The Budget Deficit and Declining Dollar

I was having a political chat with a friend a few days back – I told her that I was going to vote for the presidential candidate which I felt would spend the least money. She was shocked, “How can you say that when there are people who grow up in this country who don’t have access to healthcare?” I responded, “Well what about the national debt? Universal healthcare will add billions to the already large federal budget deficit.” She looked puzzled, “Yea - -What is the national debt? I never really understood that.” I immediately understood where she thought her argument was coming from. I also think I am now one step closer to understanding Democrats, but I digress.

The next day I had an interesting conversation with my roommate, who is also a finance guy. We had both just come home from our jobs and began talking about how the dollars that Americans were working these ridiculous hours for (hours that European nations would consider side de facto slavery) were essentially having their value slowly seeped away from them by the federal government’s love affair with deficits. Most disturbing to us was that few people talked about this problem.

People always complain about the falling dollar, and the rising prices of gas and food, but I think few realize how the dollar’s fall, and rising oil and food costs, are intimately linked to the government (and trade) deficit. I now realize that the friend I was having the political debate with is the norm, and that is why so little is done about this huge problem – nobody really understands it. Sure everyone hears about the national debt and deficit in passing but how many people actually know what it means? I challenge you to ask your friends and family, the results may shock you.

First some basics on the debt.

Today the US National debt clock reads $9,380,588,906,277.11 and has been increasing at a rate of 1.38 billion dollars per DAY since September 28, 2007. That is $31,100 dollars of debt for every U.S citizen. The U.S total public debt is the sum of money that the US government owes to states, corporations, intergovernmental agencies, individuals, and foreign governments. Of the $9.3 trillion, $5.3 trillion are held by the public (states, corporations, foreign governments and individuals.) The rest is owned by intergovernmental agencies or debt held for Social Security.  

This debt comes from the deficits the federal government runs. So when the government cuts taxes, and raises spending; as is the fashion of the day, then the federal government must auction of a variety of debt instruments to the public in order to cover its expenses. These instruments include Treasury Bills, Notes, Bonds, TIPS(treasury inflation protected securities), and United States Savings Bonds. The U.S has had federal debt from the beginning, and, with the exception of a short stint under Jackson in 1835, has always had it. But the debt has jumped from 2.6 billion in 1920 to 257.4 billion in 1950 to 9.5 trillion today- quite exponential growth.

Who is willing to buy this debt?

Lots of people are, or, more accurately, have been willing to hold US government back dollar denominated in the past. Come on - everyone likes American dollars – or, at least, they did. As of April 2008, Japan had the most US denominated debt, coming in at 592.2 billion, next was China with 502 billion, then the UK with 251 billion. These countries along with all the other debt holders combine to a grand total of 2,601 billion dollars of US debt owned by foreigners.(I am sure you have heard that China has over a  trillion US dollars- they do – but only some of them are in US government debt) In the past, central banks around the world and wealthy foreign individuals have been very willing to buy our debt (and keep interest rates here low) because they saw the US Greenback as the pinnacle of financial stability. Foreign central banks marveled at our low inflation rates and were in awe of how our dollars kept their value while other currencies seemed to go through periods of extreme inflation. After the Asian contagion crisis of 1997, Asian central banks were thirsty for dollars – they did not want another crisis and they needed dollars if they wanted to defend their currency peg the next time around. But that was several years ago and today the US dollar has lost significant value. This dollar devaluation begs pertinent questions: How willing are foreign central banks going to be to buy up dollar denominated debt? How willing will they be to peg their currencies to the dollar and hold dollars as their primarily reserve currency?

What’s the problem?

Countries may not always be willing to accept our federal government’s dollar denominated debt. In May 2007, Kuwait discontinued its dollar peg, moving instead toward a more dependable basket of currencies. With the Euro zone looking strong (or at least stronger then the US) thanks in large part to superstar Germany, nations may be apt to switch to a basket of reserve currencies which place more emphasis on the Euro. China is among the many countries considering dollar divestiture and has expressed interest in changing its reserves from its heavy weighting on the US dollar to a more diverse basket of currencies.

Worst case scenario for the greenback?

If foreigners are no longer willing to accept US debt ,or worse still if they sell the vast sums of debt that they have accrued, then you are going to see a real large shift in the supply and demand for dollars. Demand for the notes will drop off, sending interest rates up and worsening the already dismal credit situation. If foreigners try to divest their dollar holdings then supply will skyrocket as the US federal government still has to perform its 200 annual debt auctions. We all know what happens in the equity markets if there is a seller and no buyer – the price goes down. The value of the T-bills and T-bonds will go down and interest rates on those instruments will go up.

If the world becomes awash with an oversupply of US dollars, then the dollar’s strength weakens more, pushing up commodity prices for US consumers which leads into the downward spiral of rising prices causing a weaker economy and a weaker economy causing a weakening currency which in turn rises commodity prices and the cycle continues. That is, it continues until the US heads into a recession which causes less demand for commodities, which in turn lowers the prices. That is the theory at least, in actuality demand for commodities in emerging markets and other developed nations could be strong enough to support commodity prices which would be disastrous for oil importing America.  In this case, things could get really ugly for everyone except the commodity corps.  

A happier scenario for the dollar – and why it may not happen.

A flight to quality? If the world has another Asian Contagion crisis, if there is some big financial disaster somewhere in the emerging markets, then other nations might “fly to quality” and demand US dollars. (Then again they may view dollars as possessing low quality and instead opt to buy Euros.) Then the dollar becomes stronger and commodity prices go down, oil prices go down. This has happened in the recent past, in S. America, and in Asia.  But today’s situation is different. Brazil, as a nation, was recently upgraded to investment grade by Standard and Poor’s. Also, the emerging markets are resource rich, Russia has oil, and Brazil is awash with resources.

And now the most important differentiating factor -there is also more internal demand driving the emerging markets, and although the exact amount of internal demand is still up for debate (see decoupling) the existence of this new factor could make all the difference for the dollar. The world may not fly to US government securities every time there get spooked, not if their home countries have created some semblance of internal demand and domestic (for them, foreign to us) consumer confidence.  

What would be ideal?

An amendment to the US constitution requiring the federal government to balance the budget. In 1982, such a measure was put to the Senate, and it passed, but was shot down in the House by a vote of 236-187.

No candidate for 08 is talking about a balance budget, but if Americans want a strong dollar again they need to stop deficit spending and balance the budget. Unfortunately, it’s not in politician’s best interest to stop deficit spending. People like services and schools and they hate paying taxes. Americans think in the short term, the long term affects of the debt are far removed from a discussion on a road that needs to be repaved or a new school that need to be staffed with teachers. Therein lies the problem, politicians will never advocate for a balanced budget because they would never get elected. Therefore, we need to force the politicians into a balanced budget amendment so they stop trying to see who can give more services and collect less taxes in a game of financial chicken that harms every American present and future.  

In summation. 

I am in no way saying the US will default on its debt soon as Russia did in 90’s. In the short run, that outcome is virtually impossible. But the negative effects of a growing national debt such as the weak dollar, higher commodity prices (like corn, oil and steel), and inflation, are all negatives the US will have to continue dealing with if the issue is not addressed.

In short, we can’t keep running deficits forever, despite what Regan and Laffer may have told you- WE DO HAVE TO PAY OFF THE DEBT.

Footnote

Arguments for a weaker dollar.

The argument for a stronger dollar would not be complete without a peek at the advantages of a weaker dollar. A weaker dollar means fewer imports and more exports for America, at least in theory. A weaker dollar makes US labor cheaper and therefore US goods cheaper than their foreign counterparts. The dollar slid should make Boeing planes cheaper than Airbus planes.  It should also reverse or at least lessen the trade deficit, and therefore reduce out demand of foreign currency, which would strengthen the dollar. But so far, that has only happened to a mild extent. Below is the monthly trade deficit information, like the Government deficit, the trade deficit also increases the supply of dollars (by way of more demand for foreign currency) which further weakens the dollar. 

Data source

So why isn’t the trade deficit shirking with the dollar? That is a very complicated question that deals with a lot of advanced topics but the basic reason is that we are not cheap enough yet. On a market basis, the dollar is just not cheap enough compared to other currencies, people all around the world still want dollars despite the subprime mess. Essentially, the dollar has fallen vs. the Euro and many other currencies, but not vs. the much manipulate Chinese Yuan. Since the Chinese account for a large portion of the US trade deficit, the deficit has not been shrinking with the shrinking dollar. Fundamentally The Chinese are buying out debt and selling their Yuan in order to keep their labor unfairly cheap. In the recent past the Chinese have been more than willing to take our dollars – but with inflation ramping up in China, they are going to have to tightening their money supply, and that means they will have to stop buying our debt and flooding the markets with Yuan, or face a large red inflationary dragon. This revaluation of the Yuan may indeed shrink our trade deficit, but does nothing to help to US cope with the monumental problem of federal deficit spending. 

Disclosure: none

Comments

[User 142738]

Your argument that foreign governments would flock to the euro due to national debt in each currency’s respective areas is a moot point. The top twenty most indebted countries, as a percentage of GDP, includes no less than six eurozone countries (including France and Germany), but does not include the United States.

The move to peg one’s currency to the euro, and not a basket of currencies, as a replacement to the dollar can only be regarded as a politically-motivated move.

[bluesmoke]

Excellent article. If this latest development in a potentially "perfect storm" isn't a wake up call for all Americans to balance the budget, then I don't know what is...

[Melancholy Korean]

"I also think I am now one step closer to understanding Democrats, but I digress."

Look, I'm a Republican too, but that's a cheap shot. Half our budget goes toward the military. Where was our party, or at least the fiscal conservatives, as opposed to the "neoconservatives... (neo-Trotskyites) on the Iraq war? Talk about a truly idiotic use of our funds. And the Laffer curve? That was pushed hard by Ronald "Reagan" (or did you meant Don Regan)? In any case, both of 'em.

Not that the Dems have any answers. The housing bailout bill is only going to prolong the adjustment in prices that needs to take place. Whether it happens in four quarters or four years or forty years, eventually, prices will have to fall back to reasonable levels.

[domenic]

Regan and Reagan both work – but I meant Regan(no typo)- but good eyes.

You make a good point about neither party practicing fiscal conservatism – and I agree - that is why we need the balance budget amendment! See the line “So when the government cuts taxes, and raises spending; as is the fashion of the day.”
As for the cheap shot at Democrats – I was merely joking lightheartedly – if it makes you feel better I think both parties are bad.

Thanks for commenting!

[Zee4Money]

As you prepare to vote this year remember the last US Gov't to run a budget surplus was the Clinton Administration.

[JohnB]

Great graph and facts about the historical trend of national debt:
www.cedarcomm.com/~stevelm1/usdebt.htm
Guess which presidents oversaw the vast majority of debt increase? You only need to pick two last names.

[JohnB]

Let's try the URL again:

United States National Debt (1938 to Present)
An Analysis of the Presidents Who Are Responsible for the Borrowing
tinyurl.com/zb3x2

[User 217373]

We have stop overspending no matter is for military or heathly care. All Americans work longer hours. the more harder they work, the more money politicians spending. endup we are get poorer and poorer. My guess that the next few generation of Americans and great America is poor people and poor country if we are not stop the way goverment spending right now!

[skate]

Why? You and nobody else gives any answer to Why should we balance the debt, since debt is good for the economy.
Without debt, we have no growth.

As long as we have growth, the growth will cover the debt, as it is doing now. The proportion of our debt to the amount of taxes our gov takes in , is smaller than during the 90s. That would occur when Growth expands More than debt, very simple.

Without debt, we have no growth, simple.

[skate]

When we talk about debt, we must also include growth (if any), that's why the charts on debt are useless, simply because they do not include the growth.

The big increase in debt is surpassed by the bigger increase in Growth.

To top things off, the money owed by the gov (who prints money) is not owed by the People.

[kebu77]

"So why isn’t the trade deficit shirking with the dollar?"

Maybe cuz the cost of imported oil continues to rise, offsetting rising exports.

[Ganesh Sastri]

1. The article says: am in no way saying the US will default on its debt soon as Russia did in 90’s. In the short run, that outcome is virtually impossible
The US is already defaulting. Look at the billions being writtne off by UBS, Barclays, RBS, BNP, Credit Suisee etc etc.
2. Why nobody is talking of budget SURPLUS? In the late nineties, Clinton ran a few years with surpluses and stopped borrowing on Long Bond.
3. If you want to reduce trade deficit you need to increase per person PRODUCTIVITY or reduce wages in US. Lowering the exchange rate of US dollar does that. If you don't want to reduce exchange rates be willing to increase interest rates and / or reduce wages.

[metermike]

in response to skate:Why? You and nobody else gives any answer to Why should we balance the debt, since debt is good for the economy.
Without debt, we have no growth.

As long as we have growth, the growth will cover the debt, as it is doing now. The proportion of our debt to the amount of taxes our gov takes in , is smaller than during the 90s. That would occur when Growth expands More than debt, very simple.

Without debt, we have no growth, simple.

This simply is not true you can have no debt and still have growth .So basicly you are saying that if the country does not run a deficit that there is no growth since that is how you create debt.In many countries around the world the have eliminated deficits and started to pay off debt and growth exceeds that of the united states .You don't have to look far either for this just to the noth.
Another quick note:Many other countries believe that the american dollar is still over valued at its current rate.(look for interest rates to start increasing soon) Great artical