John Papaspanos Professor Escamilla 29 April 2009 Term Paper
“This is our Currency, but your Problem” Foreign Debt Accumulation and its Implications
Introduction: Following the Second World War, the United States became the largest creditor nation in the world. But two decades ago, the US relinquished its balance of payments surplus and recent reports by the Congressional Budget Office (CBO) estimate that the fiscal deficit, as a share of Gross Domestic Product (GDP), will reach 11.9 percent in 2009—the highest level since World War II.1 As a result, the US is now the largest debtor nation—not in terms of its debt to GDP ratio—but due to the sheer magnitude of its liabilities. The onset of the 2008 financial crisis has accelerated this preexisting trend of deficit spending in light of the Obama Administration’s measures to combat the recession, to bolster the banking industry, and to continue fighting the “post 9-11 reaction.”2 In the absence of a gold standard, deficit spending is enabled, and even encouraged, by channeling the vast surplus savings of foreign investors through the issuance of US Treasury notes and bills. This process not only allows for fiscal expansion by using a hitherto plentiful supply of credit (exorbitant privilege), but it also injects undue purchasing power to US consumers. This essay addresses the increasing US indebtedness to external creditors and the possible implications for the US economy. Since the US cannot continue on its current trajectory of debt accumulation without incurring undesirable economic consequences, there are three major corrections that loom on the horizon: the US dollar will gradually relinquish its status as the global reserve currency, the US will accelerate the diversification of its energy resources, and most importantly, the excessive and
irresponsible spending by the US government and the US consumer will be forcibly reduced to lower levels. 2. US Dollar: the Global Reserve Currency—for the time being Following the 1971 “Nixon Shock” when President Nixon unilaterally ended the Bretton Woods fixed exchange rate system, the US dollar has maintained its special status as the world reserve currency. Governments and corporations perceive the US dollar to have the lowest default risk among all the currencies of the world, and therefore, US dollars are demanded as the standard store of cash and liquidity to use in times of crisis. Likewise, this fundamental feature also confers the sufficient confidence to global economic actors to predominantly use the USD in trade and investment transactions. But if the USD weakens and no longer is the preferred global reserve currency, do attractive alternatives exist? In response to recent economic developments in the US, countries with the largest USD reserves—and thus, have the greatest exposure to risk— have raised this central question among other concerns about the shifting status quo. At the present time, the USD is temporarily secure as the dominant trade, reserve, and finance currency because there is no attractive alternative that can replace its role. During the financial crisis, the USD experienced a flight to safety even though the US economy, particularly the subprime mortgage market, was the source of the global contagion. But there is growing evidence that this trend will not continue indefinitely. In the weeks preceding the preliminary meeting for the G20 Summit, the Chinese government proposed replacing the US dollar as the world international currency with a new “supersovereign reserve currency” under the surveillance of the International Monetary Fund. Even though there is a low likelihood that a highly complex and impractical accounting unit will supersede the USD,3 perhaps the underlying reason Beijing released such
statements was to effectively roil the global financial waters: a) to garner international respect commensurate to its economic power, and moreover, b) to increase its leverage in the coming policy debates. However at its core, the message implicitly expressed a strong concern for the augmenting US deficit and its effects on the USD. The fiscal and monetary policy of the US government has prompted fears of inflationary pressure that may weigh down the value of the USD. Foremost, since fiscal expansion has been fueled by foreign borrowing to finance government programs (“deficit spending”) the US government has flooded the US monetary system with USD which must be repaid with interest at a later date. In Fact, the CBO has announced that the Obama Administration’s budget will generate a $1.85 trillion shortfall this year and between the years 2010 and 2019, the budget deficits will amount to $9.27 trillion, which is approximately $2.3 trillion more than the Administration’s forecast. And that doesn’t count President Obama’s budget plans to cut taxes and increase spending.4” Therefore, as the fiscal deficit increases, foreign investors must carry the negligible risk of the US government not meeting its debt obligations, or the more probable scenario of inflationary pressure eroding the value of dollar-denominated investments. In the case of China, Beijing is in a precarious position as the largest holder of US financial assets with over $2 trillion of foreign exchange reserves, about half in US Treasury bonds and other government-backed debt.5 If Beijing decides to avert the risk of holding USD by transferring its foreign exchange reserves from US dollars to a basket of currencies, it must exercise caution. Should the massive transfer prompt other countries to lose confidence and to pursue the same policy, this wide-scale shift would create extreme volatility in the global currency markets and adversely affect US consumption and the US dollar.
Given this context, Governor Zhou Xiaochuan of the People’s Bank of China, along with Premier Wen Jiabo have cautiously articulated their distress about China’s substantial holdings of US debt and their underlying fear of volatile global currency markets. Since there is no attractive alternative at this time, Zhou has evoked the creation of an international reserve currency “that is disconnected from individual nations and is able to remain stable in the long run.” But nevertheless, China is currently globalizing the yuan and promoting its influence overseas, which may reflect ambitions to eventually supplant the US dollar as the world reserve currency in the long-term. China has brokered deals with six countries, including South Korea, Malaysia, and Argentina for a currency swap arrangement to facilitate trade transactions. If these deals are repeated with other countries, the Chinese can effectively create a trading network that will use yuan and thereby bypass the US dollar. In addition, the Chinese are encouraging loans and investments to be made in yuan in order to spread its influence abroad; and even the Chinese tourists contribute to this trend when they carry yuan abroad. Amidst this paradigm shift, the European Union (EU) has not assumed a larger role as a leading international currency. This disposition can be explained either as a lack of will or the absence of capability. David Marsh, the author of “The Euro: The Emerging Global Currency,” has cited the notion that the Germans “actually did not want the deutsche mark becoming the number two reserve currency in the world after the dollar. So if you like, it’s a kind of flight into a lack of ambition. That’s the reason why we have the Euro.”6 And furthermore, the EU is an export-driven economy that would lose its competitiveness if its currency were to appreciate in value through its role as the dominant reserve currency.
Historical precedence and econometric models can predict that the USD cannot maintain its status as the dominant reserve currency indefinitely. The aforementioned analysis has led to the following conclusions: an accounting unit based on a basket of currencies will not be a feasible substitute for the USD, the EU is not willing and able to undertake ambitions to replace the USD, but there is a high likelihood that over the longterm, the Chinese yuan can offer the necessary confidence and convertibility to facilitate trade and investment flows and to become the main global currency. Both Western and Chinese analysts are predicting that the yuan will become the dominant reserve currency by 2020. In fact, the chief Asian economist for ING, Tim Condon agrees with this forecast, “That’s a reasonable time table…I see undesirable risk against the dollar and appreciation pressure on the yuan.”7 3. Implications of a Rising Deficit When foreign investors become satiated with the purchasing of US debt instruments and they begin to demand higher rates of return for their investments, the US will be forced to reduce its debt accumulation. The era of unrestricted government spending will expire when access to relatively inexpensive credit comes to an end and the implications of this process will be drastic. Hitherto, the main emphasis has been placed on the fiscal deficit, but to further understand the implications of mounting foreign debt, several key distinctions must be made vis-à-vis the types of deficit which exist. Even though the terms “budget deficit” and “trade deficit” are correlative, these twin indicators of debt are not interchangeable. The national debt (also known as the “federal government budget deficit”) is “the total amount of money owed by the federal government to creditors who hold US debt instruments such as US Treasury Bills or savings bonds.”8 Whereas the trade deficit is a component of the current account, which
includes the balance of trade (net imports), the net factor income from abroad, and the net unilateral transfers from abroad. 4. Reduction of Oil Imports Among the most “heated” debate on Capitol Hill in the recent year has been the national economic and security issue of energy dependence. The 2008 Environmental Bill failed to pass during the summer months due to record-high oil prices and the effectiveness of GOP Senators arguing that the economic costs of a carbon tax would place an enormous burden on businesses in the contracting economy. The GOP Senators also proposed the prospect of domestic oil extraction and production to detach the US economy from its foreign oil dependence. However, the pending legislation did not raise the issue of the federal deficit, which is an important factor in the reduction of oil imports in the coming years. Not only is the US lagging behind in energy efficiency standards compared to the rest of the world, but also the US economy is firmly oil-based with minimal efforts to diversify its sources of energy. Despite environmental, moral, and practical reasons to reduce the burning of fossil fuels and to implement a green initiative, the US maintained a policy of non-action until the economics involving the importation and the reliance of foreign oil has become evident. Menzie D. Chinn of the Council on Foreign Relations has advocated a policy of curtailing the importation of oil and petroleum-related products for several years. In a report released in 2005, he cited that in 2004, the “US imported about $180 billion worth of petroleum and petroleum-related products, equal to about one-third of the trade deficit.”9 As a result, the US is forced to rely on foreign imports of oil for its economic livelihood. This is not only bad economics when the price of oil will returns to pre-recession levels and the US demand remains inelastic, but this also bad
politics when the US is forced to meddle in the affairs of the Middle East in pursuit of national interests. 5. Current Account Deficit Given the clarification of terms, the fiscal and monetary policy of the US government strongly influences the current account balance. Foremost, if the US government decides to reduce taxes (i.e. Bush Tax Cuts that are set to expire) or expand fiscal spending using foreign credit, US domestic consumption rates accelerate because the US consumer has access to greater levels of discretionary income and/or more social benefits. In addition, the high demand for US Treasury bills grants the Federal Reserve leeway to maintain critical interest rates such as the federal funds rate at low levels for extended periods of time.1 In the last decade, one of the most cataclysmic results of these extended periods of “cheap credit” has been the recent housing boom by which the value of homes increased by an average 10-20% in a given year. The presence of foreign credit has allowed such an asset bubble to inflate because the strength of the USD is used to bid the price of non-tradable goods such as houses to unrealistic values. The low mortgage rates allowed buyers that were ineligible to purchase a home, in accordance to credit ratings and income streams, but these investors did so regardless through mortgagebroker loopholes such as the infamous liar loans and by refinancing their mortgages. Besides this form of non-revolving debt, consumer debt has also become a nationwide problem due to the overarching short-term gratification culture which is fueled by “easy credit” which is imported from foreign countries’ surplus savings. In fact, “over half of the financing of the U.S. current account in 2004 was accounted for by accumulation of dollars and U.S. Treasury securities by foreign central banks. This is not a “savings glut” in the sense of excess private savings flowing to the United States,”11 but more of a scarcity of savings on the part of the US population.
It is important to emphasize that the problem does not lie with the poorer countries lending capital to both the US government and the US consumer to spend excessively and irresponsibly.12 And even the arbitrary exchange rate values of East Asian countries do not affect the US current account deficit in the manner commensurate to the criticism and concern of commentators. Quite simply, the crux of the problem is inherent within the US culture of consumerism. If and when the foreign investors become satiated with the purchasing of US debt instruments and they begin to demand higher rates of return for their investments, the USD will weaken and the US government will be forced to reduce its debt accumulation. This junction may be approaching as the Chinese are now diverting a greater proportion of their savings toward domestic consumption and investment. Ergo, this trend will decrease their national savings and less capital will be available to purchase US government debt. Without the access to inexpensive credit, the US will have greater difficulties servicing its deficit; especially when the Obama administration is currently overseeing multiple government bailouts, stimulus spending, two foreign wars, and a potential overhaul of domestic programs. 6. Conclusion In conclusion, an undetermined time horizon will place the US in a difficult position to confront its debt accumulation problem. This essay has thoroughly examined the effects of excessive fiscal and trade deficits on the USD and the wider US economy. Firstly, the USD will gradually lose its status as the leading global reserve currency. Secondly, the US will be forced to cut back on its consumption of oil and petroleumrelated products because they contribute a considerable amount to the current account deficit. And finally, the era of unrestricted US government spending is due to expire whereas the US consumer will not experience the same consumption growth rates of the
past. The future generations of American citizens have a tremendous stake in the current policy debates with regard to the US deficit. Perhaps the Obama Administration will lead the country on a more sustainable path as the US executes an accommodative policy towards the developing economies. If a cooperative network is not created that can gradually correct the current economic imbalances, then the free markets will selfregulate in a more painful manner.13
1. China Proposes New Global Reserve Currency: a. b. c. 2. Anderlini, Jamil. Financial Times. China Calls for New Reserve Currency http://www.ft.com/cms/s/0/7851925a-17a2-11de-8c9d0000779fd2ac.html?nclick_check=1 Retrieved April 15 2009
Oil Import Implication: a. b. f c. Retrieved 17 April 2009 Chinn, Menzie D. Council Special Report NO. 10, September 2005. Council on Foreign Relations. Getting Serious about the Twin Deficits. http://www.cfr.org/content/publications/attachments/Twin_DeficitsTF.pd
CBO Report: a. b. Faler, Brian. Bloomberg News. CBO Projects 2009 Deficit Will Reach $1.85 Trillion. http://www.bloomberg.com/apps/news? pid=20601087&sid=a3FY84ILxIUc&refer=home
Essential background information a. b. c. Scherer, Ron. Christian Monitor. CBO: US deficit ballooning to record $1.7 trillion. http://features.csmonitor.com/economyrebuild/2009/03/20/cbo-usdeficit-ballooning-to-record-19-trillion/ Retrieved 19 April 2009
Highly informative discussion on the deficit and its effects on US economy: a. b. c. Shaw, Jonathon. Harvard Magazine. Debtor Nation. http://harvardmagazine.com/2007/07/debtor-nation.html?page=2 Retrieved 15 April 2009
Additional Information on the Federal Deficit: a. Teslik, Lee Hudson. Two Deficits, Fed Turnover.
Distinction between deficit definitions: a. b. http://www.businesspundit.com/national-debt-vs-national-deficit Retrieved 16 April 2009
Article from the Federal Reserve Web Site: a. b. http://www.newyorkfed.org/research/current_issues/ci13-11/ci1311.html Retrieved 14 April 2009
Scholarly Journal on the deficit and the exchange value of the USD: a. b. http://www.jstor.org/pss/1926907 Retrieved 20 April 2009
Federal Reserve monetizing debt: a. b. http://research.stlouisfed.org/publications/review/84/12/Monetizing_Dec 1984.pdf Retrieved 21 April 2009
Most interesting documentary by the BBC: a. b. Analysis: The Dollar and Dominance Program Transcript: http://news.bbc.co.uk/nol/shared/spl/hi/programmes/analysis/transcripts/2 3_10_08.txt Retrieved 19 April 2009
China Daily BBS: a. b. http://bbs.chinadaily.com.cn/viewthread.php? action=printable&tid=632477 Retrieved 21 April 2009
A term I use to describe the US government’s actions in response to the 9-11 terrorist attacks: establishment of the Department of Homeland Security, the Afghanistan intervention, the Iraqi invasion, and the War on Terror.
Especially after the failure of the IMF”s Special Drawing Rights was not widely used for “the expansion of trade and financial development.” (http://www.imf.org/external/np/exr/facts/sdr.htm)
Faler , Bloomberg Anderlini, Financial Times Analysis: The Dollar and Dominance pg. 5 China Daily BBS BusinessPundit.com Chinn pg. 5
This phenomenon has been cited by Alan Greenspan as the reason why the Fed failed to raise the short-term lending rates in the year 2003. Foreign investors provide an influx of credit and place downward pressure on interest rates.
Chinn pg. 19
In the sense that only investment intended to increase productivity is warranted because pure private consumption will not help the US economy become more competitive over the long-run.
With proper government action, the American Dream can continue for future generations and perhaps the 1990s will not be viewed as the last gilded age in American history before its ultimate decline.