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Shadows of Foreign Debt

Ever eager to observe and command, government officials like to record their countrymen’s economic dealings with people abroad. They create “balances of payments” which are to help them evaluate and manage economic relations. Last year the American balance posted extraordinary deficits of some $668 billion, or more than six percent of gross national product. This year it is estimated to exceed $700 billion. In any other country a deficit of just three percent would sound the alarm and could trigger a sudden flight of capital and a crash of the national currency. Moreover, the U.S. government itself is suffering huge budget deficits that amount to several hundred billion dollars annually and by now exceed a total of eight trillion dollars. Yet, few economists seemed to be disturbed; they apparently are guided by the old motto: “A poor man’s debt makes a great noise; a rich man’s debt makes no sound.”

One man’s debt is another man’s asset; the American deficit of some $700 billion signals foreign credits of the same amount. Americans obviously spend more abroad than they earn, consuming more than they are producing and ever increasing their indebtedness to the rest of the world. Only two other countries, Australia and the United Kingdom, presently suffer minor deficits. All other countries, large and small, rich and poor, finance the deficits with their trade surpluses. Japan is the biggest creditor with claims of some $170 billion. The petroleum exporting countries in the Near East follow with $110 billion, then China, Russia, and Switzerland. This world-wide imbalance of consumption and production obviously calls for an explanation and raises important questions of readjustment.

On first glance the American payment deficit springs from a spending predilection of public as well as private profligacy. All levels of government are suffering budget deficits amounting to some 4.5 percent of gross national product. In less than a decade the Federal government managed to turn a budget surplus into a deficit by way of tax reductions and spending increases. At the same time the American savings rate fell to barely one percent. Consumption accelerated due to extremely low interest rates and rapidly rising real estate prices. Home owners could convert their rising housing value into ready consumption, making their homes convenient bank automats. But some are fearful that such riches have their limits as interest rates are bound to rise and real estate prices soon may stagnate or even decline.

In their foreign dealings many American businessmen are enjoying the present situation. Virtually all their international liabilities are denominated in U.S. dollars while some 70 percent of their foreign assets are reckoned in foreign currencies. The value of foreign assets and liabilities obviously changes with every change in the exchange rates of the currencies. A fall of the U.S. dollar immediately trims the value of virtually all American liabilities while it raises the value of American assets owned abroad; a rise of the dollar effects the opposite. The visible fall of the U.S. dollar since 2002 explains why the total current-account deficit of $1.7 trillion merely added some $200 billion in external liabilities and why the 2004 current-account deficit of $668 billion merely raised external liabilities by $170 billion. Every penny of dollar depreciation benefits many American businessmen either by depreciating their debt to foreigners or appreciates their foreign investments, or both. The Federal government with rapidly rising debt of more than $8 trillion is by far the biggest beneficiary.

American officials and their academic friends are quick to reject such analyses and conclusions. They dismiss all thought of responsibility for the situation and instead point to an acute savings predisposition on the part of creditor countries. Ben Bernanke, former governor of the Federal Reserve and now chairman of the Council of Economic Advisers, insists that much of the world is suffering from an acute disorder of “savings glut ”; the United States has no choice but to increase consumption. Fortunately, it is willing and ready to act as the “consumer of last resort.” This valiant consumer also contravenes and offsets the savings glut of commerce and industry, in particular the entrepreneurial sector, which in many countries has begun to save more than it invests. It usually is the investor of the people’s savings, building plants, shops, mills, foundries, and other enterprises, ever eager to raise labor productivity. At this time many prefer to become creditors rather than entrepreneurial debtors, causing much stagnation throughout the industrial world. Even in the United States where economic expansion continues at modest rates, many corporations now prefer to invest in government securities rather than embark upon new production ventures. They are improving their balance sheets and getting ready for any conceivable readjustment.

Economists who observe such behavior may find no fault with their preparations nor with the “savings predilection” of foreigners, the official scapegoats of the international imbalance. They may even sympathize with people who are enjoying the rising value of their homes. But these economists lay the blame for the ominous imbalance of trade relations on the Federal Reserve System which, in the service of Federal deficit financing, managed to cause unprecedented maladjustments. In order to finance huge Federal budget deficits and prevent painful economic readjustments, it lowered interest rates far below market rates and glutted credit markets, which deceived and misled millions of people all over the globe. No other central bank possesses such powers; any attempt to emulate the Fed’s policies would cause its currency to crash.

Even the European Central Bank, which appeared on the scene in 1999, probably could not follow in Federal Reserve footsteps; it soon would damage the euro. Only the Federal Reserve still seems to have the capability to glut credit markets. Until the creation of the euro the U.S. dollar was the sole reserve currency of the world, held and used not only by every other central bank but also by thousands of commercial banks and countless public and private corporations. It had replaced gold as the universal medium of exchange during the early 1970s and has functioned as world money ever since. This world-wide function obviously has given and continues to give it exceptional strength that affords its issuer an extraordinary leeway for monetary expansion. It receives further support and strength from the reputation of the United States as a safe harbor for foreign investments. A reputation for principle and rectitude is itself a fortune. But how long can the dollar withstand false interest rates and massive budget deficits?

Many countries, rich and poor, now are supporting the richest country on earth. This odd situation raises serious questions of consequences if the creditor countries should suddenly tire of their chore and call a halt to the burden. What would happen if, for instance, the Asian central banks should suddenly refuse to add to their dollar holdings or even reduce them and instead decide to invest their surpluses in euros? Surely, such a reaction would lead to much international turbulence and severe economic crisis.

Economists who remember the past may point to the dollar crisis of 1979 and 1980 when the dollar was under persistent pressure from abroad, when its value was falling rapidly in relation to the currencies of other trading nations and to gold which was deemed to be a safer repository for reserves. Fueled by rising oil prices, the consumer price index soared nearly one percent every month and interest rates climbed to the highest level of the century. With markets for currencies, metals, and other commodities thrown into disarray and the rate of unemployment higher than seven percent, the Federal Reserve under the direction of chairman Paul Volcker finally “took away the punch bowl“ by raising the member bank discount rate to twelve percent and boosting marginal reserve requirements for member banks. A degree of hope was restored as many Americans realized that their government had to balance its budget and that people must live within their means, produce more efficiently, and conserve, save, and build for the future.

What we look for may not come to pass; yet we must not let the future frighten us. The present situation of American deficits and foreign credits may continue as far as the eye can see. After all, an old monetary order which had been created at the 1944 Bretton Woods Conference withstood much international disorder for more than thirty years. Some economists and their friends in government like to note the similarities of that order with the new. But this economist does not see the semblance. With his eyes on huge trade deficits and foreign debts and on grave international conflict and strife he braces for more commotion and crises to come.