Why Deficits Matter

How, exactly, could this happen? Foreign governments and private investors own almost fifty percent of U.S. debt in the form of Treasury securities and other IOUs—"an unprecedented level of external debt for a large industrial country," according to the IMF. Foreign central banks, such as those in China, Japan, and South Korea, are intentionally buying up U.S. debt in order to hold the dollar down and make their countries' exports cheaper in America. But with interest rates low at the moment, some foreign lenders are losing money on their purchases—or at least not making as much as they could elsewhere—especially since investments in the United States have been mediocre of late. Moreover, the banks and private investors run the risk that the U.S. debt will become unsustainable and the United States will either default or try to inflate its way out of debt by printing more money, after which they may be left with worthless IOUs.

If foreigners begin questioning the wisdom of holding American debt, that could lead central banks and investors to slow their purchases of dollars—or start selling them off—which would force the dollar to fall and interest rates in the United States to rise. That would in turn cut off the borrowing that has fueled domestic consumer spending, which has been propping up the U.S. economy. A rapid collapse in the dollar would mean a spike in prices (due to a rise in the price of imports, which are not always easily replaceable by domestic goods), as well as unemployment (because of a slowdown in the economy). A gradual decline of the dollar would be a much better scenario—though it might harm the economy somewhat, the transition would be more manageable. But there's no telling how fast the adjustment will come.

Is this scenario likely? In Foreign Affairs last summer, economists Nouriel Roubini and Brad Setser noted that the United States' current account deficit, which in 2002 was at about 7 percent of GDP, compared in sizes with those in Thailand and Mexico right before those two countries had major debt crises. In an interview, Setser elaborated on the comparison: "Clearly the U.S. is very different. It has strengths that Mexico and Thailand didn’t have. But it also has some increasingly important weaknesses: a very low level of exports, an economy that’s quite leveraged, and so a one percent increase in U.S. interest rates would have a much bigger impact than a one percent increase in Thai or Mexican interest rates."

Most people, of course, think the United States is in no danger of defaulting—either explicitly or by inflating its way out of debt—and that confidence seems to be preventing investors from shying away from dollars for now. The U.S. government is still widely viewed as the world’s most stable, and the international financial markets have not shown serious signs of doubting the dollar yet—foreign purchases of U.S. debt securities surged last year Indeed, the United States is still a good place to invest compared to most other nations seeking loans: it has, after all, a stable government, developed markets, and is relatively free.

But that could change if the country's debt continues to grow faster than the economy; eventually, perhaps not even the United States can sustain such borrowing, and if that realization sinks in, lenders will panic. Moreover, if persistent budget deficits continue to weaken the economy by leading to cuts in research, development, and infrastructure, the United States could start to look like a less appealing place to invest.

There are already some signs that foreign governments are starting to think along these lines. Treasury statistics from March showed international purchases slowing, making foreign central banks net sellers for the first time in six months. In January, a high-level Chinese government economist leaked news that the Chinese central bank intends to slow its purchases of dollars and shift some of its buying towards the yen and euro. U.S. financial markets get jittery whenever an announcement issues from China’s central bank, which now holds over seventy-five percent of its foreign reserves in dollars, placing it behind Japan in owning the largest portion of U.S. securities. Japan has recently approached diversification away from the dollar. Both South Korea in 2005 and Russia in 2004 have also threatened to diversify their exchange portfolios away from the dollar.

As a report from the Committee on Economic Development, a Washington think tank, puts it: "U.S. reliance on foreign investment has become so large that a mere slowing of the flow of foreign purchase of dollar-denominated assets—not even a full-blown run on the dollar—could be enough to shake markets significantly." Of course few of America's creditors want to see a crisis happen, and are thus forced to continue financing the United States. The question is how long they can keep it up.