This paper presents a new model for studying international capital flows and debt dynamics. The model emphasizes the role of expectations concerning future trade flows and returns as the determinants of a country's foreign asset and liability positions, and how revisions in these expectations drive gross and net capital flows. I use the model to estimate the drivers of the U.S. external position and capital flows between 1973 and 2008. The estimates show that most of the secular rise in U.S. international indebtedness is attributable to growing optimism about future returns on U.S. holdings of foreign equity and FDI assets. Expectations concerning future returns are also the most important determinant of net capital flows, but the flows themselves are not important drivers of the U.S. external position. My estimates also show that the transformation of world savings into risky assets by the U.S. had little effect on its external position, but the expected real depreciation of the dollar allowed the U.S. to sustain a much higher level of international debt after the 1990s.
