John,
In a few of the articles cited previously it was assumed that trade, asset flows(foreign investment), and the value of the dollar remained relatively unchanged while the implications of fluctuations in private and public debt, interest rates, and fiscal policy variables were examined. This article looks at the effects of variability primarily in the flow of funds, the trade balance, and the value of the dollar.
It is likely that few politicians have not even begun to realize what they are going to be called on to do. And while AG must have an understanding of this, it is still unlcear if he believes it.
Never being much of a Cliff Notes kind of guy, I will admit to hacking away at this fine discussion in an effort to bring the tread the essentials. There is a revealing presentation of alternative scenarios, that are neither bullish nor bearish in their intent; and which provide very interesting possible outcomes. If one has the time and inclination I urge grabing and reading the real article.
it can be found at the Economic Policy Institute site:
epinet.org
you must, however, search on 'ticking debt bomb' to obtain the article.
Yorikke
THE TICKING DEBT BOMB
Why the U.S. International Financial
Position Is Not Sustainable
by Robert A. Blecker
For the last few years, most of the economic news in the United States has been
glowing. The U.S. economy has grown at a healthy 4% average rate since 1997, with
virtually full employment and almost negligible inflation, thus returning to
macroeconomic conditions not experienced since the early 1960s. Two-and-a-half
years after Federal Reserve Board Chairman Alan Greenspan warned of “irrational
exuberance” on Wall Street, the New York stock market continues to climb to
unparalleled heights. Meanwhile, more and more observers claim that we are now in
a “new economy” that is immune to the forces that caused inflation and recessions in
the past.
Yet in the midst of this celebratory environment, certain indicators regularly cast a pall
over these otherwise sunny times. Month after month, year after year, the U.S. trade
deficit sets new records. And as the United States borrows to cover the excess of its
imports over its exports, the U.S. position as the world’s largest debtor grows by
leaps and bounds. Closely related to both of these trends is the drop in the U.S.
private saving rate, which forces the country to continue borrowing from abroad in
spite of the shift from a deficit to a surplus in the federal budget balance.
In fact, the U.S. economy’s current prosperity rests on the fragile foundations of a
consumer spending boom based on a domestic stock market bubble, combined with
foreign bankrolling of the U.S. trade deficit. If present trends continue, the growth in
U.S. international debt will not be sustainable in the long run. No country can continue
to borrow so much from abroad without eventually triggering a depreciation of its
currency and a contraction of its economy. The rising trade deficit and mushrooming
foreign debt are thus warning signals of underlying problems that-if not
corrected-could bring the U.S. economic boom crashing to a halt in the
not-too-distant future.
Addressing the U.S. international debt situation will require action on two fronts:
reducing the trade deficit and keeping interest rates low in order to reduce the burden
of servicing the debt. Four specific policies that could help to avert a serious crisis
over the next few years include: (1) promoting stimulus policies among U.S. trading
partners with depressed economies in order to promote growth and to enable them
to reduce their trade surpluses with the U.S.; (2) engineering a gradual depreciation
of the dollar; (3) using a fiscal stimulus to keep the economy growing when the
current consumption boom slows down; and (4) restructuring U.S. trade policy to
promote more reciprocal market access and to stress the interests of U.S.-based
producers exporting abroad.
.........................
Thus, these alternative forecasts forcefully demonstrate the importance of reducing
the U.S. trade deficit and keeping interest rates down in order to prevent explosive
growth of the nation’s international debt position and debt service burden, and
thereby lessen the risk of a hard landing. With a reduced trade deficit and/or a lower
interest rate, the U.S. foreign debt could stabilize in relation to GDP and become
sustainable with moderate continued borrowing. But with increased trade deficits
and/or higher interest rates, the external debt could quickly reach a level that would be
likely to spark a negative reaction from international investors, and hence be
unsustainable.
How investors may react
The question of the sustainability of the U.S. international debt revolves around two
closely related issues. First, will confidence in the U.S. economy remain strong
enough for foreigners to continue to desire to invest hundreds of billions of dollars a
year in U.S. financial assets, in order to cover our annual current account deficits?
And second, will foreign creditors continue to be willing to hold the large portfolios of
liquid U.S. financial assets that they have already accumulated? Note that these
issues mainly concern the state of investors’ psychology rather than economic
models of whether a given debt trajectory is theoretically stable. [12]
If foreign investors cease to extend new loans to the United States, or if they sell off
their existing portfolios of U.S. liquid assets, the debt growth projected in the baseline
forecast (and in the more pessimistic alternative forecasts) could not occur. By
refusing to extend new credits or selling off existing assets, foreign investors could
force painful adjustments on the U.S. financial sector and the domestic real economy.
Moreover, it is not only the reaction of foreign investors that matters. U.S. investors
could also help to precipitate a financial crisis if they decided to move more of their
assets offshore (what in developing countries is known as “capital flight”). [13] Of
course, a flight from U.S. assets requires other attractive locations to which investors
could flee. While this may seem unlikely at present, an economic turnaround in
Europe, Japan, or the emerging market nations over the next few years could create
one or more alternative poles of attraction for international money managers.
The notion of an eventual U.S. financial crisis may seem far-fetched at a time when
the U.S. economy is the envy of most of the world. Yet recent economic history is full
of episodes in which confidence in a particular economy has changed dramatically
and quickly-witness the 1994-95 crash in Mexico, which followed the pre-NAFTA
euphoria about the booming Mexican economy, or the rash of crises in East and
Southeast Asia in 1997-98, which followed many years of touting Asia’s “miracle”
economies and emerging financial markets. These experiences show that spending
booms fueled by overly optimistic expectations can lead to the creation of
unsustainable financial positions, including speculative bubbles in asset markets
and real overvaluation of exchange rates, eventually leading to a revision of
expectations and an inevitable crash (see Blecker 1998, 1999).
The United States has not been immune to losses of international confidence in the
past. In 1978-79, confidence in the United States plummeted, forcing the dollar to
depreciate and inducing the Fed to launch an infamous experiment with high interest
rates to squelch inflation at the cost of high unemployment. (These high interest rates
also led to an eventual dollar overvaluation in the early 1980s, which in turn
contributed to the rise in the U.S. trade deficit and the shift to net debtor status later in
that decade.) Earlier, the post-World War II Bretton Woods monetary system was
brought down in large measure by fears of a “dollar overhang” in Europe, which led
European governments to try to convert their dollar holdings to gold in the late 1960s.
This in turn helped motivate the Nixon Administration to end the convertibility of
dollars into gold, abandon pegged exchange rates, and let the dollar depreciate in the
early 1970s. [14]
The problem in the late 1960s was an accumulation of large amounts of U.S. dollar
reserves by foreign central banks, which engendered a fear of dollar depreciation that
eventually became a self-fulfilling prophecy. [15] The problem in the late 1990s is an
accumulation of large amounts of U.S. financial assets of all kinds-including private
holdings of stocks and bonds as well as official central bank reserves (which are
largely held in the form of U.S. Treasury securities). This situation runs the risk of
creating a fear of dollar depreciation that could again become a self-fulfilling
prophecy, only this time not so much through the actions of foreign central banks but
through those of private international investors and banks (both domestic and
foreign).
............
What matters for foreign investors is not just the net U.S. financial debt but also the
gross amount of U.S. assets that they hold in their portfolios. Figure 3 shows the
dramatic surge in foreign ownership of U.S. securities since 1995. The series for U.S.
Treasury securities includes both official holdings by foreign central banks and
private holdings by other foreign investors, in roughly equal proportions. The series
for other U.S. securities includes corporate and other bonds as well as corporate
stocks, valued at current market prices. This surge in foreign security holdings has
been driven in part by the speculative expectation that these assets will rise in price
(especially the stock market boom), and in part by foreign investors searching for safe
havens for their wealth while their own countries are in turmoil (especially U.S.
Treasury securities). The foreign holdings of nearly $1.3 trillion of U.S. Treasury
securities in 1998 account for fully 35% of all Treasury obligations outstanding at that
time (about double the percentage in the early 1990s). [16]
Once foreigners own such large amounts of U.S. financial assets, they need to be
concerned about their value-not only in dollar terms, but also in terms of foreign
currencies. If investors begin to perceive that the assets themselves are overvalued
and fear a collapse of U.S. stock or bond prices (e.g., due to a decline in the New York
Stock Exchange), then they will move to sell off their U.S. stocks or bonds, which will
push those markets down further and depreciate the dollar in the process. If investors
perceive that the dollar is overvalued, they will fear a depreciation, with the same
result.
There are no hard-and-fast rules for how big a current account deficit, net debtor
position, or gross foreign asset ownership has to be in order to generate self-fulfilling
expectations of a currency depreciation. But it is simply inconceivable that these
variables could continue to increase indefinitely without engendering such an investor
reaction at some point.
Indeed, there is one sign that international investors already expect a dollar
depreciation sometime in the near future: the fact that money market interest rates
are higher in the United States than in most other major industrialized countries. In
the first quarter of 1999, U.S. money market interest rates averaged 4.73%, while the
corresponding rates in the euro area averaged only 3.09% and in Japan a mere
0.15% (International Monetary Fund 1999a, 47). According to the theory of “uncovered
interest arbitrage,” when the interest rate on one country’s bonds is lower than that on
another’s, investors will be willing to hold the first country’s bonds only if the lower
interest rate is compensated by an expected appreciation of that country’s currency.
[17] Thus, the persistence of lower interest rates in Europe and Japan compared with
the United States suggests that international investors expect the European
currencies and the Japanese yen eventually to appreciate relative to the U.S. dollar.
This is not surprising, since both Europe and (to a much larger extent) Japan have
trade surpluses with the U.S.
The trigger for a U.S. external financial crisis does not have to come from its
international trade deficit or rising foreign debt, however. Any problems in domestic
financial markets-such as a collapse of the New York stock market or a banking
crisis resulting from overlending to consumers in an economic downturn-could
precipitate a loss of confidence and drive international investors overseas. But even if
the external debt is not the trigger, it makes the U.S. economy more vulnerable to a
loss of confidence. If confidence is lost for any reason, foreign investors will react by
selling off their portfolios of U.S. assets, which will exacerbate the decline in U.S.
asset markets and put downward pressure on the value of the dollar. Moreover, if
foreign investors refuse to lend more, they will force the U.S. to reduce its trade deficit,
either through a massive depreciation of the dollar, a painful contraction of the
domestic economy, or some combination of both.
.....................
The current willingness of foreigners to lend to the U.S. in its own currency thus does
not avoid, and in a sense only tightens, the constraints placed upon domestic
monetary policy in order to maintain “confidence” in the dollar. While other countries
are more free to let their currencies depreciate in order to improve their external
competitiveness and solve their payments deficits, the United States cannot allow the
dollar to depreciate too much if it wants to preserve the role of the dollar as the
world’s predominant international reserve currency and the primary vehicle for
international lending activity. As a result, current international monetary arrangements
can force the United States to keep the dollar at an exchange rate that is overvalued
from the standpoint of balancing U.S. trade, and which therefore results in chronic
large trade deficits and persistent foreign debt accumulation.
Even if the United States succeeds in avoiding a hard landing for the dollar, it may not
be able to avoid one for the real economy. In fact, efforts to rescue the dollar could
well backfire and make matters worse for domestic workers and firms. If the dollar
starts to fall and the government wants to prevent a rapid collapse in the dollar’s
value, the most likely reaction would be an increase in interest rates by the Fed in
order to reassure wary investors (just as the U.S. advised Mexico, Korea, Brazil, and
other countries to raise their interest rates in the aftermath of their financial crises).
High interest rates would be likely to slow the economy, especially by raising the
costs of consumer and business borrowing and thus stemming the current rapid
growth of consumption and investment spending.
If interest rates are increased, however, the existence of large debt burdens, both
domestic and foreign, creates vulnerabilities that are generally ignored in standard
economic models. With consumer debts rising to record levels in relation to
household income, [18] a rise in interest rates would increase household debt service
burdens [19] and could push financially strapped families over the edge into
bankruptcy (especially if unemployment begins to rise as a result of higher interest
rates). The same is true for corporations that have become highly
leveraged-regardless of whether they borrowed for productive investments or for
mergers, acquisitions, and buyouts. If interest rates spike upward while sales growth
slackens and cash flow shrinks, highly indebted firms could become illiquid and the
risk of corporate bankruptcy would increase. And if personal and business
bankruptcies rise, banks that have lent heavily to consumers and corporations could
be in serious trouble-as they were in the Asian crisis countries. Furthermore, the
existence of complex derivative contracts and unregulated hedge funds has allowed
investors to create highly leveraged financial positions that could be difficult to unwind
without significant losses in the event of a general financial panic in the U.S.
Moreover, as shown earlier, higher interest rates would imply greatly increased net
outflows of interest payments to foreign creditors, which would worsen the current
account deficit and depress U.S. national income. Thus, the large domestic and
foreign debts of the United States could potentially turn a soft landing into a hard one.
This could happen if bankruptcies rise, banks fail, and domestic incomes have to be
squeezed to permit greater outflows of net interest payments. Even the International
Monetary Fund, while projecting a gradual slowdown of U.S. growth in its baseline
forecast, and normally relatively optimistic in its outlook, warns ominously of the
possibility of a hard landing for the U.S. economy:
The willingness of foreign investors to continue financing the rapidly
growing external deficit of the United States at current interest rates
may not continue, in which case downward pressure on the dollar
might be another cause of higher interest rates. All these factors could
give rise to larger and more abrupt adjustments in private sector
behavior, and a more abrupt economic slowdown, than envisaged in
the baseline. (IMF 1999b, 26)
How big a “hit” could the U.S. economy take in the event of such a crisis? Some
simple calculations reveal that a serious economic depression could easily result.
Suppose that the U.S. was forced by a withdrawal of net foreign lending to balance its
current account. Conservatively, this would require shrinking the current account
deficit by 3% of GDP, or about $270 billion at current prices (given a GDP of
approximately $9 trillion in 1999). Suppose further that the dollar falls only by enough
to eliminate half of this gap. It can easily be estimated [20] that to close the rest of the
gap (i.e., to reduce the trade deficit by $135 billion) via income adjustment, national
income would have to fall by about 6% in real terms. [21] This would be an adjustment
on the order of magnitude of what has been felt in crisis countries such as Brazil,
Mexico, Korea, and Thailand in recent years, and much larger than the drop in output
in any recent U.S. recession. That a depression of this magnitude would be needed
to eliminate even half of the U.S. current account deficit via income reductions is a
result of the U.S. economy’s extreme openness to imports, which requires a major
income squeeze to achieve a significant reduction in the volume of imports.
Policy implications
The rising trade deficit and international debt of the United States are sustainable
only as long as foreign investors are willing to continue lending this country the
hundreds of billions of dollars annually required to cover the underlying trade deficit
and service the increasing foreign debt. This dependency on international borrowing
makes U.S. policy making vulnerable to the decisions of both domestic and foreign
investors about whether they want to keep their funds pouring into U.S. financial
markets or prefer to send those funds elsewhere. Moreover, the projections in this
paper show that in just a few years, under a range of plausible assumptions, the U.S.
external debt burden could rise to a level that would be likely to alarm financial
investors and cause a sudden withdrawal of funds from U.S. financial markets and
dollars. In that event, confidence in the U.S. dollar would plummet, and the United
States would be forced to accept a major dollar depreciation or to raise interest rates
sharply to prevent one. Either way, the U.S. economy could be put through a painful
economic contraction.
The issue, then, is not whether the U.S. can sustain large increases in its foreign
debt position, but rather when and how the country will make the adjustments needed
to correct the underlying problems. The worst-case, hard-landing scenarios do not
have to happen if policy measures are taken soon to prevent them. Just as the
Federal Reserve’s interest rate cuts in the fall of 1998 helped to stabilize global
financial markets and to prevent a U.S. recession, additional policy interventions both
in the U.S. and abroad could help to slow down the growth of the U.S. foreign debt
and prevent a future financial meltdown. But time is growing short, and-as recent
experiences in Asia and elsewhere show-the longer action is delayed, the more
difficult it can be to prevent a major economic downturn once a financial crisis erupts.
As the simulations in this paper reveal, alleviating the U.S. international debt burden
requires action on two fronts: reducing the trade deficit in order to lessen the need for
future borrowing, and keeping interest rates low in order to reduce the burden of
servicing the debt. While there is no magic cure for U.S. indebtedness, there are
several measures along these lines that could help to ensure a “soft landing” and
avert a serious crisis over the next few years:
First, the U.S. cannot act alone, and it cannot continue to serve as the world’s
“consumer of last resort” indefinitely. Thus, significant domestic stimulus
policies are needed in our major trading partners with depressed economies:
Europe, Japan, other Asian countries, and Latin America. This is a win-win
strategy, which will benefit our trading partners and relieve trade tensions by
boosting their growth and reducing their surpluses with the U.S. Without such
foreign demand expansion, it will be much harder for the United States to
reduce its trade deficit at a socially acceptable cost. The types of stimulus
policies that are needed vary from country to country. In Europe and Latin
America, standard monetary and fiscal stimuli would probably suffice
(although in Latin America, debt relief would also help). In Japan and other
Asian countries, structural reforms to increase consumption and liberalize
imports are also necessary.
Second, the dollar needs to come down gradually to a level that is more
consistent with balanced trade. Engineering a gradual depreciation rather
than a collapse will not be easy, but keeping interest rates low and cutting
them further would be useful for this purpose as well as to mitigate the debt
service burden. Recovery in Europe, Japan, and other areas would also help
by boosting confidence in their economies, thus sparking appreciation of
foreign currencies. In the long run, target zones with crawling bands should be
used to stabilize the dollar’s value at a lower level (Blecker 1999). Capital
controls and foreign exchange restrictions (such as a “Tobin tax” on currency
transactions) could be used to prevent speculators from pushing the dollar
down too far, too fast. However, if there is a loss of confidence and the dollar
falls-and especially if international cooperation has been lacking-it would
be better to let the dollar drop than to raise interest rates through the roof and
sacrifice jobs and incomes to maintain a strong currency. If a hard landing is
unavoidable, it is better to have one for the dollar than for the real economy. [26]
Third, raising the incomes of U.S. workers and reducing economic inequality
could help by allowing families to finance their consumption expenditures
more out of current income and with less borrowing, leading to a recovery of
the personal saving rate. This in turn would require labor market policies such
as strengthened minimum wage laws and union organizing rights, as well as
a commitment by the Fed not to raise interest rates and slow the economy in
response to workers’ gains (see Palley 1998). In addition, when the
consumption boom slows down, as it inevitably will, the U.S. government
needs to be prepared to use a fiscal stimulus (such as an increase in public
investment spending); trying to preserve a budget surplus in a slowing
economy would be a recipe for turning a mild recession into a severe,
1930s-style depression. Tax cuts are less preferred than government
investment spending, since they would probably only boost consumption and
contribute to further shrinkage of the public sector in the future.
Fourth, U.S. trade policies need to be reoriented to promote more reciprocal
market access. These policies should stress the interests of U.S.-based
producers exporting abroad rather than the rights of U.S. multinational firms
investing abroad, especially when the latter are investing in export platforms
targeting the U.S. import market or in sales of goods produced in third
countries. For example, U.S. trade negotiators should be more concerned
about steel than bananas, and more concerned about labor rights than
intellectual property rights. New and more effective methods of stemming
import surges should be instituted, instead of relying on the time-consuming
and legalistic anti-dumping laws. And the U.S. needs to stop signing trade
agreements that do more to help U.S. businesses operating abroad than to
help U.S. workers seeking good-paying jobs at home.
If these kinds of policies are not adopted by the U.S. and its trading partners, the debt
bomb will keep ticking, eventually going off with unpredictable consequences both at
home and abroad.
June 1999 |
