capital flight from the region. But the push of funds into Latin America to escape low yields and uncertainty in the US has also been an important factor. As in Europe and Canada private capital flows have pushed currencies up across the board. Brazil and Argentina have already given back some of the improvement in their competitive positions following large depreciations in 2002 and 2003, respectively Is This System Sustainable? In spite of the growing US deficits, this system has been stable and sustainable. The current account structure and asset accumulation have been consistent with the trade account regions preferences for official investments in the US and, until early this year, the capital account regions preferences for private financial investments in the Us. But as Us debts cumulate, US willingness to repay both Asia and Europe comes more naturally onto the radar screen, so the system that was previously stable could run into trouble Normally, a private investor would require a much higher return than before to keep capital flowing to the s. This could happen in both of two ways. Yields in the US would have to rise and the dollar would depreciate sharply so that an expected subsequent appreciation would further boost the yield to foreign Investors But our analysis of behavior of trade account countries suggests that Asia will displace Europe in sendil exports to the US and will accept an even larger inflow of US securities. If so, yields in the US will not We see the start of this now in the form of euro appreciation. But trade account countries will resist appreciation. They will cumulate even more low-yielding US securities. A Europe that lets this happen will see its exports squeezed out and in the extreme may even start selling its claims on the Us to be acquired by Asia as the capital account region avoids what it sees as the potential collapse of the system As evidence for this combination of European and Asian actions, US yields have generally fallen, stock prices risen, and spreads have contracted. This has happened even in the face of a sharp depreciation in dollar-euro and other capital account region currencies and a sharp rise in the US current account deficit Asian exchange rates have hardly moved by comparison against the Usd There is a rising volume of complaints in the US about the unfair trade advantages of Asias undervalued currencies, aimed primarily at China, but curiously not at Japan whose goods are more directly competitive with manufactured goods in the US. Also, there have been claims that undervalued currencies inevitably lead to over-heating and inflation and so must be self-correcting. However, it will take a long time to get to such a point. For example, in China, M2 growth of 16% is consistent with price stability, and only recently has it risen to 20%, which will lead to inflation of about 5% in two years time(0.5% right now) As interim measures, there is room to raise bank reserve requirements or domestic interest rates. To head off trade partner commercial policy, there may be a token revaluation of up to 3%, over the course of time, or a redirection of imports to the Us. But support of growth is the primary motivation, with above 40% of the population yet to be absorbed from the farming sector. And even if this reserve of labor were gone, India is ready to graduate to the periphery with its vast supply of underemployed workerscapital flight from the region. But the push of funds into Latin America to escape low yields and uncertainty in the US has also been an important factor. As in Europe and Canada private capital flows have pushed currencies up across the board. Brazil and Argentina have already given back some of the improvement in their competitive positions following large depreciations in 2002 and 2003, respectively. Is This System Sustainable? In spite of the growing US deficits, this system has been stable and sustainable. The current account structure and asset accumulation have been consistent with the trade account region’s preferences for official investments in the US and, until early this year, the capital account region’s preferences for private financial investments in the US. But as US debts cumulate, US willingness to repay both Asia and Europe comes more naturally onto the radar screen, so the system that was previously stable could run into trouble. Normally, a private investor would require a much higher return than before to keep capital flowing to the US. This could happen in both of two ways. Yields in the US would have to rise and the dollar would depreciate sharply so that an expected subsequent appreciation would further boost the yield to foreign investors. But our analysis of behavior of trade account countries suggests that Asia will displace Europe in sending exports to the US and will accept an even larger inflow of US securities. If so, yields in the US will not rise. We see the start of this now in the form of euro appreciation. But trade account countries will resist appreciation. They will cumulate even more low-yielding US securities. A Europe that lets this happen will see its exports squeezed out and in the extreme may even start selling its claims on the US to be acquired by Asia as the capital account region avoids what it sees as the potential collapse of the system. As evidence for this combination of European and Asian actions, US yields have generally fallen, stock prices risen, and spreads have contracted. This has happened even in the face of a sharp depreciation in dollar-euro and other capital account region currencies and a sharp rise in the US current account deficit. Asian exchange rates have hardly moved by comparison against the USD. There is a rising volume of complaints in the US about the unfair trade advantages of Asia’s undervalued currencies, aimed primarily at China, but curiously not at Japan whose goods are more directly competitive with manufactured goods in the US. Also, there have been claims that undervalued currencies inevitably lead to over-heating and inflation and so must be self-correcting. However, it will take a long time to get to such a point. For example, in China, M2 growth of 16% is consistent with price stability, and only recently has it risen to 20%, which will lead to inflation of about 5% in two year’s time (0.5% right now). As interim measures, there is room to raise bank reserve requirements or domestic interest rates. To head off trade partner commercial policy, there may be a token revaluation of up to 3%, over the course of time, or a redirection of imports to the US. But support of growth is the primary motivation, with above 40% of the population yet to be absorbed from the farming sector. And even if this reserve of labor were gone, India is ready to graduate to the periphery with its vast supply of underemployed workers