Large foreign holdings of U.S. debt can pose a risk to the U.S. economy, but, so far at least, we have benefited. The "carry trade," borrowing undervalued currencies, mostly the Japanese Yen, and investing it in U.S. debt has been around for a long time. When the dollar is falling, why are Japan and China continuing to hold such large positions? The short answer is we are their largest customer, and they are struggling to hang on to their export business with us.

Japanese holdings of Treasury debt as of the end of February totaled $586.6 billion, down 5.8% from last June. China increased its holdings over the same period from $477.3 billion to $486.9 billion, a 2.0% increase. Considering the dollar has depreciated since then by 9.6% against the Yen and by 8.1% against the Yuan, that's quite a loss the Japanese and Chinese have suffered in the value of those holdings and of the interest income streams they yield.

Last September, some Fed economists studied the exchange rate pass-through of export prices to the U.S. They concluded:

"First, we find strong evidence--based on a range of empirical exercises and data sources--that the prices foreign exporters charge in the U.S. market are more responsive to the exchange rate than is the case for other markets on average. In this respect, the United States is special. Second, we also find evidence that the dollar plays a unique role in the determination of global traded goods prices, apparently reflecting both the prominent international role of the dollar and the centrality
of the U.S. marketplace. Third, moves in the exchange rate sensitivity of export prices over time appear to have been significantly affected by country and region-specific factors, including the Asian financial crisis (for emerging Asia), deepening economic integration with the United States (for Canada), and the effects of the 1992 ERM crisis (for the United Kingdom)."

In other words, they found that foreign exporters, and particularly those from Asia, cut their prices and cut profits to maintain market share in the U.S. Also, there is a large advantage to being the world's currency.

However, there is a limit to how far the U.S. can push its advantage. Our current account deficit has approached 7% of GDP. That would be a danger level for most other countries.

The issue is how do we adjust to a lower current account deficit, and can we do so without further damaging our economy.

There are lots of ways to reduce your current account deficit and our dependence upon foreign debt holders. It's a well known accounting identity that the current account deficit equals national investment minus national savings. In other words, we import foreign capital to make up for our lack of savings to pay for the investment we do to keep our economy growing and to replace worn out or obsolete capital. As a nation, over the past seven years, we have had a zero savings rate, we have consumed beyond our means, and we have borrowed from foreigners to pay for it. To reduce our current account deficit, we can save more, spend less, invest less, raise interest rates, raise taxes, cut government spending, or allow the value of the dollar to drop. You will notice that the only one of those solutions that we have adopted so far, and by default, was to lower the value of the dollar. Our economy is slowing because of the credit crisis, and that has slowed investment in housing by a lot. Neither is a preferred way to solve our current account deficit. Both risk future economic turmoil. The sooner we adopt some of those other solutions, the more quickly we will secure our economic future. If we fail to do so, we risk more unpalatable solutions forced upon us as foreigners stop buying our debt and as the value of the dollar plunges unexpectedly.