The Dollar, the Deficit, and American Competitiveness

Lael Brainard
Lael Brainard National Economic Advisor - National Economic Council

May 19, 2005

Dual Deficits Post Serious Risk

In the world of finance, the playing field is not flat. The United States has special privileges that are the envy of the world. But we are in the process of squandering them.

Our addiction to foreign capital poses perhaps the greatest risk to the global economic outlook and to our near term competitiveness. Although it is both real and present, this risk appears to be off the radar screen entirely. The nation has taken a historical surplus and turned it into record deficits. A lot of people ask, quite correctly, “Why should that matter?” So far, we have had our cake and eaten it too, in the form of low inflation, cheap borrowing, and low interest mortgages. The question is whether it can go on. I strongly believe the answer is no.

It is foreign borrowing, pure and simple, which has enabled our. Last year alone, the nation borrowed over $600 billion or 5.5 percent of our income from foreigners. Of course, we have borrowed heavily in earlier periods. But at that time, we were still net creditors. What is different now is that we already owe a lot of debt to the rest of the world, and with the baby boom retiring, the nation should move further in that direction.

Between 2000 and 2004, debt to GDP went from 14 to 26 percent. That puts us smack in between Brazil and Argentina on the eve of their financial crises in 2001, with debt to GDP ratios of 18 and 33 percent respectively. The full awkwardness of our situation can be best appreciated in light of the historical observation that until now, hegemonic powers have been net suppliers of capital to the rest of the world, not a net drain as the US is today.

A recent Brooking conference concluded that there is NO historical precedent. There have been advanced economies with similarly large borrowings relative to their GDP, such as Australia and New Zealand, but none comes close to the size of the US—the world’s largest economy and the world’s largest borrower.

The “don’t worry be happy” crowd will reply: So what is the problem? The rest of the world seems eager to finance our borrowing. In one sense that is true. Under normal market circumstances, one would expect a waning appetite for a country’s securities as investors worried about fiscal irresponsibility.

Instead, foreign official lenders have stepped in to maintain the enormous appetite for US securities as private investors’ appetite ha cooled. Over the last few years, there has been a big shift away from private investors in Europe and elsewhere buying US corporate securities towards central banks in Asia buying US Treasury Securities. Net private capital inflows as percentage of total net capital inflow fell from 97 to 63 percent between 2000 and 2003. Meanwhile, inflows of foreign official assets—in the form of purchases for US Treasury Securities—as share of total capital inflow rose from 7 to 23 percent during the same period.

Contrary to Secretary Snow’s reassurances, the US is not the best investment in the world, when you take into account the risks of substantial further currency appreciation and the growth slowdown necessary for turning around the trade deficit.

So what are the dangers? They threaten both our international economic leadership and our economy. You know the hard landing story. There is a sudden rush to the exits, people dump dollar assets, the Fed is forced to sharply raise interest rates and growth both here and abroad is sharply curtailed.

But the alternative is not so good either: it amounts to delaying the pain. This course is equally risky, although in subtler and thus perhaps more dangerous ways. As Nouriel Roubini and Brad Setser have shown, our current account deficit will swell to 8 percent of GDP in 2008, with net debt on track to reach 50 percent of GDP and 500 percent of exports. If we awake to this issue later rather sooner, which is to say if our foreign partners continue to indulge our consumption binge in order to preserve their export binge, it will be much more painful to fix it.

Concerted Global Action and the Question of China

So far, whether by default or design, the Treasury appears content to approach this problem as one for the markets to work out on their own. Treasury’s position that exchange rates should be and are market driven has contributed to the erosion of the dollar’s value and increasing frustration on the part of Europe. The current policy of leaving it to the market is quite unsettling to the market and begs the difficult question of global burden — sharing in the adjustment process. So far, those countries with market rates Europe, Canada, Australia, and Latin America — have taken a disproportionate share of the burden.

Meanwhile, a 20 percent depreciation in the dollar would lead to a loss for the People’s Bank of China equivalent to 8 percent of gross domestic product, which is about the ex‐post size of a severe emerging market banking crisis. It is also a block to smooth international adjustment.

If we wanted to manage the problem rather than hold our breath and react, there are several historical episodes that point the way. We have been to the precipice before; in fact, that was one of the strongest early drivers for the creation of the G7. The exit strategy has involved tough domestic constraints combined with concerted action with our major trade partners.

In the present circumstances, that means restoring fiscal responsibility at home, pressuring China to act responsibly on its exchange rate, and getting commitments from Japan and Europe on stimulating domestic growth.

Unfortunately instead of getting countries around a negotiating table to nail down commitments, and taking hard headed action on the budget at home, the administration’s response has been tepid and defensive. Meanwhile, the normally statesmanlike US Senate has lost patience and is gearing up to threaten 27 percent tariffs if China does not take action on its currency imbalance.

Ending Tyranny on Planet Earth

I recognize the administration has its hands full with “ending tyranny on Planet Earth” and “dismantling the New Deal” — as my friend at Cato describes it. Opening markets and establishing the nation’s finances on a firm footing just may not seem to have the same kind of urgency. But I cannot think of a single instance in history where the world’s largest military power was also the world’s largest debtor. And something tells me that one thing or the other is going to have to give eventually.

I take comfort from the fact that the Department of Homeland Security is running crisis simulations. I hope the Department of Economic Security — otherwise known as the Treasury — is doing the same. And I hope Treasury is Red Teaming the global financial markets, even as it works on a domestic plan to get our own house in order, and an international plan to get all the major players working together.