« Post-Election Wisdom | Main | Trade-Deficit Clarification» Don Boudreaux
December 01, 2006
Three Common Mistakes Regarding Debt Holdings
Don Boudreaux
Worrying about the fact that most (52 percent) of Uncle Sam's outstanding debt is now owned by foreigners, the writer of this editorial in today's edition of USA Today commits at least three common mistakes.
First, the writer wrongly lists as one problem with large foreign holdings of U.S. government debt the fact that
It props up the nation's other deficit — its chronic trade deficit. The purchase of treasury bills is part of a broader trend of foreigners recycling their dollars back to the United States to invest in everything from government debt to the home mortgages, instead of using them to buy more American goods and services."
This remark reveals a kind of confused double-counting. If the holding of Uncle Sam's debt by foreigners is a problem, then that's the problem. The fact that such holdings also cause the measured current-account deficit to be higher is irrelevant.
Second, the above quotation is infected with the mercantilist fallacy that exports are the great blessing of international commerce. But, in truth, isn't it better that foreigners save their dollars and invest them in the U.S. economy rather than spend all of their dollars buying U.S. goods and services? If you doubt that such investments are good for the economy, ask yourself how you'd respond if the writer of this op-ed had instead complained that Americans are saving and investing too much in dollar-denominated assets rather than spending all of their incomes buying American goods and services. Would you reckon that such profligacy on the part of fellow Americans is good for the U.S. economy? If not, why would you suppose that profligacy on the part of dollar-income earners who happen to live outside of the United States is good for the U.S. economy?
The third, and related, mistake is in this passage:
It [large holdings of Uncle Sam's debt by foreigners] makes the U.S. economy hostage to the whims of foreign investors, including governments. Eventually, they could decide they have better places to invest than in U.S. debt securities. This might be a gradual decision. Or it might not be. If the latter, it would cause a surge in interest rates (because the Treasury would have to offer more enticing terms to attract buyers) and trigger a recession.
Of what relevance is the nationality of government-debt holders? Answer: none. It is of no relevance. To see why, suppose that all of Uncle Sam's debt were owned by Americans. Would this editorial writer then have written: "It makes the U.S. economy hostage to the whims of domestic investors. Eventually, they could decide they have better places to invest than in U.S. debt securities. This might be a gradual decision. Or it might not be. If the latter, it would cause a surge in interest rates (because the Treasury would have to offer more enticing terms to attract buyers) and trigger a recession."
..........
Cato Chairman Bill Niskanen has a response published in the same edition of USA Today, making points largely, if not wholly, different from the ones I make above.
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Comments
"It [large holdings of Uncle Sam's debt by foreigners] makes the U.S. economy hostage to the whims of foreign investors, including governments."
Of course, it also makes foreign investors hostage to the whims of the U.S. government. Indeed, one could argue that a government may be more likely to default on its debt obligations when those who hold the debt are foreigners.
Posted by: John Thacker | Dec 1, 2006 10:04:58 AM
John,
Absolutely right. And considering that our "government" speaks for voting taxpayers, what amazes me is the confidence that foreign investors have in our willingness to repay them.
Posted by: Randy | Dec 1, 2006 1:16:50 PM
John- Very nice point.
I also think it is odd that people talk about foreigners (read ASIANS) like they are stupid neanderthals with little understanding of world finance.
I often hear the fear of these foreigners dropping all of their government debt in one fell swoop. Just like the FED uses churning to sureptitiously raise and lower interest rates, foreigners understand that dropping all of their currency/bonds on the market at one time would not only ruin the financial market it would also cause their asset to lose value in an extreme way. They are benefited by doing it secretly. And flooding the market isn't exactly the best way to keep a secret.
They realize that flooding the market will ruin their assets just like it will ruin ours. Like the Chinese are going to call up their stockbroker and say "Yep...SELL IT ALL. How many Billions will we lose? DO IT."
Maybe the fallacy behind all of these "mistakes" is the idea that my interests are different than those of someone in Shanghai, Bangkok, Ho Chi Minh, Cairo, and Copenhagen. Or to put it another way...maybe the root is just Xenophobia.
Posted by: Adam Malone | Dec 1, 2006 1:24:56 PM
You mean xenophobia is a bad thing?
Posted by: nunyabidness | Dec 1, 2006 1:45:03 PM
"isn't it better that foreigners save their dollars and invest them in the U.S. economy rather than spend all of their dollars buying U.S. goods and services?"
As great as this is, it takes on a dark pall when it is being done out of equilibrium. Some day the accounts will have to be settled, and every investment in the US (if all has gone well) will result in a larger cash outflow than the principal inflow.
This is especially ominous when we're talking about the trillions of treasury securities these foreigners hold, which we must pay back, plus interest. Where has that money been "invested"?
Oh, right, on things like the Iraq war, pointless homeland security buildup, and the usual slough of ineffective government programs. Color me unenthused.
Posted by: Aaron Krowne | Dec 1, 2006 5:26:59 PM
Aaron,
There's nothing about the nationality of creditors that matters for the concerns you raise.
Posted by: Donald J. Boudreaux | Dec 1, 2006 5:40:33 PM
"Of what relevance is the nationality of government-debt holders? Answer: none. It is of no relevance".
Yeah, try saying that to people from Argentina or Russia. Foreigners can realize that they are being duped and stop financing the US. Nationals dont have that many choices (and the gov. has a lot of leverage with local banks ).And yes, the debt is nominated in dollars, and the Fed can print more. But in that case they will have to a)pay a much higher int. rate or b) live withint their own means. What a change.
Posted by: ed | Dec 1, 2006 5:47:37 PM
I would love for someone to explain something about this issue to me.
When we (American consumers, businesses, etc.) buy foreign products, this gives the foreign suppliers U.S. dollars, right?
They then have to use those dollars for things that can be purchased in dollars, right? Or trade those dollars for other useful currencies, right?
In this case, they don't buy an equivalent amount of our goods and services, but instead invest in U.S. government securities, obviously because they see this as a good investment, right?
Assuming for the sake of this query that having foreigners hold these securities is a bad thing, what would be the consequences if the federal government were to limit the ability of foreigners to purchase government securities?
Wouldn't the foreign entities have to find another use for their dollars? Won't those dollars, one way or another, directly or indirectly, have to be recycled back to the United States?
At the end of the day, foreign suppliers are not going to give us valuable products for mere pieces of paper or electronic bank credits, right? They're going to have to use the dollars they receive for their exports to the U.S. to purchase *something* valuable from this country, no?
So if they can't buy our government securities, then they'll buy something else from us, like land or buildings or more of our goods and services, right? Would this be *better* for our economy and national security for any reason?
Thanks. I look forward to reading any replies.
Posted by: Steven M. Warshawsky | Dec 1, 2006 6:16:30 PM
"Yeah, try saying that to people from Argentina or Russia. Foreigners can realize that they are being duped and stop financing the US. Nationals dont have that many choices (and the gov. has a lot of leverage with local banks )."
Are you seriously asserting that non-Americans have the easiest time in the world of purchasing US securities, but Americans can't easily purchase non-US securities? Ludicrous.
Posted by: Noah Yetter | Dec 1, 2006 7:16:57 PM
"Are you seriously asserting that non-Americans have the easiest time in the world of purchasing US securities, but Americans can't easily purchase non-US securities?"
Americans can, but they wont. Are you saying that the nationality of public debt holders around the world is uncorrelated to the nationality of the holder? I dont see lots of American rushing to buy 0,5% Japanese bonds. Except, of course, in the case of US.
Posted by: ed | Dec 2, 2006 12:19:29 AM
If the ownership of American debt/equity is a matter of indifference and if the trade deficit/surplus is also a matter of indifference is the value of the dollar in the world market also a matter of indifference? This is not a rhetorical question, I'm just curious.
Posted by: Kent Gatewood | Dec 2, 2006 2:27:06 PM
Can somebody who knows answer this:" if the US were not selling debt (because it had no national debt and balanced its budget every year), what on earth would the Chinese, Japanese, etc. do with their dollar credits from the uneven trade? Obviously, my econ knowledge is much weaker than the typical poster here, but I honestly would like to know the answer.
Posted by: Jeff | Dec 2, 2006 5:20:51 PM
Debt neutrality theories depend on that the people who own the debt will someday be taxed to pay it. Then government running a deficit must matter if it is being financed by non taxpayers. I suspect that much of the upset over foreign ownership comes from people who do not want to believe government debt matters because it violates their world view.
Posted by: joan | Dec 2, 2006 8:27:29 PM
The interesting scenario here, and I think both Profs Boudreaux and Roberts have discussed this before, is that it is not in the interests of these debt holders to have us “up the creek” as it were. Remember, bonds are debt securities, and represent no ownership interest in anything.
This is what Don is implicitly saying here. Here’s why:
Imagine (and this won’t happen anytime soon, but it theoretically could happen, and maybe sooner than we wish given current fiscal spending proclivities) the US Government can no longer meet its debt obligations, and we default. No interest payments. US Govt debt becomes junk.
Suddenly, the Chinese are holding a bunch of (potentially) worthless paper, offering them nothing.
Posted by: MesaEconoGuy | Dec 2, 2006 8:56:12 PM
Steven W.'s questions strike me as particularly good ones. Is there a good economist who can answer them?
Posted by: John | Dec 2, 2006 9:07:17 PM
I'll take a stab at it:
The short answer, they will buy goods and services form other people who wish to be paid for dollars, or they will sit on it.
When people engage in trade, they exchange one set of goods for another.
These exchanges fall into two categories, direct and indirect.
A direct exchange is one where both participants intend to consume or use what has been traded. An example of this is the situation where a fisherman trades a barell of fish to a sailmaker in exchange for a new sale and the sailmaker eats the fish.
In indirect exchange, one of the participants is not receiving a good he wishes to consume, but will trade for something else that they will consume. For example, the fisherman might trade his catch for needles, which he then sells to the sailmaker for a sail.
Now, when lots of trading is taking place, indirect exchange will dominate, and people will begin to exchange the goods they make or their services for a limited number of commodities that they are most confident that they will be able to trade for something else in the future.
These commodities then get a special name; they are known as money. Initially, their value will be dependent primarily on their relative usefulness. However, as they are increasingly used as money, their value will also be dictated by its usefullness in trade. Eventually, the value will be more a function of their usefulness in trade, and only residually dependent on their original usefulness as a consumption good.
As the economy grows more complex, nearly every transaction will consist of one party exchanging a good or service and receiving payment in some form of money.
People can do one of four things with the money they receive:
1) They can consume it (make jewelry out of gold, light their cigars with $100 bills etc)
2) They can trade it for something else
3) They can save it or invest it in some capital improvement (buying a better tool, developing a better boat, opening a shop)
4) They can hold onto it (which merely means they will do one of the previous three at some point in the future.
So let's look at what happens when a manufacturer does any of these
1) If a person consumes the money, it is removed from the money stock. All other things being equal, it reduces the pool of money available to facilitate a constant amount of trade. End result, the unit value of the remaining money increases.
2) If a person trades it for something else, then the unit value of the money stays constant, and they balance their consumption with production.
3) If they invest it, they will either get a capital improvement or a capital loss. A capital improvement (the investment pays off) will generally result in an increase in production per unit cost. The upshot of this is a larger number of goods being produced, which again if all else is held equal, means that each good will sell at a lower price. This translates into a higher standard of living. Conversely, if the investment does not work out the situation will be akin to 2.
However, the increased productivity will result in higher profits, which again puts them in a position of trying to decide what to do with their profits. So at the end of the day, they will have *more* money that they will have to consume, spend, invest, or sit on.
4) When a person sits on the money, it is as if it is temporarily removed from circulation. Initially, the result is as in 1). Then when they decide to do something with it, the effects previously take place, coupled with inflation since the hoarded money reenters the market identically to newly created money entering the market.
In the end, the money finally exits a person's hands for good when they trade it for something the consume, or they directly consume it.
The nationality of the person holding the money is irrelevant.
Posted by: tarran | Dec 3, 2006 12:22:37 AM
Don Boudreaux suggests that people who hold dollars (regardless of nationality) contribute more productively to the American economy by investing in securities than by purchasing American goods and services. Why? Don't American producers benefit when people buy their goods? And won't they in turn buy other goods, benefiting other American producers? And so on?
Also, won't it be important to consider what types of securities people buy to determine whether the U.S. economy is improved? If people invest in companies that produce wonderful new technologies, then the economy will undoubtedly grow. But if they buy U.S. gov't securities and the proceeds are used to finance useless (if not counterproductive) activities, then I presume the economy will be harmed.
Posted by: John | Dec 3, 2006 11:47:39 AM
John: "if they buy U.S. gov't securities and the proceeds are used to finance useless (if not counterproductive) activities, then I presume the economy will be harmed."
I certainly believe government activity harms the economy when it uses resources that would be used more efficiently by private enterprise. But it's the government spending that takes the resources, not the foreign financing of that spending.
Won't foreign purchases of U.S. securities actually help the economy? by holding down interest rates and reducing the cost of private investment in capital goods?
Isn't it possible that absent the foreign financing of government spending, the government budget deficit would be even greater? With higher interest rates, the economy might not expand as fast, leading to lower tax revenues. Further, the higher interest rate for government debt might increase the government's budget deficit even more.
Posted by: JohnDewey | Dec 4, 2006 11:59:45 AM
"So if they can't buy our government securities, then they'll buy something else from us, like land or buildings or more of our goods and services, right?"
My guess would be that they'd buy high-grade corporate debt, since that would be the closest substitute to government bonds. AAA-rated fixed rate corporate bonds from a US company are safer than the debt from many (most?) foreign governments. Or they could buy mortgage pass-throughs or a variety of other assets from our deep, liquid financial markets, since we have a lot to choose from.
US assets are considered safe in part because of our strong legal system and our overall stability. Note that the bursting of the internet bubble caused no true instability, just some short term economic uncertainty and concern - instability is not the same as a recession or other tough economic times.
What if we all wake up tomorrow morning and find that the Chinese Communist Party has adopted the rule of law, largely eliminated corruption, fully modernized their banking system and solved their non-performing loans problem, adopted strong, transparent accounting standards and trained enough accountants to enforce them, and generally developed the strong institutions that they would need to be a good investment alternative to the US? If that suddenly happens, then perhaps funds will suddenly flood out of the US to their new, safer home. But how many countries are likely to build strong, stable institutions in the blink of an eye? Our competitive advantage won't vanish suddenly.
Posted by: Ann | Dec 4, 2006 3:38:46 PM
There's a lot of debate here about whether foreigners should by debt versus good/services from america with their "excess" dollars.
When foreigners buy US debt and equity, they are lowering the cost of capital for US companies and making us more competitive internationally as well as raising corporate profits from domestic operations. Incidentally, foreigners don't just buy US Treasury securities: they by bonds from Fannie&Freddie; "private label" MBS; stocks; and various other corporate bonds. Capital (blended debt and equity) in the US is amazingly inexpensive and the corporate profit numbers show it.
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