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Does Foreign Ownership of U.S. Debt make us Vulnerable?
I would like to thank the hosts of Marginal Revolution for giving me the opportunity to answer questions about my book "The Price of Liberty: Paying for America's Wars" and for allowing me to enter into a dialogue with your contributors on the issues I have raised in the book.
If you have not had the opportunity to see it, I also encourage you to read an Outlook piece I did for the Washington Post on May 6. It contains some of the views contained in my book. The Post has been kind enough to allow us to circulate this piece.
In view of the many very interesting postings on Marginal Revolution about international financial matters, I thought it would be useful to focus on one particular aspect of US strategic vulnerability -- the growing risk that in the event of a major catastrophe in the US -- from a major new act of terrorism, another massive hurricane, or a pandemic -- the foreign capital that we have become used to receiving from the rest of the world, to the tune of $700 to 800 billion annually on a net basis at relatively low cost, will not be available in abundant amounts.
Alexander Hamilton called the debt the nation had accumulated during the Revolution the "price of liberty" and insisted that it be faithfully repaid, especially to foreign lenders, whose financial support was critical to the success of the Revolution. He recognized that were there to be another war foreign funds would also be critical to American success -- so financial strength, which he took to mean sound finances and robust international creditworthiness, was important to future military strength.
The same is true today. If another major terrorist attack were to take place the budget deficit will increase dramatically as revenues drop due to economic weakness and the government has to bear the cost of recovery and retaliation. Foreigners would then be reluctant to buy American financial assets or will demand a higher risk premium -- i.e. higher interest rates -- to do so. In either case there would be a major financial disruption harming an already weakened economy. It is worth noting the contrast between today and 9/11; in 2001 the US had had four years of surpluses as opposed to four years of deficits, and then we were only half as dependent on foreign capital as we are today. Both differences increase our vulnerability -- and bigger imbalances in the next decade will add to that vulnerability.
This is a concern I have. I would be interested in whether others share it. Do you believe that heavy and growing dependence of foreign capital constitutes a strategic vulnerability in the event of a catastrophic attack. And if so what should be do to reduce this vulnerability?
I look forward to a dialogue on this and related subjects during my blog tour this week and thank you for your willingness to provide your thoughts.
Bob Hormats, Author,
"The Price of Liberty: Paying for America's Wars" (Times Books)
Posted by Robert Hormats on May 29, 2007 at 07:30 AM in Books | Permalink
Comments
It's long seemed to be a point of weakness for the US, but
does anyone, any country, benefit from the downward spiral
sceanrio? I see the risks, and worse case scenario is truly
awful, but the rest of the world, the lenders, specifically
have benefited from america's profligate ways, and it would
likely be in their best interests to continue to keep US
interests rates low.
Posted by: glenn at May 29, 2007 7:51:51 AM
>the cost of recovery and retaliation
Even the Marshall Plan didn't pay to re-arm Germany and Japan.
Posted by: Cormac at May 29, 2007 8:24:42 AM
Do you believe that heavy and growing dependence of foreign capital constitutes a strategic vulnerability in the event of a catastrophic attack.
Not for the US. Probably for the lenders. They will have lost money. We would still have the stuff (or factories or whatever the capital bought).
Anti-foreign investment advocates say, "We must limit foreign investment, for if the foreigners suddenly stop investing, we'll suddenly be in a bad position.", but I hear, "Let's go ahead and be in the bad position. That way it can't suddenly get any worse."
Posted by: Jody at May 29, 2007 8:36:45 AM
But Jody, we don't have the factories. All we have are cheap t-shirts, houses, a bunch of cars that are expensive to fuel and maintain, and some Web 2.0 widgets. Unless foreigners start buying up our excess housing inventory...can I interest any of you Saudi gentlemen in a Ft. Myers condo?
Posted by: Morgan at May 29, 2007 8:51:16 AM
Morgan, they already are -- the most obvious impact of foreign capital is in the mortgage boom, and the main noticeable effect of swings in long term interest rates is on house prices.
Bob, so you're saying we used up a lot of the available foreign capital for 9/11 and Iraq, leaving us vulnerable to a credit crunch after a second terrorist attack? Suppose we hadn't invaded Iraq and we instead had saved our money to get ready for a possible second attack. After a second attack, would you advocate borrowing foreign capital to keep the economy going, or would you advocate waiting again, in case of a third or fourth attack? Should the foreign capital be permanently held in reserve, or does your argument give us a rule for deciding when it is appropriate to tap it?
If so, IMHO this sounds like an argument for an offensive strategy. If we hold our military and financial assets in readiness, in case of another attack, then each attack reduces our readiness and increases our vulnerability to the next attack. The only way to prevent a downward spiral is to deploy all our assets after the first attack, to break our enemies before they can strike again. (Assuming of course that our leadership isn't too incompetent to implement any strategy successfully).
Posted by: DK at May 29, 2007 9:42:51 AM
Do you believe that heavy and growing dependence of foreign capital constitutes a strategic vulnerability in the event of a catastrophic attack. And if so what should be do to reduce this vulnerability?
Not only isn't it a vulnerability, it's an asset. It gives foreigners a stake in our economic success and thereby an indirect stake in our winning the wars we fight. If an attack does increase the risk of investment in the US, capital may indeed go elsewhere. But that is just as true of domestic capital as foreign. Foreign investment is no worse than domestic investment from an economic point of view, and may actually be BETTER from a political point of view, as it gives foreigners an incentive to support us.
Posted by: Ilya Somin at May 29, 2007 9:50:48 AM
What's the difference between us and foreign investors?
Or do you just mean foreign governments which can tax people to invest
in the US and the worry is that those funds aren't being friven by
market fundamentals and could be particularly fickle?
Wouldn't so-called US investors demand a similar risk premium after
another catastrophe? And why would it be different than 9/11 - put a
different way wouldn't it be the burden to show that it *would* be different?
And why suppose the market hasn't priced in an assumption of another attack?
And that continued avoidance of such would further lower the risk premium
demanded by investors both here and abroad?
Why would a swing from surplus to deficit - in the context of total
investable funds - put us on the brink? We're not talking about a huge
percentage of the federal budget yet alone of the economy...
If anything, doesn't the existence of substantial liquid investors provide
a sorely needed disciple and constraint on US policymakers?
Finally, is there any 'solution' that would not be worse than the supposed problem?
Posted by: Gary Leff at May 29, 2007 9:51:33 AM
In the global scheme of things, it doesn't matter who loses the money, if wealth is destoyed the entire world will be affected. The question is why are fast growing nations investing in America instead of their own countries? America was a voracious importer of capital and capital goods during its rapid growth phase, but even now continues importing capital when there are much better prospects, according to the naysayers.
We also don't need a terrorist attack or catastrophe to cause foreigners to cut off funding. When the demographically challenged Japanese and Europeans retire, they'll switch from savings to consumption.
Posted by: Matt at May 29, 2007 9:54:16 AM
All we have are cheap t-shirts, houses, a bunch of cars that are expensive to fuel and maintain, and some Web 2.0 widgets
This comment is kinda tangential as it's more to do with the trade deficit than the investment of foreign capital, but what they hey, that's part of the fun of blogs.
Contrary to your opinion Morgan, the US does have factories, and it actually manufactures more than it ever has. It's just that manufacturing occupies a smaller percentage of the US economy than it used to and it also requires fewer people to manufacture the same number of goods. In the meantime, companies like Intel, Microsoft, Qualcomm, IBM, google, yahoo and lots of others have created and filled market niches which did not used to exist.
As another way to look at this natural evolution of the market, there's an unlimited demand for services, but a finite amount of space in the closet for goods. An analogy I like to draw is to the saying that Microsoft and Intel are competing to see if Microsoft can use up processor cycles faster than Intel can add them. Likewise GE and Toll brothers are competing to see if manufacturers can occupy sq ft faster than Toll brothers can add them. (After using Vista, I think Microsoft is ahead at the moment.)
Unless foreigners start buying up our excess housing inventory...can I interest any of you Saudi gentlemen in a Ft. Myers condo?
And here's the concept which Morgan is working with in that statement but not quite grasping.
Money is worthless in and of itself.
So if the foreigners choose not to buy our wares, while continuing to take dollars, then in the trade we got something for nothing. Even if it's a T-shirt, a house or anything else you care to list, it's still something. And something for nothing sounds like a good deal to me.
From my perspective, the bigger the trade deficit the better - cause we get the stuff and they get nada in return.
Posted by: Jody at May 29, 2007 10:08:50 AM
The question is why are fast growing nations investing in America instead of their own countries?
They're managing (whether consciously or not) the risk of their portfolios.
Their own country provides plenty of growth, but it's quite risky. Of the stable large (to some extent, those are synonomous) economies, the US provides the best growth.
Or to give an analogy: If all you have are penny stocks, you might want to look at high yield CDs or bonds to mitigate some of the risk of your investment. The small fast growing nations are the penny stocks, and the US is the high yield CD.
Posted by: Jody at May 29, 2007 10:20:23 AM
"... the US does have factories, and it actually manufactures more than it ever has. It's just that manufacturing occupies a smaller percentage of the US economy than it used to and it also requires fewer people to manufacture the same number of goods."
We have lost or are losing whole industries. Okay in peacetime, not so good during wars.
Posted by: rj at May 29, 2007 10:24:44 AM
Everything old is new again. Wasn't it just seventy years ago that cash-strapped governments in places like Germany and Italy were "discovering" that domestically held debt didn't matter and it was debt in the hands of foreigners that was all the trouble. Perhaps someone should look up what happened with that theory...
Posted by: Grant Gould at May 29, 2007 10:28:21 AM
Most of the countries that are prominently funding the U.S. current account deficit, chiefly the oil exporters and China, lack a viable opposition party, by design of the governing power. Everything said about the U.S.'s need for capital in the event of an emergency applies to these countries, and applies moreso because (1) the governing party in these systems faces greater consequences if they should lose power than does the governing party in a constitutional democracy, and (2) such governments are less likely to receive funding in the event of an existential emergency because it is unknown whether a successor government will honor the debts of its predecessor.
I submit, then, that these governments have a greater need for currency reserves in hand than does the U.S. government, and that the market is simply moving liquid capital to those who value it most highly.
Posted by: Cyrus at May 29, 2007 10:48:38 AM
We have lost or are losing whole industries. Okay in peacetime, not so good during wars.
Bastiat had a good rebuttal to this point: Nations made interdependent through trade cannot afford to fight wars against each other. It is better to prevent wars than to win them.
Posted by: Cyrus at May 29, 2007 10:51:39 AM
Oh, I am *shaking* in my boots about the possibility of having to borrow more money from foreigners. I mean, if suddenly the US needed to borrow a lot more money, or the Chinese dumped their US bonds, the yield on 10-year Treasuries could SURGE to six ... perhaps even six and a half percent. At those extorionist rates, people will make a *killing* on new purchases of government bonds.
Posted by: Person at May 29, 2007 11:13:41 AM
Do you believe that heavy and growing dependence of foreign capital constitutes a strategic vulnerability in the event of a catastrophic attack.
Whats the old saying? "If you owe the bank $100,000 you are in trouble, if you owe the bank $100m, the bank is in trouble."?
I am not sure what the point of reign-in control is for the foreign lenders, but I don't have any doubt they would try to reign in with higher rates, etc for a period of time until they understand that the scenario would involve a major loss on their side in the end, at which point it would be better for them to provide the crutch for us to stand on. What that point is I don't know, also it would have to be realized by many different parties acting cohesively I would think.
Posted by: cyanbane at May 29, 2007 12:25:26 PM
"It is worth noting the contrast between today and 9/11; in 2001 the US had had four years of surpluses as opposed to four years of deficits, and then we were only half as dependent on foreign capital as we are today."
Are we "dependent on foreign capital?" Or are foreigners dependent on the US's financial markets and government bonds as a way to store liquidity that they don't know what to do with? Maybe both: it's a case of interdependence. But if I were to call it one way or the other I think they're more dependent on us than vice versa.
There is the possibility of a panic, a run on the US dollar, which could have disastrous consequences. There's a disturbing quirk here: the possibility of "multiple equilibria," of "rational panics." If everyone else thinks the dollar is sound, I can afford to assume the dollar is sound; but if, somehow, everyone else starts thinking the dollar will crash, then it will crash, so I'd better get out of the dollar as fast as I can even if I'm bullish on the US economy. Such events are almost by definition unpredictable, and I'm not even sure that the fact that foreigners hold a lot of US debt has anything to do with it... except that it might make us vulnerable in weird ways to international law. What if a charismatic and widely-admired UN secretary-general, with the reputation of a Gandhi, decided to veto a US foreign policy move by ordering all foreign governments to sell US bonds and refuse to buy more, and to expropriate US-based multinationals overseas? Suppose his moral authority is so great that everyone expects him to be obeyed? Can he *create* the rational panic that crashes the dollar? With what consequences?
Posted by: Nathan Smith at May 29, 2007 12:28:05 PM
"in 2001 the US had had four years of surpluses as opposed to four years of deficits"
This is a trivial point. What matters to your argument is the government's borrowing capacity, i.e., what's available to us in the case of an emergency. On Sept. 10, 2001, overall US debt was about $5.8 trillion. Today, it's about $8.8 trillion. The fact that we had a surplus or deficit of a few hundred million is twattle in comparison, a point reinforced by the continued conundrum of low interest rates.
While one might find the increased debt appalling for various other reasons, the impact on our borrowing capacity is, unfortunately, not one of them.
Posted by: M. Hodak at May 29, 2007 12:30:16 PM
If I'm not mistaken, Hamilton also wanted to have the federal government assume states' debts so that rich Americans would have a larger stake in the success of the country. I believe that to be true about foreigners as well. In fact, I believe that their investment in our bonds makes us all the more secure in the face of a potential economic downturn.
Posted by: Tim V at May 29, 2007 12:46:11 PM
"Oh, I am *shaking* in my boots about the possibility of having to borrow more money from foreigners. I mean, if suddenly the US needed to borrow a lot more money, or the Chinese dumped their US bonds, the yield on 10-year Treasuries could SURGE to six ... perhaps even six and a half percent. At those extorionist rates, people will make a *killing* on new purchases of government bonds."
What you are failing to understand here is the herd mentality of the financial markets. If China begins dumping their US bonds, what do you think all the hedge funds and other countries are going to do as they see the value of their bonds go dropping?
I imagine that smaller funds would immediately jump on the bandwagon to try to limit their loss, which would incite others, until it snowballed completely.
Posted by: Sean at May 29, 2007 1:03:48 PM
@Jody:
"This comment is kinda tangential as it's more to do with the trade deficit than the investment of foreign capital, but what they hey, that's part of the fun of blogs. "
Isn't the capital surplus the mirror image of the trade deficit?
Posted by: JSK at May 29, 2007 1:25:31 PM
Sean: Wouldn't hedge funds be more contrarian than that?
Posted by: Person at May 29, 2007 1:27:22 PM
Isn't the capital surplus the mirror image of the trade deficit?
Not necessarily, but they are closely related (hence "kinda" tangential).
The quick answer is "google exorbitant privilege"; the longer answer follows.
Let me give you an extended analogy. Suppose you get cash for doing work. What can you do with it?
1) You can spend it (Mmmm... shiny new TV)
2) You can invest it (stocks, savings, ...).
3) You can just hold onto it neither investing nor spending (beyond numismatists, people used to do this by stuffing it into/under a mattress, but over a small enough time scale, everyone does this - just look in your wallet)
4) You can destroy it. (that happens from time to time whether accidentally or on purpose. The Feds are the only ones I know who destroy large sums of money on purpose, but then again they also print it as they see fit too.)
Ignoring other factors, this all has to balance out as
Cash In = Spent + Invested + Held + Destroyed.
Analogizing this to a country (or foreigner) which has received cash from another country, they can
1) Spend it
2) Invest it
3) Hold onto it
4) Destroy it
In the model I think you have in your mind, you're considering just 1) and 2) where 3) and 4) are negligible so that
Cash In = Spent + Invested
Specifically, if you have yen, you need to either buy something from Japan or invest it in Japan. This is what I call the theme park model of currency where the theme park money is only good for purchases in the theme park. (Some countries take this analogy a little too far. When I visited the Bahamas, I had an easier time spending US dollars than Bahamian dollars.)
While I gave it a silly name, under a lot of circumstances, the model holds true as 4) is generally negligible in a macro sense and 3) is rare. For instance if you receive some Bahts for Christmas, they're not purchasing anything outside of Thailand.
However, the theme park model breaks down for some countries and the US in particular. First, you don't have to spend US dollars in the US. Lots of countries accept them as currency (see my Bahamian experience), they're used a lot in black markets (the fact that we have a trade deficit despite the massive overseas counterfeiting should tell you that money out doesn't have to equal money in), and noticeably in the oil markets. So foreigners can and do spend a significant amount of US dollars outside of the US.
Second, numerous countries around the world hold ginormous amounts of dollars as cash reserves. They do it some with others (notably the Euro, Pound, and Yen), but nowhere near to the extent of the dollar. Thus significant amounts of dollars just get held onto.
So the model the US is operating under with the rest of the world is
Cash In = Spent in the US + Spent elsewhere + Invested + Held.
The upshot being, cash out is not just cash in for the US as people spend it elsewhere and like to hold onto it as a cash reserve.
Posted by: Jody at May 29, 2007 2:55:17 PM
Dr. Hormats,
Welcome to the heavy play of the blogosphere. I have not read your book, but your article is very thought provoking.
I have a few questions.
1) Following up on Jody, I am one who has long agreed with you (in print even, although I shall not bore people
with the self-citations in detail), that US foreign borrowings are dangerous for the country in the long run.
However, while we continue to pile up record foreign net indebtedness unlike anything ever seen anywhere,
our net investment flow in the current account continues to be barely in deficit and sometimes still in surplus.
Some have argued that this is evidence of "dark matter" in the international asset balances, and that the US
really is in much better shape than appears. Do you have a view on this?
2) Perhaps you argue differently in your book, but in your article you lump social security, medicare, and
medicaid together into a single "entitlements" problem, and then go go focus almost entirely on social
security. But, is it not true that the medical parts of this are much more the problem? The medicare
fund is already in deficit and rising, with health care costs zooming. The social security fund still has
a rising surplus, and the projections that it will eventually run a deficit are based on assumptions that
have not come about, such as that the US growth and immigration rates will fall sharply below historic rates.
If rates stay at or even not too far below, historic rates (see the low-cost scenario of the SSA Trustees,
which has been too pessimistic in the last decade) the fund runs a surplus forever. Is not the focus on
social security really a way of attacking the larger issues given that so much of the publich has bought
this phoney argument that social security "is in crisis," and so they might be able to be talked into
tax increases and benefits cuts for general budgetary purposes, even though social security itself is
doing fine fiscally?
Posted by: Barkley Rosser at May 29, 2007 6:37:19 PM
What are the implications to our national debt if oil is pegged to the euro rather than to the dollar?
Posted by: fustercluck at May 29, 2007 11:02:45 PM
