly, some foreign 
official purchases may be misclassified as foreign private ones because 
they are conducted through private-sector traders.
    Foreign investors also hold a growing share of securities of U.S. 
agencies and government-sponsored enterprises (GSEs), evidently 
reflecting a drive to increase the returns on their investments. At the 
end of 2006, those investors owned about $1.2 trillion of such 
securities, more than twice as much as in 2001. The countries with the 
largest holdings were China, with about 23 percent of all such foreign 
holdings, and Japan, with about 17 percent.
    Examining only the securities of the Treasury Department and of 
agencies and the GSEs that are held by foreign investors, however, 
obscures the broader and more fundamental issue: the rising net foreign 
claims on the United States that result from the nation's current-
account deficit. The specific distribution of those foreign claims 
among different types of assets (U.S. government debt, equities, real 
estate, and so forth) may be important for considering some questions 
(for example, the potential for short-term disruptions in specific 
financial markets), but the overall level of those claims is more 
important in weighing other issues (for example, the vulnerability of 
the U.S. economy to adverse economic shocks). It is therefore important 
to emphasize that Treasury and other agency debt held by foreign 
investors represents only a portion of the total claims on the United 
States owned by the rest of the world.
    According to the Bureau of Economic Analysis, the total amount of 
claims on the United States held by foreign investors in 2005 amounted 
to $13.6 trillion--9 percent more than in 2004 and 52 percent more than 
in 2000. A little more than 17 percent in 2005 was U.S. government 
securities, up from about 13 percent in 2000 (see Table 1 below). As 
noted, much of the rise in the share of U.S. government securities was 
associated with increased holdings by foreign governments, rather than 
by foreign private investors. The key point, though, is that however 
the claims are allocated among different asset types and foreign 
owners, the broader issue is the overall rise in net foreign claims on 
the United States assets; that rise is necessary to finance the 
nation's current-account deficit.

              the fall in the u.s. current-account balance
    The current-account balance fell from -1.7 percent of GDP in 1997 
to a record 6.1 percent last year (see Figure 1 below). At the same 
time, the outstanding amount of net international assets (holdings of 
claims on foreign entities by U.S. investors minus holdings of claims 
on the United States by foreign investors) fell from about -10 percent 
of GDP to about -20 percent in 2005 (see Figure 2 below).

    To examine why the deficit in the current-account balance has 
increased in recent years, it is useful to examine trends in both net 
domestic investment and net national saving.\6\ Net domestic investment 
climbed steadily throughout the 1990s and then declined, on balance, in 
the early 2000s. On average, it has been 7 percent of national income 
since 1990 and in the past four years (see Figure 3 below).

    Net domestic investment can be financed either by net national 
saving or net foreign claims on U.S. assets. Since the late 1990s, it 
has been financed more and more by foreign claims, as the rate of net 
national saving has declined from an average of 4\1/2\ percent in the 
1990s to an average of 1 percent in the past four years. From that 
perspective, the low level of national saving has been responsible for 
the elevated level of the current-account deficit.
    The decline in the rate of national saving in the 2000s largely 
reflects movements in both federal and private net saving rates (see 
Figure 4 below). The decline in the federal net saving rate from 2000 
to 2003 accounts for much of the decline in the net national saving 
rate over that period. After 2003, however, the rate of net federal 
saving rose, but the net national saving rate was little changed 
because the net private saving rate fell. Although federal saving and 
national saving do not move in lockstep, there is generally a close 
relationship between changes in federal saving and changes in national 
saving. Put simply, the more the federal government saves, the more the 
nation tends to save as a whole.

    From another perspective, the elevated level of the nation's 
current-account deficit has been driven by the willingness of foreign 
investors to provide capital to the United States. In other words, the 
nation's rate of domestic investment is possible, given the rate of 
domestic saving, only because foreign entities have been willing to 
invest significant sums in U.S. assets and securities. From this 
perspective, inflows of capital from abroad affect the current account 
by raising the exchange value of the dollar and asset prices in the 
United States. The strong dollar encourages purchases of imports by 
U.S. residents and discourages purchases of U.S. exports by the rest of 
the world. Higher asset prices and correspondingly lower interest rates 
encourage consumption and investment.
    The willingness of foreign investors to buy U.S. debts and assets 
reflects the attractiveness of the United States as a destination for 
international investment because of its stable political environment, 
developed legal institutions, deep and liquid capital market, and 
strong banking and financial system, among other advantages. Moreover, 
because the U.S. dollar is the major medium of international 
transactions, it is less susceptible to extreme and sudden 
depreciation.\7\ Indeed, the longevity of the large U.S. current-
account deficit can be viewed as reflecting a sequence of events that 
caused demand for U.S. assets to grow even faster than the supply. 
Between 1997 and 2000, a host of developments--financial globalization, 
a succession of financial crises (the 1997-1998 Asian crisis, Russia's 
default of 1998, and the Brazilian real crisis of 1999), and weaker 
economic growth in other industrial countries than in the United 
States--all added to the demand for U.S. assets.\8\ By propelling the 
dollar and U.S. asset prices higher, those developments contributed to 
widening the current-account deficit.
    A significant share of the nation's overall external financing has 
been from foreign governments in recent years, as suggested by the 
trends in foreign ownership of U.S. government debt (see Table 2 
below). In 2006, for example, net official inflows (purchases of claims 
on the United States by foreign governments net of purchases of claims 
on foreign entities by the U.S. government) were $448 billion, more 
than half of the $811 billion current-account deficit. Net official 
inflows also have grown rapidly in the past few years; in 2000, for 
example, net official inflows were only $42 billion. Almost all 
official purchases of U.S. assets were made by a handful of Asian 
governments, particularly China, which did so in order to keep its 
currency from appreciating outside of the band specified by its managed 
exchange rate policy. The Japanese government was also actively making 
purchases to keep the yen from rising before the spring of 2004.

          the unsustainability of the current-account deficit
    Regardless of whether its financing is provided by foreign 
governments or foreign private investors, the large U.S. current-
account deficit, analysts generally agree, cannot be sustained 
indefinitely at its present high level relative to GDP. The United 
States--like any other country--cannot continue accumulating debt at a 
rate faster than its ability to repay it. If policy actions or other 
economic developments do not reduce the current-account deficit, at 
some point foreign investors will become less willing to keep adding to 
their holdings of U.S. assets.
    To be sure, net U.S. international assets have changed little 
relative to GDP in recent years despite the large current-account 
deficit, but that situation is unlikely to continue over the long run. 
Movements in asset prices and in the exchange rate have raised the 
dollar value of U.S.-owned foreign securities and direct investments 
overseas by more than that of U.S. securities and investments held by 
foreign investors, offsetting the consequence of the current-account 
deficit. However, such favorable effects of valuation cannot be relied 
on in the long term, and sooner or later net U.S. international assets 
will begin to fall rapidly relative to GDP if the large U.S. current-
account deficit persists.
    A persistently large current-account deficit will, over time, make 
foreign investors less willing to provide low-cost financing for it. To 
date, foreign demand for dollar assets has not yet weakened 
significantly, in part because the dollar is still the major 
international reserve currency. However, once investors accumulate 
enough dollar assets to facilitate international transactions and to 
meet their other needs for holding reserves, they are likely to slow 
down their purchases of dollar assets for those purposes and 
increasingly will buy or sell dollar assets on the basis of the 
expected returns. For example, the Chinese government announced in 
March this year that it would establish an investment agency to more 
``profitably'' and ``efficiently'' manage a portion of its foreign 
reserves, which exceeded $1.2 trillion in the first quarter of this 
year.\9\ Thus, to the extent that investors and governments believe 
that the U.S. current-account deficit will cause the dollar to 
depreciate, which reduces the expected return on dollar assets, the 
demand for dollar assets will fall.
    Once foreign demand for U.S. assets begins to grow more slowly than 
the supply, there will be growing downward pressure on the dollar and 
U.S. asset prices. A lower dollar raises the prices of imports and 
reduces U.S. residents' purchasing power at home and abroad, and lower 
asset prices make U.S. residents poorer. As a result, U.S. residents 
will be less able and willing to borrow and spend, thereby lowering the 
current-account deficit; the exchange rate and asset price adjustments, 
in other words, will facilitate the reduction in the current-account 
deficit. As long as foreign demand for dollar assets does not drop too 
suddenly, the adjustment in the current account will be a gradual one. 
In that case, growth of the U.S. economy is likely to remain on track. 
The gradual rise in exports and decline in imports will entail more 
production and employment in sectors that export and sectors that 
compete with imports, helping to offset the negative effects of the 
gradual adjustment in asset prices, interest rates, and the prices of 
    How bumpy the adjustment of the U.S. current account will be thus 
depends on what happens to foreign demand for U.S. assets. If short-
term factors boost the growth in the demand for U.S. assets above the 
growth in supply, the U.S. current-account deficit may temporarily 
widen further. However, it seems implausible that foreign demand for 
U.S. assets will be boosted repeatedly by short-term factors. Once 
long-term downward pressures on demand begin to outweigh temporary 
supports for dollar assets, they will push down the dollar and those 
asset prices, facilitating the decline of the current-account 
    Various factors may mitigate the risk of the type of sudden 
collapse in foreign financing that would be associated with a 
relatively rapid adjustment of the current account. For example, the 
unique role of the U.S. dollar as the world's main reserve currency 
should help to reduce the probability of a sudden stop of foreign 
financing, at least in the near future (although some analysts have 
warned that the dollar's role as a primary reserve currency cannot be 
taken for granted over the long run). Furthermore, nearly all U.S. 
international liabilities are denominated in dollars, and about 
twothirds of U.S. holdings of assets abroad are equity assets, 
denominated in host countries' currencies. Therefore, a large 
depreciation of the dollar would lower net U.S. liabilities to foreign 
investors not only by lowering net imports but also by boosting the 
dollar value of U.S. assets abroad. Consequently, the depreciation 
would not necessarily feed on itself and become a fullblown dollar 
crisis, unlike the effects of a sharp drop in the currency of a country 
with a large amount of debt denominated in foreign currencies.\11\
    Thus, the more likely scenario appears to be a gradual adjustment, 
in which the current account falls gradually over time.\12\ 
Nonetheless, given the likelihood of a continued decline in the United 
States' net international assets as a percentage of GDP, a risk remains 
that adjustments in the foreign exchange rate and the current account 
will occur more rapidly than anticipated and that the effects of a 
rapid adjustment on the economy will be much more severe than with a 
gradual adjustment. That risk probably increases as the nation's net 
international assets fall as a percentage of GDP.

                             POLICY OPTIONS

    Because the current account is equal to the difference between 
national saving and investment in the United States, policies that 
influence saving or investment will affect it. Although the current-
account deficit could be improved by reducing investment, that outcome 
would be undesirable. With less investment, the U.S. capital stock 
would grow more slowly, which would reduce the growth of productivity 
and real wages over time. Therefore, the more desirable options for 
reducing the current-account deficit are those that would raise 
national saving.
    Focusing on national saving may be particularly important in light 
of the economic and budgetary outlook in the United States over the 
next several decades. Rising federal health care costs, in particular, 
will place mounting pressure on federal spending, and if revenues 
remain at their current shares of GDP, the federal budget deficit is 
projected to grow rapidly, which could substantially reduce national 
saving.\13\ Over the past four decades, Medicare's and Medicaid's costs 
per beneficiary have increased about 2.5 percentage points faster per 
year than has per capita GDP. If those costs continued growing at the 
same rate over the next four decades, federal spending on those two 
programs alone would rise from 4.5 percent of GDP today to about 20 
percent by 2050 (see Figure 5 below). Indeed, the rate at which health 
care costs grow relative to income is the most important determinant of 
the long-term fiscal balance; it exerts a significantly larger 
influence on the budget over the long term than other commonly cited 
factors, such as the aging of the population.\14\

    National saving can be increased in a number of ways that could 
involve higher government saving and/or higher private saving. Raising 
government saving through deficit reduction is one of the most reliable 
ways through which policymakers could boost national saving. That goal 
could be achieved through higher taxes, lower spending, or both.\15\ 
Given the nature of the nation's long-term fiscal challenge, 
controlling the growth of federal health care costs seems a key 
component of deficit reduction over the next several decades. A variety 
of evidence suggests that opportunities exist to constrain health care 
costs both in the public programs and in the overall health care system 
without adverse health consequences, although capturing those 
opportunities to reduce costs without harming health outcomes involves 
many challenges.
    National saving could also be increased through higher private 
saving. In evaluating policies to raise private saving, it is important 
to include their effects on government saving. For example, general tax 
incentives for private saving financed through higher budget deficits 
might not generate enough additional private saving to offset the 
higher budget deficits. Consequently, even if such policies increased 
private saving, they might not raise national saving. By contrast, 
deficit-neutral policies that encouraged private saving would work to 
raise national saving (because the increase in private saving would not 
be offset by a reduction in government saving).
    Various options for raising private saving in such a manner have 
been proposed--for example, establishing automatic aspects for 401(k) 
and similar savings plans. Currently, many such plans leave it up to 
the employee to choose whether to participate, how much to contribute, 
which investment vehicle offered by the employer to select, and when to 
pull the funds out of the plan and in what form. Workers are thus 
confronted with a series of financial decisions, each of which involves 
risk and a certain degree of financial expertise. Many workers shy away 
from those decisions and simply do not make them, and the result is 
often a lack of participation. Research has suggested that 
participation and contribution levels can be substantially affected by 
changing the defaults at each of those points of decision. Indeed, one 
of the strongest empirical findings from behavioral economics is that 
automatic enrollment--that is, enrolling workers in a plan unless they 
opt out, as opposed to requiring them to sign up in order to 
participate--boosts the rate of participation substantially.\16\ 
Legislation enacted last year makes it easier for corporations to offer 
401(k)-type plans with automatic enrollment and other automatic 
features, and researchers have proposed ways of expanding the same 
logic to individual retirement accounts.\17\ If such proposals were 
financed in a deficit-neutral manner, so that any gains to private 
saving were not offset by decreases in government saving, they could 
increase national saving. However, even if they were implemented in 
that manner, they would probably generate only a fraction of the saving 
needed to close the current-account deficit.
    However it is accomplished, achieving a higher level of national 
saving also entails drawbacks. In the end, policies that raise national 
saving have one thing in common: They reduce consumption of goods and 
services and/or leisure. What makes the policies different is how they 
affect specific households and how they affect the economy at large. 
Therefore, choosing the appropriate saving policy inevitably involves 
balancing the economic effects of alternative policies with their 
distributional consequences.
    Despite those various trade-offs and however it is accomplished, 
encouraging higher national saving probably represents the most 
effective step that policy-makers can take to facilitate the necessary 
reduction in the current-account deficit and reduce the risk of a 
severe economic disruption in foreign financing.


    \1\ Budget of the United States Government, Fiscal Year 2008: 
Analytical Perspectives, p. 235.
    \2\ Although not strictly comparable, the percentage of federal 
debt held by foreign investors was estimated to be 32 percent in 1997 
and 15 percent in 1985.
    \3\ Department of the Treasury, Federal Reserve Bank of New York, 
and Board of Governors of the Federal Reserve System, Report on Foreign 
Portfolio Holdings of U.S. Securities, as of June 30, 2006 (May 2007).
    \4\ See Department of the Treasury, Frequently Asked Questions 
Regarding the TIC System and TIC Data, available at www.ustreas.gov/
    \5\ Ibid.
    \6\ Those net measures account for depreciation of the existing 
capital stock.
    \7\ The dollar's status as the major reserve currency has meant 
that foreign demand for dollar assets has increased as other economies 
and international transactions have grown.
    \8\ Financial globalization has allowed private foreign investors 
to participate in the U.S. capital market more fully. See Congressional 
Budget Office, The Decline in the U.S. Current-Account Balance Since 
1991 (August 6, 2004).
    \9\ The announcement did not specify how much of the reserves would 
be managed initially by the new agency, but Chinese officials and the 
press have suggested an amount of up to $300 billion.
    \10\ The trade-weighted dollar exchange rate relative to currencies 
in major industrial countries, computed by the Federal Reserve Board, 
declined about 9 percent between November 2005 and May 2007.
    \11\ For such an indebted country, its currency's depreciation 
necessarily raises the domesticcurrency values of its international 
debt and interest payments on that debt but may not have a significant 
effect on the value of its trade surplus (especially if its exports 
rely significantly on imported materials). Thus, its net debt could 
become higher even as its currency depreciates, putting greater 
downward pressure on its currency.
    \12\ See Congressional Budget Office, Will the U.S. Current Account 
Have a Hard or Soft Landing? (June 11, 2007).
    \13\ See Congressional Budget Office, The Long-Term Budget Outlook 
(December 2005).
    \14\ See Statement of Peter R. Orszag, Director, Congressional 
Budget Office, Health Care and the Budget: Issues and Challenges for 
Reform, before the Senate Committee on the Budget (June 21, 2007).
    \15\ In evaluating alternative ways to reduce the budget deficit, 
it is important to be mindful of the potential effects of those 
policies on private saving. Some policies could reduce private saving. 
However, although the impact would depend on the nature of the policy 
change, reductions in private saving, if they occurred, would probably 
not be large enough to completely offset the gains to national saving 
from lower budget deficits.
    \16\ See, for example, Brigitte Madrian and Dennis Shea, ``The 
Power of Suggestion: Inertia in 401(k) Participation and Savings 
Behavior,'' Quarterly Journal of Economics, vol. 116, no. 4 (November 
2001), p. 1160.
    \17\ See J. Mark Iwry and David John, Pursuing Universal Retirement 
Security Through Automatic IRAs (Washington, D.C.: Retirement Security 
Project, February 2006).

    Chairman Spratt. One of the questions we pose to all of the 
witnesses is what is the risk of a hard landing as opposed to a 
soft landing? Is there any way you can predict, number one, 
when will it approach the limits, when we will be in danger of 
really hitting the wall and suffering the consequences, the 
dire consequences that all of our witnesses paint out here, and 
what is the risk that the landing will be hard, abrupt, and 
difficult to adjust to as opposed to a smooth glide-path 
    Mr. Orszag. As I noted in both my oral testimony and my 
written testimony and as the recent CBO issue brief argues, 
again, the more likely scenario for a variety of reasons is a 
gradual adjustment in which things operate smoothly, but there 
is some risk, and I would not want to quantify it, that cannot 
be ruled out of a more disruptive and sudden adjustment that 
could occur.
    And I think the key point is that the policy response to 
either kind of scenario is basically the same, which is that 
ultimately something has to change and you may as well start 
now to be raising national saving, getting the budget deficit 
further under control.
    So regardless of whether you put that risk of a severe 
disruption at, you know, this level or at that level, the 
policy response is quite similar.
    Chairman Spratt. There was a commission, I cannot recall 
when it was appointed, but fairly recently, five or six years 
ago, on the balance of payments. And its members divided about 
four to three or five to two on the issue of hard landing 
versus soft landing versus hard landing.
    Those who came out fearful of a hard landing said their 
biggest concern is the problem of asset holders dropping assets 
that are declining in value, that once an asset holder sees 
that his assets are declining rapidly in value, he does not 
want to be the last person holding that particular asset.
    Is that a risk and is there some way we can protect against 
    Mr. Orszag. Again, I would come back to first in terms of 
protecting against risk. Taking action sooner rather than later 
is the best possible step. I think the problem becomes that in 
these kind of scenarios that you are discussing, which, again, 
I would put lower probability on but not zero relative to a 
gradual adjustment, things can go wrong in an amazing array of 
ways. And you just do not want to find yourself in that 
    And I have written academic papers or other papers 
delineating some of the ways in which things can go wrong, but 
I think the point is they can go wrong in multiple ways and 
temporary phenomenon can feed on itself and become particularly 
    Chairman Spratt. What about exogenous inflation, if you had 
factors in the world economy beyond our control and run-up in 
resource prices, oil and other resources, maybe different kind 
of different things that created inflation and caused foreign 
holders of our debt to fear that the dollar may be inflating 
away its value?
    Mr. Orszag. I think the people who are concerned about a 
sudden adjustment are particularly worried about some dramatic 
decline in demand for U.S. assets which could be prompted by a 
whole variety of different potential contingencies, including 
potentially the view that, however it arose, that inflation in 
the United States would take off and that the Fed would not be 
able to contain it.
    Chairman Spratt. What I am getting at----
    Mr. Orszag. That would just be one of many possible 
scenarios that could engender the type of concern that some 
analysts have identified.
    Chairman Spratt. What I am getting at is that foreign 
capital thus far has been a cushion. It has helped us absorb 
what otherwise could be adverse economic effects of a big run-
up in national debt by buying and funding a lot of that debt. 
But it is also it seems to me a precarious way to finance our 
national debt.
    Would you agree? We were all, not all of us, there were 
some brought up on Friedman, others of us were brought up on 
Samuelson, to believe that the national debt was not so bad 
because we owed it to ourselves. Now we have a debt that 
increasingly is owed to others.
    Would you agree that a debt owed to ourselves is less 
problematic than a debt that we owe to foreigners?
    Mr. Orszag. I think I would come back to the fundamental 
driver here, which is that the reason that we are accumulating 
those claims to foreigners is that we are saving such a low 
level of national income.
    It is highly unusual for the world's leading economic power 
to be saving only one or two percent of its national income and 
that is the fundamental driver of a lot of----
    Chairman Spratt. The fact that it aggravates the savings 
rate, the domestic savings rate?
    Mr. Orszag. Well, necessarily it will mean that you are 
either only investing one or two percent of your income 
domestically, which then robs workers in the future of 
productive equipment and other things that will improve their 
standard of living, or it means that you are investing more 
than that and financing it by increasing claims on your assets 
from foreigners.
    Chairman Spratt. I have got lots of other questions, but 
there are lots of other members who want to put a question to 
you, so let me turn next to Mr. Ryan.
    Mr. Ryan. Thank you. I have a lot of questions, too, but I 
will try and keep it limited as well. You could go down so many 
    I wanted to get into the twin deficit theory with you, but 
I think I will not belabor that.
    Dr. Orszag, our capital markets are very attractive, 
correct, to foreign investors?
    Mr. Orszag. Yes. If you look at observed behavior, that 
would appear to be the case, yeah.
    Mr. Ryan. Right. So the hard landing theory, obviously we 
do not want a hard landing here. We could precipitate a hard 
landing if we do things in our economic policy that makes the 
U.S. capital markets less attractive to investment, correct?
    Mr. Orszag. That would be a risk associated with making our 
capital market significantly less attractive, yes.
    Mr. Ryan. Right. So if we want to have a soft landing as we 
use this vernacular, it is important that our economic policy, 
the things we do, whether it is how we regulate capital flows, 
how we tax capital, those all speak to our attractiveness of 
our capital markets to foreign capital and whether or not we 
are going to have a soft or hard landing if and when we have a 
landing, correct?
    Mr. Orszag. The key determinate of the speed of adjustment 
is foreign demand for U.S. assets and there are lots of things 
that affect that, including the attractiveness of our capital 
    Mr. Ryan. So one of the more important things for us to do 
in our own interest is to make our capital markets as 
attractive as possible. You would agree with that, correct?
    Mr. Orszag. There are obviously tradeoffs involved. Again, 
one of the factors that affect continued foreign demand for 
U.S. assets is the relative attractiveness of U.S. financial 
    Mr. Ryan. Right. Right. So the one thing we can reach 
consensus on is we are spending too much money. I think you 
would agree with that.
    Mr. Orszag. Well, we are not saving enough money, yes.
    Mr. Ryan. And saving rate, as we calculate our savings 
rate, when we overspend, meaning we have chronic deficits and 
chronic debt, that negatively affects our savings rate. I 
wanted to ask you a question about your last chart.
    Jose, if you could bring up his last chart, the healthcare 
spending chart.
    Can you walk me through this one more time because I find 
this of all your observations the most fascinating. The dotted 
line on the bottom is if healthcare inflation tracked with 
regular inflation. What is that exactly?
    Mr. Orszag. In particular what it is is that if the so-
called excess cost differential, that is healthcare costs per 
beneficiary minus income per capita, were zero in the future, 
it isolates the pure effect of demographics. The only reason 
that that line is rising is that there are more beneficiaries 
on Medicare and Medicaid and they are growing older.
    Mr. Ryan. Right. But it is not rising at a precipitously 
high pace if the costs are increasing with the rest of income 
in society, right?
    Mr. Orszag. And, therefore, the pure effect of aging on the 
budget is much smaller than it is often portrayed as.
    Mr. Ryan. Right. So what you are trying to say here is the 
root cause of our future budget dilemma is healthcare 
    Mr. Orszag. The long-term fiscal challenge basically 
collapses to the rate at which healthcare costs grow relative 
to income per capita, yes.
    Mr. Ryan. So healthcare inflation is----
    Mr. Orszag. Healthcare cost growth, I would----
    Mr. Ryan. Okay. Okay. And if we can do things that bring 
healthcare cost growth in line with other cost growth, this you 
are saying can generally take care of a vast majority of our 
budget and fiscal problems with respect to our healthcare 
    Mr. Orszag. If you could bend that curve, the more you bend 
that curve, the degree to which you bend that curve is 
basically the degree to which you are getting the long-term 
fiscal challenge under control. There would be further steps 
that are required, but that is the key determinate.
    Mr. Ryan. Okay. So where we ought to be focusing our 
efforts in your opinion, would it be on tackling these 
healthcare entitlements which represent the largest portion of 
our present value unfunded liability? Should we be focusing our 
efforts on attacking the cost increases of healthcare in 
America and our healthcare entitlements if we want to get the 
biggest bang for our buck in order to reduce future 
    Mr. Orszag. If your concern is the long-term fiscal 
imbalance facing the nation, trying to bend this curve is 
perhaps the most auspicious step that you could take.
    Mr. Ryan. Do you think we can bend the curve by going after 
just changes to Medicare and Medicaid law without addressing 
underlying healthcare reforms or is the better path to take in 
order to get better results for Medicare and Medicaid cost 
growth and, therefore, indebtedness to go after the healthcare 
marketplace and the way it works right now and the inflation 
rate that it produces?
    Mr. Orszag. I do not think it is going to be plausible to 
bend this curve for Medicare and Medicaid while healthcare cost 
per beneficiary and the rest of the health system continues at 
the same rate without creating massive access problems.
    Mr. Ryan. Have you taken a look at cost differentials 
between different kinds of products that are offered in the 
marketplace vis-a-vis insurance, whether it be, you know, 
traditional low co-pays, low deductibles, first dollar type 
coverage plans versus higher deductible, more consumer-based 
plans? Have you looked at that and have you done any modeling 
on that?
    Mr. Orszag. Yes, we have. We put out a report last December 
that goes into some detail about the effects of different kinds 
of plans along the lines that you are discussing.
    Mr. Ryan. Do you believe that to the extent that an 
individual with a policy who has a fiscal incentive, a shopping 
incentive to save more of their own money while they go out and 
purchase health insurance has more of a likelihood to be more 
cost conscious and, therefore, contribute to lowering the cost 
increases in healthcare?
    Mr. Orszag. There are steps that can be taken on both the 
provider side and the consumer side to try to bend this curve.
    On the provider side currently, Medicare in particular is 
paying largely on a fee-for-service basis and the evidence 
suggests that when we pay more, we do not necessarily get 
better quality.
    On the consumer side, one of the things that has happened 
over the past three or four decades is the share of healthcare 
costs that come out of pocket has actually declined markedly 
and the evidence does suggest that that has played a role in 
increasing healthcare costs.
    Mr. Ryan. So axiomatically on the reverse, if the more 
share comes out of pocket, you will lower the cost increases?
    Mr. Orszag. You would at least lower cost to some degree, 
    Mr. Ryan. Okay. All right. I do not want to chew up too 
much more time. I have a lot more questions, but maybe if we do 
    Thank you.
    Chairman Spratt. Mr. Edwards.
    Mr. Edwards. Thank you, Mr. Chairman.
    I find it interesting that we are holding this hearing 
today on the impact of foreign-held U.S. national debt on the 
same day on the front page of the Washington Post, there is a 
third part of a four-part series talking about Vice President 
Cheney, who is the architect of the Bush economic policies that 
led to the largest deficits in American history.
    One of my hopes is that today's hearing will debunk Mr. 
Cheney's flat out wrong statement or declaration that deficits 
do not matter. I think while we disagree on the origin of the 
deficits, I would hope there would be bipartisan agreement that 
deficits do matter, that Vice President Cheney, the architect 
of the Bush economic policy, was dead wrong in his declaration.
    Mr. Ryan talked a little bit, Dr. Orszag, about the basis 
of the deficits. He made a statement, and I wrote it down, tax 
relief is not the reason for deficit.
    Let me ask you a question. Based on your analysis for 
fiscal year 2007, what percent of this year's deficit is the 
result of tax cuts passed since 2001 approximately?
    Mr. Orszag. I would have to give you the exact number later 
and it depends how you do the accounting. But the revenue 
effect of the 2001 and 2003 tax legislation is roughly one and 
a half percent of GDP, which is about the size of the federal 
deficit today.
    Mr. Edwards. So put that in lay terms. Had we not had the 
tax cuts passed since 2001, according to CBO analysis, the 
deficit would be how much smaller?
    Mr. Orszag. If you just do a simple accounting exercise 
that takes that estimated revenue effect from the Joint 
Committee on Taxation and compare it to today's deficit, it 
would roughly eliminate the deficit, but I would have to get 
back to you to give you that exact figure.
    Mr. Edwards. Okay. So----
    Mr. Ryan. Would the gentleman yield?
    Mr. Edwards. The gentleman has had a lot of time. In round 
two, I think it would be healthy to have a discussion on this, 
but the gentleman has had quite a bit of time. I would like to 
take mine.
    Mr. Ryan also said entitlements are the biggest problem and 
I agree with him on that. I would like to point out the fact 
for the record, and let me put this in terms of a question.
    Since Medicare was created in 1965, has there been any 
single increase in expenditures for the Medicare program larger 
than that passed in the Republican Congress on Medicare Part D? 
Has any other increase in the history of Medicare been larger 
in its increase and expenditures than that passed in wee hours 
of the morning with a lot of arm twisting by the Republican 
Majority in the House and the Congress, or is that the largest 
increase in Medicare entitlement spending in the history of 
that program?
    Mr. Orszag. I would have to check with regard to ESRD, but 
I believe that the Part D expansion in terms of the long-term 
fiscal impact was the largest since 1965.
    Mr. Edwards. And I think that is a fact. I think Mr. 
Cooper, my colleague, says the total liability of that long 
term is $8 trillion. So those who decry entitlement spending 
were actually the authors as a party, as the Majority in the 
Congress, the largest increase in Medicare entitlement program 
in the history of that program, even as we talk about how it is 
healthcare expenditures that are going to be a threat to future 
    Let me ask also in terms of the foreign-held debt, in light 
of our difference with Mr. Cheney that deficits do not matter, 
I know the debt has increased, foreign-held debt has increased 
dramatically since the Bush Administration has taken over. I 
think over $1.4 trillion or so.
    China holds 23 percent of that foreign-held debt. Japan 
holds 17 percent. What are some of the other three or four 
other countries that hold significant U.S. debt?
    Mr. Orszag. There are European countries, the UK in 
particular. I would note that some of the allocations by 
country can be----
    Mr. Edwards. I understand.
    Mr. Orszag [continuing]. Difficult to allocate.
    Mr. Edwards. Does Venezuela hold any U.S. debt?
    Mr. Orszag. I am sure it holds some, yes.
    Mr. Edwards. Okay. Let me ask you, what would be the--we 
have about 50 seconds remaining--what would be the economic 
impact on our economy if China announced today that it was 
going to cash in a substantial amount or let us go the full 
way, if China announced today they were going to cash in all of 
their U.S. debt holdings, what would be the economic impact on 
the American economy?
    Mr. Orszag. Well, again, without commenting on the 
probability of that happening, the result would depend in part 
on the response of other financial participants, but that is 
the kind of thing that those worried about the risk of a sudden 
adjustment with severe economic dislocations that would concern 
    Mr. Edwards. Okay. Severe economic dislocations. Is that 
similar to devastating to the American economy under most 
likely scenarios?
    Mr. Orszag. Again, I think it is difficult to play out all 
of the ways that things could go wrong should they do so.
    Mr. Edwards. Thank you.
    Chairman Spratt. Mr. Lungren.
    Mr. Lungren. Thank you very much, Mr. Chairman.
    It has been kind of fun sitting here. I do not know how Mr. 
Orszag feels there, but you are kind of reminding me of a 
tennis ball and we just keep hitting lobs to you and we are 
lobbing you back and forth seeing if we can make some points 
    When I was here before, I remember Nancy Reagan was blamed 
for everything and now it is Dick Cheney. I served ten years 
with Dick Cheney and, frankly, if most members would vote the 
way Dick Cheney did on spending, we would not have this 
    Oftentimes he and I were out there being one of twenty-two 
or thirty against spending, but we were told by the other side 
that deficits did not matter. I do not know what has happened 
to Dick. I think he must have had just a bad moment. He was 
probably quoting one of his friends from across the aisle.
    I would like to ask a question about the chart we were 
talking about, the medical inflation, and try and understand 
that a little better. And the reason is this. I recently had a 
conversation with a friend of mine and he talked about open 
heart surgery that he had. I remember my dad had open heart 
surgery when he was 57 which allowed him to go back to work as 
a practicing physician until he was 70. He then had a redo when 
he was 70 some years of age that allowed him to live until he 
was 83.
    This fellow mentioned that his dad had an open heart 
surgery done when he was 80 years old and he lived until he was 
94. In both those cases, I know for a fact my dad would not 
have lived as long as he did and this gentleman's father would 
not either.
    So I am trying to figure out what the medical inflation 
means on this. Those are two people who would not have been 
alive had they not had the procedures. The procedures cost 
money, that they were procedures that were not done, well, 
probably five years before my dad has his. And while I want to 
see us do what we can to bend that curve, what does that 
medical inflation mean with respect to those kinds of things, 
that is procedures which are additional procedures than what we 
used to do that are not really a trade-out for something that 
was already there, but actually extends the lifetime of these 
individuals and presumably causes them to continue to receive 
Social Security benefits and causes them to be subject to other 
medical procedures in the future? How do you distinguish from 
that and bending the curve from inflationary aspects of the 
healthcare system?
    Mr. Orszag. Well, as the designated tennis ball, let me 
take a crack at that.
    Mr. Lungren. Yes, sir.
    Mr. Orszag. I think there is a wide variety of evidence 
suggesting that technological advances in medicine have on 
average produced significant improvements in life expectancy 
and standards of living.
    But there is also a significant amount of evidence that 
technologies are often applied in very low return settings or 
negative return settings and that if you look, for example, 
across different regions of the United States, cost per 
beneficiary in Medicare with the same technologies vary 
substantially by a factor of two or three in ways that do not 
reflect underlying riskiness to the patients and do not 
generate better health outcomes in the higher spending regions.
    And I think, therefore, there is a significant opportunity 
for looking, it is going to be hard to capture, but looking for 
better value rather than just higher cost healthcare. That is 
the real challenge.
    Mr. Lungren. The reason why I bring that up is it is 
awfully difficult for us to attack the issue if the public and 
we believe it is the first type of thing that I talked about 
versus what you have suggested. And I do not care, Democrat, 
Republican, who you are, it is easy to demagogue from the first 
part and interfere with us to try and get to that second part 
that you referred to. And that is probably the largest 
challenge I see on the fiscal side for us for the next ten 
    On the charts that you had with respect to savings, does 
that savings that you have of private savings, does that 
include value of homes because many Americans, whether it is a 
good thing or bad, see a much higher percentage of their 
savings reflected in what they have in their houses today 
versus what they had ten, twenty, thirty years ago?
    Mr. Orszag. No, it does not. This is the national income 
and product account definition of saving and it is the relevant 
definition for the funds available to finance domestic 
investment. So that is for this purpose why----
    Mr. Lungren. It is for that purpose, but I was just 
thinking. We have higher home ownership percentages today 
across the board than we had, I think, at least in my lifetime 
and perhaps a large amount of that is as the result of tax 
policy which drives people to have homes because of the tax 
benefits they get in addition to the fact of proud home 
    And, yet, we do not count that. And I understand why we do 
not count that in terms of what you are talking about, but I 
just wonder if we would want to necessarily alter individuals' 
decision making in that regard.
    Mr. Orszag. Well, there are various different parts of the 
question. In terms of the measured saving rate in the national 
income and product accounts, the housing price appreciation 
that has occurred likely did have some downward effect on that 
measured rate of private saving.
    Another question is what the mortgage interest deduction in 
particular does to home ownership and there I think there is a 
range of views among economists about the degree to which it 
actually does succeed in significantly boosting home ownership 
or not. And we could have a longer discussion about that.
    So there are a couple of different components to your 
    Chairman Spratt. Mr. Lungren, we have got to move on.
    Mr. Lungren. Thank you very much, Mr. Chairman.
    Chairman Spratt. Yes, sir.
    Mr. Blumenauer.
    Mr. Blumenauer. Thank you, Mr. Chairman.
    I would like to take up just on part of the previous 
discussion you have been having. While we are not taking home 
values per se, there has been a lot of capital flow that has 
been resulting from the securitization of home finance 
    It looks like there might be a lot of air in some of these 
funds, domestic and international, that may be the result of a 
housing bubble that may be about to burst or is bursting or a 
huge shift in the subprime market.
    And I am trying to get a sense of the extent to which you 
have any thoughts about the softness in these transactions and 
these hedge-fund investments may have in the overall 
availability of capital in this country.
    Mr. Orszag. CBO is very closely monitoring developments in, 
for example, the subprime market and when we come out with our 
updated economic projections as part of our August update, I 
will have more to say at that time on our view of developments.
    Mr. Blumenauer. Okay. Good.
    Mr. Orszag. You would like more now.
    Mr. Blumenauer. No, no, because I am not interested in your 
torturing the data and I am not interested in more of the ping-
pong game. I think certain obligatory charts and lines have 
been put on the table and I am, frankly, eager to hear the next 
four witnesses as well.
    But I would just give you one more chance to help us sketch 
what might be the implications if there is a lot of air in, A-
I-R, in these portfolios, what that might mean in terms of the 
impact of our net savings rate, capital expansion, what has 
fueled a run-up in corporate profits and activity or at least 
shielded people from other economic realities if, in fact, this 
is squishy. I am not asking you to put parameters around it 
now, but if you can just talk about the implications.
    Mr. Orszag. Sure. First with regard to implications, one of 
the factors that is likely to increase private saving over the 
next several years is sluggishness or softness in the housing 
market. That is just the reverse of what I was delineating 
    I think a big question with regard to the subprime market 
in particular is how much it spreads to other financial 
products and the rest of the housing sector. And that was the 
part where I was being a little bit cautious about what CBO 
would or would not be saying.
    Mr. Blumenauer. Mr. Chairman, this is an area of particular 
interest to me. And I appreciate this hearing and I will be 
quiet and we can move on. But at some point, our circling back 
and having a hearing on the implication of what has been 
happening in the housing market which has been a critical part 
of our economic growth over the last ten years, I think all of 
us can agree to that, whether we think it is healthy or not, 
whether we are from areas where there has been a run-up, 
whether we feel squeamish about some of the industry practices 
and people that have been shoved into the subprime market maybe 
who did not need to be there.
    But I think this has very profound implications on really 
the underlying health of our economy and might give us some 
early indicators of where things might go. And if you and our 
certified smart people on the staff would consider it, I think 
it might be useful to be able to have some discussion about 
where we are and where we are going with that.
    Chairman Spratt. Okay. We will take that up later.
    Now Mr. Simpson.
    Mr. Simpson. Thank you, Mr. Chairman. I am glad to be here 
and listen to this and the China doomsday scenario and all that 
sort of stuff that Mr. Edwards proposes.
    I would like to ask if we are going to call this the Bush-
Cheney deficit, if we could call it the Bush-Cheney economy 
seeing as how it happens to be one of the strongest economies 
we have had in quite some time. So if you do that, I would 
appreciate both that.
    The other thing I would like to know is, you know, we 
always ask these questions, these doomsday scenarios and stuff, 
and then we like to go down on the floor and we say we have had 
testimony that it would be devastating to our economy, that it 
would destroy it, that we would all essentially might have a 
nuclear bomb would be better off than that, even though the 
scenario that they propose does not make sense.
    Would it make sense for China to call in all the debt and 
what would it do to China's economy?
    Mr. Orszag. China has a significant disincentive to do 
that, which is that it would, to the extent that some of these 
processes that we are describing actually happen, it would 
impose costs on China also.
    Mr. Simpson. Is this like economic mutually assured 
    Mr. Orszag. I would not use that kind of wording, but----
    Mr. Simpson. We tried that with the nuclear era. But I 
mean, it would make no financial sense or economic sense for 
China to do that; is that right?
    Mr. Orszag. There would be a disincentive to China doing 
that. But what I would say is that because so much of this is 
associated with foreign official activity, the motivations of 
an official body may differ from those of a private investor.
    Mr. Simpson. Let me ask you another question. On your chart 
where you list net private savings, net federal savings----
    Mr. Orszag. Yes.
    Mr. Simpson [continuing]. How do you determine net private 
savings? Congressman Lungren was asking whether housing was 
included. What exactly is included in that?
    Mr. Orszag. That is a measure of your current income 
excluding capital gains minus how much you spend. That is the 
measure of savings that the Bureau of Economic Analysis uses 
for this purpose.
    Mr. Simpson. We have always assumed, and I agree, there is 
legitimate disagreement about whether tax cuts pay for 
themselves, whether they make sense or not and in the long run 
whether they pay for themselves or not, and the argument on our 
side of the aisle has always been that it increases economic 
activity which increases the tax revenue which comes back to 
the federal government.
    Do we know, even though it is probably none of our 
business, do we know what the American people did with their 
tax cuts over the last few years, the reduced federal taxes 
that they had to pay?
    Mr. Orszag. There have been a few empirical studies done, 
not very many. What I would say is that the overwhelming bulk 
of the evidence suggests that while there is some offsetting 
impact on economic activity, tax cuts do not come close to 
paying for themselves.
    Mr. Simpson. Do we know, though, what the consumers did 
with their savings? I noticed in your chart on private savings 
that after 2001, there was an uptick in savings.
    Mr. Orszag. There have been, again, just a few studies 
done. There was one, for example, done on what households did 
with the rebates that were associated with the original 
legislation. We could respond in writing. I do not want to try 
to characterize it.
    One of the difficulties is that it is hard to parse out, 
money is fungible, it is hard to parse out, you know, that this 
money went to that purpose basically.
    Mr. Simpson. It would be interesting to know and would help 
us when we try to determine federal policy, but I have a hard 
time coming up with your net private savings, how you come up 
with that when there are investments that make sense that would 
be considered savings. Ask any farmer where their savings is. 
Their savings are in their land.
    Mr. Orszag. This is the definition that has been embodied 
in the national income and product accounts, it is not a CBO 
definition, basically since the national income and product 
accounts were created, and it reflects a notion of saving that 
is appropriate for evaluating how much is available to finance 
domestic investment by corporations, for example, and things 
like computers and buildings.
    Mr. Simpson. And every commercial I see on TV that 
investment in higher education returns a net increase to the 
    Mr. Orszag. And if you wanted to----
    Mr. Simpson. My wife invests in clothes.
    Mr. Orszag. The semantics here can get difficult. If you 
wanted to classify, for example, expenditures on higher 
education as investment, that would change both the saving rate 
and investment rate, but it would not change the difference 
between the two.
    Mr. Simpson. I thank you and I look forward to the panel.
    Thank you, Mr. Chairman.
    Chairman Spratt. Thank you, Mr. Simpson.
    Mrs. Sutton.
    Ms. Sutton. Thank you, Mr. Chairman. Thank you so much for 
being here to talk about this extremely important issue.
    You know, massive holdings, foreign holdings of U.S. debt 
has had a palpable effect. It is not theoretical. It has had a 
palpable effect on workers. Where I come from, it has had a 
palpable effect on our economy.
    The Economic Policy Institute recently estimated that while 
exports to China supported 189,000 jobs here in the U.S., 
imports displaced production that would have supported six 
times as many.
    The jobs displaced by the increasing trade imbalance have 
largely been in the manufacturing sector. And, in fact, in my 
home State of Ohio, we have lost over 200,000 jobs since 2001 
in the manufacturing sector under the Bush-Cheney economy.
    So, Dr. Orszag, could you discuss the link between China's 
investment in treasuries and the trade deficit that is causing 
us to lose American jobs and just talk about how currency 
manipulation plays into that?
    Mr. Orszag. Let me try to again break that down in a couple 
different parts.
    Ms. Sutton. Sure.
    Mr. Orszag. First, I want to say CBO is doing a significant 
amount of work on various forces that are affecting a broad 
array of American families, including relatively sluggish real 
income growth in significant parts of the income distribution, 
including high levels of economic volatility, that is, for 
example, earnings volatility, a lot of which gets sort of 
associated with international trends perhaps incorrectly, but 
kind of gets wrapped up together. So I just wanted to note that 
CBO does a lot of work in this area.
    The second thing I would say is I would be again more 
focused on overall levels of net national saving and what is 
happening there because that is tied to the nation's overall 
current account deficit than a particular bilateral trade or 
current account and trade imbalance in particular.
    And then finally, it is the consensus view among economists 
that at least over the long term, international trade may 
affect the types of jobs that we have but not the number.
    So this is coming back to my first point. I think the 
fundamental issue for most American families is what is 
happening to their income. Is it becoming more or less 
volatile? Is it too volatile? Is it growing at a sluggish rate 
and what can we do practically to improve their standards of 
    Ms. Sutton. Okay. Would you more specifically address the 
issue of currency manipulation?
    Mr. Orszag. What I would say about that is that there are a 
variety of estimates suggesting that the Chinese currency is 
undervalued relative to the dollar, that the estimates vary 
depending on the model, that perhaps evidence--well, that there 
is a variety of estimates out there again, and that I would not 
necessarily use terms like the one that you used in conjunction 
with currency that is potentially misaligned relative to its 
underlying level.
    Ms. Sutton. Okay. And, Dr. Orszag, you sort of alluded to 
this a little bit earlier in one of your responses about 
motivating factors that might be at play when foreign 
governments make investments in our debt.
    And you, I believe, if I understand you correctly, you were 
talking--the question was raised about China's best economic 
interest. Is it in their best economic interest to continue to 
invest so heavily in our treasuries? And I guess the question 
that is begged is what are the other factors that might explain 
why its government or entities like that would have made such 
massive investments in U.S. treasuries or may continue to do so 
even though it is not in their best economic interest?
    Mr. Orszag. Well, there are a variety of factors driving 
this investment by foreign official institutions. One is the 
overall current account deficit that we have which necessitates 
as a mirror image capital in-flows.
    The second is with regard to China in particular its effort 
to manage its exchange rate which requires purchasing dollars 
and selling domestic currency in order to achieve that 
objective. And the result is a significant accumulation of 
dollar assets.
    And then the question is, what are those dollar assets 
invested in. And for a foreign official entity that is 
concerned about safety and liquidity, U.S. government debt 
becomes a particularly attractive investment vehicle.
    So the question then becomes, is that always going to 
continue. And I think, again, the view is that at some point, 
the portfolio even of an official entity becomes saturated in 
dollar assets and there may be some diversification out of 
    Chairman Spratt. Let us see. Mr. Alexander, is he here?
    Mr. Porter.
    Mr. Porter. You go.
    Chairman Spratt. Mr. Tiberi.
    Mr. Tiberi. Thank you, Mr. Chairman. Your comments there 
are fascinating. If I could follow-up on that.
    I had a conversation recently with an economist over this 
same issue and was challenging him on this concept of China 
investing in U.S. treasuries. And the challenge that he had 
back, and you just kind of mentioned it, if you could expand 
upon it, is part of the reason why others invest in us is that 
there is not a safer investment in terms of if you look around 
the world in terms of a government, in terms of an economy, in 
terms of our laws in the world.
    Can you further comment on that in terms of if you were in 
another country looking at investing in foreign debt? If you 
are looking at Europe and Asia and the Middle East and Africa 
and South America and Central America and the Far East and the 
United States, what would you look for in terms of investing in 
bonds and treasuries?
    Mr. Orszag. Well, again, I mentioned security yields 
associated with the risk return, tradeoffs, and liquidity. And 
consistent with your comment is the fact that roughly two-
thirds of official reserves globally are still invested in 
dollar assets suggests that we continue to be a preferred 
vehicle for such investments.
    But I would note that that is a privilege or a benefit that 
is not guaranteed to continue forever and ever. It depends in 
part on what we do and what happens abroad.
    Mr. Tiberi. The benefit of U.S. treasuries you are saying?
    Mr. Orszag. The benefit of the fact that foreign official 
entities have chosen and continue to choose to invest such a 
large share of their reserves in dollar assets.
    Mr. Ryan. Mr. Tiberi.
    Mr. Tiberi. Yes.
    Mr. Ryan. Could I ask just a follow-up?
    Mr. Tiberi. I will yield to the gentleman.
    Mr. Ryan. What proportion of our foreign-held debt in China 
in particular is callable versus noncallable debt?
    Mr. Orszag. By callable, again, U.S. Treasury debt is not 
like private debt.
    Mr. Ryan. Yeah. But there are callable instruments we have 
and then the vast majority of them have fixed mature rates, 
    Mr. Orszag. The vast majority have fixed maturities.
    Mr. Ryan. Right. So the vast majority of the debt could not 
be called tomorrow by the Chinese? Most of it, it would just 
expire when it matures, correct?
    Mr. Orszag. Yes. But one can obviously----
    Mr. Ryan. They buy in fixed ten, twenty, thirty-year notes, 
    Mr. Orszag. One can move your portfolio out of a bond by 
steps other than just redeeming the bond. You can sell the 
    Chairman Spratt. They do not call on the Treasury. They 
sell it in the open market.
    Mr. Orszag. You have to have a buyer.
    Mr. Tiberi. That is why I was confused by that.
    Mr. Ryan. But the idea that tomorrow they could cash in all 
of the debt and crash the system would require that they would 
be able to do that and it does not sound like they could; is 
that correct?
    Mr. Orszag. No. Again, we are going down a hypothetical, 
but it is not necessary to literally redeem a bond in order to 
have an effect on the market. You can sell the bond and that 
affects the pricing and the yield on the bond.
    Mr. Ryan. Thank you, Mr. Tiberi.
    Mr. Tiberi. Thank you.
    Can we have chart one up, Minority chart one?
    Yeah, that is it. Back to the entitlement issue, Dr. 
Orszag. This chart speaks for itself. When you do your scoring 
with respect to taxes and spending on entitlement, let me give 
you a question that was asked to me and see how you would 
answer it. I had difficulty answering it.
    This is from a physician, a heart physician in Columbus, 
Ohio. And this was during the debate on Medicare, the Medicare 
drug benefit. And he said to me, you guys have it all wrong in 
the sense that the Medicare system then did not allow him to 
regulate a patient's heart, did not pay for it, but, yet, paid 
for him cracking open the chest to repair the heart, which cost 
tens of thousands of dollars, and said that if you allow me to 
regulate this person's health through tests, through a drug, 
there will be less of a cost and a better patient outcome than 
if you would keep the system currently in place where you pay 
for me to repair the heart.
    But, yet, the scoring does not indicate that. And I 
explained that to him. And he said, well, that is what is wrong 
with the federal government. You do not take into real-life 
situation where me as the doctor on the ground is actually 
seeing these patients and can actually save the federal 
government money and keep the quality of life of the patient 
    How would you respond to that, to that physician, that 
heart surgeon who asked that question to me?
    Mr. Orszag. That CBO continues to monitor the evidence on 
what works and what does not, that this is one of the various 
different approaches that are being discussed.
    But, for example, there is a pilot project in the Medicare 
Program, the so-called Coordinated Care Demonstration Project, 
which tries to provide a sort of centralized process for the 
various different medical interventions that are warranted for 
someone with a severe chronic condition. The evidence suggests 
that those programs are not paying for themselves, let alone 
actually reducing cost.
    Mr. Tiberi. Well, your assumption is, though, according to 
this doctor, just if I could just finish this question, but 
your assumption is that you assume that every single patient is 
going to still have the open heart surgery despite the 
prevention because you do not take into account the savings 
according to this doctor of not having the heart fixed.
    Mr. Orszag. Where there is evidence of offsets like that, 
so you do X and then you reduce cost over here, we take that 
into account. So conceptually we try to take it into account, 
but it is often the case that the evidence in favor of many 
propositions, including on preventative medicine and including 
on disease management, it is not as strong as some 
practitioners make it seem.
    And, again, we are always looking for additional hard 
evidence on what works and what does not and then that would be 
reflected in the scoring process.
    Chairman Spratt. Mr. Doggett.
    Mr. Doggett. Thank you, Mr. Chairman.
    And thank you for your excellent testimony. I thought that 
Mr. Edwards made some important observations earlier in his 
questions about the devastating impact of these Bush-Cheney 
economic policies supported by Republican Congresses on our 
families. I think that has to be put, of course, into 
historical context of folks that talk like deficit hawks, but 
live deficits.
    Under President Reagan, we hit almost a trillion and a half 
dollars in deficits. Under President Bush the first, we only 
got a little over a trillion dollars in deficits. Under 
President Clinton, of course, we achieved about $62 billion, 
$63 billion in surplus. That was the result of true fiscal 
    And now, of course, under President Bush, the biggest 
talker and preacher against deficits and excessive spending and 
in favor of fiscal responsibility, but the all-time top hitter 
in achieving almost unlimited deficits, we are hitting on $2 
trillion. He has not quite gotten there yet, but the kind of 
irresponsible policies he has had take us in that direction.
    And I want to yield back to Mr. Edwards to make further 
observations about what the impact of these irresponsible 
policies are on the typical American family.
    Mr. Edwards. Mr. Chairman, I want to respond. Mr. Simpson 
had asked if we are going to call this the Bush-Cheney deficit 
and the Bush-Cheney debt, which it is, largest in American 
history, we should also call it the Bush-Cheney economy.
    I want to agree with him on that and I would like to 
submit, if I can send to the Committee, a report done by the 
Center on Budget and Policy with data from Commerce and Labor 
and Federal Reserve.
    Compared to a response to coming out of previous recessions 
over the last 30 years, the Bush-Cheney economic impact was 
less in GDP growth, less in consumption growth, less in 
investment growth, net worth, less in wages and salary growth, 
less in employment growth.
    There is one area the Bush-Cheney economic policy has 
worked. That is it has had huge increases in corporate profits. 
But in every other way, it has been worse than our response to 
recessions in the last 30 years.
    And median household income of the nonelderly population 
has gone down by nearly four percent under the Bush-Cheney 
economic program while aggregate national income and corporate 
growth have gone up.
    Mr. Doggett. Dr. Orszag, let me then inquire of you about 
one aspect of these perhaps consequences of some of these 
policies that has not yet been explored and that is the direct 
impact on the private sector of the acquisition of private 
assets by foreign owners.
    As you know, within the last year, there has been concern 
expressed about the Chinese purchasing a major oil company 
here. There is concern that was expressed about one of the Gulf 
states taking over our ports.
    I noticed within this last week, perhaps a little less 
strategic, the acquisition of Barney's in New York by Dubai. 
And I believe the Russians are getting plenty of petro dollars 
also and may be looking at the United States. I guess they will 
not be buying any media outlets since they are basically in the 
business of shutting down media outlets at home.
    But what is likely to be the consequence as far as foreign 
acquisition of private assets of continuing the same policies 
that you are talking about today?
    Mr. Orszag. Well, again, if you look at the net impact, 
there are lots of shifts in portfolios that are always 
occurring, but the net impact of running a current account 
deficit is that foreign claims on U.S. assets increase. In 
recent years actually, those have been disproportionately in 
government securities and disproportionately from foreign 
official entities.
    And if you look at some of the subcategories, for example, 
direct investment, that is foreign purchasers buying more than 
ten percent of a domestic firm, we are actually now 
experiencing net capital outflows in that subcategory of the 
capital account rather than net capital inflows.
    Mr. Doggett. Is Chinese acquisition a part of Blackstone an 
indication of any potential future shift of Chinese investment 
and purchasing of U.S. investments?
    Mr. Orszag. Again, what I would say is that over the past 
several years, the net impact of capital inflows have been 
disproportionately in government securities as opposed to some 
of these other higher-profile, if you will, portfolio decisions 
and, again, disproportionately coming from official entities.
    Beyond that, there are lots of shifts of portfolios in 
particular investments that go on all the time. And I am not 
reading too much into that particular one.
    Mr. Doggett. Thank you.
    Chairman Spratt. Thank you, Mr. Doggett.
    Mr. Smith from Nebraska.
    Mr. Smith. Thank you. I appreciate this discussion here 
today and it is quite enlightening as a new member. And I have 
been trying to follow the issues over the past few years.
    But in light of the discussion about Medicare Part D, were 
there competing measures that would have cost more than the 
Republican adopted Medicare Part D plan?
    Mr. Orszag. There were a variety of proposals floating 
around at the time and I have not gone back and checked, but I 
am sure that some of them were more expensive than the enacted 
    Mr. Smith. Okay. Thank you. And I realize CBO, I guess the 
rules, if you will, stipulate that the scoring is done not in a 
dynamic fashion, but perhaps a static fashion.
    But would you agree that an increase in the capital gains 
tax would create a disincentive to make a relevant sale or 
economic transaction and would that be good for the economy?
    Mr. Orszag. An increase in the capital gains tax would 
temporarily reduce the incentive for realizations. The longer-
term effects are more complicated and the bulk of the evidence 
suggests that changes in capital gains taxes do not have a 
substantial effect on either the sort of net realization rates 
or the broader economy.
    Mr. Smith. Okay. We are going to see, I guess I would 
predict, the expiration of several tax relief measures. Do you 
have any concern about consumer behavior in those last six 
months, those last twelve months, what the relevant case might 
be and the long-term impact of those changes in behavior?
    Mr. Orszag. Again, if you are running up against a 
significant change, especially in something like a capital 
gains tax rate, you often get a significant amount of shifting.
    So, for example, if the capital tax gains rate is about to 
go way up, shifting realizations into the period in which the 
capital gains rate is lower and we would anticipate that that 
would occur.
    Mr. Smith. And do you have a concern about that creating 
somewhat of a false economy or false revenue outlooks?
    Mr. Orszag. That kind of phenomenon has happened in the 
past and I am not sure that I would associate a significant 
concern with it as opposed to just recognizing that it does 
    Mr. Smith. Okay. But as we look to the future and try to 
predict as your office often does, are you looking at 
adjustments there? Is it sort of all formula driven?
    Mr. Orszag. No, no. Maybe I can answer the question what is 
the CBO's analysis of what would happen if the tax legislation 
expired as scheduled. And there are a variety of effects. Over 
time, one of the effects is that the budget deficit is smaller 
than it would otherwise be. That boosts long-term economic 
    On the other hand, marginal tax rates are higher than they 
would otherwise be and on net, that impairs long-term economic 
performance. And CBO's analysis suggests that the net impact is 
relatively modest from those two forces.
    Mr. Smith. Okay. And another question that I have is we 
have talked about government spending here today as well as 
personal savings or lack thereof. Which do you think is a 
bigger concern, government spending or lack of personal 
    Mr. Orszag. I do not know that I would want to parse it 
that way. What I would say is I think the evidence suggests 
that the biggest, from a policy perspective, the biggest impact 
that you all can have is through public saving.
    Efforts at boosting private savings through policy 
interventions have often not succeeded that well, although I 
would note my written testimony delineates that encouraging 
automatic saving, that is that you are in a 401k or you are in 
an IRA unless you opt out, appears to have a significant effect 
on contributions and participation rates.
    Mr. Smith. Okay. Thank you, Mr. Chairman.
    Chairman Spratt. Mr. Becerra.
    Mr. Becerra. Dr. Orszag, thanks for being with us. Thank 
you for your testimony.
    Let me make sure I have this correct. We see the share of 
our debt being more and more held by those who are foreigners, 
China, Japan. Oil exporting countries are buying up our 
    As we try to figure out how to finance our government's 
operations, we are putting our bonds, our treasuries out for 
market and more and more the people who are buying or the 
entities that are buying are foreign partners or in some cases 
foreign competitors, correct?
    Mr. Orszag. That is correct. A rising share of our 
publicly-held debt is held by foreigners.
    Mr. Becerra. And more and more, it is not United Kingdom 
that is buying our debt or even Japan, which has become a 
friendly nation towards us over the last 50 years, but China, 
some of the same oil exporting countries that we continue to 
claim, as the President said, we want to remove ourselves from 
this addiction to oil.
    They are the ones that are buying more and more of our debt 
that we put out there, correct?
    Mr. Orszag. In terms of trends, that is correct.
    Mr. Becerra. Now, right now we have experienced fairly low 
interest rates, historically low interest rates for quite some 
time. But if all of those foreign buyers of our debt were to, 
for whatever reason, decide not to buy and we could no longer 
sell it so easily, that would cause us to have to raise the 
interest we offer on those treasuries that we are trying to 
sell which would cause the rest of the markets around the 
nation to have to offer interest rates that are higher as well. 
Would that not be the consequence?
    Mr. Orszag. That is indeed the case.
    Mr. Becerra. Okay. So if I keep following this logical 
train of thought, in the housing market, we continue to hear 
about people having to give up their home because of 
foreclosures. They can no longer afford to pay the payment on 
their mortgage because the interest rates have gone up on these 
adjustable rate mortgages and now they are having to give up 
their homes. They are losing them on foreclosure.
    If for whatever reason, China or one of these oil exporting 
countries decided to play politics with us, say China decided 
to take over Taiwan finally and we said, no, you cannot do 
that, we are going to defend Taiwan and they said you are going 
to do what, maybe we are not going to buy any more of your 
Treasury certificates.
    What could happen to something like our home ownership 
rates, our housing market in America if interest rates were to 
become volatile and increase dramatically?
    Mr. Orszag. Upward pressure on interest rates would 
discourage home ownership and also discourage various other 
types of consumption, both of which would tend to--well, the 
net effect of which, by the way, would also be to increase the 
private saving rate.
    Mr. Becerra. You say it in such a neutral tone.
    Mr. Orszag. Yeah. I am trying.
    Mr. Becerra. The sky would fall on those who try to own a 
    My other concern is this as I continue to hear this play 
out. We are right now still in the midst of a War in Iraq where 
160,000 American troops are still based in a country where we 
were told we would fight a three to six-year battle, war, with 
the cost at no more than about 50 billion.
    Now we are well beyond a half a trillion dollars in cost, 
unclear when the President would even consider having us come 
out even though this Congress has tried to push to have an end 
date. We are financing this principally through debt. We are 
deficit spending to pay for the war because we are in a deficit 
to begin with.
    So the question is this. In our 230-year history, can you 
think of a time where at the same time that we are spending 
hundreds of billions of dollars on a war when we are in 
deficit, have we ever faced a similar circumstance while we 
have been in war while we have also at the same time cut the 
taxes on the wealthiest Americans in this country?
    Mr. Orszag. I do not believe that is the case. I actually 
think we may have had a previous exchange on a similar topic. I 
had asked CBO staff to look into whether there had ever been a 
revenue reduction during a time of war. And if my memory serves 
me correctly, there was an engagement with Mexico in the late 
19th century in which we also reduced a tariff rate at 
approximately the same time. And that was the only time in 
history that the CBO staff could uncover.
    Mr. Becerra. So a tariff rate versus what we have seen to 
the tune of several trillion dollars in tax cuts that have gone 
principally to those at very highest income levels and we have 
a deficit that has grown to historic levels. And at the same 
time, we are finding our foreign competitors are buying up our 
Treasury certificates.
    And it just seems like this vicious cycle does not end, but 
at the same time, it does not seem like at the White House 
there is any control over how we spend our money.
    So whether it is because we want to maintain home ownership 
rates at high levels or whether it is because we want to try to 
do right by the men and women who are serving us in the 
military who are in Iraq abroad, I would think that what we 
would try to do is heed what you are saying and try to have 
more fiscal responsibility and that is perhaps why Congress has 
decided to go with the PAYGO system in operation so that we 
will no longer continue to increase the size of the deficit.
    So no question there other than to say thank you for your 
testimony and for your comments that you have always provided 
to this Committee.
    Chairman Spratt. Mr. Etheridge.
    Mr. Etheridge. Thank you, Mr. Chairman. Let me thank you 
for holding this meeting and let me thank you for leading this 
Committee through the PAYGO system to get us back on track 
because I think it is important.
    Dr. Orszag, thank you for being here. Your testimony today 
is important.
    You know, we are seeing record deficits and the policies 
that have been put in place in the last few years got us here. 
And it has made it very difficult for us, I think, this year 
for us to meet some of the pressing needs and I will talk about 
that in a minute.
    But too often in this town, the debate dissolves into 
soundbites and some talking points that are repeated over and 
over and over again and we get charts that try to make our 
points. And the truth is I want to get to something that I 
think is important that hopefully gets to where the American 
people are.
    I do not understand all this stuff sometimes, but most 
folks understand that have a bill to pay what the interest is 
on it. And I want to follow-up what my colleague was just 
talking about. I happen to disagree with the Vice President. 
Deficits do matter.
    And with that, let me ask you this question. Do you 
remember what the amount of interest we were paying in 2000, 
the actual interest on the national debt and how much interest 
we will pay this year on the national debt given that we are 
keeping the interest rate down to the point we are? I will not 
go into what will happen when it would balloon, but what those 
numbers actually are in the millions of dollars.
    Mr. Orszag. Luckily I do not have to rely on my memory 
since I brought the CBO budget and economic outlook. In fiscal 
year 2000, net interest payments were $223 billion.
    Mr. Etheridge. All right.
    Mr. Orszag. And in 2006, they were $227 billion.
    Mr. Etheridge. Say it again now.
    Mr. Orszag. In fiscal year 2006, net interest payments were 
$227 billion.
    Mr. Etheridge. Two hundred and twenty-seven billion. And it 
was how much in 2000?
    Mr. Orszag. Two hundred and twenty-three.
    Mr. Etheridge. It only went up $4 billion?
    Mr. Orszag. One of the things that has happened in the 
meanwhile is that there has been an evolution of interest 
rates. We have exceptionally low interest rates now in the 
United States.
    Mr. Etheridge. Okay. Now, my question, the question is that 
as we have seen this tremendous growth in deficits being bought 
by and large overseas, it means that the dollars that 
historically in World War II and all those times we were 
running deficits was paid through the America citizens which in 
effect meant that money was turning over in the American 
    Those dollars now are being bought overseas. What portion 
of our debt, our total debt is bought overseas? The reason I 
ask this question, of the $227 billion, it could grow very 
rapidly. It is no longer enriching our country. The interest is 
going somewhere else, to China. As you have said, about a 500 
percent increase, which means not only are they buying debt, 
they also are part of the balance of payment deficit we have.
    And what was that balance of payment with China in 2000 
versus the balance of payment in 2006? Do you happen to have 
that number?
    Mr. Orszag. Yeah. Let me answer this in two parts. So with 
regard to the publicly-held debt, again somewhat above 40 
percent of the nation's publicly-held debt is now owned by 
    Chairman Spratt. How much?
    Mr. Orszag. Slightly above 40. It is 42 or 43. With regard 
to the nation's current account deficit with China according to 
our data, and the numbers are a little different in their data, 
that was a little bit above $200 billion last year. And, 
actually, I will have to get you the number from 2000. I do not 
want to misquote it.
    Mr. Etheridge. Okay. That being said then, roughly of the 
$227 billion in debt, we can figure 42 to 43 percent of that 
interest is going outside the United States that is no longer 
available within our economy that would turn over to generate 
economic activity. And that would no longer be savings in the 
American economy which could be turned into education, to 
healthcare, to a host of other issues, more savings for the 
American people.
    Mr. Orszag. Again, I do not have the data on the maturity 
structures, et cetera, but roughly speaking about 40 percent of 
net interest payments----
    Mr. Etheridge. Whatever that number may be.
    Mr. Orszag [continuing]. Would be flowing to foreigners.
    Mr. Etheridge. Okay. Thank you.
    I think, Mr. Chairman, the point is, and I thank you for 
holding this hearing and I thank you, Dr. Orszag, because, you 
know, these things are important.
    I remember asking the question to the Treasury Secretary 
Paulsen about whether or not deficits bothered him and whether 
it kept him up at night. And he said it did not.
    Well, I think these numbers ought to bother all of us and I 
am glad we have started on a track now to start getting back to 
a balanced budget because I think these debts being held by the 
people who are not necessarily going to be working in our best 
interest are important for us to get on better ground.
    Thank you, Mr. Chairman. I yield back.
    Chairman Spratt. Thank you, Mr. Etheridge.
    Mr. Cooper of Tennessee.
    Mr. Cooper. Thank you, Mr. Chairman.
    Dr. Orszag, as you know, Standard & Poors of New York has 
projected that by 2012, the U.S. Treasury bond will lose its 
triple A credit rating. Furthermore, they have projected that 
by 2015, the United States of America will have the same credit 
rating as Greece or Estonia.
    By 2020, they say that our credit rating, if things do not 
change, will be that of Poland or Mexico. And by 2025, they say 
that the U.S. Treasury bond will be below investment grade, 
junk debt, on par with the bonds of Brazil or Panama.
    What in your professional opinion would be the impact if in 
2012 we take the first of S&P projections, it is the closest at 
hand, and the U.S. Treasury bond loses its triple A credit 
    Mr. Orszag. I guess the way I would answer that is that we 
are on a fiscal path in which the problems grow gradually worse 
over time and they are going to continue getting worse if we do 
not tackle some of the things that we were talking about 
    It is hard to parse out exactly where trigger points would 
be so that there would be sort of discrete adjustments. What 
you were describing may be one among many things that would put 
that gradual deterioration on a more sudden path.
    Mr. Cooper. I think it is a problem that clearly the next 
President will have to confront if S&P is even in the ballpark 
of being correct.
    Mr. Orszag. Every budget analyst that I know suggests that 
the United States is on an unsustainable fiscal path and that 
the problem needs to be addressed. It would be better to 
address it sooner rather than later.
    Mr. Cooper. Exactly. I was just about to mention the 
precious word unsustainable. Everyone agrees on that, but who 
is doing anything about it? The reason the S&P projection is 
not a prediction is they think some policy makers are going to 
intervene. Well, things are keeping on pretty much business as 
    You mentioned in your testimony that the best way out of 
the dilemma is to boost the savings rate and then you offer an 
addition to the automatic 401ks that we passed last year, 
perhaps some automatic IRA proposal, and then you say that 
would hardly dent the problem that we face.
    What can we do that would dramatically boost the national 
savings rate?
    Mr. Orszag. I think the single best thing under your 
control or single-most effective thing largely under your 
control is to move the federal fiscal balance from its current 
level of one and a half percent GDP deficit and much larger 
projected deficits perhaps even into surplus and to get it on a 
more sustainable path.
    Mr. Cooper. But although we hope to have a budget 
improvement, I think most policy makers would tell you at least 
privately we do not see a way out of these deficits for the 
foreseeable future.
    And no one is trying to reform the entitlement spending 
that was discussed earlier that must be addressed if we are 
going to curb growth in healthcare spending.
    Mr. Orszag. And one of the reasons that I am putting so 
much emphasis on CBO increasingly becoming the Congressional 
Health Office is to provide options to you on what might help 
bend that curve. So we are doing a lot of things, at least for 
our part, to provide you with more options that you could 
    Mr. Cooper. Your CBO budget options book is excellent. You 
could emphasize healthcare a little bit more and we would 
appreciate that. We would also welcome more ideas on ways to 
boost private savings because if you were to poll members of 
Congress, you would find that our own personal savings behavior 
is very regrettable. Just we mirror the public at large.
    So I think suggestions along those lines would be very 
helpful because here we all agree it is unsustainable, but no 
one is doing much about it, either as policy makers or as 
individuals. We say the words, but we must not mean them 
because we are letting the day of reckoning come closer and 
    Is there an opportunity for CBO staff to work on ways to 
boost, suggestions for us to boost private savings rates in 
this country, something bolder than automatic IRAs?
    Mr. Orszag. Sure, although I would note, and, again, this 
is not a recommendation that I am making, but I would note that 
the evidence in favor of the proposition that a lot of saving 
behavior is driven by inertia and that that is a significant 
factor in savings rates for many American families. I would not 
downplay that too much.
    Mr. Cooper. But today after 20 or 30 years of IRAs, what, 
only ten percent of Americans have one with any substantial 
savings inside?
    Mr. Orszag. And that is in no small part in my opinion 
because you have to take active steps to go and sign up, go to 
a bank to get it. Even small impediments to taking action to 
contributing have large effects.
    The evidence from 401ks suggest that even, you know, having 
to read through a document at work and sign up has a 
significant deterrent effect. If you are in a plan unless you 
opt out, your participation and contribution rates are a lot 
    The same logic could be applied to the IRA setting, but it 
would require a variety of changes and I do not think it would 
be a small matter in terms of the required statutory changes 
    Mr. Cooper. Thank you, Mr. Chairman. I see my time has 
    Chairman Spratt. Thank you, Mr. Cooper.
    Ms. Kaptur.
    Ms. Kaptur. Thank you, Mr. Chairman.
    Dr. Orszag, welcome. Do you have any recent number on what 
we are projected to pay in interest to these foreign holders of 
our debt this fiscal year? It is over 200 billion, is it not, 
somewhere between 100 and 200 billion?
    Mr. Orszag. That seems high in terms of interest on the 
U.S. Treasury debt paid to foreigners, again going through the 
math that we were walking through before.
    Ms. Kaptur. I did not find it in your testimony.
    Mr. Orszag. I do not believe I provided it in my testimony. 
But total net interest payments will be a little bit above $200 
billion. Foreign entities own about 40 percent of the debt. So 
doing the math, that would be roughly $80 billion or so.
    Ms. Kaptur. Okay. So we are approaching $100 billion. That 
is not insignificant. That is larger than many of our 
governmental departments. NASA's budget is $16 billion, for 
example. So you are talking about big money here.
    You are talking about substitutional effects in the 
government of the United States where we could be spending 
those dollars on, for instance, veterans. I think the veterans 
budget is what, 60 to 70 billion a year now. I mean, you think 
about what that displaces in terms of our economy and that has 
been on an upward path.
    I can tell you when I got to Congress, the amount of 
foreign investment in U.S. securities was about eight percent 
and I used to rail against it over in what was then called the 
Banking Committee. Now we are over half and America has lost 
their independence in my opinion.
    And all of the actions that have occurred over the last 20 
years, whether it is the destruction of our thrift 
institutions, changing the name of the Banking Committee to the 
Financial Services, charging people and giving them no interest 
in their checking accounts, all the fees we are placing on 
people, the lack of emphasis on savings, no postal saving stamp 
program like Franklin Roosevelt.
    As a grandmother, if you want to buy a--try to buy a 
savings bond. You are too young to buy one. And your grandmom 
wants to give it to the grandchild. Good luck. They want to 
mail it in the mail. When ordinary people wanted help, the 
government of the United States fights them every step of the 
way. So it is really interesting to me we are part and parcel 
of the problem, but we cannot see our way out of it.
    Let me ask you about the Saudis. I see your chart here on 
oil exporting countries and who owns what of this debt. Okay? 
Does that include the special arrangements the Saudis have with 
our government for the reinvestment of over a trillion dollars, 
but it is done in dollar denominated assets? It does not appear 
to me that that is in your chart. What can you tell us about 
when that agreement was struck at Treasury and how that works 
compared to the purchases by other countries of our bonds?
    Mr. Orszag. I think I will have to reply in writing to you. 
I do not have anything to say about that at this point.
    Ms. Kaptur. Yeah. Treasury never wants to say anything 
about that and it is pretty significant and it is different. 
And I think your charts underestimate the impact of that inside 
this economy and the close linkage between the reinvestment of 
those assets inside this economy. I think the numbers are worse 
than you presented in your charts.
    I wanted to ask you about does the Treasury or anyone else 
identify the top specific foreign purchasers of U.S. debt for 
each fiscal year and, if not, why not?
    Mr. Orszag. There is an identification by country of 
holdings of different types of assets including public debt. 
And we could provide those to you.
    Ms. Kaptur. So we could track them back to----
    Mr. Orszag. Yes. Now, there are various flaws in the data. 
For example, those are typically based on surveys often of 
custodians of assets. There can be banks in the UK holding the 
asset on behalf of someone else. And so the country breakdowns 
can often be a bit off relative to an underlying reality.
    Ms. Kaptur. All right. I am going to ask some questions for 
the record for you to get back to us on that.
    Mr. Orszag. Okay.
    Ms. Kaptur. What is the linkage you have seen between our 
trade deficit and the increased foreign holdings of our debt?
    Mr. Orszag. The trade and current account deficits 
necessitate the mirror image of them is a net capital inflow 
from abroad and part of that net capital inflow, actually in 
recent years a very large share, has occurred in the form of 
purchasing Treasury securities. So there is a direct connection 
between our current account deficits and net capital inflows 
from abroad. They are the mirror image of each other.
    Ms. Kaptur. I know we have got other witnesses today, but I 
am pretty concerned about these hedge funds and the investors 
in those not being disclosed.
    Would you support a federal law that would require 
disclosure of anything over five percent in any of those hedge 
funds that would be of a foreign nature, foreign purchases of 
assets held by those hedge funds? Do you see any disadvantage 
to doing that?
    Mr. Orszag. Again, my role as CBO Director is not to 
support or not any particular legislation. We would be happy to 
provide an analysis of the pros and cons to you which I would 
rather do again in writing since I know that our time is 
    Ms. Kaptur. Okay. Thank you very much for being here today 
and I look forward to replies to the questions I have asked.
    Chairman Spratt. Thank you, Ms. Kaptur.
    Ms. Kaptur. Thank you, Mr. Chairman.
    Chairman Spratt. Mr. Berry.
    Mr. Berry. Thank you, Mr. Chairman.
    Dr. Orszag, we appreciate your effort. You keep referring 
to net interest. What is gross interest?
    Mr. Orszag. It is significantly higher. It includes 
payments to various different, for example, the Social Security 
Trust Fund, which is part of the federal government.
    Mr. Berry. How much is it?
    Mr. Orszag. From memory, it is certainly north of $100 
billion a year. It will take me a second to get.
    Mr. Berry. That is fine.
    Mr. Orszag. Okay. While you are asking your next question, 
I will look it up.
    Mr. Berry. Okay. When you present the net interest that we 
paid in 2000 and then what we paid in 2006, there appears to be 
very little impact on the interest that we are paying as it 
relates to the amount of money we owe because we have borrowed 
a couple or $3 trillion more than we owed at that time. Am I 
correct about that?
    Mr. Orszag. That is correct. And one of the reasons for 
that is that the--well, there have been a variety of changes. 
But, for example, looking at the interest rate on U.S. 
government debt is one factor that is affecting because you 
have the stock of debt and then the interest rate that is paid 
on the debt and you are focusing on the fact that the stock of 
debt has gone up as we have run these deficits, but the other 
factor is the interest rate.
    Mr. Berry. So does the amount of debt that we owe have any 
impact on the interest rate?
    Mr. Orszag. Yes, it does, but there are other factors that 
affect interest rates also. And those other factors have 
resulted--one of the phenomenon that has occurred over the past 
several years is we have a very flat and actually for a period 
of time we had an inverted yield curve which is unusual.
    So a longer-term Treasury security like a ten-year bond 
typically yields more than, you know, a three-month Treasury 
bill. That yield curve has been very, very flat over the past 
several years, unusually flat.
    Mr. Berry. You have testified, and I have heard many others 
say the same thing, that tax cuts do not pay for themselves. Do 
farm bills pay for themselves? Do the American people get their 
money's worth out of a farm bill?
    Mr. Orszag. I think the question of the sort of costs and 
benefits of agricultural programs is that is a different 
question than the economic return to a tax cut. Basically I am 
not going to touch that.
    Mr. Berry. Thank you, sir.
    Chairman Spratt. Mr. Scott.
    I see our patient forebearing second panel next. You are on 
deck. We are sorry to have kept you so long.
    Mr. Scott, proceed.
    Mr. Scott. Thank you.
    Dr. Orszag, the gentleman from California had a situation 
where we had to go to defend Taiwan and China could use the 
fact that we are borrowing money from them as a negotiating 
    What would happen if China decided as part of the deal they 
would not lend us money to defend Taiwan against them? What 
would happen? Could we manage without borrowing money from 
    Mr. Orszag. The impact on our economy would depend in part 
on the reaction of other investors, whether they would step in 
rapidly or not. But a very sort of sudden and significant 
withdrawal of flows of Chinese investment into U.S. Treasury 
securities would likely have some at least short-term 
disruptive effect. And how big that would be would depend in 
part on what happened in the rest of the market and whether 
other investors stepped in.
    Mr. Scott. Interest rates are international.
    Mr. Orszag. They are influenced by international capital 
    Mr. Scott. How much fluctuation, annual fluctuation is 
there in international interest rates? I mean, are they pretty 
stable from month to month, year to year, or can they go up a 
point, two, three points a year?
    Mr. Orszag. Fluctuations of two or three basis points in a 
year are unusual, but not unprecedented.
    Mr. Scott. We have a chart here that shows that in 2001, we 
had about a trillion dollars in international debt; 2007, 2.2 
trillion. How much did the overall debt, national debt increase 
from 2001 to 2007?
    Mr. Orszag. Roughly a trillion and a half dollars or so, I 
    Mr. Scott. Well, this is 1.2 trillion.
    Mr. Orszag. I do not know what chart you are looking at, 
    Mr. Scott. This one.
    Mr. Orszag. Oh, I am sorry. That is foreign-held debt. So I 
was giving you the numbers for all publicly-held debt. Foreign-
held debt has increased by about three-quarters as much as the 
increase in----
    Mr. Scott. Okay. Well, foreign-held debt went from one to 
2.2. How much did the overall national debt go up?
    Mr. Orszag. By a little bit above 1.5 trillion.
    Mr. Scott. One point five. So out of the net 1.5 trillion 
increase foreign-held net went up 1.2 which is 70 percent?
    Mr. Orszag. That is roughly correct.
    Mr. Scott. Of the net debt was financed from overseas 
    Mr. Orszag. That is correct.
    Mr. Scott. You had an exchange where the bond rating might 
be adversely affected. Can you say how close we are to a 
tipping point where foreign countries might stop buying and, in 
fact, might start selling debt and what that might do to our 
interest rates?
    Mr. Orszag. There is a risk of a sudden and severe 
adjustment. That risk, I think, is small, but perhaps growing. 
And I cannot identify a particular trigger point for you.
    One of the inherent elements of a situation like this one 
is that there are steps that one would presumably want to take 
to avoid the risk of something happening even if you cannot 
identify exactly when it could happen or even the exact 
probability of it occurring.
    Mr. Scott. What order of magnitude of interest rate shock 
would we be looking at?
    Mr. Orszag. Again, it depends on exactly what happened. And 
someone once said that this kind of situation, things can go 
wrong in such a wide variety of ways that it is just difficult 
to parse out all of the various different scenarios. But there 
have been estimates suggesting a hundred basis points or more 
type of adjustment.
    Mr. Scott. Now, if we had not messed up the budget starting 
in 2001, we had projected that we would be able to pay off the 
debt held by the public by approximately 2008. Is that true? 
The projections in early 2001 would pay off the national debt?
    Mr. Orszag. As you will remember at that time, there was 
significant discussion about what would happen in the situation 
in which all the publicly-held debt had been paid off.
    Mr. Scott. And so all of this risk that we are discussing 
now would not have been there if we were in the process of 
paying off the debt held by the public?
    Mr. Orszag. Or another way of putting it is in the kind of 
scenario where you were running significant budget surpluses, 
net national saving would be significantly higher.
    Chairman Spratt. Dr. Orszag, as always, thank you for your 
excellent presentation, your responsive answers. We look 
forward to hearing you shortly, I think tomorrow or the next 
day, on----
    Mr. Orszag. Thursday, yes.
    Chairman Spratt [continuing]. Thursday. Thank you again for 
your participation and for CBO's input.
    Now our second panel, Dr. Robert D. Hormats, Dr. Mickey 
Levy, Dr. Kenneth Rogoff, and Dr. Brad Setser.
    If you have no objection as a panel, we will proceed in the 
order I just mentioned unless you want to change the order, Dr. 
Hormats, Mickey Levy, Kenneth Rogoff, and Brad Setser. Is that 
agreeable with the panel?
    Mr. Hormats, thank you for participating.
    And thank you for your patience, all of you. Your prepared 
statements will be made part of the record and to the extent 
you wish, you can summarize them.
    The floor is yours.



    Mr. Hormats. Thank you very much, Mr. Chairman and members 
of the Committee. It is a pleasure to be here and I will just 
try to make a few key points relative to the broader issues 
that I have described in my written testimony.
    One, you have discussed in previous prior testimony the 
domestic savings versus investment imbalance. The domestic 
issues are one part of the equation. The other is the question 
of where the capital to fill the domestic saving shortage comes 
from and the point has been made frequently that the biggest 
increases have come from China and the oil producers.
    There tends to be a lot of focus on the reserve 
accumulations of central banks, but I just want to emphasize 
that the critical issue for these countries is the enormous 
amount of net savings as reflected in their current surpluses 
so that we can be very reliant on foreign capital supplies from 
countries that have very low reserves.
    The reserve accumulation occurs when the central bank buys 
up dollars or other currencies, but the reliance of the United 
States on foreign capital would be there whether the reserves 
have been accumulated or not because it really relates to the 
net savings of these countries or, put another way, the net 
exportable savings.
    In my testimony, I was asked particularly to look at some 
of the scenarios for the unwinding of this huge dependence. 
What could occur that would cause a major disruption or 
interruption in the inflows of this capital? So I have briefly 
laid out three separate scenarios.
    One is what I call the benign scenario. Essentially the 
benign scenario occurs and is occurring already with respect to 
the oil producers. The oil producers now are as a result of 
what was up until recently a decline in oil prices and as a 
result of an increased amount of domestic demand and domestic 
investment using a growing share of their surpluses so that 
their trade surpluses which were over 500 billion in 2006 are 
likely to be under 400 billion this year and under 300 billion 
in 2008 which means they will have less investable savings, 
less net export of savings to provide our markets.
    And the same thing could occur in other countries. If you 
see in China or any other major supplier of capital increase in 
domestic demand and more of their money is used at home, there 
would be less exportable savings. That is a relatively benign 
scenario because it is demand led. It is based on the fact that 
they have more demand for their capital. They invest more at 
home. They grow more rapidly. They buy more American goods and 
they use more of their goods at home.
    That is a good scenario, but it does suggest to us that the 
exportable savings of these countries does have limits and one 
limit is that they may want to use more of their savings at 
home, means there is less available to export to us and other 
    The next scenario is what I call the disruptive scenario. 
If you look at the countries China, Saudi Arabia, Russia, big 
owners of large amounts of reserves and large amounts of excess 
capital, if they were to consciously and abruptly shift a large 
portion away from the dollar market as a result of some 
political conflict or for some other reason, a trade dispute, 
that would have a very adverse impact on our economy because 
others watching them would probably also sell dollar assets 
because they do not want to be the last one through the door.
    And that would push interest rates up rather significantly 
in this country, maybe very significantly, in fact. The dollar 
would decline. The net effect would be a marked slowdown in 
U.S. growth, possibility a recession.
    Now, at some point, other countries and other people might 
come in to buy the cheaper dollar and the cheaper assets, but 
it could take a long time for that to occur. It is like 
catching a falling knife and it would be a very disruptive 
    The third scenario is what I call the highly disruptive 
scenario and that is consider, for instance, a major terrorist 
attack on the United States which struck America's 
infrastructure, for instance, the Port of New York, the Port of 
Long Beach, or a major dirty bomb that goes off in the center 
of a major American city that rendered the city or part of it 
uninhabitable for decades or a disruption in a major airport or 
railway station or subway system through Anthrax which would 
take it out of commission for a long time.
    In such circumstances, foreign investors, particularly 
private sector investors, initially would perceive a 
significant risk of their U.S. investments and might pull money 
out or simply not put any more money in. And the budget 
implications of that would be enormous. The economy would 
weaken, therefore revenues would decline. The government would 
have to spend a lot more money on reconstruction, rebuilding, 
retaliation, recovery.
    And foreign central banks seeing this big increase in the 
budget deficit would either perhaps decide they want to be more 
cautious about concentrating large amounts of additional assets 
into dollars or in some cases decide to withdraw some dollar 
assets which, again, would push interest rates up dramatically 
and have an adverse effect.
    And even if the central banks did not panic and decided not 
to do this, there would be perhaps so much cutting of private 
sector money in the United States or withdrawals that it would 
present a major issue to the central banks to have to work 
together to stem that tide of a collapse of the dollar and an 
increase in U.S. interest rates.
    How much damage would be done would depend in part on the 
fiscal situation of the United States. If we had a very large 
budget deficit at the time and were heavily dependent on 
foreign capital, we would be more vulnerable to this than if we 
were in a strong fiscal situation and we were not as dependent 
on foreign capital and we did not have as much debt.
    So the underlying fiscal situation would have some effect 
on how the markets perceived the impact of such a terrorist 
attack on the American fiscal situation. And I think this is 
worth looking at. The underlying fiscal strength of this 
country would have some impact on how foreigners perceived the 
degree of risk that would occur as a result of such an attack.
    Let me conclude because I know there will be time for 
questions. The book that you have in front of you and that I 
have given a number of members and is on the table in back 
makes one fundamental point that I think is well worth keeping 
in mind. The title of the book is ``The Price of Liberty.'' It 
comes from Hamilton.
    And Hamilton made the point very clearly that there is a 
very close link between the fiscal strength of the United 
States and its national security. He was very much of the view 
that if you want to have the opportunity to borrow at 
reasonable rates during a crisis, a war or some other 
emergency, the country has to be credit worthy so that 
investors see it as a good place to invest their money.
    If the underlying fiscal circumstances are weak as a result 
of bloated budget deficits, for instance, that makes it harder 
for the government to borrow in emergency situations. And if it 
does borrow, it would presumably have to pay a lot more, 
particularly if, as Mr. Cooper indicates, there is a risk that 
there be a downgrading of American assets. That would make it 
even more difficult for the United States to borrow in those 
    So the underlying circumstances of our country, I think, 
would have a major impact on this. And his judgment is if you 
want to have a resilient economy, an economy that can marshall 
resources during a crisis, you cannot wait until the crisis 
occurs to put the economic house in order. It has to be put in 
order beforehand and that gives this country the resilience to 
muster the resources it needs in an emergency and to borrow at 
reasonable rates if such an emergency were to occur.
    Thank you very much, Mr. Chairman.
    [The prepared statement of Robert D. Hormats follows:]

        Prepared Statement of Robert D. Hormats, Vice Chairman,
                     Goldman Sachs (International)

    Mr. Chairman and Members of the House Budget Committee, it is a 
great pleasure for me to appear before this committee to discuss an 
issue of great economic, financial and national security importance to 
our country--the growing dependence of the United States on foreign 
    I have been asked to discuss several aspects of this issue, with a 
focus on the types of events that could lead to a sharp decline or 
reversal of the large amounts of funds that have been flowing into this 
country in recent years.
    A few words of background might help to put this in context. First, 
it is worth noting that the U.S. is, and will remain, heavily dependent 
on foreign capital as long as out country's level of savings remains 
substantially below its level of investment--as it has been for many 
years. That imbalance is possible only if foreign investors--
individuals, institutions and governments--are willing to finance it 
through the acquisition of U.S. assets (including stocks, bonds, real 
estate) or provide direct loans to U.S. entities. The current account 
balance reflects this savings/investment imbalance and thus tracks the 
net inflow of investment funds from abroad into the U.S. In 2006 the 
current account deficit was over $800 billion--roughly 6.5% of the 
nation's GDP.
    The US will continue to be heavily dependent on foreign capital if 
this large domestic savings/investment imbalance continues. For 
example, even if the much focused on increase in the U.S. trade and 
current accounts imbalance with China were to be eliminated tomorrow, 
the U.S. would still experience the same sized imbalance with the world 
as a whole if our internal savings shortage remained the same--only it 
would be shifted to different nations. The nation's aggregate current 
account imbalance, and its dependence on foreign capital, would not be 
reduced. If we wish to reduce our dependence on foreign capital--and 
our vulnerability to its sharp interruption--we need to boost savings 
at home. Without that, the much focused on goal of an adjustment in the 
dollar/Chinese RMB exchange rate, or any other bilateral measure for 
that matter, will have negligible effect.
    A different set of issues relates to where the capital that fill 
the U.S. savings shortfall comes from--and the answer is, increasingly, 
from world's the emerging nations. In recent years there has been a 
dramatic shift in the current account positions of the emerging 
economies. This represents their export of surplus savings to the rest 
of the world--and constitutes a new and unusual feature in the world 
economy. Their growing current account surpluses collectively are the 
major counterpart to the growing U.S. current account deficit.
    It is the enormous amount of net savings in these countries--as 
reflected by their current account surpluses--rather than their 
reserves or central bank purchases of securities per se that enable 
them to be large capital exporters. Although reserves and central bank 
purchases have receive the lion's share of attention, the underlying 
factor in their current account surpluses is this unusually high rate 
of savings. And their surplus savings goes to countries that have the 
largest savings deficits--at the top of the list being the U.S.
    Although the world's largest savers have included a shifting cast 
of nations during the last decade, the vast increase over the last 
three years comes from two sources: China and the major oil producers. 
While China gets most of the attention, and has the largest reserves 
and savings surplus of any nation, collectively the largest increase in 
savings over the last three years has been by the large oil producers 
(such as Saudi Arabia, Russia, Iran, Nigeria and Kuwait), who are 
recycling enormous sums of windfall oil revenues into the world's 
financial markets.
    Recent increases in oil prices caused the value of export revenues 
of these nations to climb from $743 billion in 2004 to $1.245 billion 
in 2006--an increase of $500 billion. About half of that added income 
was spent on imported goods and services and half was recycled back 
into global capital markets. Together these countries had a net trade 
surplus of $533 billion in 2006; but that is expected to fall to below 
$400 billion in 2007 due to lower oil revenues and increasing level of 
imports. China's balance of payments surplus continues to rise at a 
rapid rate and the country recorded a current account surplus of $250 
billion in 2006.
    It is important to recognize that all of the accumulated savings 
and surpluses do not necessarily find their way into the foreign 
exchange reserve holdings of central banks. That occurs when a central 
bank buys dollars, or other foreign currency, with local currency. For 
instance, Saudi Arabia might have a large trade surplus, but unless the 
Saudi central bank buys those foreign currencies up from private 
holders and corporations with its local currency, the riyal, they will 
not be added to its reserves. If a country does intervene in the 
currency markets, e.g. China buys up dollars with its currency, the 
RMB, the dollars are added to its reserves. Much of the reserve 
accumulation of recent years has occurred because foreign central banks 
buy dollars that they earn on the trade account or that come in as the 
result of foreign investment or speculation in their local currency to 
avoid a sharp rise in their currencies vis-a-vis the dollar, and then 
put dollars they buy into dollar denominated assets which they add to 
their reserves.
    All told, as of May, 2007 China's foreign exchange reserves 
amounted to over $1.2 trillion; Japan, $887 billion; Russia, over $250 
billion; and South Korea, $244 billion. Of China's reserves, over $400 
billion is held in the form of U.S. Treasury securities and--based on 
recent estimates--between $300 and $400 billion in the securities of 
U.S. agencies, dollar denominated issues of the World Bank and 
corporate bonds. All told, foreign official holdings of U.S. Treasuries 
are approaching $1.2 trillion. But, it is again worth emphasizing that 
America's dependence on foreign capital--and outstanding foreign 
holdings of American assets--would be just as great if none of the 
dollars in the hands of foreigners were added to central bank reserves, 
but instead remained in private hands.
    The enormous increase in the global accumulation of net savings and 
their investment in the U.S. financial market are key factors 
producing, inter alia, very low real interest rates in this country, 
which in turn has helped to fuel the U.S. housing boom and other 
aspects of growth. They also have been instrumental in narrowing credit 
spreads between the highest rated creditors and lower rated creditors, 
because lower interest rates encourage investors to push money into 
higher yielding assets--usually of lower quality--and thus push down 
interest rates on those securities as well.
               the impact of a reduction in capital flows
    The heavy reliance of the U.S. on capital flows from abroad raises 
the question of the likely impact of a reduction or reversal of those 
flows on the U.S. economy and financial markets. There are several 
possible scenarios for this occurring.
Benign Scenarios
    A relatively benign scenario is already at play among the oil 
producers--not as the result of a any conscious effort to cut off funds 
from the U.S. or any other country but as the result of lower prices 
for their exports (until recently) and their rapidly growing demand for 
imports as they use their added wealth to build new public 
infrastructure and factories and to boost domestic consumption. Their 
trade surpluses are expected to fall from an annual level of $533 
billion in 2006 to under $400 billion this year to under $300 billion 
in 2008, which means they will have less available savings to invest 
    Similar developments are likely to occur in some of the other 
surplus countries, for instance in the emerging markets of Asia, other 
than China. China itself is likely to continue to record substantial 
additional trade surpluses and thus generate substantial amounts of 
excess and exportable savings for several years at least. But even that 
could eventually change as domestic demand grows due to a broadening of 
domestic consumption and purchasing power (as the Chinese government 
seeks to increase living standards in central and western China and 
especially in rural areas which feel left behind by the surge in urban 
prosperity) and improved capital markets that enable the Chinese to use 
more of their large savings at home rather than exporting such a large 
portion abroad. These are rather benign and demand led scenarios--that 
could evolve over time and enable adjustment to be quite smooth. But 
they should also serve as a reminder that the U.S. cannot indefinitely 
relay on abundant supplies of external capital.
    In the case of a gradual decline in net available savings from, 
say, China the impact on the U.S. rest of the world would be gradual--
increasing real interest rates and widening interest rate spreads 
between the best credits and lower rated credits. However, as noted 
above, this would be less of an interest rate story than a demand 
story, as higher domestic demand in China would boost U.S. and other 
nations' exports to that nation and would channel more goods produced 
in China away from the world export market into meeting domestic 
Disruptive Scenarios
    But what if the scenario were less benign? Suppose, for instance, a 
high savings nation such as China or Saudi Arabia or Russia were to 
consciously and abruptly shift a large portion of its funds away from 
the U.S. dollar market and put them into assets denominated in other 
currencies? That risk is often posed in discussions over U.S. 
dependence on foreign capital. The likelihood of China, for instance, 
doing this in current circumstances is very low because such a move 
would be profoundly disruptive to its trade and therefore, to its 
domestic economy. One of the reasons authorities in Beijing have 
adopted a gradual approach to currency revaluation is that too rapid an 
appreciation of the RMB vis-a-vis the dollar would weaken the 
competitiveness of PRC exports in the U.S. and other dollar markets and 
that would slow the growth of jobs in China, risking social unease in a 
nation that has to find new jobs for some 30 to 40 million people 
    But were such a scenario to occur, there would be significant 
implications for U.S. financial markets and the U.S. economy. Let's 
suppose, hypothetically, there were a major dispute that caused a large 
creditor nation to deliberately shift a substantial portion of its 
foreign exchange accumulation to other currencies, such as the Euro. In 
that circumstance, the dollar would drop sharply and interest rates in 
the U.S. would spike, as a savings-short American economy would find 
itself with insufficient funds. As the dollar fell and bonds weakened, 
other investors, foreign and American alike, could sell off dollar 
assets and buy those denominated in other currencies.
    Such measures would cause a sharp drop in bond prices and thus 
higher interest rates as the government and corporations scrambled to 
obtain needed capital. That would produce a market slowdown in U.S. 
growth--or possibly a recession. Of course, as the dollar dropped and 
interest rates rose in the U.S. those countries that were the 
recipients of this new money--the result of investors fleeing dollar 
assets--might well come to see American assets as a desirable 
investment and buy them, helping to reverse the deterioration. But this 
would likely take a lot of time--and considerable damage could be done 
in the interim.
Highly Disruptive Scenarios
    Other scenarios would be even more worrisome. Consider, for 
example, the implications of a terrorist attack on America's physical 
infrastructure--such as a dirty bomb that renders a large section of an 
American city uninhabitable for decades, or incapacitates a large 
American port such as Long Beach or New York, or an anthrax attack in a 
major airport, railway stadium or subway system that takes many months 
to clean up. In such circumstances, foreign investors, particularly 
foreign private sector investors, would perceive a significant risk to 
their U.S. investments.
    One response would be to sell their stocks, causing a plunge in the 
U.S. market--already doubtless rocked by the attack. And the budget 
deficit would widen significantly after such an attack--due to weaker 
revenues resulting from the decline in and disruption of economic 
activity after the attack and the need for tens or even hundreds of 
billions of dollars of added government spending for reconstruction, 
recovery and retaliation. Foreign central banks then might be reluctant 
to add to their already large stock of U.S. government assets, pushing 
up interest rates and thus further harming an already damaged economy.
    And even if central banks did not panic into selling dollars, and 
continued to buy dollar assets at their accustomed pace, private 
holders of dollars might engage in panic bond selling or simply hedge 
by selling dollars for foreign securities. As noted above, not all 
foreign held dollar assets are in the hands of foreign central banks. 
Enormous amounts are held by large financial institutions such as 
insurance companies, pension funds, and corporate treasuries as well as 
by individuals. And many American institutions and individuals might 
engage in similar behavior as they see the dollar drop and bond and 
stock prices fall. Whether a massive joint effort by central banks 
could counter this sharp sell off is highly questionable. And it 
doesn't need to be a terrorist attack to trigger such a calamity; a 
devastating earthquake or a catastrophic hurricane could have similar 
    How much damage would be done, and for how long, would likely 
depend on the soundness of America's fiscal policy and the nation's 
overall financial soundness at the time. It is worth recalling that the 
country had recorded four years of budget surplus before 9/11 and at 
the time was paying down earlier accumulated debt; also it was far less 
dependent on foreign savings than it is today (the current account 
deficit was only 4% of GDP compared to 6.5% today).
    By most projections, this imbalance will grow in the future. 
Sharply rising Social Security, Medicare and Medicaid payments plus 
climbing interest payments on the federal debt will produce bloated 
deficits and rapidly rising debt levels. And given the nation's low 
savings rate, these would entail even greater dependence on foreign 
capital and still greater amounts of dollar holdings in foreign central 
banks and institutional accounts if, in fact, foreigners continued to 
be willing to supply funds abundantly during this period.
    In such circumstances, a catastrophic terrorist attack would be far 
more likely to cause large numbers of foreign investors to curb flows 
of capital to the U.S. or sell off dollar-denominated assets, and to 
cause Americans to do likewise, than were the nation in better 
financial shape--with a budget surplus, a far lower level of domestic 
debt, and less holdings of dollars abroad. Even if there were 
significant central bank cooperation to mitigate the financial 
implications of such an event, the task would be made more difficult if 
this nation's underlying fiscal position had been eroded by a widening 
of domestic and international imbalances.
    Because we know that one of the stated objectives of terrorists is 
to cause massive disruption in the U.S. economy, such financial 
vulnerabilities could lead potential perpetrators to feel that they can 
do a great deal of damage not simply by their initial act, but also 
because of the secondary and tertiary economic disruptions that would 
occur because of the subsequent turmoil in a more vulnerable financial 
environment. In finances as in military affairs, vulnerability 
frequently invites aggression.


    So a key point in determining the implications of such scenarios is 
the soundness of American finances at the time. In the book that many 
of you have before you, The Price of Liberty: Paying for America's 
Wars, I trace the history of American wartime financing from the 
Revolution, through the War of 1812, the Civil War, the two World Wars, 
and the Cold War to the present.
    Alexander Hamilton recognized from the very beginning that 
America's financial strength was vital to its security. If the country 
did not manage its finances well, he reasoned, it would not have the 
resources needed to defend itself in time of war and it would lose 
credibility in the eyes of creditors, making borrowing in time of war 
or other national emergency all the more difficult. He was especially 
zealous about maintaining the confidence of foreigners, whose funds had 
been critical to the Continental Army's success in the Revolution. 
Failing to retain their confidence, he surmised, would mean that they 
would be reluctant to lend the nation money in a crisis, rendering its 
economy vulnerable to disruption and perhaps depriving it of the 
resources to defend itself.
    Over two centuries have passed since Hamilton held office, but 
these principles are just as relevant today. And indeed this nation is 
more dependent on foreign capital during this war than during any in 
our history.
    The Iraq War is the first significant conflict during which the 
U.S. has not raised taxes, cut non-security domestic spending and has 
relied so heavily on foreign funds to finance its budget deficit. 
During all other major wars, taxes were increased, non-security 
programs were cut substantially, and borrowing was financed almost 
entirely by Americans. While the current war represents only a small 
portion of GDP--around one percent per annum compared to World War II, 
over 35%; the Korean War, over 10%; and the Vietnam war, a bit less 
than that--it soon will become the second most expensive war in 
American history, second only to World War II. It represents such a 
small portion of GDP because the underlying economy has grown so 
dramatically during the last 60 years.
    But that does not mean that future funding for national security 
will be easy.
     First, as after the Vietnam War, there will be demands for 
a large ``peace dividend'' after the U.S. leaves or downsizes in Iraq;
     Second, many national security needs--of the military, the 
intelligence community and homeland defense--have been postponed as the 
Iraq War has sucked up roughly $100 billion annually in budget 
resources. Many of these will need funding in the future;
     Third, the government will have a large bill to meet the 
medical needs of wounded veterans for decades to come;
     Forth, entitlement payments will grow dramatically in the 
next decade, possibly squeezing down the discretionary portion of the 
budget, of which defense constitutes the single largest component. If 
that is to be avoided, taxes will have to rise and/or borrowing will 
have to increase; and,
     Finally, if the U.S. remains a savings short economy and 
borrowing needs rise due to increased entitlement payments and growth 
in other areas of the budget, dependence on foreign funds will 
increase, adding to the county's vulnerability in the face of a 
disruption of such funds.
    All of this suggests that reliance on foreign capital will increase 
and that as this nation attempts to meet its domestic social agenda and 
its national security agenda we run the risk of greater vulnerability 
to a disruption in the flow of foreign funds. Stepping up to the hard 
realities of putting our entitlement programs on a more sustainable 
footing, developing a multiyear strategy to fight the War on Terror and 
meet other security needs, while ensuring the fiscal resilience to 
address unexpected demands on our nation, will be a major challenge for 
this and future Congresses and for the next president.

    Chairman Spratt. Dr. Levy.

                    STATEMENT OF MICKEY LEVY

    Mr. Levy. Yes, Mr. Chairman. Thank you very much for the 
opportunity to speak today.
    The debate about the high U.S. current trade account 
deficits have been going on for quite a while, many decades. 
The long-standing concerns about the current account imbalances 
and that they would cause severe damage to the U.S. economy 
have not unfolded. They are overstated. And I think one of the 
reasons why they are overstated is so many people in the United 
States think parochially and they do not think about what is 
going on in the world.
    In fact, foreign capital inflows have fueled economic 
growth. If you look over the last couple decades or through 
history, rising trade and current account deficits occur when 
the U.S. economy is strong, when there is stronger job 
creation, when there is stronger investment.
    Now, I would say that these will not unhinge the economy as 
long as international trade and capital is allowed to flow 
freely, the U.S. dollar is allowed to fluctuate, and the policy 
makers, both the monetary and the fiscal policy makers, pursue 
low inflation, pro-growth economic policies.
    Now, the debate about fiscal policy should not be 
influenced by the current account deficit. If you look at the 
U.S. or if you look at other countries like Japan and Germany 
that have budget deficits higher than the U.S. but large 
current account surpluses, the twin deficit framework does not 
work. They do not hold water. They do not move in tandem.
    What fiscal policy makers have to do is address what they 
are capable of doing and that is address the long-run unfunded 
liabilities, particularly the entitlement programs.
    Efforts to adjust fiscal policy to reduce the current 
account deficit without considering how the changes in fiscal 
policy, that is the tax spending structures underlying the 
deficit changes or the allocative impacts of those on the 
economy could lead to undesirable side effects not just in the 
U.S. but internationally.
    Now, if the world, if every country had about the same rate 
of economic growth, same rate of savings, same rate of 
investment, imbalances would be minor. But the reason why we 
have imbalances around the world is countries are growing at 
different rates, different rates of saving, different rates of 
    The U.S. for about 15 years straight grew dramatically 
faster than all of Europe and Japan, from 1990 until 2004. 
Capital flowed in to the strong United States. At the same time 
as Europe, particularly Germany and Japan languished, they had 
excess saving relative to weak investment opportunities. They 
had excess saving and they had to do something with that 
    Now, more recently China, India, other countries have 
accumulated large amounts of assets. They are excess savers. 
Now the OPEC nations and Russia are also excess savers. The 
excess savers that invest in the United States do not do so to 
bail out the United States. They do so because it is in their 
economic best interest to do so.
    And I would like to touch on that a touch more. They 
voluntarily invest in U.S. assets. And I must note in my 
position, I am able to sit down with the heads of portfolios of 
all the leading central banks around the world and a lot of the 
private investors as Bob does also. And what I find is they are 
absolutely economically rational in over-weighting ownership of 
dollar denominate assets. They have no intention of changing. 
They are attracted by the U.S.'s rule of law, historic 
stability, high interest rates, et cetera, et cetera.
    So once again, it is not just that the U.S. benefits 
because if we did not have capital inflows, our investment 
would be constrained to saving and we would not have the same 
pace of economic growth or job creation or investment or 
economic future. But foreigners who invest in the U.S. benefit 
just as much.
    The decades long worries that foreign investors are 
abruptly going to pull out of U.S. assets, they are just 
absolutely misplaced. The reason why they are misplaced is they 
do not think about it from the other side of the balance sheet. 
What do excess saving nations do with their excess saving?
    Now, if you take the central banks that have accumulated a 
tremendous amount of assets and have to invest internationally, 
they respond to the same variables that we do in the U.S. What 
drives interest rates are U.S. economic growth, inflation, and 
the Federal Reserve's inflation fighting credibility, fiscal 
policy and fiscal credibility, and they make their investment 
decisions the same as U.S. investors.
    And I just ask the following question. Do you think we 
would be any less vulnerable if our U.S. debt were held by 
leveraged hedge funds or pension funds for all U.S. managers?
    Think of the following. Over the last six, seven years as 
the U.S. publicly-held debt has increased and a large portion 
of it has been bought by foreign sovereign institutions, real 
interest rates have been low. Our cost of financing the deficit 
has been very, very low. They have actually gotten the short 
end of the stick because not only have they gotten higher 
interest rates than they would in other industrialized nations, 
but they have also incurred a weaker dollar.
    I would also note that the financial variables that are 
crucial to a sound U.S. economy like interest rates, corporate 
bond yields, the stock market, foreign exchange, these are 
driven by economic and inflation fundamentals.
    Once again, foreign investors, be them private investors or 
foreign central banks, they are affected by the same day-to-day 
fluctuations. They respond to the same economic data. And what 
would lead them to shift would be a significant change in 
policy that led them to believe there would be a decline in 
their expected rate of return on dollar denominated assets.
    Now, earlier Congressman Edwards and others said, well, 
what if China sells all their U.S. Government debt. Well, it is 
not going to happen, but let us speculate, just hypothesize it 
did. They would be hurt more than anybody else, including the 
U.S. Maybe Japan would be hurt more because the dollar would 
fall and the mark to market on their asset books would get 
    Now, the initial response may be a rise in interest rates. 
Okay? Other investors around the world, including hedge funds 
in Chicago and Los Angeles and London, would jump on the higher 
interest rates and buy. And while there would be higher 
volatility in the short run, rates would not be that much 
    And some of the discussion about just static analysis, what 
would happen, do you think, not to use names, but do you think 
Goldman Sachs or Bank of America portfolio managers would sit 
on the sidelines if rates went through the ceiling while the 
economy is growing moderately and the Fed is doing a great job 
keeping inflation under control? Absolutely not.
    So, yes, you would have higher volatility, but I would 
emphasize the point that the United States benefits by net 
foreign capital inflows. It always has through history. It will 
continue to do so. Foreigners that have excessive saving 
benefit by being able to invest in the United States.
    And let me make one other point here. There is also a lot 
of concerns that the recent decline in the dollar could push up 
inflation. Not so. The Federal Reserve is the gatekeeper on 
inflation. As long as it follows low inflation, monetary policy 
with credibility, the lowered dollar will not push up 
inflation. It will change relative prices.
    And all you have to do is look at the pricing behavior of 
European, say, auto exporters to the U.S. as the dollar has 
fallen about 25 percent. They have not increased prices 
materially and the reason is the Fed has been doing a very good 
    So let me just wrap up here. We have imbalances around the 
world. The imbalances reflect imbalances in economic growth. It 
just so happens that the U.S. rate of economic growth has 
slowed while Germany and Japan have maintained their momentum. 
So rates of growth among industrialized nations are narrowing 
and the trade deficits actually started to come down as has the 
current account deficit.
    If you look at it from both sides of the balance sheet, it 
is not that big a problem, but let me just conclude by saying 
we live in an internationalized world. It is imbalanced. And 
the trade deficit which, by the way, the trade and current 
account deficit soared during the Clinton years. That is good 
because it was associated with economic strength and job 
creation and investment. Okay. That is actually good. So it was 
    But I would just conclude by saying the fiscal policy 
makers should address the long-run problem. And let me give you 
the best example of how you should think about how fiscal 
policy should not be considered in the context of the current 
account deficit.
    The best fiscal policy you can come up with now is a 
meaningful reform of the long-run entitlements. Okay? If it is 
properly structured to grandfather in changes in the benefit 
structure, it will not have any benefit. It will not do 
anything to the current account or trade deficit in the near 
term, but it will still be the best thing for the nation in the 
long run.
    And let me just conclude by saying I think it would 
increase Congress' credibility to come up with a long-run 
    [The prepared statement of Mickey Levy follows:]

         Prepared Statement of Mickey D. Levy, Chief Economist,
                            Bank of America

     The debate about the high U.S. trade and current account 
imbalances--and worries about their dire consequences--has been going 
on for decades. Long-standing concerns that these imbalances will 
severely damage U.S. economic and financial performance have not 
unfolded and are overstated. The foreign capital inflows have fueled 
U.S. economic growth, and contributed to job creation and business 
investment, homeownership and higher standards of living. The large 
U.S. current account deficit and foreign accumulation of U.S. debt will 
not unhinge the U.S. economy, as long as international trade and 
capital are allowed to flow freely, the U.S. dollar is allowed to 
fluctuate and the U.S. policymakers continue to pursue low inflation 
pro-growth economic policies.
     The debate about fiscal policy should not be influenced by 
the debate about the U.S. current account deficit. Sustained healthy 
economic performance requires coming to grips with the long-run Federal 
budget imbalance, which requires reforming the entitlement programs by 
making their benefit structures economically rational and fair. 
Delaying necessary reform only increases the eventual cost of 
adjustment. Fiscal reform must focus on improving U.S. government 
finances and making them conducive to maximum sustainable economic 
growth. Efforts to adjust fiscal policy to reduce the current account 
deficit without regard to how changes in the structure of the 
underlying tax and spending programs would affect economic performance 
are unwise and could generate unintended and undesirable economic and 
financial side effects.
     History shows that budget imbalances and current account 
imbalances do not move in tandem in the U.S. or overseas. The so-called 
``twin deficit'' framework is not a rational basis for conducting 
fiscal policy or for thinking about global imbalances. Currently, the 
U.S. budget deficit is 1.3 percent of GDP while its current account 
deficit is 5.6 percent; both Japan and Germany have large current 
account surpluses (3.9 percent and 5.1 percent, respectively) despite 
running budget deficits (Japan's is 5.8 percent of GDP).
     The U.S. trade and current account imbalances and the 
large current account surpluses overseas and the large net 
accumulations of foreign holdings of U.S. debt have been a natural 
consequence of global differences in rates of economic growth, 
investment and saving. From the early 1990s through 2005, the U.S. 
economy expanded significantly more rapidly than other industrialized 
nations, raising demand for capital and imports. The U.S. has 
insufficient national saving relative to investment. Until recently, 
foreign industrialized nations have grown more slowly, both in terms of 
GDP and investment, dampening their demand for imports and capital. 
China, other Asian nations and more recently, OPEC nations as well as 
Russia, benefiting from higher oil prices, have excess saving relative 
to investment. The capital inflows into the U.S. from excess saving 
nations--largely through their accumulation of U.S. debt--provide the 
U.S. capital necessary to continue healthy economic expansion.
     Foreign assets owned by the U.S. have risen, but U.S. 
assets owned by foreigners have risen more rapidly, so the U.S. net 
foreign debt is $2.5 trillion. U.S. ownership of foreign assets is 
heavily in equity and direct investment, which provides relatively high 
returns, while foreign investment in U.S. assets is largely in U.S. 
debt securities, which provide relatively low yields. Consequently, the 
U.S. net international income position is near balance.
     Foreign investors, including Asian central banks, which 
have accumulated over $2 trillion of foreign currency reserves, 
voluntarily invest their surpluses heavily in U.S. assets. Their 
investment decisions are economically rational: they are attracted by 
the U.S.'s rule of law and historic stability; healthy economic 
performance and relatively high real interest rates; low inflation and 
credible central bank; and liquid markets. Excess saving nations 
benefit just as much from their investments in U.S. dollar denominated 
assets as the U.S. benefits from the net foreign capital inflows. U.S. 
and global economic growth and standards of living are improved by 
capital that flows internationally from excess savers to high expected 
rate of return activities.
     Decades-long worries that foreign investors will abruptly 
sell their U.S. assets are misplaced. Such concerns tend to ignore the 
objectives and needs of excess savings nations, and what drives their 
investment decisions and behavior. Foreign investors, including central 
banks, seek high risk-adjusted rates of return. Foreign nations that 
have accumulated U.S debt will not shift out of dollars quickly in a 
way that would jar financial markets unless there is a dramatic shift 
in economic fundamentals, or shifts in U.S. policies perceived to be 
damaging to U.S. economic or financial performance. A jarring shift out 
of U.S. dollars likely would damage foreign owners of U.S. assets as 
much as it would damage the U.S.
     Financial variables that are crucial to sound U.S. 
economic performance, including interest rates, corporate bond yields, 
the stock market and foreign exchange rates, are driven primarily by 
fundamental U.S. and global trends in economy and profits, inflation, 
and central bank and fiscal policy. Investment decisions by foreign 
holders of U.S. assets may temporarily affect financial markets, just 
as decisions by U.S. investors do, but they do not influence Fed 
behavior or inflation or how the U.S. economy performs.
     Foreign investors are subject to many of the same 
economic, inflation and financial market fluctuations as U.S. 
investors. Their investment behavior is at least as stable as that of 
U.S. investors, and their ownership of U.S. assets does not raise the 
risk or vulnerability of U.S. economic and financial market performance 
any more than if those assets instead were owned by U.S. pension funds, 
money managers or hedge funds.
     Concerns that the recent decline in the U.S. dollar will 
push up U.S. inflation and damage financial markets and the economy are 
misplaced as long as the Federal Reserve pursues a credible low 
inflation monetary policy. Under a low inflation monetary policy 
regime, even if the U.S. dollar continues to fall, relative prices 
would change, and real interest rates may rise modestly, but inflation 
would not be pushed up. It is inappropriate and misleading to assert 
that current U.S. dollar weakness will have a similar impact as the 
1970s when the Fed was pursuing an inflationary monetary policy.
     The U.S. trade and current account deficits have begun to 
recede from their peaks, and I expect they will decline materially, 
particularly as shares of GDP. The U.S. demand for capital and imports 
has slowed in response to the recent soft-patch in U.S. domestic 
demand, while its exports are growing rapidly, driven by strong global 
growth and the weak U.S. dollar. The economic momentum in Japan and 
Europe (particularly Germany), which reflects in part structural 
improvements, is narrowing economic growth differentials among 
industrialized nations and increasing expected rates of return on Euro- 
and yen-denominated assets. Accordingly, the growth of foreign demand 
for U.S. assets has slowed, while the U.S.'s financing gap between 
national saving and investment has begun to recede.
     The government's net costs of servicing debt owned by 
foreigners have been low, and concerns are misplaced. My largest 
concerns are not the magnitude of the global imbalances or the foreign 
accumulation of U.S. government debt, rather the potential for 
wrongheaded policies that would interrupt international trade or 
capital flows, or domestic policies that would damage U.S. growth 
prospects and reduce expected rates of return on U.S. dollar-
denominated assets.


    If the U.S. and other major nations had similar rates of economic 
growth, investment and saving, global imbalances would be minor. But 
they do not. The rising U.S. current account imbalances are largely the 
story of the relatively stronger U.S. growth from 1990-2005 and global 
demand for U.S. assets. This has happened before; the U.S. has 
experienced long periods of relative economic strength simultaneous 
with large net capital inflows and wide current account imbalances (the 
best example is the U.S. industrial revolution). In recent decades, 
periods of rising current account deficits have been associated with 
strong growth in GDP, investment and jobs, and rising homeownership. 
This should not come as a surprise: foreign capital flows into the U.S. 
when it is strong, investment and employment are rising and expected 
rates of return are high. The only periods recently when the U.S. trade 
and current account deficits declined occurred when GDP slumped and 
employment fell.
    From the early 1990s, when the U.S. current account was in balance, 
through 2005, the U.S. economy grew persistently faster both in terms 
of nominal and real GDP growth and investment than all other 
industrialized nations (see Chart 1). The growth differentials were 
sizable and cumulative. Consequently, U.S. imports of goods and 
services rose significantly faster than foreign demand for U.S. 
exports, and demand for U.S. assets rose, so the U.S. current account 
deficit rose commensurately (see Charts 2 and 3). Until recently, the 
economies of Germany and Japan languished, and so did their imports. 
Reflecting this, they ran high trade and current account surpluses. 
That is, they had excess saving relative to investment, and were 
unattractive to foreign investment flows.
    Noteworthy, Japan has run high current account surpluses, despite 
huge government budget deficits. Its budget deficit is nearly four 
times higher than the U.S.'s and its government debt is approximately 
170 percent of GDP, more than four times higher than the U.S.'s 37 
percent. This is not surprising: for over a decade, Japan's economy and 
investment languished, and it attracted little foreign capital inflows; 
its saving far exceed investment and it was a sizeable exporter of 
capital. Devotees of the so-called ``twin deficit'' paradigm should 
heed the message provided by this international comparison.
    The composition of U.S. imports illustrates the strength of U.S. 
businesses as well as consumer spending growth: presently, 40 percent 
of U.S. goods imports (and 33 percent of total U.S. imports of goods 
and services) are industrial supplies and capital goods used for 
business production and expansion (see Chart 4). Those shares rose 
during the 1990s. It is inappropriate and misleading to place all of 
the blame on the U.S. consumer for rising imports and trade and current 
account deficits.
    The rising current account deficit in the 1990s illustrates both 
the widening gap between U.S. investment and saving, and the strong 
foreign demand for U.S. dollar-denominated assets. They both occurred 
simultaneously: as global demand for U.S. assets rose--modestly through 
the mid-1990s and then jumping during the 1997 Asian crisis--capital 
availability and rising asset prices fueled U.S. domestic demand. 
Consumption and business investment rose rapidly--and U.S. saving fell 
further behind surging investment. The U.S. current account deficit, 
which rose to approximately 1.5 percent of GDP by mid-1997, jumped 
dramatically to 4.5 percent by year-end 2000 (see Chart 3). Yet the 
U.S. dollar appreciated even as the current account deficit rose 
because foreign capital readily flowed into the U.S. seeking high risk-
adjusted rates of return.
    The rate of net national saving was flat during the 1990s, as high 
business saving and a shift from the government's cash flow deficit to 
surplus was offset by the declining rate of personal saving. Despite 
the lower rate of personal saving, the real net worth of households was 
rising with the appreciation of real estate and the stock market. 
Households felt richer and more confident and so they spent a larger 
portion of their take-home pay. The rate of personal saving, which only 
measures the portion of disposable personal income that is spent, does 
not capture appreciation of real estate or stocks or bonds, and as such 
is a very limited--and misleading--measure of saving.
    New Dimensions in Global Imbalances. The trends in global trade and 
current account imbalances so far this decade reflect new dimensions in 
global economic performance and international trade and capital flows. 
First, the U.S. recession in 2001 and associated slump in investment 
and domestic demand that carried into 2002 reduced the demand for 
imports, which temporarily lowered trade and current account deficits. 
Import growth subsequently resumed, contributing to a surge in the 
trade deficit through 2005. While the trade imbalance has continued to 
rise in nominal terms, in real terms it has begun to drift down, and as 
a percent of GDP, it peaked at 5.7 percent in 2005Q1 and has receded to 
5.3 percent in 2007Q1. This reflects in part slower import growth since 
early 2006 that has been associated with weaker consumer and business 
spending growth in response to the Fed's interest rate hikes and the 
adjustment in housing.
    Second, global economic growth has strengthened and international 
trade has been growing rapidly. U.S. exports have risen over 8 percent 
annualized, and the U.S. remains the world's largest exporter of goods 
and services. The U.S. maintains a healthy ``competitive edge'' in a 
wide array of industries, and is well positioned, both in terms of what 
it exports and to where it exports, for export growth to remain strong 
(see Charts 5 and 6). Importantly, the economic momentum in Japan and 
Germany reflects structural improvements that will sustain healthier 
growth. These trends abroad are contributing to narrower economic 
growth differentials among industrialized nations, and increasing the 
attractiveness of investing in Europe and Japan. In turn, they will 
serve to narrow global imbalances.
    Third, Asian nations have been large net savers and have 
accumulated foreign currency reserves at an historic pace (see Tables 1 
and 2). Combined they have become the world's largest exporters of 
capital, which is a twist on history insofar as some of them, most 
notably China, are relatively poor nations in terms of GDP per capita 
but also growing rapidly. The largest portions of their surpluses have 
been invested in U.S. debt securities.
    Fourth, China has emerged as a dominant global factor in both 
international trade and finance. As a major manufacturing hub that 
imports supplies and materials, and produces and exports finished 
products, it runs trade deficits with most other Asian nations, and 
huge trade surpluses with the U.S. (presently, approximately $220 
billion) and Europe. Benefiting from its surging trade surpluses, high 
foreign direct investment and extraordinarily high rate of saving, 
China has accumulated approximately $1.2 trillion in currency reserves.
    Fifth, benefiting from the dramatic rise in oil prices since 2004, 
OPEC nations and Russia have become large excess savers. In the last 
several years, the cumulative rise in surpluses by these nations has 
been dramatic (see Table 3). The fact that global oil transactions are 
conducted in U.S. dollars is a key factor explaining the large share of 
these surpluses that have been accumulated in U.S. dollar-denominated 
    Stronger growth in Europe and Japan, and more moderate growth in 
U.S. domestic demand, and associated narrowing in real interest rates 
(as the European Central Bank and Bank of Japan have continued hiking 
rates, narrowing the gap with the Federal funds rate) and expected 
rates of return on investment will generate a narrowing of the U.S. 
trade and current account deficits.


    U.S. economic and financial performance has benefited from the 
nation's ability to run high current account deficits. The economy is 
no more vulnerable as a result of the foreign accumulation of U.S. debt 
than if that debt were owned by U.S. pensions, money managers or hedge 
funds. Reliance on net foreign capital inflows allows the U.S. to 
leverage its resources and economic strengths. If U.S. investment were 
constrained to national saving, there would be insufficient investment, 
and economic growth, job creation and standards of living would be 
lower. Similar to U.S. corporations that borrow to leverage their 
resources and expansion, the key to the sustainability of the current 
account deficits is what the net capital inflows are used for and what 
is the rate of return on the capital relative to the costs of financing 
it. Historically, the benefits have far exceeded the net costs.
    The majority of U.S. assets owned by foreign investors are debt 
securities, primarily U.S. government and agency debt (see Charts 7 and 
8). This is particularly true of U.S assets held by foreign central 
banks. While foreign holdings have increased substantially as a share 
of outstanding U.S. government debt, foreign purchases of U.S. equity 
and direct investment are minor relative to the dramatic rise in 
household and corporate net worth (see Chart 9). According to the 
Federal Reserve's Flow of Funds Accounts of the United States and the 
Bureau of Economic Analysis, foreign ownership of U.S. equity assets 
and direct investments total $4 trillion, compared to U.S. household 
net worth of $56.2 trillion.
    Rather than be concerned about the increased foreign ownership of 
U.S. government debt, Congress should be thrilled with the highly 
favorable outcome: the government's real costs of servicing the debt 
have been very low, and the capital inflows have facilitated stronger 
U.S. economic growth. So far this decade, when foreigners have 
accumulated U.S. government debt rapidly, yields on U.S. government 
bond have been below their longer-run average in nominal and real 
terms. The real government bond yields have been far below real GDP 
growth, while profits and real household net worth have grown 
significantly faster than output and the unemployment rate has receded. 
Clearly, the net returns on the foreign purchases of U.S. government 
debt have been highly favorable.
    Foreign purchasers of U.S. government bonds generally have not 
fared as well. Foreign holders of U.S. government debt receive a yield 
on their bonds with virtually no credit risk but they do have interest 
rate and currency risk. In reality, they do not own claims on future 
U.S. economic performance. Although yields on U.S. government bonds 
have been significantly higher than yields in other industrialized 
nations, net real returns to foreign purchasers of U.S. government debt 
have been reduced by the decline in the U.S. dollar. In contrast, 
foreign purchasers of U.S. private assets--bonds, equity or direct 
investments--own claims on returns from U.S. production, and have 
enjoyed higher rates of return. A reallocation of foreign owned U.S. 
assets away from government debt and into equities and direct 
investments would generate higher returns but would involve higher 
    U.S. purchases of foreign assets, in contrast, have provided 
substantially higher yields, based on the significantly heavier 
weighting in equity and direct investments, sharply appreciating global 
asset values, and the decline in the U.S. dollar.
    Concerns about heightened economic vulnerability arising from 
foreign accumulation of U.S. government debt hinge in part on an 
assumption that foreign investors have significantly different 
objectives than U.S. investors. In reality, their objectives are 
similar: they seek high expected rates of return on a risk-adjusted 
basis. They base their investment decisions on the same fundamentals as 
U.S. investors: indicators of economic performance, inflation, 
expectations about Federal Reserve behavior, and the soundness of 
fiscal policy. They have little sway over how those variables behave. 
In practice, particularly in the case of foreign central banks, foreign 
holders of U.S. debt tend to be less leveraged and more ``buy and 
hold'' type of investors than their U.S. counterparts.
    I am hard-pressed to see any heightened vulnerability arising from 
foreign ownership of U.S. debt. Expectations of a sharp decline in the 
U.S. dollar would temper the foreign demand for U.S. assets. However, 
U.S. bond yields exceed those in other major industrialized nations 
(except the UK), and U.S. markets are attractive for other reasons. 
Over time, if overseas industrialized nations maintain their healthy 
economic expansions, and as financial markets in emerging nations 
mature and become more liquid, foreign investors may gradually reduce 
their shares of assets allocated into U.S. dollars. That is not a cause 
for alarm. As long as U.S. economic performance remains sound, the Fed 
maintains its inflation-fighting credibility and other polices are 
conducive to healthy growth, foreign demand for U.S. government debt 
will remain healthy.

                      NOTES ON U.S. FISCAL POLICY

    The primary problems with Federal government finances are not 
short-term cash flow issues. The Federal budget deficit is estimated to 
be approximately 1.3 percent of GDP in Fiscal Year 2007. Tax receipts 
have risen above 18.5 percent of GDP, modestly above their long-run 
average, and spending growth has slowed. The Congressional Budget 
Office projects that under current law, the budget returns to 
surpluses. Presently, despite the enormous jump in defense and national 
security spending, the U.S. budget deficit is among the lowest of all 
industrialized nations, and U.S. government debt as a percent of GDP is 
far below other nations (see Charts 10 and 11). With the U.S. deficit 
declining as a share of GDP and well below government interest rates, 
the debt/GDP ratio is projected to decline in the near term.
    However, the longer term outlook for government finances is 
distinctly negative. Top fiscal policy priorities are entitlement 
reform, which is necessary to close the long-run gap posed by the 
unfunded liabilities of the government's retirement and health care 
programs, and tax reform. Based on current law benefit and tax 
structures and reasonable economic and demographic assumptions, the 
long-run projected unfunded liabilities of the social security and 
Medicare systems are so enormous--the present value of the gap between 
projected long-run benefits and taxes is estimated to be approximately 
6 percent of GDP--that reform requires modifying benefit structures to 
make them economically rational. Tax hikes to close the gaps would be 
so large they would damage economic performance.
    Fiscal policy decisions about the entitlement programs must be made 
based on sound economics, and not arithmetic modifications to long-run 
projections that ignore the allocative impacts of the tax and spending 
changes. Changes to social security must be phased in so that older 
workers have time to adjust their retirement plans, and they must be 
fair. American citizens expect eventual reform because they sense that 
the current benefit structure cannot be sustained. Congress's 
credibility will rise when it successfully tackles the issue. Reforms 
of Medicare and Medicaid are even more imperative and will be more 
difficult to achieve. Successful reform necessarily will involve the 
introduction of incentives that influence the supply of and demand for 
medical services.
    Tax policy must deal with the unintended, increasing burden imposed 
by the Alternative Minimum Tax, the extraordinarily burdensome 
complexity of the personal and corporate tax systems and the phasing 
out of key provisions of the 2001, 2002 and 2003 tax legislations.
    The details of both entitlement and tax reform are far beyond the 
scope of these hearings. But the starting point for success requires 
that fiscal reform must be aimed at improving the government's domestic 
finances consistent with sustained healthy economic performance, and 
not for the explicit purpose of trying to reduce the current account 
deficit. The U.S. current account is affected by numerous factors 
beyond the scope of fiscal policy--including differing rates of 
economic growth, investment and saving around the world, demographics, 
and inflation--which explains why there is no reliable linkage between 
budget imbalances and current account imbalances. I encourage Congress 
to pursue sound fiscal policies that will strengthen long-term U.S. 
economic performance, and to reassess the premises of many concerns 
about the U.S. current account deficit and the holders of government 

    Chairman Spratt. Thank you, Dr. Levy.
    Dr. Rogoff.


    Mr. Rogoff. Thank you, Mr. Chairman, and thank you to the 
Committee for inviting me to testify here.
    I want to just start by framing the issue a little bit 
differently. There has been a lot of discussion about how much 
U.S. debt is held by foreigners. But, of course, as many of you 
have pointed out, we have a giant, very liquid, very healthy 
capital market.
    And I think the real number to think about is not the 2.2 
trillion but the $14 trillion that foreigners hold overall in 
U.S. assets, in equity, direct foreign assets, and other 
liabilities. That is the real number that matters.
    Of course, on the other side of the balance sheet, we hold 
about 11 trillion in assets, abroad less. We are net debtors. 
However, because we are much better financial managers, we are 
much more innovative, it is a very strong sector of our 
economy, we actually earn about as much money on our 11 
trillion on average as they earn on their 14 trillion.
    And that is part of the reason the problem has not spun out 
of control faster, that we have gotten a good rate of return. 
In fact, in recent years, and then this is more of a 
coincidence, due to circumstances like the dollar going down, 
foreign stock markets rising particularly faster, U.S. net debt 
has actually grown quite a bit more slowly than you would think 
from looking at the trade balance. The trade balance is about 
700, 750 billion, but the net debt has been going up at only 
half that rate. That probably will not continue.
    And certainly I think the point to underscore is that, you 
know, this is part of a much larger picture which is 
fundamentally a very healthy one for the United States, that 
financial globalization is something we benefit from a lot.
    Now, I do think there is an awfully strong case to improve 
our tax system and both Dr. Hormats and Dr. Levy have mentioned 
the entitlement system. And I could not agree more.
    I would add to that the tax system has gotten more complex 
and probably less equitable in recent years. And I wish we 
would see a big tax simplification, something like the flat 
tax, a consumption tax, which I think would do a lot to help 
savings. And I think a combination of those things is really 
needed and would address a lot of the underlying concerns.
    Now, in my testimony, I took to heart the title you gave us 
which is, is our economy vulnerable, so I went through some 
doomsday scenarios, largely sarcastically, I suppose, or 
dismissing them because I do not think the really worst ones 
are that big a concern.
    I mentioned the China one which has already been discussed 
here and everyone has made the point they shoot themselves in 
the foot. It is not really an issue.
    There is a rise of what are called sovereign wealth funds 
where, you know, China has $1.2 trillion in assets. They are 
getting a little tired of holding Treasury bills which do not 
pay much. And they are starting, all of the big foreign 
official holders, are moving more into higher return assets. 
And, of course, the most spectacular recent investment was 
China buying part of the Blackstone IPO.
    I think there is a potential here to have some financial 
debacles simply because although the previous speaker assures 
us, you know, that they behave very rationally, I think maybe 
the ones that are smart enough to be talking to him may be 
behaving rationally, but there is a lot of nontransparency, bad 
    And I have no doubt that given the explosion of financial 
markets, we will see some, you know, financial tales that will 
surpass anything we have seen before. But I do not think it 
will bring down international financial markets. It will more 
likely bring down the country and possibly the government that 
is the instigator.
    And I might add in the meantime our very successful 
financial sector will probably make even more money off of 
these guys while they are investing in these sovereign wealth 
funds. Governments have a terrific record of losing money when 
they go against the private sector. And I am convinced that 
will continue.
    And then finally, just, you know, forgive me, but I asked 
the question because I took your title very literally, should 
we think of any really crazy things we should worry about and I 
remember Goldfinger where he, of course, tries to corner the 
gold market. And we have the Hunt brothers in the 1980s.
    And I think actually the deeper financial markets that we 
have probably make us more robust to these things than we used 
to. It is not easy to corner the commodity markets anymore.
    However, although some of these doomsday scenarios, I 
think, are unlikely and not such a great concern, although more 
transparency, better regulation, I mean, the usual things is a 
good idea. And I think this is a growing issue when you are 
dealing with some of the sovereign wealth entities.
    I do think our foreign borrowing is a vulnerability if we 
are forced to tighten our belts quickly. And I will just start 
with Dr. Hormats' third scenario because that is the kind of 
one that worries me where we have something really catastrophic 
happen here. And then all of a sudden, the fact that we are 
borrowing $800 billion and suddenly we do not seem that 
attractive, that is a real problem.
    Now, when foreigners just try to simply get their money 
out, it will drive equity prices down. It will affect bond 
prices. But, frankly, our economy is pretty resilient to that. 
We are very widely spread. I mean, there will be losses, but we 
are resilient to that.
    We are not so resilient to all of a sudden not being able 
to borrow this fresh new money, this $800 billion that we get 
every year. I would regard this borrowing as a vulnerability, 
and I strain. I cannot think of a really good analogy.
    But I mean, since we are talking about soft landing and 
hard landing, you know, if you are parachuting down from a very 
high level and, you know, you are aimed at a nice soft patch of 
land, fine, you will land softly. But if a gust of wind comes 
along, you can be in trouble.
    It is a ten-year landing here, fifteen-year landing from 
this soft landing scenario that Dr. Orszag talked about at the 
beginning and we are vulnerable.
    And I think that as Dr. Orszag emphasized, starting to 
think about policies which would increase our national saving 
sooner rather than later and working in coordination with 
international agencies like the International Monetary Fund to 
try to promote policies in other countries that would help 
improve the scenario is something that is important to think 
    Now, and, again, to echo Dr. Hormats, you know, I mean, 
when something happens, it is too late and this is a 
vulnerability. And the fact that we live in this great world 
does not mean it will not happen.
    Argentina is doing great now. I promise you they will have 
another default, but they are not worried about it right now.
    Thank you.
    [The prepared statement of Kenneth Rogoff follows:]

  Prepared Statement of Kenneth Rogoff, Thomas D. Cabot Professor of 
 Public Policy and Professor of Economics, Harvard University,\1\ and 
                 Visiting Fellow, Brookings Institution

    With the United States running a current account deficit at 6 
percent of national income, foreign nationals have been accumulating 
U.S. assets at a spectacular rate. Taking into account recent stock 
market gains, foreigners now hold well over $14 trillion of U.S. 
assets, more than a 100% of U.S. gross domestic product. Foreigners, 
mainly foreign central banks and government investment funds, hold more 
than $2.5 trillion in U.S. Treasury securities alone. Incredibly, the 
United States absorbs roughly 70 percent of all net saving produced by 
the world's current account surplus countries, including China, Japan, 
Germany and the oil exporting countries. Borrowing on this scale by any 
large country, much less the world's pre-eminent economy is 
unprecedented in modern world history.
    \1\ Kenneth Rogoff, Department of Economics, Littuaer Center 232, 
Harvard University, Cambridge MA 02138-3001; Phone: 617-495-4022, Fax: 
617-495-7733; [email protected], http://www.economics.harvard.edu/
    Many observers are asking whether U.S. indebtedness to foreigners 
might pose any subtle hidden threats to the U.S. economy or, even to 
U.S. national security. With China alone holding $1.2 trillion in 
reserve assets and foreigners collectively holding more than twice that 
in U.S. Treasury securities, is there any risk that the United States 
might be subject to economic blackmail? What about the rapid 
proliferation of so-called sovereign wealth management funds, most 
famously China's $3 billion investment in the private equity group 
Blackstone? Sovereign wealth funds now control nearly $2 trillion in 
assets, more than stand-alone hedge funds. Is there a risk that foreign 
governments will use their financial relationships to compromise U.S. 
security? Is there any danger of exotic ``Goldfinger''-like scenarios 
where foreign governments might use their massive leverage to 
precipitate a wholesale financial collapse in the United States?
    The short answer is these more extreme risks are unlikely to 
materialize, but the United States continued dependence on foreign 
borrowing is a significant vulnerability in the event of shock, such as 
a collapse in US housing prices, or an extreme national security 
breach, that might slow the inflow of new funds into the United States. 
In this testimony, I will first discuss why the more extreme scenarios 
are relatively implausible, then go on to discuss where the real 
vulnerabilities lie.

                               AND CHINA

    As foreign wealth continues to explode in a number of transparency-
challenged countries, we are likely to see some spectacular financial 
debacles. Governments have a long tradition of losing massive amounts 
of money in financial markets. This tradition is not likely to end 
anytime soon, which is good new for global private investors, some of 
whom continue to reap huge profits at governments' expense. However, 
any attempt by a well-heeled foreign government to use its financial 
leverage to upset the US economy will almost certainly backfire. The US 
economy will not wilt, and the foreign instigator will either lose a 
bundle of money immediately, or get caught and be forced to forfeit the 
gains. The key to U.S. resilience is our country's credibility in debt 
markets; the U.S. governments' credibility in international debt 
markets is so great that it is virtually impossible for any such crisis 
to precipitate a default. Absent, this risk, it is very unlikely for a 
foreign-instigated financial crisis to spin beyond the control of the 
Federal Reserve and other regulators.
    For example, were China to suddenly reallocate a large share of its 
predominantly dollar portfolio into Euros, the ensuing dollar decline 
would inflict a massive capital loss on the Central Bank of China. A 20 
percent drop in the dollar against the Yuan would cost the Chinese 
Central Bank well over a hundred billion dollars. Fundamentally, when a 
debtor owes the bank a large enough amount, the debt becomes the bank's 
problem. China, whose reserves amount to 50 percent of its GDP, faces 
risks far to great to ever seriously consider this option. Of course, 
over time, one can expect China to significantly diversify out of 
dollar assets, but the time frame will be one that markets can easily 


    One should entirely dismiss the risks posed by the recent trend 
towards riskier investment strategies by sovereign investors, notably 
the so-called ``sovereign wealth funds.'' With deep pockets and the 
potential to draw on vast credit lines, sovereign wealth funds can 
potentially take larger and more leveraged risk positions than even the 
most aggressive private hedge funds. Given many of these funds weak 
governance and lack of transparency, global regulators are rightly 
concerned that one of these funds may precipitate a significant 
financial crisis. An ill-considered massive bet by a sovereign wealth 
fund, or perhaps the actions of a rogue trader within a sovereign 
wealth fund, could cause a massive price fluctuation in a financially-
sensitive part of the global economy. Here again, however, the big 
loser would be the government that owned the sovereign wealth fund, and 
would ultimately have to foot the bill for a catastrophic loss. True, 
there could be substantial collateral damage as in international 
financial crisis, but again, given the solid fundamentals of the U.S. 
financial system, prompt response by regulators and the Federal Reserve 
should be able to contain the problem.

                            GOLDFINGER RISK

    Yes, one can imagine more far-fetched and devious schemes to upend 
the global financial system. In the James Bond movie ``Goldfinger,'' 
the villain aims to bid up the value of his own gold holdings by 
irradiating the gold in Fort Knox, thereby cornering the market. In the 
real world, the Hunt brothers were accused of cornering the futures 
market in silver in the early 1980s. Given today's spectacular 
explosion in global financial assets, it is easy to imagine financial 
fraud and crime surpassing all previous benchmarks. Yet, in the scheme 
of things, deeper financial markets probably make things safer not 
riskier. It is far harder to corner a commodities market today than it 
was twenty five years ago. Rather than resisting financial 
globalization, the right approach is to continue to promote better 
corporate governance at home, and greater transparency on the part of 
financial entities, including sovereign wealth funds. In pursuing these 
goals, the United States should continue to work closely with 
multilateral agencies such as the International Monetary Fund or the 
Bank for International Settlements.
     the united states is a big winner from financial globalization
    In contemplating any policy actions, it is important to recognize 
that the United States is a massive winner from financial 
globalization. Although it is true that the United States is a large 
net debtor (with roughly $3 trillion in net debt), the cost to the 
United States has been relatively modest because, on average, Americans 
have earned a significantly higher return--about 1.5 percent higher--on 
their holdings of $10 trillion in foreign assets than foreigners have 
earned on their holdings of $13 trillion in U.S. assets. This 
differential has met that U.S. net debt accumulation has been 
significantly less rapidly than our $800 billion trade balance deficit 
might suggest, typically half as much. U.S. financial firms are the 
envy of the world, they arguably constitute the United States' most 
successful export industry. Any attempt to block foreign entities from 
engaging in the United States could lead to retribution that backfires 
and hurts U.S. interests.


    Of course, this does not mean that US should give privileged tax 
treatment to hedge funds and private equity any more than it should 
give better treatment to other export or import-competing industries. 
But a patchwork fix could prove highly counterproductive. Faced with 
the rapidly changing winds of globalization, the United States needs--
now more than ever--a much cleaner and simpler tax system. A flat tax 
with a large exemption at low incomes would likely prove far fairer and 
more efficient in practice than the current labyrinth of taxes.


    I have argued that growing international indebtedness does not 
seriously expose the United States to any of the more extreme doomsday 
scenarios. This is not to say that we should greet the US current 
account deficit with equanimity. It is a significant vulnerability that 
could significantly amplify the effects of growth crisis precipitated 
either by economic factors (say, a historic collapse in housing 
prices), or geopolitical factors (a terrorist attack of unprecedented 
dimensions on U.S. soil.) If the United States were forced to cut back 
the flow of its new borrowing by say, a half--to $400 billion per year, 
the trade-weighted dollar could easily fall 20-25 percent, and interest 
rates could rise by close to one percent across the board.\2\ On 
impact, it is quite possible that financial markets would overshoot.
    \2\ For calibrations on how a closing up of the US current account 
might affect the trade weighted US exchange rate, see Obstfeld and 
Rogoff (2005, Brookings Papers on Economic Activity, and 2007, National 
Bureau of Economic Research.)
    Thus, in a crisis, the United States' position as a big net 
borrower could prove an Achilles' heel that considerably amplifies the 
magnitude and duration of a crisis. Although this risk has not 
materialized even after years of very high US deficits, it remains a 
concern. Policies to raise US public and private savings would be a 
helpful step towards ameliorating these risks. So, too, would be more 
flexible exchange rates in Asia and a greater reliance on domestic 
demand for growth in Europe. Coordinated policies have been advanced by 
the International Monetary Fund for many years now, though with 
relatively little traction, especially in China but also in the United 
States. While it is true that US current account is showing signs of 
stabilizing this year, the ``soft landing'' scenario will take at least 
a decade to fully materialize, leaving the U.S. vulnerable to a ``hard 
landing'' scenario in the interim.
    In sum, the United States, with its superior legal system and 
transparency, is a big winner in financial globalization. Integration 
of global financial markets has helped lead to lower interest rates and 
a more stable US economy. Foreign investment in the United States has 
to be viewed in the context of the larger picture, which takes into 
account the enormous success of U.S. investors abroad. Doomsday 
scenarios, while theoretically possible, seem remote. However, although 
these extreme risks are remote, the United States massive dependence on 
foreign borrowing remains an important vulnerability. Any global 
macroeconomic or geopolitical shock that leads to a sharp contraction 
of the US current account deficit is likely to produce a massive dollar 
drop, and possibly a sharp interest rate rise, that would considerably 
amplify the adverse effects of the shock on the U.S. economy. It would 
be far better to take steps to gradually close up the United States 
massive borrowing gap than to wait for such a crisis.

    Chairman Spratt. Argentina was one of the wealthiest 
countries in the world in 1925 and in two generations, their 
whole economic fortune was reversed. And that is why we are 
sitting here asking if the fundamental decisions we are making 
now that might have such a profound effect on our future.
    Dr. Setser.

                    STATEMENT OF BRAD SETSER

    Mr. Setser. I want to thank the members of the Committee 
and the Chairman of the Committee for inviting me to testify. 
It is a particular honor to participate on such a distinguished 
    I think it is fair to say if Dr. Rogoff thinks foreign 
holdings of U.S. debt are something of a vulnerability, I tend 
to think they are somewhat larger of a vulnerability than he 
does, so I think that you will find that my testimony is a 
little bit less optimistic than Rogoff's, though I was perhaps 
not quite as pessimistic as Dr. Hormats and certainly far more 
worried than Dr. Levy about the consequences of not only large 
but rapidly growing foreign holdings of U.S. debt.
    I am going to focus on overall foreign holdings of U.S. 
debt stripping out equities but including holdings of assets of 
U.S. liabilities other than treasuries. So you have foreign 
holdings of corporate bonds, foreign holdings of housing debt.
    In total at the end of 2006, foreigners held about $10 
trillion in U.S. debt. About five trillion of that is long 
term. And of that long term at the end of 2006, the best I can 
tell, about 800 billion was held by the various entities of the 
Chinese government and around 700 billion by the Japanese 
    By the end of 2007, given ongoing global financial 
integration and given the need to take on additional debt to 
finance the current account deficit, our gross debt will rise 
to about twelve trillion. Six trillion of that will be long 
term and Chinese holdings will likely rise to between 1.1 and 
$1.2 trillion.
    I mention China specifically because China's very large and 
rapidly growing current account surplus which likely will reach 
$350 billion this year combined with ongoing capital inflows 
into China means that Chinese reserves are on track to increase 
by between 450 and $500 billion this year.
    To put that into perspective, it means that China's 
government has the capacity to buy a Unico or similarly sized 
company every month and still have enough money left over to 
buy the entire net issuance of U.S. treasuries.
    Because of this, China necessarily is financing a 
relatively large share of investment here in the United States 
and China is the largest single buyer of U.S. treasuries, 
largest single buyer of U.S. agencies, the largest potential 
source of demand for many other securities. And as a result, 
people will watch Chinese government moves very closely, and it 
is the largest actor in the world's foreign exchange markets.
    Now, I want to focus specifically on three points in more 
detail. The first is a point that Dr. Rogoff alluded to which 
is that despite the ongoing deficit the United States has run 
over the last several years, the United States' net 
indebtedness or actually its net international investment 
position, that is the broadest measure of the U.S.'s external 
position, one that includes equity investments, has not 
deteriorated by much.
    Now, that is a little bit deceptive because the net debt 
position just looking at changes in debt has deteriorated quite 
significantly. It has deteriorated by about $4 trillion since 
2000 which is about equal to the sum of the ongoing current 
account deficits.
    But that has been offset by a very strong rise in the 
dollar value of U.S. equity investments abroad. I do not think 
actually that has so much to do with U.S. financial skill. It 
probably has more to do with the fact that the U.S. had a lot 
of investment in Europe and the euro dollar moved by about 40 
percent over that period, generating a large gain in the dollar 
value of U.S. assets.
    Even in local currency terms, though, foreign equities have 
outperformed the U.S. equity market and I think many investors, 
including some of the central banks around this world, have 
recognized that they would have been better off instead of 
lending the U.S. money, they had insisted that to finance the 
deficit the U.S. hand over some other equity assets.
    Now, I do think that over time, the relatively generous 
terms on which the world has been willing to lend to the U.S. 
will likely evolve and that over time, the U.S. income balance 
will change and the U.S. will start making significant interest 
payments to the rest of the world.
    The second point I want to emphasize is the large role that 
foreign central banks and sovereign wealth funds have played in 
financing our current account deficit. Back in 2000, the U.S. 
was attracting about 50 to 100 billion in net inflows from 
official actors. Between 2002 and 2004, that rose to about 400 
billion. It fell a little bit in 2005, then rose to around 450 
billion in 2006. And in the first quarter of this year, 
according to the data from the BA, it was around $600 billion 
or about 70 to 75 percent of the current account deficit.
    Now, that probably in all honesty is an understatement 
because some of the difficulties in tracking purchases made 
through London. But in broad terms, as the U.S. slowed relative 
to the rest of the world, foreign central banks increased the 
amount of their financing, offsetting a fall in private flows. 
Had that not happened, the recession that we have experienced 
would likely have been worse.
    That is my third point, which is that to date, official 
flows have generally been a source of stability, not a source 
of instability because in general, the official central banks 
have offset falls in private flows.
    Here, I would frame the risk a little bit differently than 
some have. Now that the market has become accustomed to the 
expectation that the official sector will increase its 
financing when private demand for U.S. asset falls, all the 
official sector has to do to precipitate difficulties is not 
live up to that expectation.
    So if the official sector the next time private demand for 
U.S. assets falls did not increase its purchases from an 
already high level, in my view, there would be an impact on 
U.S. financial markets.
    But I think looking ahead, we should be wary of several 
different kinds of risk. I think the first risk well spelled 
out by Dr. Hormats is the risk that foreign investors overall 
and particularly foreign central banks may shift from 
financing, you know, providing too much financing to the U.S. 
to providing too much little.
    Now, earlier it was mentioned that foreign central banks 
would be shooting themselves in the foot if they sold. I would 
actually argue it is the contrary, that they are shooting 
themselves in the foot whenever they buy.
    China right now is investing 15 percent of its GDP in 
building up its reserves buying U.S. dollars which are likely 
to depreciate over time. If the dollar depreciates by 33 
percent, they are going to lose five percent on GDP on an 
aggregate and one-third of each marginal dollar that they buy. 
They would be better off shooting themselves in the foot now 
because they are going to have to shoot a much bigger bullet in 
their foot in the future.
    So there is some risk that they may reevaluate the policy. 
And I do not think this policy reflects the financial 
attractiveness of the United States. I think it is much more a 
reflection of the necessities created by their decisions to peg 
to the dollar.
    The second risk is ironically the opposite. It is that 
central banks will continue to provide the U.S. with too much 
financing, blocking necessary adjustment, and allowing the 
underlying disequilibrium to build. That implies larger debts 
over time and eventually more interest payments to the rest of 
the world.
    And I think the third risk, and this would conclude, is 
that our foreign creditors will change the terms on which they 
are willing to finance the United States. Dr. Orszag mentioned 
that foreign central banks may conclude that they are saturated 
with dollars.
    I think most foreign central banks have already concluded 
that they are saturated with their U.S. Treasury holdings and 
they are looking to find investments that offer higher yields 
in large part because they realize that they are stuck in the 
    Now, as that happens, there will be tensions associated 
with the shifting portfolios and I think it is unrealistic to 
expect that foreigners will be willing to finance the U.S. on 
as generous of terms, terms which have implied very large 
losses in their own local currency terms and in very large 
losses relative to what they would have obtained had they 
invested in, say, euros. It is unlikely that those generous 
terms will continue. So even if ongoing flows remain, the cost 
of those flows to the U.S. economy will likely rise.
    My policy recommendations are the same as those that have 
been put forth before, although I would also add that given 
that the U.S.'s petroleum deficit is about $300 billion, steps 
to reduce our energy consumption could also contribute to an 
orderly adjustment.
    Thank you.
    [The prepared statement of Brad Setser follows:]

  Prepared Statement of Brad Setser, Senior Economist, Roubini Global 
Economics and Research Associate, Global Economic Governance Programme, 
                       University College, Oxford


    I want to thank the members of the committee for inviting me to 
testify. It is a particular honor to participate in such a 
distinguished panel.
    At the end of 2006, foreigners held an estimated $10 trillion in US 
debt--roughly $5 trillion in long-term debt securities and $5 in short-
term securities and cross-border bank claims. Roughly $800 billion of 
the $5 trillion in long-term claims were held by China's government 
(counting some securities held by China's state commercial banks) more 
than the perhaps $700 billion in long-term US debt securities held by 
Japan's government.1 By the end of 2007, total foreign holdings of US 
debt will rise to around $12 trillion, total foreign holdings of long-
term debt securities will be close to $6 trillion, and long-term debt 
held by China's government likely will rise to around $1.1 trillion.
    I mention China specifically because the strong recent rise in 
China's current account surplus, along with ongoing private capital 
inflows into China, has made China's government the largest single 
source of (net) financing for the US current account deficit. China's 
foreign exchange reserves--counting the reserves likely to be shifted 
to a new investment agency--are set to rise by between $450 and $500 
billion in 2007, with between $300 and $350 billion of that increase 
flowing into US assets (Chart 1). China's foreign assets are growing so 
rapidly that it could buy a company the size of Unocal every month--and 
still have enough money left over to buy all the Treasury bonds that 
the US needs to sell to finance its budget deficit. Right now, China's 
government is the largest single buyer of US Treasury and US ``Agency'' 
bonds, the largest potential source of demand for many other dollar-
denominated financial assets and--given that it must sell a fraction of 
the dollars it accumulates intervening in the foreign exchange market 
to keep the dollar share of its reserves from rising--also the largest 
actor in the foreign exchange market.
    Financial integration implies rising foreign holdings of US assets 
and rising US holdings of foreign assets. But so long as the US is 
running a large external deficit, foreign holdings of US assets will 
need to rise faster than US holdings of foreign assets. The large US 
current account deficit--roughly $800b in 2006--has been financed 
primarily by placing debt, and specifically long-term debt securities, 
with foreign investors. US direct investment abroad, along with US 
purchases of foreign equities, recently have exceeded foreign direct 
investment in the US and foreign purchases of US equities.
    My testimony will emphasize three points:
     To date, the United States' large trade deficit has not 
resulted to a significant deterioration in the United States' net 
international investment position (US liabilities to the world net of 
US holdings of foreign assets) or to a deficit in the income balance 
(the gap between the interest and dividends the United States receives 
on its investments abroad and the interest and dividends the United 
States pays to foreigners). Going forward, that is likely to change. 
The United States should not expect foreigners--including foreign 
governments--to finance the United States on as generous terms as the 
US has enjoyed over the past few years.
     Foreign central banks and government-owned investment 
funds have played an important role financing the US current account 
deficit over the past several years. As the US economy has slowed 
relative to the rest of the world in late 2006, reducing the 
attractiveness of US financial assets to private investors abroad, the 
share of the US external deficit financed by foreign central banks 
increased substantially.
     Official financial flows have generally been stabilizing 
rather than destabilizing; foreign central banks have bought dollar-
denominated assets, financing the US deficit, when private investors 
haven't wanted to. Bringing the US deficit down in a gradual, orderly 
way will require ongoing central bank financing. However, the United 
States ongoing dependence on inflows from foreign central banks still 
poses substantial risks. The US should worry both about the possibility 
that foreign central banks will provide the US with too little 
financing, forcing rapid and disruptive adjustment, and the possibility 
that foreign central banks will provide the US with so much financing 
that a necessary adjustment is deferred.
    One theme will run throughout my testimony: the United States has a 
strong interest in a process of gradual adjustment that reduces the 
United States' need to borrow from the rest of the world to finance 
domestic investment. The absence of any adjustment is undesirable: it 
implies that foreigners will continue to finance a very large share of 
all US domestic investment and a large buildup of the United States' 
foreign debt. Too rapid adjustment is also undesirable. A sharp fall in 
foreign financing of the US would lead the dollar to fall, stimulating 
US exports, but it would also push up US interest rates, leading other 
parts of the economy to slow. Gradual adjustment--say 1% of GDP a 
year--would facilitate the shift of resource from sectors of the 
economy that have benefited from the low interest rates associated with 
large (net) inflow of foreign savings to the US toward sectors that 
would benefit from a weaker dollar. Gradual adjustment also provides 
foreign governments time to take steps to stimulate domestic demand and 
wean their economies off export-led growth.


    The United States' current account deficit topped $800b--roughly 6% 
of US GDP--in 2006. Its 2007 deficit is likely to be comparable in 
size. As the US economy emerges from its recent growth slump, the US 
current account deficit is likely to resume its increase in the absence 
of a fall in oil prices or large additional falls in the dollar.
    Right now, the current account surpluses that offset the US deficit 
are overwhelmingly found in East Asia and the world's oil-exporting 
economies. Should oil prices stabilize, rising domestic spending and 
investment in the oil-exporting economies should reduce their current 
account surplus. However, East Asia's surplus looks set to continue its 
rise. China's current account surplus was $250b (a bit under 10% of 
China's GDP) in 2006. Its 2007 surplus is expected to rise to $350-
400b--an unprecedented sum. Japan's current account surplus is also 
rising, in part because of rising interest income from Japan's large 
holdings of foreign debt. So long as East Asia's surplus continues to 
rise, global adjustment will be difficult. Surpluses in one region have 
to be offset by deficits elsewhere.
    A current account deficit indicates that a country saves less than 
it invests; a surplus indicates a surplus of savings over investment. 
The US consequently must finance its savings shortfall either by 
placing debt with investors in the rest of the world, attracting large 
(net) inflows into its equity market or attracting large net inflows of 
foreign direct investment. New foreign equity investments in the US--
whether direct investment or the purchase of foreign stocks--have been 
more than offset by new US equity investments abroad. Inflows into the 
US banking system have generally been offset by outflows from the US 
banking system. By contrast, foreign purchases of US debt securities 
have exceeded US purchases of foreign debt, providing the large net 
inflows needed to cover the United States current account deficit.
    As a result, the US net debt position--the gap between what the US 
has borrowed from the world and what the US has lent to the world--has 
deteriorated dramatically over the past six years. Since the end of 
2000, total foreign holdings of US debt have increased from $4.3 
trillion to close to $10.0 trillion while US lending to the rest of the 
world has increased from $2.9 trillion to an estimated $4.6 trillion. 
Net US external debt consequently has increased from $1.5 trillion at 
the end of 2000 to about $5.4 trillion at the end of 2006--the $4 
trillion increase is in line with the cumulative $3.6 trillion US 
current account deficit over this time frame.
    However, the overall US net international investment position--the 
difference between all US assets abroad and all US liabilities to the 
world--hasn't deteriorated at the same pace. The dollar value of US 
equity investment abroad has increased far more rapidly that the dollar 
value of foreign equity investment in the US. The dollar value of US 
equity investment abroad increased from $4.5 trillion in 2000 to $9.1 
trillion in 2006, while the dollar value of foreign equity investment 
in the US increased from $4.3 trillion to an estimated $5.9 trillion. 
The United States' net equity position consequently shifted from rough 
balance to a $3 trillion surplus (Chart 2).
    The improvement in the US net equity position largely reflects 
capital gains on existing US equity investment, not large (net) US 
purchase of foreign equities.2 Since the end of 2000:
     Foreign equity markets generally outperformed the US 
equity market in local currency terms.
     The dollar's slide against European currencies and the 
Canadian dollar has substantially increased dollar value of existing 
investment in Europe and Canada.
    Indeed, the capital gains on US equity investment abroad since 2002 
have been large enough to entirely offset the increase in debt 
associated with the current account deficit, so the US net 
international investment position hasn't deteriorated.
    The income balance--the gap between the interest and dividends that 
the US pays to the rest of the world and the interest and dividends 
that the US receives from the rest of the world--also has not 
deteriorated as rapidly as many had feared. The revised data from 
Bureau of Economic Analysis (BEA) indicates that the US actually 
received more interest and dividend income from the rest of the world 
than it paid out in 2006 (Chart 3).
    Here too the overall balance can be disaggregated into the interest 
payments on debt and the dividends payments on equity. As one would 
expect, payments on US external debt have increased substantially. 
Interest payments on US external debt likely totaled $430b in 2006, up 
from a low of $170b in 2003 and $250b in 2000 (Chart 4).3 This trend 
continued in the first quarter of 2007: the q1 data suggests the 2007 
US interest bill will be substantially higher than $500b. However, 
interest income on US lending abroad--which seems to be primarily 
short-term--also has increased. Right now, the implied interest rate on 
US lending is close to 6%, while the implied interest rate on US 
borrowing is close to 4.5% (Chart 5). In my judgment, this large gap is 
unlikely to persist. As the average interest rate on the United States 
(large) stock of external debt rises, the US income balance should 
begin to deteriorate.
    The US income balance has also been helped by a large ongoing gap 
between the reported dividend income of US direct investment abroad and 
foreign direct investment in the US, a gap that stems more from low 
reported returns on foreign direct investment in the US than high 
reported returns on US direct investment abroad (Chart 6).
    The ability of the United States to run large deficits without much 
deterioration in its net international investment position or a 
significant deterioration in its income deficit reflects the 
willingness of the United States' external creditors to add to their 
holdings of US debt when--at least in retrospect--they would have 
received far larger financial returns had they invested in foreign 
equities. Foreigners would have fared better if they had forced the US 
to sell its existing external assets rather just buying US debt.


    No one doubts that foreign central banks--including the People's 
Bank of China--have been very large buyers of US debt securities. The 
BEA data show that official purchases of US assets rose from under 
$100b a year in 2000 and 2001 to nearly $400b in 2004. Official inflows 
then fell to $275b in 2005--a year when rising US short-term rates and 
the Homeland Investment Act helped support the dollar--before rising to 
$440b in 2006 and an annualized $600b in the first quarter of 2006.
    Large as these inflows are--the $440b in central bank purchases of 
US assets in 2006 far exceeded the $155b in marketable Treasuries 
issued to finance the US fiscal deficit in 2006, and the large 
cumulative increase in central bank holdings of Treasuries since 2000 
has limited the increase in marketable treasuries held privately (Chart 
7)--the BEA data likely understate the role central banks and sovereign 
wealth funds have played in financing the US external deficit. The BEA 
data do not capture the dollars that central banks have on deposit in 
banks outside the US. Those dollars are then lent out, and indirectly 
help to increase private demand for dollar-denominated debt, including 
US dollar denominated debt.4 Most importantly, recent BEA data do not 
capture large central bank purchases of US assets made through private 
custodians in London and other financial centers. The BEA's data is 
revised annually to reflect the information provided by United States 
Treasury's annual survey of foreign portfolio investment in the US, 
which tends to do a better, though still imperfect, 5 job of capturing 
the ultimate ownership of US debt securities. However, the most recent 
data points tend to substantially understate central bank purchases of 
US assets.
    A number of technical difficulties complicate efforts to determine 
the exact impact of central bank demand for US debt on US yields. 
Custodial bias makes real-time estimates of the size of official 
inflows hard. The shift in central bank demand from Treasuries to 
Agencies after 2005 further complicates analysis. But many studies find 
a substantial impact--100 to 150bp at the peak of central bank demand 
for US assets in 2004 (Warnock and Warnock, 2005, Moec and Frey, 2005). 
When the analysis of the recently revised data--which shows far higher 
central bank purchases in 2006 than the BEA had previously indicated--
is completed, I would expect to find that central banks exerted a 
similar impact in 2006.
    Central bank demand for US debt, generally speaking, has allowed 
the US to finance a larger deficit at lower cost than otherwise would 
have been the case. Assessing the long-term impact of these policies on 
the overall US economy is difficult, since strong demand for debt 
securities and low interest rates help some sectors even as other 
sectors are hurt by other countries efforts to keep their currencies 
    Central bank demand for US debt has helped lower the interest 
burden of the US government. It has encouraged heavy household 
borrowing, both to support consumption growth in excess of income 
growth and--between 2003 and 2006--a surge in residential investment. 
More recently, low interest rates have supported strong demand for 
corporate debt, whether from firms looking to buy back their equity 
(and thus push up their stock price) or private equity firms, which 
borrow heavily to buy the listed stock of publicly traded companies.6 
Conversely, those sectors of the US economy that compete with imports, 
particularly imports from emerging economies, and that export goods and 
services have been hurt by the policies that gave rise to these large 
official inflows.
    In aggregate, I believe the negative long-term impacts of the 
policies that have given rise to large official inflows to the US 
outweigh the positive. While many in the US clearly have gained from 
low interest rates, it is hard to argue that the US has been borrowing 
from abroad to invest in ways that will generate the future export 
revenue needed to repay the United States' growing external debt. 
Suburban housing is not an obvious source of export revenue--and firms 
that borrow to buy back their equity rather than to finance new 
investment are not obviously increasing the United States' future 
export capacity either. Many abroad have also gained from their 
government's efforts to prop up the dollar--not the least China's 
export sector. But these policies will also generate losers, notably 
taxpayers in emerging economies who will at some point incur large 
losses on their government's dollar holdings.
    Nonetheless, it is important to recognize that central banks have 
generally acted to stabilize rather than to destabilize the foreign 
exchange and bond markets. Since early 2004, the IMF's data on central 
bank reserves indicate that central banks effectively have bought 
dollars--and dollar-denominated bonds--when private market participants 
have been unwilling to do so, helping to stabilize US and global 
financial markets. As a result, a fall off in (net) private demand for 
US assets has not let to a large drop in overall foreign demand for US 
assets, allowing the US to finance its large deficit at a relatively 
low costs. Volatility in private demand for US assets has translated 
into volatility in central bank dollar reserve growth, not volatility 
in financial markets or in aggregate financial flows to the US.
    This has been particularly apparent over the last three quarters. 
As the US economy slowed and growth abroad picked-up, net private 
capital inflows to the US fell. US demand for foreign assets rose, and 
demand for US assets from private investors abroad fell. The BEA's 
data, for example, show for q1 that central banks provided about $150b 
in direct financing to the US in the first quarter--a net inflow equal 
to about 75% of the US current account deficit.
    The $150b in official inflows in q1 is if anything an under-
estimation of likely central bank financing of the US in the first 
quarter. The high-frequency data released by the US (The monthly 
Treasury International capital data and the quarterly BEA balance of 
payments data) tend to overstate private purchases and understate 
official purchases. Lower frequency data--notably the United States 
annual survey of foreign portfolio investment--tends to do a better job 
of picking-up central bank purchases of US assets. The last survey--
which covered the period between June 2005 and June 2006--showed $345 
in official purchases of long-term US debt, $125b more than in the 
unrevised data. The last survey, for example, revised the United States 
estimate of Chinese purchases of US debt up by $90b. (See Chart 8; 
Chinese holdings of US Treasuries jump every June, when the survey data 
is released). There is no reason to think that this pattern will 
    I consequently prefer high-frequency estimates of the increase in 
central bank dollar holdings that are derived from reported increase in 
foreign central bank reserves, along with an estimate of the share of 
those reserves that are held in dollars. This methodology has its 
limits. It will, for example, over-estimate central bank purchases of 
dollars if central banks are reducing the dollar's share of their 
reserves. Nonetheless, this methodology accurately predicted the large 
upward revisions in central bank holdings in the last survey (see 
Charts 9 and 10).
    With total global reserve growth topping $250b in q1, this 
methodology implies that central bank demand for dollar assets now tops 
$200b a quarter. Preliminary data for q2 suggests global reserve growth 
will top $300b by a substantial margin, which implies a truly 
extraordinary $250b in central bank demand for dollar assets in q2. The 
very strong recent growth in the New York Fed's custodial holdings--
which have been running at an annualized pace of close to $500b this 
year--provide strong indirect evidence of a strong rise in US 
dependence on inflows from foreign central banks (Chart 11).


    Ongoing US dependence on central bank demand for US assets carries 
with it three risks:
     Central banks stop adding to the dollar holdings.
     Central banks resist all market pressure for adjustment, 
allowing the underlying disequilibrium--and total foreign claims on the 
US, to build.
     Foreign governments change the terms of their financing of 
the US.
    Professor Rogoff, a fellow member of this panel, has argued that 
the large credit line extended by emerging economy central banks to the 
US constitutes a kind of reverse foreign aid. Both relatively poor 
emerging economies and wealthy oil exporting economies that are 
intervening heavily to keep their exchange rates from appreciating are 
effectively ``over-paying'' for US dollar-denominated assets. Should 
they stop intervening, their exchange rates will rise--reducing the 
value of their existing dollar holdings in local currency terms.
    The resulting losses potentially are quite significant. Chinese 
intervention in the foreign exchange market is currently close to 15% 
of its GDP. If the RMB is undervalued by 33% against a basket of euros 
and dollars that corresponds with China's foreign currency reserves, 
the annual cost of this policy is roughly 5% of China's GDP.8 It is 
possible--though unlikely--that China might conclude that its interests 
would be better served running a 5% of GDP fiscal deficit to finance a 
social security system and better health care rather than incurring an 
expected loss of 5% of its GDP lending to the US and Europe. Of course, 
the effective subsidy that China extends to American borrowers also 
benefits China's export sector--there are strong interests inside China 
that seek to maintain the current policy. However, those who depend on 
the kindness of strangers shouldn't take their continued kindness for 
    Emerging economies do not need to sell their existing reserves to 
shake the system--all they need to do is stop adding to their dollar 
reserves/ dollar assets of their investment funds. Indeed, if emerging 
markets just held their purchases of US assets constant at a time when 
private demand for US assets fell, they could have a substantial impact 
on US financial markets. The markets now expect that emerging economy 
central banks will be the dollar's buyer of last resort.
    China is the largest single source of financing for the US external 
deficit. China probably accounted for about 1/3 of all long-term debt 
purchased by foreigners in 2006, and more like 1/2 of all foreign 
purchases of Treasuries and Agencies. The strong increase in the pace 
of Chinese reserve growth implies that China will likely account for a 
higher share of total purchases in 2007. Changes in how China allocates 
its immense and rapidly growing portfolio consequently could have a 
large impact on US markets. A reduction in Chinese purchases of all US 
debt would have the largest impact, but even shifts in the kinds of 
assets that China buys now could have a substantial impact. For all the 
attention that China's $3b investment in Blackstone generated, it 
likely represents less than one week's worth of Chinese purchases of 
    China is not the only actor with the potential to shock the US 
financial system. The Institute for International Finance recently 
reported that the oil-exporting economies of the Gulf have more 
accumulated foreign assets than China. They also hold nearly as large a 
share of their assets in dollars, even though only 10% of their imports 
come from the US. Should the Gulf states change the dollar's share of 
their portfolio suddenly, they too could potentially put substantial 
pressure on the dollar.
    This risk isn't new. Back in 2003, Former Treasury Secretary 
Lawrence Summers warned that the United States dependence on credit 
from countries selling goods to the US was generating ``a balance of 
financial terror'': the US was dependent on China for large-scale 
financing, while China depended on the US to provide sufficient demand 
for its products. More recently, Summers noted that one lesson of the 
cold war is that a system based on a balance of terror can be stable 
for quite some time.
    However, the system's current apparent stability is in some ways 
deceiving, as the costs emerging economies are being asked to bear to 
sustain the United States existing current account deficit are rising. 
Emerging market reserve growth has doubled since early 2006, rising 
from around $600b to around $1.2 trillion, as private investors shifted 
funds from the US to the emerging world. To be sure, large scale 
reserve growth generates benefits for exporters in emerging economies. 
But rapid reserve growth also limits the domestic monetary policy 
autonomy of many emerging economies, as well as generating financial 
losses--now generally hidden--that taxpayers in emerging economies will 
eventually have to absorb. The constellation of interests that supports 
the status quo may not last forever. At some point, the perceived costs 
of buying dollars when the dollar is under pressure may exceed the 
perceived benefits that emerging market economies gain from resisting 
market pressures for appreciation.
    One risk is that emerging economies suddenly stop adding to their 
dollar holdings, forcing the US to adjust to fall off in foreign 
financing too rapidly. Another risk, ironically, is that emerging 
economies will continue to add to their reserves at a pace that allows 
the US to continue to defer a necessary adjustment.
    Substantial swings in the private sector's willingness to finance 
US external deficits--and a large gap between the size of the US 
deficit and net private inflows in 2003, 2004, 2006 and so far in 
2007--have not translated into large swings in the US external accounts 
or sharp swings in US economic activity. However, strong central bank 
demand for US debt--a byproduct of their decision to resist market 
pressure for their currencies to appreciate--risks thwarting all 
adjustment, not just thwarting disruptive adjustment.
    If the US trade deficit remains constant as a share of GDP, the 
deterioration in the US income balance associated with a rising stock 
of external claims on the US implies a growing current account deficit 
over time. The Congressional Budget Office's recent analysis of the US 
external deficit accurately noted that a sharp adjustment process would 
bring the US deficit down quickly, limiting the overall increase in US 
net external indebtedness. By contrast, a period without any 
adjustment--or a further rise in the US external deficit--that is 
followed by a period of gradual adjustment implies that the overall US 
external debt stock would rise even further than would be the case if 
the US deficit started to fall now.
    This risk is not entirely theoretical. The recent slowdown in US 
growth--combined with an acceleration in global growth--created close 
to ideal conditions for the US external deficit to fall. Strong global 
growth supported US exports. The slowdown in US growth slowed the 
increase in US imports. Indeed, the US deficit with those regions of 
the world--Europe and North America--that have allowed their currencies 
to appreciate has fallen substantially. However, the US deficit with 
East Asia continues to rise (Chart 12). At a result, the fall in the 
United States overall deficit has been modest. Most of the improvement 
in the current account deficit from its recent peak in the third 
quarter of 2006 stems from lower oil prices.
    A final risk that is worth noting: the rest of the world may change 
the terms associated with its financing.
    Countries like China have resisted taking policy steps--like faster 
RMB appreciation or a major initiative to stimulate domestic 
consumption--that would lower their current account surplus and reduce 
the scale of their purchase of US assets. However, such countries are 
clearly seeking to invest in US assets that offer the prospect for 
greater returns than US Treasuries.
    Such an evolution is natural. China holds far more liquid Treasury 
and Agency securities than it needs to address even a most draconian 
shock. Moreover, China's heavy concentration in US fixed income 
securities (Chart 13)9 is itself a risk. A rise in Chinese holdings of 
US equities is a natural by-product of China's large surplus, the 
United States large deficit and a balanced Chinese portfolio of US 
assets. China's willingness to hold such a high share of its national 
wealth in low-yielding debt is far more unusual than its interest in 
exploring alternatives that offer higher potential returns.
    The current pace of accumulation of Chinese foreign assets suggests 
that China's total foreign assets will rise from about $1.5 trillion at 
the end of 2006 (with about 1.2 trillion of that reserves and reserves-
like assets) to more than $3 trillion by 2010. A world where China 
creates a $1.5 trillion dollar investment fund, rather than adds $1.5 
trillion to its reserves, over the next few years isn't impossible to 
envision. Even if China adds roughly equal sums to its reserves and 
investment fund over the next few years (Chart 14), its investment fund 
could reach be the largest in the world by 2010. Creating an investment 
fund won't eliminate the constraints on China's overall portfolio that 
stem from China's continued adherence to its dollar peg. However, 
shifts in the kind of assets that China is purchasing could still 
influence US markets. A Chinese move away from long-term fixed-income 
debt could increase US interest rates by as much as 50 basis points.
    Other central banks now adding to the reserves rapidly (Russia) and 
other central banks with large existing stocks of reserves (Korea and 
Japan) have either announced that they are creating a new investment 
fund (Russia, Korea) or are rumored to be considering an investment 
fund (Japan). All seem to be struck by the high returns Singapore has 
obtained from its investment funds. So long as oil prices remain high, 
the assets of existing investment funds in Norway will continue to grow 
as well. All these funds already hold substantial quantities of US 
equities, both directly and through their investment in private equity 
and hedge funds.
    Trying to shut the investment funds of foreign governments out of 
US markets is neither feasible nor desirable. So long as the United 
States is running large external deficits, US government is unlikely to 
be in a position where it will be able to dictate what kind of U.S. 
assets its creditors are allowed to buy. Moreover, any move to shut 
government investment funds out of the US market would invite foreign 
governments to try to limit US investment in their markets.
    Nonetheless, the growing presence of government investment funds in 
US equity markets raises a host of questions--questions about US 
capital market regulation as well as questions about the transparency 
of large investment funds. Edwin Truman of the Peterson Institute has 
argued that the increased role of central banks and sovereign wealth 
funds in global capital markets implies that both should adhere to a 
higher level of transparency. He specifically has called for more 
disclosure of their investment strategies as well as the currency 
composition of their portfolios. I second Dr. Truman's suggestion, 
along with a recent suggestion from the Treasury's Acting Under 
Secretary, Clay Lowery, that the IMF encourage investment funds to 
develop a code of best practices.


    So long as the US is running a large external deficit, foreign 
holdings of US assets will need to rise faster than US holdings of 
foreign assets. In many ways, the past few years have been atypical. 
The United States' external deficit has been financed entirely by the 
net sale of debt securities rather than by the net sale of equities, in 
no small part because of unprecedented growth in central bank reserve 
assets. The low interest rate on US external debt--relative to both the 
returns the US has achieved on its equity investment and the interest 
rate on US external lending--has allowed the US to continue to earn 
more on its foreign investment than it pays on its foreign debts.
    These patterns are unlikely to persist. So long as emerging 
economies are unwilling to allow their currencies to appreciate and run 
large current account surpluses--especially with private capital 
flowing in net into emerging economies--many governments around the 
world will be accumulating external asset rapidly. Over time, though, 
more of those assets will be handed over investment funds and fewer 
will be held as central bank reserves. The US will likely both have to 
sell more equity to the rest of the world and pay a somewhat higher 
interest rate on its external debt than it has recently.
    Foreign investors--and right now that means foreign governments--
now finance, directly and indirectly, a larger share of domestic US 
investment than makes sense over time. While rapid central bank reserve 
growth and large official financing of the US deficit can help the US 
postpone the necessary adjustment, the longer the adjustment is 
deferred, the greater the long-term risks.
    The process of adjustment is more likely to be smooth if it is 
supported both by policy changes here in the US and abroad. The US 
government should adopt policies that would allow the US to finance 
more investment out of domestic US savings, just as many emerging 
economies should put more of their savings to work at home. Further 
reduction in the fiscal deficit and a new push to reduce our energy 
import bill--the United States ``petroleum'' deficit is now close to 
$300b--are the most obvious policies for the United States. Governments 
in emerging markets need to do more than complain about US profligacy, 
particularly when their purchases of US debt have masked the 
consequences of the United States' low level of savings and large 
resulting external deficit. East Asian economies with high savings 
rates--notably China--have substantial scope to take policy steps to 
support domestic consumption. Most governments that now manage their 
exchange rate against the dollar--whether in the Gulf, Latin America or 
East Asia--would benefit from additional exchange rate flexibility.
    Both the United States large deficit and equally large surpluses in 
many emerging economies built up gradually over time. Bringing the US 
deficit and emerging economy surpluses down without tremendous costs 
will also take time. If the US and the world are to adjust gradually, 
they need to get started.


    \1\ The US has not formally released data on the total stock of 
foreign claims on the US for the end of 2006. I have drawn on the data 
from the 2005 net international investment position, the 2006 capital 
account data from the Bureau of Economic Analysis, the 2006 Treasury 
survey of foreign portfolio investment in the US and China's reserves 
data to compile these estimates. The actual data should be released at 
the end of June.
    \2\ Since the end of 2000, cumulative US direct investment abroad 
has exceeded foreign direct investment in the US by about $200b. 
Portfolio equity inflows and outflows are roughly equal.
    \3\ These estimates are derived from the balance of payments data 
released by the Bureau of Economic Analysis. The exact number for 2006 
though depends on dividend payments on foreign portfolio investment in 
the US--a data point that the BEA has yet to release. I assumed that 
2006 dividend payments matched 2005 dividend payments. Since these 
payments are small, this is not a large source of error.
    \4\ Foreign central banks purchases of euro and pound denominated 
securities also help to generate indirect demand for US debt, as such 
purchases push down European yields and make US assets relatively more 
attractive to private investors in the US and Europe.
    \5\ The survey data seems to understate the Middle East's likely 
holdings of US assets, perhaps because neither the high-frequency data 
BEA data (which is derived from the Treasury's TIC data) nor the annual 
survey picks up foreign central bank funds--and sovereign wealth 
funds--that are managed by private portfolio managers.
    \6\ Central banks are not large direct participants in this market 
but by lowering yields in Treasury and Agency bonds (and buying these 
bonds from pension funds and other investors) they encouraged other 
investors to reach for yield. Significant central bank deposits in the 
international banking system have also supported the leveraged loan 
    \7\ In the first quarter of 2007, the increase in the New York 
Federal Reserve Bank's custodial holdings of US treasury and US Agency 
bonds exceeded the estimated increase in central bank holdings of US 
treasury and US Agency bonds in the BEA's balance of payments data by 
about $20b. Central banks who buy US securities in London sometimes 
hand those securities over to the New York fed; the transfer of 
custodianship though is not considered a sale.
    \8\ This calculation ignores the ``carry'' the Chinese government 
gets from borrowing at low interest rates in China to buy US dollar 
debt. It is clear, though, that these interest gains--which themselves 
stem from China's artificially low interest rates--are not large enough 
to offset the capital losses from a substantial RMB appreciation. 
China's reserves are now roughly 45% of its GDP. China's central bank 
will eventually face a loss equal to 15% of China's GDP.
    \9\ The best data on China's holdings of US assets comes from the 
annual US survey of foreign portfolio investment. As of June, 2006, 
China held slightly a bit under $700b in US debt: $375b of US Treasury 
bills and notes, $260b of ``agency'' bonds, and $60b of corporate debt. 
In addition, China held slightly over $20b of US equities--and a bit 
over $15b in plain old bank deposits. Treasuries and Agencies accounted 
for 90% of all Chinese holdings of US securities, debt securities 
accounted for 99.5% of China's US portfolio (Chart 5) and US securities 
accounted for around 70% of China's total reserves (included reserves 
shifted to the state banks. The US data does not distinguish between US 
assets held by China's private sector (including its state commercial 
banks) and US assets held by China's State Administration of Foreign 
Exchange. However, given the size of China's reserves, it is reasonably 
to assume that the State Administration of Foreign Exchange accounts 
for most of China's recorded holdings of US securities.

                           CHARTS AND GRAPHS

    Chairman Spratt. Thank you all for the range of your 
opinions and for some very provocative proposals.
    Let me ask you again about what happens if we have some 
rapid adjustment, some rough, rocky road that leads to those 
holders of dollar denominated assets to dump their assets and 
to the phenomenon that Lester Thoroshe described of having most 
of the holders decide they did not want to be the last man out 
on a declining asset.
    Could a scenario like this happen if foreign investors 
looked at the charts that we were looking at earlier and 
decided that given the projection of the cost of Medicare and 
Medicaid and Social Security, two multiples as a percentage of 
our GDP, that it would be inevitable that we might try to 
inflate our way out of our debt or that we would be asking 
secondly foreigners to underwrite not just our economy but 
transfer payments?
    Not investment in assets like the British did with the 
building railroads out west in the second half of the 1800s but 
for Medicare, for Medicaid, for Social Security, for transfer 
payments upon which there would be no significant return. Could 
you imagine a scenario in which foreigners are looking at 
something like that?
    Mickey Levy keeps shaking his head, but is that a scenario 
to be concerned about?
    Mr. Levy. Can I take a crack at that? We are all concerned 
about the unfunded liabilities of the entitlement programs and 
there is no question but that they need to eventually be 
    If you look through history over time, you will find that 
interest rates tend not to be that correlated with budget 
deficits or expected budget deficits, that interest rates tend 
to be driven by the rate of economic growth, inflation, and the 
Federal Reserve's inflation fighting credibility.
    So if you talk about scenarios of shocking the system, you 
have to ask, well, if you shock the system, what is going to 
happen to economic growth and inflation. As long as the economy 
is growing moderately and inflation is under control and the 
Fed is conducting its job with credibility, do not look for a 
sharp rise in interest rates because if one even huge investor 
sells, whether it is a foreign investor or domestic investor, 
other investors will look at the fundamentals and be buyers.
    So it is a complex issue and I just do not think you could 
say if you shock the system, then what if.
    Chairman Spratt. Others? Dr. Rogoff?
    Mr. Rogoff. Yeah. Well, I mean, one piece of your comment I 
actually think people are not concerned enough about which is 
that over the--there is this view that inflation will never be 
a problem again because we solved it. I think we live in a very 
benign world. Growth has been very fast. The central banks of 
the world have a relatively easy job in the political economy 
of bringing down inflation because things are pretty good.
    We do not have inflation anywhere. The Congo does not have 
inflation. They have had, you know, trillions of percent 
inflation since 1970, same with Brazil. But it is possible that 
some of the social stresses that we face, not soon, but in 15, 
20 years, could put pressures on the system that we do not, you 
know, fully admit today. But I do not think they would fall 
uniquely on the United States. So, you know, yes, it is an 
awkward position, but where would investors go? Are they going 
to go into Japan which is aging sooner, to Europe which is 
aging sooner, to China which has a big problem? So there is not 
a natural----
    Chairman Spratt. But all of those countries have 
substantially higher savings rates.
    Mr. Rogoff. Yeah. Partly because their aging problem is 
upon them. I mean, that is one of the reasons it is argued that 
they do have higher savings rates. So I think that we could see 
a generalized decline in asset prices some day when people get 
worried about this and that could cause a lot of problems.
    And I do think our vulnerability of needing to keep 
borrowing fresh money is a concern. But this is a global 
phenomenon. I do not think it is uniquely our problem.
    Mr. Setser. Yes. I would just add that, you know, there are 
many different scenarios that worry me. I probably worry too 
much. But I would argue that the time scale in which the trade 
deficit needs to correct is more likely to come sooner rather 
than later while the time scale associated with the entitlement 
problem is later rather than sooner.
    And by that, I mean the trade deficit right now is around 
six percent of U.S. GDP and it seems to me that that is going 
to need to adjust downward within the next ten years where the 
entitlement problem starts to bite perhaps at the end of that 
ten-year period.
    Mr. Hormats. I think it is a sort of a slow motion train 
wreck and it is also true that other countries have similar 
problems. In fact, a lot of countries in some cases have even 
greater amounts of unfunded liabilities relative to their GDP.
    But, you know, we are the biggest country in the world in 
terms of the economy and I think we cannot be responsible for 
what other countries have done. We can be responsible for what 
we are not doing.
    And I think, Mr. Chairman, you have raised a point of long-
term vulnerability. We now have to suck up a huge portion of 
the world savings. You are quite right. The savings rate in 
most other countries is considerably higher than here and a lot 
of it is important in the United States because we have such a 
large savings gap between our investment and our savings rate.
    And I do think that the more dependent we are on this 
foreign capital, if some disruption should occur, and I 
associate myself with those who believe that China or any other 
country is not willingly going to pull the rug out from under 
the dollar or the capital markets in the United States because 
they have an interest in American assets and they have an 
interest in selling here and they do not want the dollar to 
collapse, but if there were to be some untoward, some 
unexpected event like, for instance, an act of terrorism, the 
more reliant we are on foreign capital to fill what will be a 
greater requirement if the budget deficit rises as a result of 
entitlements, then we do become more vulnerable if, and even if 
it is a small if, but if there is a disruption in the inflow of 
that capital for whatever reason.
    So those big numbers down the road, it is not right away, 
but as you point out, it is somewhere down the road. Those do 
imply a vulnerability to an interruption that is greater than 
would be the case today.
    And the other point I would add is it is not just 
foreigners who might pull their money out in the event of a 
major crisis. It is Americans. In an open global capital 
market, they may conclude, you know, that if something goes 
wrong here, they have other options to put their money 
elsewhere also.
    So we tend to focus a lot on the buildup of liabilities and 
vulnerability to foreigners, but in an open global market, even 
if we had no liabilities to foreigners, even if we were in 
balance with a large number of Americans being able to move 
their capital abroad, if we do not run our fiscal policy 
properly, they have the option of moving also. So in a global 
world, they can go both ways.
    Chairman Spratt. Mr. Ryan.
    Mr. Ryan. Thank you, Mr. Chairman. This is very interesting 
and enlightening.
    I think it seems to me we are getting one solid conclusion 
out of this hearing and the various testimonies and that is 
people have difference of opinions on the magnitude of this 
risk with respect to how foreigners might act. And I do not 
think you see this. Neither of you said this is the number one 
    But it seems like the one thing that we know for certain 
that is an undisputable fact is demographics and the state of 
the promises that our government has made with respect to our 
entitlement programs and the trajectory that we are on with 
those entitlement programs.
    So since we are the fiscal policy makers, I will just ask 
each of you and we will just go from, you know, the way you 
started, should the number one thing we focus on here as fiscal 
policy makers be to contain the growth of entitlement spending? 
Should we not be mostly concerned with the growth rate of 
entitlements, their call on debt, and the credit of the United 
States government?
    Is this not ultimately a monetary in addition to a fiscal 
policy problem and if we had to pick one problem that we need 
to focus on where we can make the best difference, would it not 
be containing and constraining the growth of entitlements?
    Mr. Hormats. Yes. I think that in the medium and long term, 
they are unsustainable. If you look at the Trustee's report of 
Medicare and Social Security both, those numbers, and we saw 
the chart before, those numbers are not sustainable.
    And it is not going to happen today or tomorrow, but I 
think we have all indicated if you do not start acting in the 
near term, it will be much more difficult to deal with in the 
longer term. The pain of adjustment will be considerably 
greater and the degree of vulnerability will be considerably 
greater as well.
    So this is something that needs to be addressed and we need 
a very candid discussion with the American people as to why it 
should be addressed and why you simply cannot duck the issue. 
These are going to be tough.
    In some cases, there will be groups that do not like this 
potential solution or that one, but it does strike me that in 
the medium and long term, if we do not deal with that issue, we 
are going to have a much more difficult set of fiscal issues to 
deal with.
    And to get to your point on monetary policy, Ben Bernanke 
when he testified a couple months ago said that even though the 
budget deficit was improving, this may well be the calm before 
the storm.
    Mr. Ryan. Right. Right.
    Mr. Hormats. This was the storm he was talking about, just 
this. And he was also implying at that point, the Fed may not 
be able to do that much about it, you know.
    Mr. Ryan. They can only monetize so much. They just 
    Mr. Hormats. Yes. And he was in effect saying that, you 
know. That is right.
    Mr. Levy. Let me just add two points to the need for 
entitlement reform. Firstly, it has to be grandfathered in. 
Well, let me start out with another point.
    The gap between under current law projected long-run 
benefits and projected long-run taxes called FICA contributions 
is so large, you cannot close the gap by raising taxes in an 
arithmetic way. You have to address the benefit structure.
    The other thing I would say is to be fair, and you want to 
be fair about this, you have to grandfather it in so that it 
does not affect workers, say, over 55, so they have the time to 
adjust their work/leisure decisions.
    The third thing I would say is the American citizens at 
this point fully recognize that the current benefit structures 
are unsustainable and I think Congress would build credibility 
by addressing them rather than passing it on to the next 
    This has been going on forever. I mean, we have known since 
1972 the long-run projections on Social Security and Medicare 
have not made sense. And it has just been delayed and delayed. 
And I just think Congress would--it is a tough issue, but I 
think you would build huge credibility for yourself by honestly 
saying, hey, we have got a long-run problem. We need to 
rationalize economically our long-run benefit and tax structure 
and we will phase it in in the fairest way possible.
    Mr. Ryan. Let me interject and I will just keep it within 
the context of this question. It would be nice to know, and 
maybe it is not a question one can answer, is if we proceeded 
with a sincere, workable, real entitlement reform plan, if 
Congress actually did this and the President signed it, would 
we get reward from the financial markets and would that reward 
from the financial markets, this lead other countries to say, 
gosh, there is a premium to be had for stepping up to the plate 
and solving these problems and so Sarcosi's hand would be, you 
know, aided and Merkel and Germany and Japan would see, you 
know? Would we be able to show leadership and would we get a 
fiscal and a capital market dividend by doing that? Do you 
think that that is quantifiable in any way possible and do you 
think it would occur? And anybody who wants to speak, please 
feel free.
    Mr. Levy. I would say unambiguously, yes. And what you need 
to do is go back to 1993 when President Clinton came into 
office. He put through a package that increased taxes, but also 
reduced spending on a wide range of issues. And the spending 
cuts did not add up to that much, but they sent a message. And 
within a year, bond yields came down significantly. And I just 
think it was a great way to build credibility.
    Mr. Hormats. I agree with that. And I would also add that 
if this does not happen, the closer we get to the point where 
these imbalances----
    Mr. Levy. Where the lines cross.
    Mr. Hormats [continuing]. Really get out of kilter, the 
market is going to start anticipating one of two things unless 
there is a change. One is higher taxes which is bad for growth 
if they get way out of line or higher borrowing which pushes up 
interest rates considerably.
    And the market has not reacted yet, in part because some 
people think growth will resolve the problem. I do not believe 
it will and most people do not. And the other is they think the 
President and the Congress in their wisdom at some point will 
get to it.
    Well, if we get to 2009 with a new Administration and a new 
Congress and we do not see the beginnings of this, they are 
going to start projecting out. And I agree with Dr. Levy. I 
think you would get really good marks and it would also 
embolden other countries.
    Some countries have actually done a lot better, Britain, 
Canada, Chili, Singapore, Sweden. A number of other countries 
have begun to address these much more boldly than we have.
    Mr. Rogoff. I want to frame the question a little 
differently. I certainly agree we have to do something about 
entitlements. But it is mostly medical care. And when you think 
about what the problem is, it is not an accounting problem.
    What is the problem? The problem is that we are having a 
lot of technological innovation. People are getting longer life 
expectancies, better quality of life. And as we Americans get 
richer and we are going to continue to get much richer over the 
next century, we want to spend more of our money on that.
    There are several prominent economists, David Cutler, my 
colleague at Harvard, Robert Hall at Stanford, who have 
estimated that the current 16 percent or whatever it is the 
health sector takes up is going to be 30 percent by the year 
2030 and a lot of that will just be quality improvements.
    And the dilemma we face is that when healthcare was three 
percent of GDP, we will just say everybody should have it. I 
mean, what is there to discuss. When it is 30 percent of GDP, 
it is Marxism. I mean, how do you handle this? It is not an 
easy problem. I have written about this myself.
    Mr. Ryan. Especially in defined benefits sense of the word, 
    Mr. Rogoff. Well, it is going to be hard to have a stable 
equilibrium when, you know, people see what is going on and 
some people are living longer and healthier lives. It is a real 
political challenge of the future. I have written about this 
    I want to come back, though, to the current account a 
little bit. And I agree with Brad. I mean, that is a problem 
that is sooner not later. That is a problem that may just have 
a soft landing in ten years, but it might not. That is going to 
hit us a lot faster than the budget deficit. There are a number 
of reasons that it is more difficult to handle, one of which 
is, you know, by gosh, we just do not export that much and it 
is not that easy to adjust overnight if we have to.
    And if you look at the numbers, that is a much more 
immediate vulnerability and I think is a serious issue. And we 
tend to be lulled to sleep about it a little bit because it has 
been a great economy. But if we enter a period where it is not, 
suddenly we could wish we had taken some steps sooner.
    Mr. Setser. Rather than take up more of the Committee's 
time, I will just second Dr. Rogoff's remarks.
    Chairman Spratt. Mr. Cooper.
    Mr. Cooper. Thank you, Mr. Chairman, and thanks to this 
very distinguished panel. We appreciate your wisdom.
    I would like to thank Dr. Hormats in particular. This is a 
great book. It should be required reading on the other side of 
the aisle as well as our side of the aisle. As he points out, 
we are going through the first war in American history that is 
deliberately unpaid for.
    There are so many issues that are important to touch on. I 
think the average listener would hear things like the ten to 
fifteen-year window of vulnerability that Dr. Rogoff described, 
a window during which we hope we can work toward a soft 
landing, but it will not happen automatically, it will take 
real effort on our part, and a window in which we are 
vulnerable to a myriad of circumstances that could happen 
around the world.
    We have also heard that basically one country can control 
the value of our currency and it depends on their perception of 
risk reward. One expert panelist says they are doing the 
rational thing by investing such a huge percentage of their 
savings in treasuries. Another panelist says, well, they 
actually would have gotten a lot better return if they had done 
a lot of other things.
    It worries me because the one thing that all the panelists 
can agree on is the need for entitlement reform, but that is 
precisely what is not happening nor is likely to happen for the 
foreseeable future here in Washington.
    We have one of Dr. Hormats' former Goldman Sachs colleagues 
now running the Treasury Department and it seems to me that he 
finds it easier to discuss serious issues with the Chinese than 
with the U.S. Congress. If that is not a warning sign on the 
slowness of entitlement reform, I do not know what it is.
    I mentioned earlier in asking Dr. Orszag some questions the 
Standard & Poors projection that within about five years, the 
U.S. Treasury bond would lose its triple A rating. I would like 
to ask each of the panelists whether you are in relative 
agreement or disagreement with that projection. Start with Dr. 
Hormats and go down the line.
    Mr. Hormats. I have not had a chance to read it 
unfortunately. Although now that you mention it, I certainly 
    I do think there is that risk that as these numbers grow 
for the reasons you have mentioned, the attractiveness of U.S. 
assets, they become less desirable. They become less attractive 
assets. Whether they will be downgraded to that point, I do not 
know, but I do think they are certainly less attractive.
    I would have to look at why they have come up with these 
various downward gradations to be able to answer. But certainly 
they are less attractive, sure, absolutely they are.
    Mr. Cooper. In your testimony, you went further than that. 
You said in finance and in military affairs, vulnerability 
breeds aggression.
    Mr. Hormats. Yes.
    Mr. Cooper. So our financial weakness actually motivates 
terrorists and others to do harm to us.
    Mr. Hormats. Yes. And it is certainly true. You are quite 
right. There are clearly terrorists who would if they could get 
weapons of mass destruction and deploy them, they would that. I 
mean, fortunately we would be able to stop it and maybe they 
have not gotten ahold of them anyway. Let us hope they have 
    But the fact is one of the goals of the terrorists, and we 
know this from intelligence reports, is to disrupt the American 
economy. Now, whether we have a budget surplus or budget 
deficit, they are still going to try to do that. We had a 
surplus last time and they blew up the World Trade Centers with 
airplanes and the Pentagon.
    But I would also say that to the extent they think they can 
really disrupt this economy, whatever they do, there will be a 
multiplier effect if our fiscal situation is weak and we are 
not in a very strong fiscal situation to be resilient and to be 
able to come back quickly.
    If they think they can disrupt the American economy, it 
just adds one more incentive to them to do this. And they will 
try to do it anyway, but they will have a greater incentive or, 
not a greater, an additional incentive if they think they can 
really wreak havoc on our fiscal situation.
    And Osama Bin Laden has said that his goal is to bankrupt 
the United States. He said that in October 2004 and a lot of 
intelligence people believe that is their goal. So we should 
not play into this by giving them a weak fiscal situation that 
would make whatever attack they decide to do even worse.
    Mr. Cooper. Dr. Setser, the S&P, agreement or disagreement?
    Mr. Setser. I have not looked closely at the S&P report, so 
I do not want to comment on its details. S&P is evaluating the 
risk that the U.S. government will default on its obligations, 
i.e., not pay.
    In all honesty, I do not think that is the most important 
risk foreign investors in buying U.S. Treasury bonds face. I 
think the most important risk they face are much more tied to 
currency risk, which is not something that Standard & Poors 
    And my personal view is that the risk associated with the 
currency stemming from the factor that Dr. Rogoff mentioned, 
the fact that the U.S. export is about 11 percent of its GDP 
and is running roughly six percent of GDP trade and transfers 
deficit, that that math is in a lot of ways much worse than 
even the long-term fiscal math, although a lot depends.
    Obviously if you go far enough out and have a high-end 
projection on healthcare, the fiscal math can look very bad. 
But in the short run, I think the currency math associated with 
a large trade deficit relative to the U.S. exports face that I 
think is the most important risk.
    Mr. Cooper. I see my time has expired. Is there a moment 
for Dr. Levy or Dr. Rogoff?
    Chairman Spratt. Yes.
    Mr. Cooper. The two others had not had a chance to answer. 
That is okay. Quickly.
    Mr. Levy. I just think their report and what they say is so 
misleading that it does not even deserve merit. And if they 
could come out with a report like that and not in the same 
report identify South Korea, Japan, every European nation whose 
unfunded liability's projections are much larger than ours, the 
U.S. has among all large industrialized nations the lowest 
budget deficit as a percent of GDP and the lowest debt to GDP 
ratio. I do not know what S&P is thinking about.
    Mr. Cooper. Dr. Rogoff.
    Mr. Rogoff. Well, it does sound as far fetched as the 
Goldfinger exercise. I mean, I just do not see that short of 
time frame the U.S. credit declining, you know, for the reasons 
Dr. Levy said. I will second what Dr. Setser said about you 
look at the math on the trade balance, it is a lot scarier.
    Mr. Cooper. Thank you.
    Chairman Spratt. Ms. Kaptur.
    Ms. Kaptur. Thank you, Mr. Chairman.
    Dr. Hormats, prior to 9/11, give me a sense here, how 
important was the Cantor Fitzgerald Brokerage in transacting 
U.S. Treasury bond sales? Extraordinarily important?
    Mr. Hormats. It was a major player.
    Ms. Kaptur. They were the major player; were they not?
    Mr. Hormats. Yes.
    Ms. Kaptur. Thank you very much.
    Could you also tell me in the early 1980s, did you have 
anything to do with structuring the special agreement made with 
Saudi Arabia to convert their investments in our market into 
dollar denominated investments?
    Mr. Hormats. Did I? No, I did not.
    Ms. Kaptur. You did not. All right. Thank you.
    Could you tell me what the profits of Goldman Sachs were 
last year, please?
    Mr. Hormats. I do not recall, but I will submit it to you 
in a follow-up and I will give you our annual report with all 
the details.
    Ms. Kaptur. Thank you.
    And also, they were substantial. They were quite a bit over 
the prior year; were they not?
    Mr. Hormats. Which year was this, last year?
    Ms. Kaptur. Last year.
    Mr. Hormats. They were, I would say, reasonably good, yes.
    Ms. Kaptur. Yes. What about Bank of America, Dr. Levy? What 
were your profits last year?
    Mr. Levy. Do not know. I would be pleased to submit them 
for the record.
    Ms. Kaptur. Thank you very much.
    And I would just comment on your statement that the trade 
deficit has not gone up. The trade deficit in the first quarter 
of this year is higher than it was in the last quarter of last 
    I would like to ask what will the role of your two banks be 
with China's new Wealth Sovereignty Fund? Both your companies, 
I am told, hold at least a five percent share in Chinese owned 
banks. You may deny or accept or modify that fact. And the 
Chinese government announced in March of this year it was 
creating a new fund to buy foreign technology equities and 
    I would like to know will your firms be involved in 
advising on these purchases, making those investments in your 
corporate name, or will the Chinese be passive investors in 
this system?
    The Financial Times reported that Goldman Sachs made a 100 
percent $4 billion profit off your Chinese bank investments in 
just five months. Doctor, I do not know if that is true or not. 
I hope you can confirm it for the record.
    And for the sake of disclosure, Mr. Chairman, I have to ask 
    Your presence here today in advising us, obviously you have 
a lot of respect in the international financial community, but 
one might say is there some kind of sweetheart deal by the 
government of China for your companies, Goldman, Bank of 
America, to use your enormous influence before the government 
of the United States because of the investments that you are 
associated with.
    So my first question is, what will be your role with regard 
to China's new Wealth Sovereignty Fund?
    Mr. Hormats. I do not know and I was not prepared to answer 
that, but I will certainly go back and try to get you an 
    Ms. Kaptur. You are in charge of the international 
financial transactions?
    Mr. Hormats. Well, I am not in charge of that. I simply do 
not know the answer. I am not in charge of all parts of the 
international, but I will certainly get you an answer.
    Ms. Kaptur. So you do not know whether your firm will be 
advising or participating----
    Mr. Hormats. I do not know. Do not forget there is a point 
to be made about this fund. The fund is very much in an 
inchoate stage. It has not been fully put together yet and, 
therefore, I do not know what the fund is exactly going to look 
    The Chinese have said they are going to do this as you 
correctly point out, and there was an article in the FT, but 
the details of it have not yet been released. And I have no 
idea whether we are going to play a role or not play a role.
    But I am more than happy to get you whatever information I 
can get and if I am able to get any, I will be more than happy 
to provide it.
    Ms. Kaptur. The Financial Times story that you made a 
hundred percent $4 billion profit off your Chinese bank 
investments in just five months, can you confirm or deny that?
    Mr. Hormats. I will get back to you on that.
    Ms. Kaptur. That is very interesting.
    Mr. Hormats. But in terms of the testimony here, I come on 
my own to try to provide the best judgment I possibly can and 
this is my judgment. It has nothing to do with any relationship 
we may have with any other country. I am trying to provide a 
factual and judgmental assessment of what I think is in the 
interest of the United States.
    Ms. Kaptur. Well, I would say, Mr. Chairman, you know, when 
witnesses come before us and there are international financial 
questions before us, disclosure is important. And to the extent 
we can obtain that for the people of the United States who are 
paying the freight here, I think it is very important for us to 
do that.
    Mr. Hormats. I agree. The more transparency, the better.
    Ms. Kaptur. Absolutely.
    Mr. Hormats. That is a good part of our American system.
    Ms. Kaptur. Absolutely.
    Dr. Hormats, do you know what percent of Goldman Sachs is 
owned by interests from other countries? I was told the 
Japanese had a 20 percent share in your company. Is that true?
    Mr. Hormats. I do not know. Well, a long time ago, but I do 
not know what the portion--you mean what percentage of our 
stock is owned by foreigners? I have no idea, but I----
    Ms. Kaptur. Of the actual equity in your firm.
    Mr. Hormats. I know what you mean exactly. I mean, I do not 
know that we know it. But if it is knowable, I am sure it is 
public information. If it is public information, I am more than 
happy to provide it.
    Ms. Kaptur. Then I would be very grateful if you could 
provide it to the record.
    I will ask the same question of Mr. Levy. Bank of America?
    Mr. Levy. Bank of America has a ten percent passive 
minority investment in CCB Bank in China. That is the extent I 
know about it.
    Ms. Kaptur. Thank you. To the extent you can----
    Mr. Levy. I am only an economist.
    Ms. Kaptur. To the extent you can provide clarification for 
the record, it would be greatly appreciated.
    Mr. Chairman, in ending, let me just say that these 
gentlemen live in the macro world and it is a very important 
one. I am actually a Jeffersonian Democrat, not a Hamiltonian. 
I do not have a Hamiltonian mindset.
    I am troubled as an American citizen that our savings are 
negative, that the dollar is in decline in value, that local 
banks that used to belong to people in our community have now 
become derivative institutions and part of the problem of the 
American savings rate going down.
    I am troubled that wages and income levels are stuck for 
the majority of people I represent, that the State of Ohio has 
the number one housing foreclosure rate in this country. I see 
that the extremely wealthy are doing extremely well. The rest 
are struggling and we have more poverty.
    This is not an America that I want to give to my children 
and grandchildren. So I appreciate your listening to me. You 
live in very special circumstances and work in very special 
circumstances. Not all Americans share in that. And I 
appreciate your listening today.
    Thank you, Mr. Chairman.
    Chairman Spratt. Yeah. Let me thank each one of you for 
coming, for taking your own----
    Mr. Scott. Mr. Chairman.
    Chairman Spratt. Oh, I beg your pardon. I beg your pardon. 
Mr. Scott came back in the room.
    Mr. Scott. Thank you, Mr. Chairman.
    Chairman Spratt. I yield to the gentleman from Virginia.
    Mr. Scott. Thank you.
    I want to follow-up with the question with Mr. Levy. I 
think your answer to Ms. Kaptur's question was who the bank 
owns. I think the question she was interested in is who owns 
the bank in terms of your stockholders.
    Mr. Levy. I do not know. It has been a decades long 
publicly-held firm.
    Mr. Scott. Is there any problem with foreigners buying 
equity positions in United States corporations?
    Mr. Levy. Not as far as I am concerned. As long as it does 
not jeopardize, you know, national security, the answer is no.
    Mr. Scott. Does anybody think there is a problem with 
American companies being bought up by foreign interests?
    Mr. Rogoff. I mean, fundamentally no as long as we maintain 
transparency and good corporate governance. I mean, frankly, 
when you are borrowing $800 billion a year, they want to buy 
something. So, you know, it is not surprising that they're 
doing this.
    Mr. Scott. Is there any problem with the fact that we 
cannot finance our national debt without foreign help? The 
increase in the net national debt was about 1.5 trillion the 
last couple of years. Increase in net foreign holdings is about 
    Mr. Setser. I will try to answer that question. I mean, I 
think it depends on where you stand. It depends a little bit on 
where you sit. The fact that we have been able to finance our 
debt by placing a large share of that debt with foreign central 
banks has kept U.S. interest rates low.
    Low U.S. interest rates have benefited those who hold 
housing, particularly in coastal communities, since the housing 
prices have gone up much more in some parts of this country 
than in others. It has helped many who borrow. It helped 
private equity funds who borrow debt to buy equity.
    But the counterpart to all this is that the countries that 
are intervening in the foreign exchange market to build up this 
foreign exchange which they lend to the U.S. are holding their 
currencies down and holding the dollar up and that is hurting, 
unambiguously hurting parts of this country. It is hurting 
Ohio. It is hurting Michigan.
    I mean, it is hurting those parts of the country that 
specialize in trade and manufactured goods production and those 
parts of the country have not seen the same upward appreciation 
in housing prices.
    So I think the overall impact is a little hard to assess 
because it has such a disparate effect on different parts of 
the country and I think we should recognize that.
    Mr. Scott. Well, based on where we are borrowing the money 
from, does this borrowing pattern translate in any way into oil 
    Mr. Setser. I would say that high oil prices are one of the 
reasons why and the recycling of those petro dollars have 
contributed to very high savings rates and have helped hold 
U.S. interest rates.
    You know, without these large demand for U.S. securities, 
primarily debt securities, from countries intervening in the 
exchange rate and countries building up petro dollars, U.S. 
interest rates would have been higher.
    Mr. Scott. Does that translate into higher oil prices?
    Mr. Setser. I think it works the other way is what I was 
trying to suggest.
    Mr. Scott. Okay. So borrowing money from Saudi Arabia is a 
good thing for oil prices?
    Mr. Setser. I would put it the other way, that high oil 
prices mean the Saudis have lots of money which they will 
invest somewhere. And recently the Saudis, I think in 
particular, have been building up their central banks' assets 
very rapidly. And while they are very secretive, it is 
reasonable to assume that some of that is going into the U.S. 
securities markets.
    Mr. Scott. If one country, China, for example, decides to 
stop buying U.S. dollars, is there a possibility of a herd 
effect which could magnify the problem?
    Mr. Hormats. I think as I mentioned, it is unlikely the 
Chinese would do that because they have an interest in holding 
dollar assets. As you know, one of the questions has been 
whether they will allow their currency to appreciate sharply 
against the dollar. And so far, they have allowed it to 
appreciate, but only very gradually. They do not want to see a 
precipitous decline in the dollar, in part because they already 
have a lot of dollar denominated assets and in part because 
they want to have their goods remain competitive in dollar 
markets, the U.S. and other dollar or dollar-related markets.
    So the probability of their pulling the rug out from under 
our currency or our capital markets is very, very low. If there 
were some circumstance where any country that held a lot of 
reserves were to do this, and it would have to be very 
extenuating circumstances, much more than any sort of normal 
act, then other countries might, as I mentioned in my 
testimony, decide that they wanted to sell before the dollar 
fell too much.
    But I think the odds of that scenario are pretty unlikely 
unless some really traumatic event were to occur. And if it 
happened, it would be very, very tragic, very traumatic for our 
system. But the odds of it occurring, I think, are relatively 
    But as I say, they are not zero and the more dependent we 
are on foreign capital, there is always some risk that some 
untoward event, some unexpected event could occur. And it need 
not be China. It could be any other central bank too.
    Mr. Scott. Mr. Chairman, I guess I just need to study up on 
international financing because the idea that we seem to be 
better off borrowing from foreign countries rather than saving 
and balancing our budget and being in a capital plus situation 
did not seem to--I just----
    Mr. Hormats. Well, I think we are better off if we can roll 
out our own savings. It would be better if we had a higher 
savings rate. I do not think any of us would argue about that. 
But the fact is since we do not, unfortunately we have to get 
it from somewhere and we get it from those countries that do 
have high savings rates. But you are quite right. It is not the 
best of circumstances. I think if we could find a better way 
that we did not have to rely that much, it would be better.
    Mr. Levy. Would you rather have extraordinarily weak 
economic growth, no job creation, dismal investment 
opportunities, so then you would have excess saving and a 
current account surplus?
    Mr. Scott. I think the last time we had a budget surplus 
when the stock market was doubling about every five years, we 
were creating more jobs than in recent history. And I thought, 
you know, and I do not know, I am not an expert on this, but I 
thought that was a good thing.
    Mr. Levy. I was referring to the current account, the 
current account issue.
    Mr. Scott. I was referring to jobs and the stock market.
    Chairman Spratt. To our panel, let me extend the thanks of 
the whole Committee for your participation, for your written 
testimony, for your oral presentation, for your answers. We 
very much appreciate it. We have learned a great deal about 
this matter from you and we are indebted to you for having come 
and being so patient and forebearing and participation. Thank 
you very much.
    [Whereupon, at 5:04 p.m., the Committee was adjourned.]