How Scary Is the Deficit?

American Power and American Borrowing

Our Money, Our Debt, Our Problem

The U.S. current account deficit—the gap between what the United States earns abroad and what it spends abroad in a year—is on track to reach seven percent of gdp in 2005. That figure is unprecedented for a major economy.  Yet modern-day Panglosses tell us not to worry: the world's greatest power, they say, can also be the world's greatest debtor. According to David Levey and Stuart Brown ("The Overstretch Myth," March/April 2005), "the risk to U.S. financial stability posed by large foreign liabilities has been exaggerated." Indeed, they write, "the world's appetite for U.S. assets bolsters U.S. predominance rather than undermines it."

But in fact, the economic and financial risks that arise from the U.S. current account deficit (and the resulting depen­dence on foreign financing) have not been exaggerated. If anything, they have received too little attention—and are set to grow in the coming years.

Levey and Brown make three basic arguments. First, they claim that foreign central banks will probably continue to finance U.S. deficits. Second, they predict that even if foreign central banks do pull back at some point, private investors will step in. And finally, they assume that even if this financing does not materialize, a dollar crash would hurt Europe and Japan more than it would hurt the United States. Unfortunately, there is a good chance that all of these assumptions will prove false. Foreign central banks may well stop financing growing U.S. deficits, private equity investors might not take their place, and the resulting adjustment process would prove quite painful for the United States.

DEBT DYNAMICS

U.S. external debt is now equal to more than 25 percent of gdp, a high level given that exports are a small fraction of U.S. gdp. More important, the United States is adding to its debt at an extraordinary pace. The U.S. current account deficit is now comparable to those of Thailand and Mexico in the years leading up to their financial crises.

In the late 19905, the United States borrowed abroad to finance private in­vestment. Today, however, the country does most of its foreign borrowing to finance the federal budget deficit, which is projected to be close to 3.5 percent of gdp in 2005. (In 2000, the United States had a surplus equal to 2.5 percent of gdp.) Recent economic growth has not reduced the budget deficit, but it has increased private demand for scarce savings; the net result has been even more borrowing from abroad. In 2004, foreigners bought an amazing $900 billion in U.S. long-term bonds; the United States exported a '  dollar of debt for every dollar of goods it sold abroad. Looking ahead, the U.S. debt position will only get worse. As external debt grows, interest payments ,   on the debt will rise. The current account deficit will continue to grow on the back of higher and higher payments on U.S. foreign debt even if the trade deficit sta­bilizes. That is why sustained trade deficits will set off the kind of explosive debt dynamics that lead to financial crises.

Nothing to worry about, argue Levey and Brown: foreigners may own a majority of U.S. Treasury bonds, but their holdings of other types of U.S. debt and equities remain limited; the United States, unlike other debtors, borrows in its own currency, displacing the negative consequences of a falling dollar onto its creditors; and the United States has substantial assets abroad, the value of which rise as the dollar falls.

In recent years, the rising value of ex­isting U.S. assets abroad has in fact offset much of the new borrowing the United States has taken out to finance its trade deficit, and Levey and Brown bank on similar gains in the coming years. But this bet is unwise. Most U.S. assets abroad are in Europe. Since the dollar already has fallen by around 40 percent against the euro, further falls in the dollar are likely to be against Asian currencies, and the United States holds relatively few Asian assets.

THE KINDNESS OF STRANGERS

The falling dollar also reduces the value of foreign investments in the United States. Eventually, foreign creditors are likely to demand higher interest rates to offset the risk of further decreases. Over the past few years, the United States has found a novel way out of this dilemma: rather than selling its debt to private investors who care about the risk of financial losses, it has sold dollar debt at low rates to foreign central banks. The extent of U.S. dependence on only ten or so central banks, most of them in Asia, is stunning: in 2004, foreign central banks probably increased their dollar reserves by almost $500 billion, providing much of the financing the United States needed to run a $665 billion current account deficit. These banks are not buying dollar-denominated bonds because they are attracted to U.S. economic strength, the high returns offered in the United States, or the liquidity of U.S. markets; they are buying them because they fear U.S. weakness. If foreign central banks stopped buying dollar-denominated bonds, the dollar would fall dramatically against their currencies, U.S. interest rates would rapidly rise, and the U.S. economy would slow.

Foreign central banks have financed the United States to keep their export sectors—heavily dependent on U.S. consumer spending—humming. But they now must weigh the benefits of providing the United States with such "vendor financing" against the rising costs of keeping the current system going.

Now, foreign central banks with large dollar holdings are facing the prospect of huge losses as a result of the dollar's decline. A 20 percent increase in the value of the yuan against the dollar would reduce the value of China's roughly $450 billion in dollar reserves by about $100 billion— 6 percent of China's gdp. In four years, if nothing changes, Chinese dollar reserves could reach $1.4 trillion, raising the costs of a falling dollar to $300 billion—some 12 percent of China's gdp. In short, the longer China continues to finance U.S. deficits, the larger its ultimate losses.

More important, the current arrange­ment increasingly risks creating domestic financial trouble. Growing reserves natu­rally lead to growth in the money supply, raising the risk of inflation. In order to avert this risk, central banks must resort to a process called "sterilization": selling local-currency bonds to reduce the amount of cash in circulation. But this process is expensive, especially if local interest rates are higher than dollar interest rates. Chi­nese domestic interest rates are low, so China does not face this problem. But it does face another: rapid monetary growth has contributed to a boom in bank credit, excessive investment growth, and a real estate bubble. Thus far, China has used price controls to keep prices from rising, but such controls, which cause deep distor­tions in the economy, cannot keep the lid on inflation forever. Eventually, rising domestic prices will erode China's competitiveness even if it keeps its currency pegged at its current level. China is likely to let its cur­rency appreciate rather than accept socially and politically destabilizing inflation.

Let's face it: most Asian central banks view financing the U.S. deficit as a burden, one that they would rather not shoulder. A recent survey of central banks (which did not include the People's Bank of China or the Bank of Japan) indicated that most want to scale back their dollar purchases, and some smaller central banks are already adding more euros and yen to their portfolios. In March, a former manager of China's currency reserves questioned China's current development strategy, asking why it should seek out foreign investors looking for a 15 percent return on their investment only to have the central bank lend these funds back to the United States at 4 percent. China will conclude that rapid accumulation of dollar reserves no longer serves its interests sooner than optimists think.

Many claim that Asian central banks have to hold on to their dollars—and the U.S. bonds that they have bought with their dollars—because a sell off would drive the market for dollars lower and thus be self-defeating. This argument, however, misses a key point: foreign central banks do not need to dump their existing stocks of U.S. dollars to cause financial distress in the United States; they only need to slow their new purchases of dollar debt. If central banks decide that $2.5 trillion in dollar reserves is enough, the result will be a sharp fall in the dollar and a sharp rise in U.S. interest rates.

Levey and Brown further argue that even if foreign central banks scale back their financing, there is little to worry about, since the United States is on the verge of a new information technology (it) revolution that will attract a new wave of investment from abroad. Alas, there is little evidence to suggest this pleasant scenario will come to pass. In both 2003 and 2004, equity investors took more than $150 billion out of the United States: U.S. direct investment abroad exceeded foreign direct investment in the United States, and U.S. purchases of foreign stocks exceeded foreign purchases of U.S. stocks. High equity inflows are more likely to come because a further fall in the dollar makes U.S. assets fire-sale cheap than because of a scramble to get in on another it boom.

Other countries do of course depend on U.S. spending to make up for a lack of demand inside their own economies. But the United States cannot take comfort in the fact that the necessary "adjustment" will be painful abroad. If a falling dollar slows German, Japanese, or even Chinese growth, it will become even harder for the United States to reduce its trade deficit by exporting more—a key part of any "soft landing" scenario.

And even if the United States has rel­atively little to fear from a falling dollar, it has much to fear from an increase in inter­est rates. If central banks ever cut back on their dollar purchases, private investors abroad would likely demand much higher interest rates. They would have to be compensated for the risk of buying a dol­lar that may fall even more. Given how leveraged the U.S. economy has become, with large domestic and external debts, any large rise in interest rates would do significant damage.

POWER DRAIN

There is little doubt that U.S. external debt and the current account deficit are eroding the appeal of the U.S. approach to eco­nomic policy, an important element of U.S. "soft power." Asian policymakers, in particular, view U.S. economic policy not as a model but as a problem: the United States' "exorbitant privilege"—Charles de Gaulle's term for Washington's ability to finance deficits by printing dollars— comes at their expense.

The United States has a particularly delicate relationship with China, which is currently the single biggest buyer of U.S. debt. To date, disagreements on other issues have not prompted China to slow its accumulation of dollar reserves, but that is not to say that it could not happen in the future. The ability to send a "sell" order that roils markets may not give China a veto over U.S. foreign policy, but it surely does increase the cost of any U.S. policy that China opposes. Even if China never plays its financial card, the unbalanced economic relationship be­tween the United States and China could add to the political tensions likely to accompany China's rise.

Economic power usually flow to creditors, not debtors. While the United States roams the world looking to sweep up any spare savings to finance its huge deficits, China roams the world looking for new places to invest its surplus savings— including in oil and gas resources and in states that Washington has judged pariahs. This is a far cry from the early days of the Cold War, when the United States used its surplus savings to finance the recon­struction of its allies, cementing political alliances with strong economic ties.

Levey and Brown are right that so far, the world's appetite for U.S. credit has bolstered the U.S. ability to be a global hegemon "on the cheap." The United States exports enough to pay for only two-thirds of its imports; after recent tax cuts, the U.S. government collects enough non-Social Security revenue to cover only two-thirds of its non-Social Security spending.  Foreigners made up the difference last year, buying enough U.S. Treasuries to fund the entire budget deficit. But without access to this easy financing from foreign central banks, the U.S. gov­ernment and the U.S.  electorate will have to make the kinds of unpleasant choices they have thus far avoided: among guns, butter, pork, tax cuts, and low interest rates.

It is far better for Washington to act now, when it can act on its own terms, than to wait until sharp falls in foreign demand for dollar debt forces it to act. The most important step, of course, is to start cutting the budget deficit rather than just talking about cutting the budget deficit. This will require reversing some recent tax cuts, not just controlling spending. Otherwise, the only way to reduce U.S. demand for foreign savings would be through a sharp decrease in private investment and consumption— with disastrous consequences for the U.S. economy. The Bush administration has been lucky over the past few years—the growing value of U.S.-held European assets has kept U.S. external debt from rising, and foreign central banks' willingness to buy U.S. debt has helped keep U.S. interest rates low in the face of large deficits— but its luck could easily turn.

Arguing that deficits—external as well as domestic—do not matter does not make them go away. Celebrating the United States' real economic strengths while ignor­ing the real—and growing—economic vulnerabilities associated with unprece­dented current account deficits is dangerous.

brad setser is a Research Associate in the Global Economic Governance Programme at University College, Oxford. NOU KIEL ROUBINI is Professor of Economics at

New York University's Stern School of Busi­ness and Chair of Roubim Global Economics.