Why Deficits Matter: The International Dimension

The Issue

Foreigners account for about $2.2 trillion, or a little over half, of the outstanding total of $4.3 trillion of US Treasury securities held by the public. Official institutions, mainly central banks, account for about 60 percent of this total. In addition, foreigners as a whole probably hold close to $1 trillion, or about 15 percent, of US government agency securities (see tables 1 to 4).

These totals and ratios have risen rapidly over the past 20 years. From 1985 to 2005, foreigners acquired almost 75 percent of the overall increase in outstanding treasuries. From 1995 to 2005, domestic holdings actually fell while foreign holdings grew by twice the aggregate increase. Since 2001, foreign purchases of treasuries have accounted for most of the rise in the total outstanding.1

These data raise the obvious question of whether the United States in general and the US government in particular have become excessively dependent on foreigners to finance our domestic economy and indeed our federal budget. The ultimate concern is whether these holders, or perhaps some subset of them such as foreign governmental institutions, might precipitate a financial crisis by rapidly selling off large amounts of treasuries for economic or even political reasons.

Foreign Holdings of Treasuries

The answer to these questions is two-fold. First, we do not need to worry very much about foreign holdings of US treasury securities per se. The US capital markets are so large and so liquid, and the treasury market is a sufficiently modest component of it, that foreign shifts from treasuries to other dollar investments could readily be accommodated by a reallocation of the portfolios of other investors. We should worry even less about the risk of liquidation of treasuries by foreign official institutions, including the largest holders in Japan and China, who are the least likely sources of disruption of our financial markets in view of their responsibilities for financial stability and their institutional aversion to being blamed for any disruption of the world economy--and, unfortunately, due to the desire of many of these countries to maintain undervalued exchange rates to bolster even further their international competitiveness.2

It would in fact be a mistake to overemphasize the 50 percent share of foreign holders of US treasuries. The reason is that treasury long-term debt accounts for less than 10 percent of the total stock of outstanding long-term US securities (table 3). The addition of US government agency securities, of which foreigners hold about 15 percent, leaves their holdings of all governmental paper at about 20 percent of the overall capital market. Hence there is plenty of room for reallocation of investment portfolios by different groups of investors among different asset classes. If foreigners decided to shift their holdings of treasuries to US agencies or corporate bonds (or bank deposits or some other assets), as they in fact seem to be doing (at least from short-term treasury bills) in recent years, other investors would be attracted by the reduction in prices of treasuries to make switches in the opposite direction. There might be some alteration in the relative prices of the different US assets, with a modest increase in the cost of financing the federal debt, but major disruptions would be highly unlikely.

When seen in this larger context of the entire US capital market, foreign holdings are more on the order of 15 percent. This figure is considerably less than their share of 50 percent in the treasury market by itself. Foreigners hold only about 10 percent of US equities and about 20 percent of corporate bonds.

This conclusion receives strong empirical support from the experience of the last few years. Foreign holdings of treasuries fell in 2000-2001, but the exchange rate of the dollar continued to rise throughout that period. Conversely, foreign holdings of treasuries rose sharply in 2003-04 while the dollar was declining steadily and substantially. There is simply no clear relationship between changes in foreign holdings of treasuries and the value of our currency.3

Total Foreign Capital Flows to the United States

Second, however, we do need to worry considerably about total foreign holdings of dollar assets and, in particular, the extent to which our economy has become dependent on new capital inflows to finance both our external and internal deficits because those inflows could slow abruptly or even totally dry up at virtually any time. Because of the direct impact of the federal budget position on total national saving, and thus on our current account imbalance with the rest of the world, I believe that this US dependence on foreign funding is one of the major reasons we should adopt a national policy objective of restoring the modest federal budget surpluses that were in place as recently as 1998-2001.

At the margin, the role of foreigners in financing the US economy is much more salient than suggested by the averages cited above: They accounted for virtually the entire increase in the total holdings of all US long-term securities, including equities and corporate bonds, from 2000 to June 2005 (the latest date for which comprehensive data are available, see table 3). It is true that this period is distorted by the sharp fall in equity prices after early 2000 and our ratio of dependence on foreign investors is considerably lower--though still close to 50 percent--if different base periods are chosen. But the United States has clearly become reliant on external funding for a very large proportion of the investment needed to fuel our domestic economy, and we need to carefully consider the implications thereof in setting national economic policy.

These financial flows are a manifestation of the very large and rapidly growing deficits in the US merchandise trade and current account balances with the rest of the world. Those deficits hit $850 billion to $875 billion in 2006, about 7 percent of GDP. They have increased by an average of $100 billion annually over the past four years (and by an annual average of over $80 billion for the past nine years). Funding those deficits requires the United States to attract $3 billion to $4 billion of foreign money (including direct investment as well as financial capital) every working day. As a result, our net foreign debt had climbed to $2.7 billion at the end of 2005. In addition, the United States exports capital (including direct investment as well as portfolio capital) in the range of $500 billion to $1 trillion every year, which must also be offset by capital inflows.4

Hence we must attract $7 billion to $8 billion of foreign capital every working day to