Our Money, Our Debt, Our Problem [with Reply]

Author(s): Brad Setser, Nouriel Roubini, David Levey and Stuart Brown
Source: Foreign Affairs , Jul. - Aug., 2005, Vol. 84, No. 4 (Jul. - Aug., 2005), pp. 194-
200
Published by: Council on Foreign Relations

Stable URL: https://www.jstor.org/stable/20034431

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 Response

How Scary Is the Deficit

American Power and American Borrowing

too little attention-and are set to grow

Our Money, Our Debt, in the coming years.
Our Problem Levey and Brown make three basic
BRAD SETSER AND arguments. First, they claim that foreign
central banks will probably continue to
NOURIEL ROUBINI finance U.S. deficits. Second, they predi
that even if foreign central banks do pull
The U.S. current account deficit-the
back at some point, private investors wi
gap between what the United Statesstep in. And finally, they assume that eve
earns abroad and what it spendsif abroad
this financing does not materialize, a
dollar crash would hurt Europe and Japa
in a year-is on track to reach seven
percent of GDP in 2005. That figure
more is than it would hurt the United States
unprecedented for a major economy.Unfortunately, there is a good chance
Yet modern-day Panglosses tell that us notall of these assumptions will prove
false. Foreign central banks may well st
to worry: the world's greatest power,
they say, can also be the world's financing
greatest growing U.S. deficits, private
debtor. According to David Levey equity and investors might not take their
Stuart Brown ("The Overstretchplace,Myth," and the resulting adjustment
March/April 2005), "the risk to U.S. would prove quite painful for
process
financial stability posed by largethe United States.
foreign
liabilities has been exaggerated." Indeed,
they write, "the world's appetiteDEBTforDYNAMICS
U.S.
assets bolsters U.S. predominance U.S.rather
external debt is now equal to more
than undermines it." than 25 percent of GDP, a high level given
that exports are a small fraction of U.S.
But in fact, the economic and financial
GDP. More important, the United States
risks that arise from the U.S. current
account deficit (and the resulting depento its debt at an extraordinary
is adding
dence on foreign financing) havepace.
not The
beenU.S. current account deficit is
now
exaggerated. If anything, they have comparable to those of Thailand
received

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 How Scary Is the Deficit?
and Mexico in the years leading up to similar gains in the coming years. But this
their financial crises. bet is unwise. Most U.S. assets abroad are
In the late 1990S, the United States in Europe. Since the dollar already has
borrowed abroad to finance private in fallen by around 40 percent against the euro,
vestment. Today, however, the country further falls in the dollar are likely to be
does most of its foreign borrowing to against Asian currencies, and the United
finance the federal budget deficit, which States holds relatively few Asian assets.
is projected to be close to 3.5 percent of
GDP in 2005. (In 2000, the United States THE KINDNESS OF STRANGERS
had a surplus equal to 2.5 percent of GDP.) The falling dollar also reduces the value
Recent economic growth has not reduced of foreign investments in the United
the budget deficit, but it has increased States. Eventually, foreign creditors are
private demand for scarce savings; the likely to demand higher interest rates to
net result has been even more borrowing offset the risk of further decreases. Over
from abroad. In 2004, foreigners bought the past few years, the United States has
an amazing $900 billion in U.S. long-term found a novel way out of this dilemma:
bonds; the United States exported a rather than selling its debt to private
dollar of debt for every dollar of goods investors who care about the risk of
it sold abroad. Looking ahead, the U.S. financial losses, it has sold dollar debt
debt position will only get worse. As at low rates to foreign central banks. The
external debt grows, interest payments extent of U.S. dependence on only ten
on the debt will rise. The current account or so central banks, most of them in Asia,
deficit will continue to grow on the back is stunning: in 2004, foreign central banks
of higher and higher payments on U.S. probably increased their dollar reserves
foreign debt even if the trade deficit sta by almost $500 billion, providing much
bilizes. That is why sustained trade deficits of the financing the United States needed
will set off the kind of explosive debt to run a $665 billion current account
dynamics that lead to financial crises. deficit. These banks are not buying dollar
Nothing to worry about, argue Levey denominated bonds because they are
and Brown: foreigners may own a majority attracted to U.S. economic strength, the
of U.S. Treasury bonds, but their holdings high returns offered in the United States,
of other types of U.S. debt and equities or the liquidity of U.S. markets; they
remain limited; the United States, unlike are buying them because they fear U.S.
other debtors, borrows in its own currency, weakness. If foreign central banks stopped
displacing the negative consequences of buying dollar-denominated bonds, the
a falling dollar onto its creditors; and the dollar would fall dramatically against their
United States has substantial assets abroad, currencies, U.S. interest rates would rapidly
the value of which rise as the dollar falls. rise, and the U.S. economy would slow.
In recent years, the rising value of ex Foreign central banks have financed
isting U.S. assets abroad has in fact offset the United States to keep their export
much of the new borrowing the United sectors-heavily dependent on U.S.
States has taken out to finance its trade consumer spending-humming. But they
deficit, and Levey and Brown bank on now must weigh the benefits of providing

F O R E I G N AF FA I R S July/August 200s [195]

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 Brad Setser et a.
the United States with such "vendor Let's face it: most Asian central banks
financing" against the rising costs of view financing the U.S. deficit as a burden,
keeping the current system going. one that they would rather not shoulder.
Now, foreign central banks with large A recent survey of central banks (which did
dollar holdings are facing the prospect not include the People's Bank of China
of huge losses as a result of the dollar's or the Bank ofJapan) indicated that most
decline. A 20 percent increase in the value want to scale back their dollar purchases,
of the yuan against the dollar would reduce and some smaller central banks are already
the value of China's roughly $450 billion adding more euros and yen to their
in dollar reserves by about $1oo billion portfolios. In March, a former manager
6 percent of China's GDP. In four years, if of China's currency reserves questioned
nothing changes, Chinese dollar reserves China's current development strategy,
could reach $1.4 trillion, raising the costs asking why it should seek out foreign
of a falling dollar to $300 billion-some investors looking for a 15 percent return
12 percent of China's GDP. In short, the on their investment only to have the
longer China continues to finance U.S. central bank lend these funds back to
deficits, the larger its ultimate losses. the United States at 4 percent. China
More important, the current arrange will conclude that rapid accumulation
ment increasingly risks creating domestic of dollar reserves no longer serves its
financial trouble. Growing reserves natu interests sooner than optimists think.
rally lead to growth in the money supply, Many claim that Asian central banks
raising the risk of inflation. In order to have to hold on to their dollars-and
avert this risk, central banks must resort the U.S. bonds that they have bought
to a process called "sterilization": selling with their dollars-because a selloff would
local-currency bonds to reduce the amount drive the market for dollars lower and
of cash in circulation. But this process is thus be self-defeating. This argument,
expensive, especially if local interest rates however, misses a key point: foreign
are higher than dollar interest rates. Chi central banks do not need to dump their
nese domestic interest rates are low, so existing stocks of U.S. dollars to cause
China does not face this problem. But it financial distress in the United States; they
does face another: rapid monetary growth only need to slow their new purchases of
has contributed to a boom in bank credit, dollar debt. If central banks decide that
excessive investment growth, and a real $2.5 trillion in dollar reserves is enough,
estate bubble. Thus far, China has used the result will be a sharp fall in the dollar
price controls to keep prices from rising, and a sharp rise in U.S. interest rates.
but such controls, which cause deep distor Levey and Brown further argue that
tions in the economy, cannot keep the lid on even if foreign central banks scale back
inflation forever. Eventually, rising domestic their financing, there is little to worry
prices will erode China's competitiveness about, since the United States is on the
even if it keeps its currency pegged at its verge of a new information technology
current level. China is likely to let its cur (IT) revolution that will attract a new
rency appreciate rather than accept socially wave of investment from abroad. Alas,
and politically destabilizing inflation. there is little evidence to suggest this

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 How Scary Is the Deficit?
pleasant scenario will come to pass. In particular, view U.S. economic policy not
both 2003 and 2004, equity investors as a model but as a problem: the United
took more than $150 billion out of the States' "exorbitant privilege"-Charles
United States: U.S. direct investment de Gaulle's term for Washington's ability
abroad exceeded foreign direct investment to finance deficits by printing dollars
in the United States, and U.S. purchases of comes at their expense.
foreign stocks exceeded foreign purchases The United States has a particularly
of U.S. stocks. High equity inflows are delicate relationship with China, which
more likely to come because a further fall is currently the single biggest buyer of
in the dollar makes U.S. assets fire-sale U.S. debt. To date, disagreements on
cheap than because of a scramble to get other issues have not prompted China
in on another IT boom. to slow its accumulation of dollar reserves,
Other countries do of course depend but that is not to say that it could not
on U.S. spending to make up for a lack of happen in the future. The ability to send
demand inside their own economies. But a "sell" order that roils markets may not
the United States cannot take comfort give China a veto over U.S. foreign policy,
in the fact that the necessary "adjustment" but it surely does increase the cost of any
will be painful abroad. If a falling dollar U.S. policy that China opposes. Even if
slows German, Japanese, or even Chinese China never plays its financial card, the
growth, it will become even harder for the unbalanced economic relationship be
United States to reduce its trade deficit tween the United States and China could
by exporting more-a key part of any "soft add to the political tensions likely to
landing" scenario. accompany China's rise.
And even if the United States has rel Economic power usually flows to
atively little to fear from a falling dollar, it creditors, not debtors. While the United
has much to fear from an increase in inter States roams the world looking to sweep
est rates. If central banks ever cut back up any spare savings to finance its huge
on their dollar purchases, private investors deficits, China roams the world looking for
abroad would likely demand much higher new places to invest its surplus savings
interest rates. They would have to be including in oil and gas resources and in
compensated for the risk of buying a dol states that Washington has judged pariahs.
lar that may fall even more. Given how This is a far cry from the early days of the
leveraged the U.S. economy has become, Cold War, when the United States used
with large domestic and external debts, its surplus savings to finance the recon
any large rise in interest rates would do struction of its allies, cementing political
significant damage. alliances with strong economic ties.
Levey and Brown are right that so far,
POWER DRAIN the world's appetite for U.S. credit has
There is little doubt that U.S. external debt bolstered the U.S. ability to be a global
and the current account deficit are eroding hegemon "on the cheap." The United
the appeal of the U.S. approach to eco States exports enough to pay for only two
nomic policy, an important element of thirds of its imports; after recent tax cuts,
U.S. "soft power." Asian policymakers, in the U.S. government collects enough

FOREIGN AFFAIRS July/August200s [197]

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 Brad Setser et a.
non-Social Security revenue to cover New York Universitys Stern School ofBusi
only two-thirds of its non-Social Security ness and Chair ofRoubini GlobalEconomics.
spending. Foreigners made up the
difference last year, buying enough U.S.
Treasuries to fund the entire budget deficit.
Levey and Brown Reply
But without access to this easy financing
from foreign central banks, the U.S. gov Brad Setser and Nouriel Roubini portray
ernment and the U.S. electorate will hav( us as modern-day Panglosses for expecting
to make the kinds of unpleasant choices an orderly adjustment of global economic
they have thus far avoided: among guns, imbalances and sustained U.S. hegemony.
butter, pork, tax cuts, and low interest rates. But to us, they are would-be Cassandras
It is far better for Washington to act who gravely warn of U.S. decline just
now, when it can act on its own terms, than like the armies of "imperial overstretch"
to wait until sharp falls in foreign demand aficionados before them. Because Setser
for dollar debt forces it to act. The most and Roubini misconstrue the causes of
important step, of course, is to start cutting current imbalances, they lay the principal
the budget deficit rather than just talking blame for these imbalances on U.S. macro
about cutting the budget deficit. This will economic policy, while ignoring European
require reversing some recent tax cuts, not and Japanese stagnation and Asia's prob
just controlling spending. Otherwise, the lematic economic policies. The United
only way to reduce U.S. demand for foreigr States, in their view, stands alone at the
savings would be through a sharp decrease precipice, facing a stark choice: restore fiscal
in private investment and consumption sanity to eliminate external imbalances
with disastrous consequences for the U.S. or confront the prospect of nervous cen
economy. The Bush administration has tral banks severing the country's tenuous
been lucky over the past few years-the financial lifeline and setting it on the
growing value of U.S.-held European asset path to decay.
has kept U.S. external debt from rising, anc Fortunately, their rigid "twin deficit"
foreign central banks' willingness to buy view is not supported by the facts. Al
U.S. debt has helped keep U.S. interest though there are good reasons to reduce
rates low in the face of large deficits medium-term budget deficits, there is only
but its luck could easily turn. a tenuous link between the budget deficit
Arguing that deficits-external as well and the current account deficit. The current
as domestic-do not matter does not make account deficit, contrary to their depiction,
them go away. Celebrating the United is mostly the result of a post-bubble global
States' real economic strengths while ignor savings glut, especially relative to good
ing the real-and growing-economic investment opportunities. The excess
vulnerabilities associated with unprece saving of the Europeans and the Japanese
dented current account deficits is dangerous has depressed global interest rates and
BRAD SETSER is a ResearchAssociate in required a large external deficit somewhere
the GlobalEconomic Governance Programme in the global economy. Thanks to its un
at University College, Oxford. NOURIEL equaled openness to imports and capital,
ROUBINI is Professor ofEconomics at the United States has provided that deficit.

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 How Scary Is the Deficit?
Deep unilateral budget cuts, then, the voluntary nature of these U.S.-bound
would do little to correct the current capital flows.
account deficit and-in the absence of By arguing that foreign investors
perpetually postponed growth-enhancing currently fund only the budget deficit,
reforms in Europe and Japan-are a recipe rather than private investment as they
for global recession. Correcting global did in the late l99os, Setser and Roubini
imbalances will instead require a cooper mislead again. True, central banks fund
ative approach: faster growth of domestic government borrowing, but only because
demand in Europe and Asia, higher U.S. they must hold risk-free, highly liquid
saving, and a further gradual depreciation reserve assets. Most of the remaining
of the dollar. Although the current account $i trillion of foreign money that flowed
deficit is not likely to stabilize anytime into the United States in 2004 funded
soon, all the major global economic play private economic activity, as large an
ers ultimately have good reason to favor amount as in any previous year. Meanwhile,
an orderly adjustment process based on U.S. private investors and corporations are
such complementary, mutually reinforcing vigorously amassing foreign assets. They
policies. In the United States, tighter U.S. added $821 billion in 2004, almost double
monetary policy and growing bipartisan the annual average during the late 1990s.
attention to the fiscal trajectory will Setser and Roubini further warn that
eventually raise the savings rate; in Asia, Asian central banks' fears of capital losses
moderate reserve-currency diversification on dollar-denominated reserves could lead
combined with a slowed pace of export to a dollar selloff and a disorderly down
growth can be achieved with gradual ward spiral for the greenback, forcing a
macroeconomic adjustment. painful spike in U.S. interest rates. Such
According to Setser and Roubini, the arguments conflate the incentives govern
current situation is especially dangerous ing private behavior-with its fixation on
because foreign central banks are financ exchange-rate-adjusted real returns
ing three-quarters of the $665 billion with the very different constraints facing
current account deficit. This accounting central banks. The latter use reserves to
is incomplete, because it ignores most manage their exchange rates and protect
of the funds flowing into and out of the against capital-flow reversals. They care
United States-especially private foreign far less about the value of their reserves
investment, which totaled over $8oo in terms of their own domestic currencies,
billion in 2004. The $Soo billion provided as reserves do not represent claims against
by central banks, therefore, represents domestically produced goods and services.
only one-third, not three-fourths, of Therefore, capital losses measured as a
total capital inflows. Ongoing sizable share of GDP-as Setser and Roubini
additions to foreign private holdings estimate with China's reserves-hold
reflect the unmatched safety and liquidity little economic meaning. The relatively
of U.S. financial markets and the dollar's small cost of currency appreciation pales
as-yet-unchallenged key-currency role. in comparison to the enormous benefits
Portraying the United States as desperately Asia derives from maintaining competi
scrounging for surplus savings distorts tiveness in U.S. markets.

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 Brad Setser et a.
Finally, U.S. debt has eroded neither in real terms, compared to a 44 percent
the appeal of the U.S. economic model increase in personal consumption. The
nor its soft power. The "Lisbon agenda" result is an economy leagues ahead in the
of market reform in Europe, the ongoing production and utilization of information
liberalization of Asian capital markets, technology. Meanwhile, net household
and structural change in Japan all suggest wealth is at an all-time high, government
that growth-enhancing elements of the debt remains moderate by international
U.S. model represent vital complements standards, and corporations-having paid
to existing national varieties of capitalism, down their debts-are unusually liquid.
China also faces serious difficulties The tired caricature of an overconsuming
unreformed state enterprises, bankrupt and underinvesting wastrel is difficult to
banks, and the need for massive job square with a country that has combined
creation, to name only few-which Setser strong growth-interrupted only by two
and Roubini's view of global economic brief and mild recessions-with monetary
imbalances vastly underestimates. The stability over the last 20 years.0
Chinese government remains heavily
dependent on U.S. market access and
technology to manage its potentially
unstable transformation.
It is a mistake to equate borrowing with
a loss of power just because the United
States was once a net creditor and also
powerful. If power presupposes creditor
status, is the ticket to sustained hegemony
the investment stagnation, structural
unemployment, and aging populations
characteristic of Europe and Japan? Its
net debtor status notwithstanding, the
United States enjoys overwhelming
dynamism and influence rooted in rapid
productivity growth based on innovation
at the technology frontier. Meanwhile,
it serves as the "buyer of last resort," the
primary source of technology transfer,
and the global monetary anchor-the
classic hegemon providing critical
"public goods."
Setser and Roubini see the United
States as a floundering Leviathan; we see
it as a firmly grounded giant. Over the last
decade, business investment in equipmeni
and software (even excluding vital "intangi
ble investment") has increased 66 percent

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