Now that Barack Obama is in the White House, his single greatest challenge is to restart the U.S. economy, to turn it away from its descent into depression, toward sustainable recovery. Unlike the period of the Great Depression of the 1930s, when Americans held their ultimate fate in their own hands, they no longer do. Whether he fully appreciates it as he sets out on his presidency, much of the ability of Barack Obama to carry out his economic agenda will depend on the decisions of foreigners.
In sharp contrast to the Great Depression of the 1930s when the United States was the world's leading creditor nation, the U.S. is now the greatest debtor in the world. This places enormous constraints on the course the United States can pursue to cope with the economic crisis and with the broader foreign policy challenges that confront it.
Two forms of debt are particularly important to the external position of the United States: the U.S. government deficit and debt; and the U.S. current account deficit.
First, let's look at the effects of the U.S. government debt, which presently amounts to $11 trillion and is set to soar much higher. The Obama administration's economic recovery plan is driving the U.S. government's deficit from $410 billion at the beginning 2008 to well over a trillion dollars a year. The administration projects that trillion dollar deficits will persist for years to come. The U.S. federal debt is financed in part by securities held by U.S. government accounts, among the most important, the Federal Employees Retirement Funds, and the Federal Old-Age and Survivors Insurance Trust Fund. At the beginning of 2008, 55 per cent of the debt was held the "public", meaning those who purchased U.S. treasury bonds. Forty-five per cent of these "public" purchasers were made by foreigners, two-thirds of that total by foreign central banks. By far the most important of the central banks in making these purchases were those of China and Japan. When to the central banks of China and Japan are added to other purchasers from these two countries, about 47 per cent of the purchases by foreigners is accounted for. In total, foreigners have been financing about 25 per cent of the gigantic U.S. National Debt, a percentage that the Obama agenda could drive much higher.
Between them, the central banks of China and Japan hold over a trillion dollars worth of the U.S. securities used to finance the U.S. national debt They don't buy them because they regard them as a good investment. Quite the contrary. They buy them to save the United States from the crippling consequences of its own internal weakness. This, they do, not as an act of generosity, but to safeguard their vitally important export markets in the U.S. and to prevent a global economic collapse.
Suppose the Chinese and Japanese central banks, along with about eight or ten other central banks, decided to reduce their purchases of U.S. Treasury bonds. The consequence would be a sharp decline in the value of the U.S. dollar against other currencies. A lower dollar would lead to a very substantial reduction of U.S. imports. Keeping exports flowing into the vast American market is what motivates Asian central bankers to buy trillions of dollars worth of U.S. Treasury bonds.
There is a limit to this willingness to serve as lenders for the deeply indebted Americans, however. The biggest money makers in China are foreign multi nationals that set up shop in that country to avail themselves of a highly productive and relatively inexpensive labour force. Those multi-nationals are earning a far higher return on their invested capital in China than the Chinese central bank makes sustaining the U.S. dollar through its purchases of U.S. Treasury Bonds.
The Obama administration will need to sell vastly more (the dollar total could more than double) Treasury Bonds to Asian and other central bankers. This will have two effects. First, it will substantially increase the downward pressure on the American dollar against other currencies. A renewed fall in the value of the U.S. dollar will serve as yet another disincentive in the path of central bankers and private investors buying up the bonds. Buying bonds denominated in a falling currency is a money loser, especially if the interest rates on the bonds are low. To sweeten the pot, the interest rates on U.S. Treasury Bonds will have to be substantially raised, both to slow the decline in the U.S. dollar and to increase the return to the buyers of the bonds.
This, of course, creates yet another problem for the United States. Higher interest rates on American bonds make the cost of financing the rapidly expanding U.S. national debt ever more dauntingly stratospheric. Thus, borrowing immensely more from foreigners to finance the administration's stimulus program is an exercise that can only be described as fraught. The more expensive the cost of borrowing, the less effective will be the U.S. recovery program.
Continue reading this post at James Laxer's blog.