- The Washington Times - Tuesday, November 30, 2004

For more than a year, I have been predicting — not advocating, just predicting — a significant tax increase to deal with the budget deficit. My hypothesis has been that sooner or later financial markets would pressure Congress to act on the budget deficit, and that the problem would be too great to deal with by spending cuts alone.

I was unsure where, when or how this financial market pressure would arise. But it now seems clear it will come through the foreign exchange market. The dollar has dropped rapidly, and this sets in motion forces that eventually will have an effect on domestic stock and bond markets. The possibility of a major crash cannot be ignored.

The root of the problem is the U.S. current account deficit, which includes the trade balance for goods and services, plus receipts on U.S. investments abroad minus payments to foreigners on their investments here. There is also a large negative figure for unilateral transfers abroad, such as those for military programs and foreign aid.

To show the orders of magnitude, in 2003 the U.S. exported $713 billion worth of goods and imported $1,261 billion, for a deficit of $548 billion. This was partially offset by a significant surplus in the export of services of $74 billion. U.S. companies also received more in income on their foreign operations than we paid out to foreigners on their operations here, giving us a surplus of $33 billion in this area. After subtracting $67 billion for unilateral transfers, we ended up with a current account deficit of $531 billion.

Basically, this $531 billion figure must be financed by foreigners willing to invest in the United States directly or buy dollar-denominated assets such as stocks and bonds. In 2003, foreigners bought $829 billion worth of the latter, while Americans increased their ownership of foreign financial assets by $283 billion. The difference, $546 billion, approximately equals the current account deficit.

If foreigners were just interested in investing in the United States because they like our economic prospects and investment climate, this would not be a problem. Indeed, this unquestionably explains most of the private capital transfers. In places like Japan and Europe, economic prospects have been much worse than here for some time, and investors there have had little choice except to invest abroad.

But lately, a considerable portion of foreign investment has been by foreign central banks in U.S. Treasury securities. From 1999 to 2003, these rose to $249 billion from $44 billion. The figure for this year will undoubtedly be higher than last, since foreign central bank purchases of Treasuries were already at $202 billion just through June.

As a consequence, foreign ownership of the U.S. national debt has risen to $1.8 trillion, or half of the privately held debt. A decade ago, foreigners owned just over 20 percent of the debt.

The Japanese are the largest foreign holders of U.S. Treasury securities, with $720 billion in September, up from $317 billion just four years earlier. The Chinese have become the second-largest holders, with $174 billion, a sharp increase from $62 billion in September 2000.

These large Treasury security purchases are due to Japanese and Chinese efforts to prevent their currencies from rising against the dollar. They have done so by using their own currencies to buy dollars, then invested in Treasury securities.

But this cannot go on indefinitely. It complicates monetary policy and threatens foreign central banks with large capital losses if U.S. interest rates rise. (Bond prices move in the opposite direction of interest rates.)

There is growing evidence foreigners are tiring of financing the U.S. budget deficit. The Chinese and Japanese both talk about cutting back on Treasury purchases and diversifying into euro-denominated assets. To continue selling its bonds, the Treasury must increase the interest rate it pays.

Other consequences are a further fall of the dollar against foreign currencies, which will raise the prices we pay for foreign goods. This will boost inflation, which will encourage more Federal Reserve monetary policy tightening. A lower dollar also will make U.S. goods cheaper in terms of foreign currencies.

Most economists view this as a natural market process for resolving current account imbalances. Raising the cost to us of foreign goods and lowering the cost of American goods to foreigners, it should reduce imports and increase exports.

The danger is the dollar won’t fall gradually, but precipitously, which could lead to a sharp drop in the stock market and a spike in interest rates in order to defend the dollar.

Bruce Bartlett is senior fellow with the National Center for Policy Analysis and a nationally syndicated columnist.

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