December 01, 2004,
For more than a year, I have been predicting not advocating, just predicting a significant tax increase to deal with the budget deficit. My hypothesis has been that sooner or later financial markets would put pressure on Congress to act on the budget deficit, and that the magnitude of the problem would be too great to deal with on the spending side alone.
I was unsure of where, when, or how this financial-market pressure would arise. But it now seems clear that it will come through the foreign exchange market. The dollar has been dropping rapidly and this is setting in motion forces that eventually will impact on domestic stock and bond markets. The possibility of a major crash cannot be ignored.
The root of the problem is the U.S. current account deficit, which includes the trade balance for goods and services, plus receipts on U.S. investments abroad minus payments to foreigners on their investments here. There is also a large negative figure for unilateral transfers abroad, such as those for military programs and foreign aid.
To show the orders of magnitude, in 2003 the U.S. exported $713 billion worth of goods and imported $1,261 billion, for a deficit of $548 billion. This was partially offset by a significant surplus in the export of services of $74 billion. U.S. companies also received more in income on their foreign operations than we paid out to foreigners on their operations here, giving us a surplus of $33 billion in this area. After subtracting $67 billion for unilateral transfers, we ended up with a current account deficit of $531 billion.
Basically, this $531 billion figure has to be financed by foreigners who are willing to invest in the U.S. directly or buy dollar-denominated assets such as stocks and bonds. In 2003, foreigners bought $829 billion worth of the latter, while Americans increased their ownership of foreign financial assets by $283 billion. The difference, $546 billion, approximately equals the current account deficit.
If foreigners were just interested in investing in the U.S. because they like our economic prospects and investment climate, this would not be a problem. Indeed, this unquestionably explains most of the private capital transfers. In places like Japan and Europe, economic prospects have been much worse than here for some time and investors there have had little choice except to invest abroad.
But lately, a considerable portion of foreign investment has been by foreign central banks in U.S. Treasury securities. From 1999 to 2003, these rose to $249 billion from $44 billion. The figure for this year will undoubtedly be higher than last year since foreign central bank purchases of Treasurys were already at $202 billion just through June.
As a consequence, foreign ownership of the U.S. national debt has risen to $1.8 trillion or half of the privately held debt. A decade ago, foreigners owned just over 20 percent of the debt.
The Japanese are the largest foreign holders of U.S. Treasury securities, with a total $720 billion in September, up from $317 billion just four years earlier. The Chinese have become the second largest holders, with $174 billion worth, a sharp increase from $62 billion in September 2000.
The reason for these large purchases of Treasury securities is that the Japanese and Chinese have been trying to prevent their currencies from rising against the dollar. They have done this by using their own currencies to buy dollars, which are then invested in Treasury securities.
The problem is that this process cannot go on indefinitely. It complicates monetary policy and threatens foreign central banks with large capital losses should U.S. interest rates rise. (Bond prices move in the opposite direction of interest rates.)
There is growing evidence that foreigners are getting weary of financing the U.S. budget deficit. The Chinese and Japanese are both talking about cutting back on Treasury purchases and diversifying more into euro-denominated assets. In order to continue selling its bonds, the Treasury will have to increase the interest rate it pays.
Some other consequences are that the dollar will fall further against foreign currencies, which will raise the prices we will have to pay for foreign goods. This will raise the inflation rate, which will encourage additional tightening of monetary policy by the Federal Reserve. A lower dollar will also make U.S. goods cheaper in terms of foreign currencies.
Most economists view this as a natural market process for resolving current-account imbalances. By raising the cost of foreign goods to us and lowering the cost of American goods to foreigners, it should reduce imports and increase exports.
The danger is that the dollar won’t fall gradually, but could drop precipitously, which could lead to a sharp drop in the stock market and a spike in interest rates in order to defend the dollar.