How Scary Is Our Deficit?Ñ--?

Our Money, Our Debt, Our Problem

Brad Setser and Nouriel Roubini

The U.S. current account deficit -- the gap between what the United States earns abroad and what it spends abroad in a year -- is on track to reach seven percent of GDP in 2005. That figure is unprecedented for a major economy. Yet modern-day Panglosses tell us not to worry: the world's greatest power, they say, can also be the world's greatest debtor. According to David Levey and Stuart Brown ("The Overstretch Myth," March/April 2005), "the risk to U.S. financial stability posed by large foreign liabilities has been exaggerated." Indeed, they write, "the world's appetite for U.S. assets bolsters U.S. predominance rather than undermines it."

But in fact, the economic and financial risks that arise from the U.S. current account deficit (and the resulting dependence on foreign financing) have not been exaggerated. If anything, they have received too little attention -- and are set to grow in the coming years.

Levey and Brown make three basic arguments. First, they claim that foreign central banks will probably continue to finance U.S. deficits. Second, they predict that even if foreign central banks do pull back at some point, private investors will step in. And finally, they assume that even if this financing does not materialize, a dollar crash would hurt Europe and Japan more than it would hurt the United States. Unfortunately, there is a good chance that all of these assumptions will prove false. Foreign central banks may well stop financing growing U.S. deficits, private equity investors might not take their place, and the resulting adjustment process would prove quite painful for the United States.

DEBT DYNAMICS

U.S. external debt is now equal to more than 25 percent of GDP, a high level given that exports are a small fraction of U.S. GDP. More important, the United States is adding to its debt at an extraordinary pace. The U.S. current account deficit is now comparable to those of Thailand and Mexico in the years leading up to their financial crises.

In the late 1990s, the United States borrowed abroad to finance private investment. Today, however, the country does most of its foreign borrowing to finance the federal budget deficit, which is projected to be close to 3.5 percent of GDP in 2005. (In 2000, the United States had a surplus equal to 2.5 percent of GDP.) Recent economic growth has not reduced the budget deficit, but it has increased private demand for scarce savings; the net result has been even more borrowing from abroad. In 2004, foreigners bought an amazing $900 billion in U.S. long-term bonds; the United States exported a dollar of debt for every dollar of goods it sold abroad. Looking ahead, the U.S. debt position will only get worse. As external debt grows, interest payments on the debt will rise. The current account deficit will continue to grow on the back of higher and higher payments on U.S. foreign debt even if the trade deficit stabilizes. That is why sustained trade deficits will set off the kind of explosive debt dynamics that lead to financial crises.

Nothing to worry about, argue Levey and Brown: foreigners may own a majority of U.S. Treasury bonds, but their holdings of other types of U.S. debt and equities remain limited; the United States, unlike other debtors, borrows in its own currency, displacing the negative consequences of a falling dollar onto its creditors; and the United States has substantial assets abroad, the value of which rise as the dollar falls.

In recent years, the rising value of existing U.S. assets abroad has in fact offset much of the new borrowing the United States has taken out to finance its trade deficit, and Levey and Brown bank on similar gains in the coming years. But this bet is unwise. Most U.S. assets abroad are in Europe. Since the dollar already has fallen by around 40 percent against the euro, further falls in the dollar are likely to be against Asian currencies, and the United States holds relatively few Asian assets.

THE KINDNESS OF STRANGERS

The falling dollar also reduces the value of foreign investments in the United States. Eventually, foreign creditors are likely to demand higher interest rates to offset the risk of further decreases. Over the past few years, the United States has found a novel way out of this dilemma: rather than selling its debt to private investors who care about the risk of financial losses, it has sold dollar debt at low rates to foreign central banks. The extent of U.S. dependence on only ten or so central banks, most of them in Asia, is stunning: in 2004, foreign central banks probably increased their dollar reserves by almost $500 billion, providing much of the financing the United States needed to run a $665 billion current account deficit. These banks are not buying dollar-denominated bonds because they are attracted to U.S. economic strength, the high returns offered in the United States, or the liquidity of U.S. markets; they are buying them because they fear U.S. weakness. If foreign central banks stopped buying dollar-denominated bonds, the dollar would fall dramatically against their currencies, U.S. interest rates would rapidly rise, and the U.S. economy would slow.

Foreign central banks have financed the United States to keep their export sectors -- heavily dependent on U.S. consumer spending -- humming. But they now must weigh the benefits of providing the United States with such "vendor financing" against the rising costs of keeping the current system going.

Now, foreign central banks with large dollar holdings are facing the prospect of huge losses as a result of the dollar's decline. A 20 percent increase in the value of the yuan against the dollar would reduce the value of China's roughly $450 billion in dollar reserves by about $100 billion -- 6 percent of China's GDP. In four years, if nothing changes, Chinese dollar reserves could reach $1.4 trillion, raising the costs of a falling dollar to $300 billion -- some 12 percent of China's GDP. In short, the longer China continues to finance U.S. deficits, the larger its ultimate losses.

More important, the current arrangement increasingly risks creating domestic financial trouble. Growing reserves naturally lead to growth in the money supply, raising the risk of inflation. In order to avert this risk, central banks must resort to a process called "sterilization": selling local-currency bonds to reduce the amount of cash in circulation. But this process is expensive, especially if local interest