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.
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 19905, 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 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
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 rates are higher
than dollar interest rates. Chinese domestic interest rates are low, so China does not face this problem. But it does
face another: rapid monetary growth has contributed to a boom in bank credit, excessive investment growth, and a real estate
bubble. Thus far, China has used price controls to keep prices from rising, but such controls, which cause deep distortions
in the economy, cannot keep the lid on inflation forever. Eventually, rising domestic prices will erode China's competitiveness
even if it keeps its currency pegged at its current level. China is likely to let its currency appreciate rather than
accept socially and politically destabilizing inflation.
Let's face it: most Asian central banks view financing
the U.S. deficit as a burden, one that they would rather not shoulder. A recent survey of central banks (which did not include the People's Bank of China or the Bank of Japan) indicated
that most want to scale back their dollar purchases, and some smaller central banks are already adding more euros and yen
to their portfolios. In March, a former manager of
China's currency reserves questioned China's current development strategy, asking why it should seek out foreign investors
looking for a 15 percent return on their investment only to have the central bank lend these funds back to the United States
at 4 percent. China will conclude that rapid accumulation of dollar reserves no longer serves its interests sooner than optimists
Many claim that Asian central banks have to hold on
to their dollars—and the U.S. bonds that they have bought with their dollars—because a sell off would drive the
market for dollars lower and thus be self-defeating. This argument, however, misses a key point: foreign central banks do
not need to dump their existing stocks of U.S. dollars to cause financial distress in the United States; they only need to
slow their new purchases of dollar debt. If central
banks decide that $2.5 trillion in dollar reserves is enough, the result will be a sharp fall in the dollar and a sharp rise
in U.S. interest rates.
Levey and Brown further argue that even if foreign
central banks scale back their financing, there is little to worry about, since the United States is on the verge of a new
information technology (it) revolution that will attract a new wave of investment
from abroad. Alas, there is little evidence to suggest this pleasant scenario will come to pass. In both 2003 and 2004, equity investors took more than $150 billion out of the United
States: U.S. direct investment abroad exceeded foreign
direct investment in the United States, and U.S. purchases of foreign stocks exceeded foreign purchases of U.S. stocks. High
equity inflows are more likely to come because a further fall in the dollar makes U.S. assets fire-sale cheap than because
of a scramble to get in on another it boom.
Other countries do of course depend on U.S. spending
to make up for a lack of demand inside their own economies. But the United States cannot take comfort in the fact that the
necessary "adjustment" will be painful abroad. If a falling dollar slows German, Japanese, or even Chinese growth, it will
become even harder for the United States to reduce its trade deficit by exporting more—a key part of any "soft landing"
And even if the United States has relatively
little to fear from a falling dollar, it has much to
fear from an increase in interest rates. If
central banks ever cut back on their dollar purchases, private investors abroad would likely demand much higher interest rates.
They would have to be compensated for the risk of buying a dollar that may fall even more. Given how leveraged the U.S.
economy has become, with large domestic and external
debts, any large rise in interest rates would do significant damage.
There is little doubt that U.S. external debt and
the current account deficit are eroding the appeal of the U.S. approach to economic policy, an important element of U.S.
"soft power." Asian policymakers, in particular, view U.S. economic
policy not as a model but as a problem: the United States' "exorbitant privilege"—Charles de Gaulle's term for Washington's
ability to finance deficits by printing dollars— comes at their expense.
The United States has a particularly delicate relationship
with China, which is currently the single biggest buyer of U.S. debt. To date, disagreements on other issues have not prompted
China to slow its accumulation of dollar reserves, but that is not to say that it could not happen in the future. The ability
to send a "sell" order that roils markets may not give China a veto over U.S. foreign policy, but it surely does increase
the cost of any U.S. policy that China opposes. Even if China never plays its financial card, the unbalanced economic relationship
between the United States and China could add to the political tensions likely to accompany China's rise.
Economic power usually flow to creditors, not debtors. While the United States roams the world looking to sweep up any
spare savings to finance its huge deficits, China roams the world looking for new places to invest its surplus savings—
including in oil and gas resources and in states that Washington has judged pariahs. This is a far cry from the early days
of the Cold War, when the United States used its surplus savings to finance the reconstruction of its allies, cementing
political alliances with strong economic ties.
Levey and Brown are right that so far, the world's
appetite for U.S. credit has bolstered the U.S. ability to be a global hegemon "on the cheap." The United States exports enough to pay for only two-thirds of its imports; after recent tax cuts, the U.S. government collects enough non-Social Security revenue to cover only two-thirds of its non-Social Security spending. Foreigners made up the difference last year, buying enough U.S. Treasuries to fund the entire budget deficit. But without access to this
easy financing from foreign central banks, the U.S. government and the U.S. electorate
will have to make the kinds of unpleasant choices they have thus far avoided: among guns, butter, pork, tax cuts, and low
It is far better for Washington to act now, when it
can act on its own terms, than to wait until sharp falls in foreign demand for dollar debt forces it to act. The most important
step, of course, is to start cutting the budget deficit rather than just talking about cutting the budget deficit. This will
require reversing some recent tax cuts, not just controlling spending. Otherwise, the only way to reduce U.S. demand for foreign
savings would be through a sharp decrease in private investment and consumption— with disastrous consequences for the
U.S. economy. The Bush administration has been lucky over the past few years—the growing value of U.S.-held European
assets has kept U.S. external debt from rising, and foreign central banks' willingness to buy U.S. debt has helped keep U.S.
interest rates low in the face of large deficits— but its luck could easily turn.
Arguing that deficits—external as well as domestic—do
not matter does not make them go away. Celebrating the United States' real economic strengths while ignoring the real—and
growing—economic vulnerabilities associated with unprecedented current account deficits is dangerous.
brad setser is a Research Associate in the Global
Economic Governance Programme at University College, Oxford. NOU KIEL ROUBINI is Professor of Economics at
New York University's Stern School of Business and Chair
of Roubim Global Economics.