The USG Doesn’t Need Foreigners to Finance the U.S. Fiscal Deficit? Who Knew?

I usually don’t post a new entry so soon after the last post, but there was an interesting article in Monday’s Wall Street Journal by Andrew Batson.

China is center stage when it comes to fears that buyers will one day spurn U.S. Treasurys. The bond market has been the source of much political theater between the U.S. and China in recent months, with Chinese officials passing up few chances to lecture the U.S. on its profligacy.

But that has obscured an important change: The market for Treasury bonds is now more reliant on U.S. buyers — including the Federal Reserve after its recent buying spree — than the Chinese.

China held $801.5 billion in Treasury debt at the end of May. The Fed at that time held about $598 billion, although that has now risen to $704 billion. The latest figures for U.S. households, from the first quarter, showed holdings of $643.9 billion — more than double the $266.6 billion in the fourth quarter of 2008.

The rising budget deficit, which has led to record issuance in recent months, doesn’t necessarily mean the government is becoming more indebted to foreigners. While the U.S. government is borrowing furiously, the current account deficit has actually halved from an annualized $829 billion in mid-2005 to an annualized $409.5 billion in the first quarter of 2009. That shows the U.S. is now less dependent on external financing, because it is saving more domestically. The U.S. government may be in hock, but it is increasingly to its own citizens.

This shouldn’t be a surprise. The reason for the growing US fiscal deficit is to slow the economic impact of a rise in US household and corporate savings. This means that the period in which very high Asian savings were matched by very low US household savings is changing to one in which the pressures to save in Asia remain while US households are increasing their savings (or reducing their borrowing, which amounts to almost the same thing). The pool from which the US Treasury can borrow is increasing, not decreasing.

In addition, as the US current account deficit drops, foreign net purchases of dollar assets must also drop. The rising US fiscal deficit will increasingly be financed by Americans and less and less by foreigners, and the much-decried impact on US interest rates of the massive US borrowing turns out to be very small.

Brad DeLong, who also expected this to happen, has a very similar take from a different angle, which he discusses in a recent blog entry:

And the interesting thing is that I knew that this [that the market would easily absorb a huge increase in government debt] was going to be what would happen–or, rather, I strongly believed that this was going to be what would happen–and all because I had read John Hicks (1937).

Let me give you the Hicksian argument about what happens in a financial crisis–a sudden flight to safety that greatly raises interest rate spreads, and as a result diminishes firms’ desires to sell bonds to raise capital for expansion and at the same time leads individuals to wish to save more and spend less on consumer goods as they, too, try to hunker down.

In Hicks’s model, the immediate consequence is an excess demand for (safe) bonds in the hands of investment banks: bond prices rise, and interest rates falls. As interest rates fall, (a) firms see that they can get capital on more attractive terms adn so seek to issue more bonds, and (b) households see the interest rate they can get on their savings fall, and so lose some of their desire to save. The market heads toward equilibrium. But as the market heads toward equilibrium, something else happens as well: the fall in interest rates and the rise in savings is accompanied by a greater desire on the part of households and businesses to hold more of their wealth safely–in pure cash. And so the speed with which cash turns over in the economy, the velocity of money, falls. And as the velocity of money falls, total spending falls, and workers are fired, and as workers are fired and lose their incomes their saving goes from positive to negative.

Batson goes on to say in his article:

History suggests there is plenty of room for households to increase their holdings.

The Chinese government may be politically uncomfortable with lending money to the U.S., but it remains locked into purchasing Treasury bonds because of its currency’s tight peg to the dollar. The challenge for the U.S. government isn’t just reassuring China.

It also is to maintain the confidence of the domestic investors who are an increasingly important source of financing for the wave of government debt supply hitting the market.

The only point with which I disagree is on the need to “reassure” China. As I have pointed out many times, although there are plenty of good reasons for China to worry about the value of its dollar holdings, and I hope many people, not just the Chinese, are looking warily at growing US fiscal deficits and making disapproving noises, the fact is that there is little China can do about its dollar holdings without either causing a damaging rise in trade tensions with Europe (or any other country whose currency is an alternative to the dollar) or causing a collapse in its export industry. As long as China’s trade surplus directly or indirectly is connected to the US trade deficit, China will have to recycle the surplus into the dollar pool that ultimately funds the US fiscal deficit, and it is in the best interest of the US that the US trade deficit decline smoothly, which means that it is also in the best interest of the US that foreigners, including the Chinese, buy fewer US dollar assets.

What is confusing is the conflict between China’s natural position and its stated position. Rather than demand reassurance that the US will control its fiscal spending, China should be secretly hoping that the US fiscal deficit will mushroom. It is after all largely the size of the US fiscal deficit that will determine the speed with which US imports and the US trade deficit contract, and it is in China’s best interest that these contract very slowly.

On a similar subject, I was recently interviewed for a TV show about – yet again – the awful continuing prospects for the dollar as a the dominant reserve currency. Besides expressing my deepest skepticism that the most recent hullabaloo about the dollar was likely to be more reasonable than during all the previous the-sky-is-falling-on-the-dollar periods, I also said that it seems to me that the argument had somehow gotten backwards as far as its proponents and opponents were lining up.

In my view it is the US who should be agitating for an end to the US dollar as the default reserve currency, because this means that any time a country needs to grow reserves or turbo-charge domestic growth with mercantilist industrial policies, thanks to the flexibility of the US financial system and the foreign desire to accumulate dollars, it is almost always the US tradable goods sector that is forced to adjust. In a similar vein it should be foreigners, especially Asians, and most especially China, that should want to maintain the existing currency system.

I also suggested to the interviewer that in two or three years no one would be talking about this topic anymore. She was surprised and asked me why. The reason has to do, I think, with the expected evolution of the US current account deficit. For several years the US has been running, as we all know, very large current account deficits.

This means that the net accumulation of dollars by foreigners (foreign purchases of dollar assets minus American purchases of foreign assets) has been extremely high – just as in the 1960s when the combination of a trade deficit, foreign military spending, and large foreign aid programs created a dollar glut, along with heated arguments about the international role of the dollar. If the US current account deficit remains high, foreigners will continue to be large net acquirers of dollars.

But if the current account deficit declines quickly, as it has and as I expect it to continue doing for a while longer, the problem of too many dollars being held abroad will disappear – or, more technically, it will simply be the obverse of the change in investment flows into the US. Once the world stops accumulating hundreds of billions of dollars every year through the US current account deficit, the argument over the dollar will fade away and, not coincidentally, a larger portion of foreign reserves, and probably international trade, will naturally be denominated in non-dollar currencies.

Comments

[Genesis:]

"The market for Treasury bonds is now more reliant on U.S. buyers — including the Federal Reserve after its recent buying spree — than the Chinese."

I gotta hand it to you. The Federal Reserve is domiciled in the U.S. and can therefore be considered a "U.S. buyer." However, when they buy Treasuries, it changes the game entirely. The Federal Reserve controls the U.S. money supply, so when they buy treasuries it's called monetizing the debt. Their treasury purchases devalue the dollar and discourage both foreign and U.S. investors from purchasing treasuries. So you first have to take the Fed completely out of the equation and ask, can private U.S. investors finance the U.S. government deficit over the long term (since that's what you're talking about) as the government takes over health care and continuing bailouts of irresponsible banks, etc? The answer is, certainly not.

Aug 18 10:46 AM

[James Lewis:]

Everyone is an economist these days, stating this; starting that.
Thinking that they have the answer and the USA is doomed.
The fiscal deficit is too high, the budget deficit is too high.
Amercia is bankcrupt.
If China stops buying treasuries the USA will be destroyed.
China is the USA banker.
America is bowing down to China.
The USD is going to lose its status as the reserve currency.

And the simple fact is they dont have a faintest clue about what they are talking about.

It is good to know that there are some people who understand the true dynamics of the financial system. So us 'KNOW IT ALLS' can actually be educated. Thank-you Michael.

The USA balance sheet is bigger, more complex than anyone could every imagine. 30-40 trillion does not even come close to the asset base of the USA.

Foreigners, USA investors do not really have a say whether or not they purchase treasuries. If people want to sell to the USA, they have no choice but to buy treasuries. If the USA people want to save money, the US can divert the money into treasuries through a mutitude of ways. Japan, Korea, Vietnam, Mexico, Middle East countries would in a second run surpluses with the USA for special trade agreements that involve them recycling the money into Treasuries.

The USA can bail out any banks it wants, undergo healthcare reform with absolutly no problem at all. The Fed, Treasury know they can get to the destination. To them the issue is how smooth the ride is.

Employment and human resource productivity are the only structural issues that can damage the US in a very serious way. And people need to understand that as long as this is taken control of, other impurities within the system (deficits blah blah) will be resolved.

Buy America, Sell China

Aug 18 12:07 PM

[Huai Dong:]

Even we want to buy America, we want to buy cheap.

Aug 20 12:50 AM