There has been intensive discussion about the U.S. trillion-dollar annual fiscal deficits and the consequent federal debt of $16 trillion, headed for $20 trillion in three years. Far less notice has been given to the $500 billion annual foreign, or current account, deficit over the past 10 years, resulting in half of the $16 trillion of national debt held by foreigners, including $5 trillion by foreign central banks. Yet the two deficits are linked and interact, and need to be addressed jointly.
Such a twin-deficit financial crisis played out in Greece and Spain over the past several years, and there are parallels with where the United States is heading. The crisis-triggering issue was the credit rating and interest rates on sovereign debt. As creditors doubted the ability to finance the debt and anticipated a substantial decline in the currency due to departure from the eurozone, the interest rates on official debt rose quickly, which automatically increased both the fiscal and current account deficits because interest payments are an important component of the deficits.
This ominous interest rate cloud now hangs over both the eurozone debtors and the United States, but there are two critical differences. The first is that Greece was bailed out by European Union and International Monetary Fund loans at very low interest rates, together with official default on the majority of official private-sector loans, while Spain has a standby financial bailout commitment from the European Central Bank. These bailouts, moreover, are contingent on a very large reduction in the fiscal deficit over two to three years. The United States, in stark contrast, has no potential sources for an official bailout, little prospect for a substantial decline in the fiscal deficit, and there would be ferocious opposition to any talk of default for private holders of Treasuries.
The second critical difference is the sheer magnitude of the U.S. deficits, and their central role in the dollarized international financial system of the past 70 years. The unprecedented, mind-boggling magnitude is illustrated by the impact on the deficits from a rise in the U.S. Treasury rate. A 1 percent increase for a $20 trillion national debt means a $200 billion increase in the annual fiscal deficit and a $100 billion increase in the current account deficit, while a 5 percent increase in the Treasury rate would mean a $1 trillion increase in the fiscal deficit to $2 trillion, and a $500 billion increase in the current account deficit to $1 trillion, or more than 5 percent of gross domestic product.
The course of a likely rise in the average U.S. Treasury rate is unpredictable, and it could accelerate with considerable financial turbulence. As incipient inflation and concern about a fall in the dollar lead to an initial increase in Treasury rates, existing Treasuries will fall in value, which would stimulate increased sales of Treasuries and a more rapid rise in rates.
Much, of course, will depend on the reactions of governments, and a three-pronged U.S. policy response could greatly reduce the market turbulence and ease the adjustment within the American economy. The first prong, on the external front, would be decisive action to end manipulation of currencies by China and others to gain an unfair competitive advantage in trade, which would reverse the soaring U.S. trade deficit in manufacturing over the past three years to $500 billion in 2012. The second prong, on both fronts, would be strong incentives to increase domestic petroleum and natural gas production, which would increase jobs and tax revenues on the home front and eliminate the trade deficit in the energy sector. The third, broadest-based prong would be to adopt a federal budget front-loaded to substantially reduce the fiscal deficit over the next couple of years.
However sensible, the likelihood of necessary bipartisan support for this three-pronged response is close to zero, so the probable course ahead rests on how markets will react as the twin deficits continue at unsustainably high levels, and attention will increasingly focus on Treasury rates and credit ratings. Although the timing and content of this course are not clear, it will almost certainly accelerate the transition to a multi-key-currency financial system. The dollar share of central bank holdings has already declined from 72 percent in 2000 to 62 percent in 2012, and this systemic transition raises additional questions for the global economy and, in particular, for the U.S. ability to finance its external deficit.
We can learn much from the Greeks. Their failed struggle with a twin-deficit financial crisis has been noted. Hopefully, the twin-deficit warning presented here will be given serious consideration before it is too late.
Ernest H. Preeg, senior adviser for international trade and finance at the Manufacturers Alliance, is author of “The Decline and Fall of Bretton Woods?” (MAPI, 2012).