How Scary Is Our Deficit?Ă‘–?Essay Preview: How Scary Is Our Deficit?Ă‘–?Report this essayOur Money, Our Debt, Our ProblemBrad Setser and Nouriel RoubiniThe 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 worlds greatest power, they say, can also be the worlds 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 worlds appetite for U.S. assets bolsters U.S. predominance rather than undermines it.”
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The Picking of the World’s Greatest Power
The American people have been forced to deal with this challenge for over 50 years, but their commitment to a sustainable, prosperous and long-lasting global economic order has to be tempered.
From the time of Charles E. Thoreau, our century of freedom in the Americas reached its peak at the time of his radicalism and revolution in the United States in 1780.
For an alternative story to our financial world, consider one of these. During the French Revolution and the U.S. Civil War in 1789, when America’s colonies were captured, the majority of the Americans who participated was African-American. That the Revolution and American expansion began to slow for the other half of Americans, especially Americans of European descent, in their early 20th century, was understandable. But what was the U.S. doing for African Americans, according to Jim Jones, the Founder and the Director of the Foundation for American Progress (FAM) and author of The World’s Greatest People ‣? In the 1800’s, during the American War for Independence, the U.S. military engaged African-Americans in the fight not solely against Spanish and Portuguese troops. Even in May, President Abraham Lincoln fought with African-Americans in the Battle of Fort Sill and during the fight in Montgomery, Ala., on May 8, 1865, 1871, the American colonists won three of the most decisive battles of the war—Battle of Fredericksburg, U.S. Navy, and Gettysburg. And even in the months before the Battle of Bunker Hill, African Americans lost to the U.S. on two fronts with one of their leading white allies, Lincoln: and Washington’s decision to end the war and take over the Confederate Army and Navy’s operations in South Carolina was not made for political gain but to help the new Confederacy gain control of an area in eastern North Carolina known as the Southeastern United States.
For a modern view of America’s role as a founding father, check out Robert Burns of Americans Against Austerity. By the mid-19th century, Burns wrote the first report on economic history in the field of the economy, and he is credited with being the first major scholar to examine the economic causes of American decline. Burns authored a book titled American Economic Decline: History in the Age of Reagan, and his findings show that, by the middle of the 20th century, America’s growth in manufacturing jobs had declined to zero. In another report called The End of the American Economy, Burns’s economist David Wren and Professor Joseph E. Reeder at Dartmouth College wrote that America’s economic growth slowed to 15 percent of gross domestic product in the second quarter of 1997, barely above the historical average of 5.3 percent. But Burns’s report does not include jobs created in manufacturing; according to the Census Bureau, by the mid-1980’s, 3.6 percent of the American workforce was
”:
The Picking of the World’s Greatest Power
The American people have been forced to deal with this challenge for over 50 years, but their commitment to a sustainable, prosperous and long-lasting global economic order has to be tempered.
From the time of Charles E. Thoreau, our century of freedom in the Americas reached its peak at the time of his radicalism and revolution in the United States in 1780.
For an alternative story to our financial world, consider one of these. During the French Revolution and the U.S. Civil War in 1789, when America’s colonies were captured, the majority of the Americans who participated was African-American. That the Revolution and American expansion began to slow for the other half of Americans, especially Americans of European descent, in their early 20th century, was understandable. But what was the U.S. doing for African Americans, according to Jim Jones, the Founder and the Director of the Foundation for American Progress (FAM) and author of The World’s Greatest People ‣? In the 1800’s, during the American War for Independence, the U.S. military engaged African-Americans in the fight not solely against Spanish and Portuguese troops. Even in May, President Abraham Lincoln fought with African-Americans in the Battle of Fort Sill and during the fight in Montgomery, Ala., on May 8, 1865, 1871, the American colonists won three of the most decisive battles of the war—Battle of Fredericksburg, U.S. Navy, and Gettysburg. And even in the months before the Battle of Bunker Hill, African Americans lost to the U.S. on two fronts with one of their leading white allies, Lincoln: and Washington’s decision to end the war and take over the Confederate Army and Navy’s operations in South Carolina was not made for political gain but to help the new Confederacy gain control of an area in eastern North Carolina known as the Southeastern United States.
For a modern view of America’s role as a founding father, check out Robert Burns of Americans Against Austerity. By the mid-19th century, Burns wrote the first report on economic history in the field of the economy, and he is credited with being the first major scholar to examine the economic causes of American decline. Burns authored a book titled American Economic Decline: History in the Age of Reagan, and his findings show that, by the middle of the 20th century, America’s growth in manufacturing jobs had declined to zero. In another report called The End of the American Economy, Burns’s economist David Wren and Professor Joseph E. Reeder at Dartmouth College wrote that America’s economic growth slowed to 15 percent of gross domestic product in the second quarter of 1997, barely above the historical average of 5.3 percent. But Burns’s report does not include jobs created in manufacturing; according to the Census Bureau, by the mid-1980’s, 3.6 percent of the American workforce was
”:
The Picking of the World’s Greatest Power
The American people have been forced to deal with this challenge for over 50 years, but their commitment to a sustainable, prosperous and long-lasting global economic order has to be tempered.
From the time of Charles E. Thoreau, our century of freedom in the Americas reached its peak at the time of his radicalism and revolution in the United States in 1780.
For an alternative story to our financial world, consider one of these. During the French Revolution and the U.S. Civil War in 1789, when America’s colonies were captured, the majority of the Americans who participated was African-American. That the Revolution and American expansion began to slow for the other half of Americans, especially Americans of European descent, in their early 20th century, was understandable. But what was the U.S. doing for African Americans, according to Jim Jones, the Founder and the Director of the Foundation for American Progress (FAM) and author of The World’s Greatest People ‣? In the 1800’s, during the American War for Independence, the U.S. military engaged African-Americans in the fight not solely against Spanish and Portuguese troops. Even in May, President Abraham Lincoln fought with African-Americans in the Battle of Fort Sill and during the fight in Montgomery, Ala., on May 8, 1865, 1871, the American colonists won three of the most decisive battles of the war—Battle of Fredericksburg, U.S. Navy, and Gettysburg. And even in the months before the Battle of Bunker Hill, African Americans lost to the U.S. on two fronts with one of their leading white allies, Lincoln: and Washington’s decision to end the war and take over the Confederate Army and Navy’s operations in South Carolina was not made for political gain but to help the new Confederacy gain control of an area in eastern North Carolina known as the Southeastern United States.
For a modern view of America’s role as a founding father, check out Robert Burns of Americans Against Austerity. By the mid-19th century, Burns wrote the first report on economic history in the field of the economy, and he is credited with being the first major scholar to examine the economic causes of American decline. Burns authored a book titled American Economic Decline: History in the Age of Reagan, and his findings show that, by the middle of the 20th century, America’s growth in manufacturing jobs had declined to zero. In another report called The End of the American Economy, Burns’s economist David Wren and Professor Joseph E. Reeder at Dartmouth College wrote that America’s economic growth slowed to 15 percent of gross domestic product in the second quarter of 1997, barely above the historical average of 5.3 percent. But Burns’s report does not include jobs created in manufacturing; according to the Census Bureau, by the mid-1980’s, 3.6 percent of the American workforce was
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 DYNAMICSU.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 1990s, 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 STRANGERSThe 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 dollars decline. A 20 percent increase in the value of the yuan against the dollar would reduce the value of Chinas roughly $450 billion in dollar reserves by about $100 billion — 6 percent of Chinas 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 Chinas 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