Do Deficits Matter? Foreign Lending to the Treasury
By L. Randall Wray
Deficit hawks raise three objections to persistent federal government budget deficits: a) they pose a solvency risk that could force to government default on its debt; b) they pose an inflation, or even a hyperinflation, risk; and c) they impose a burden on our grandkids, who will have to pay interest in perpetuity to the Chinese who are accumulating treasuries as well as power over the fate of the dollar.
I have argued that federal budget deficits and debts do not matter so far as national solvency goes (see here). The sovereign issuer of the currency cannot be forced into an involuntary default. I have also dealt with possible inflation effects of deficit spending (see here). To summarize that argument as briefly as possible, additional deficit spending beyond the point of full employment will almost certainly be inflationary, and inflation barriers can be reached even before full employment. However, I argued that the risk of hyperinflation for a country like the US is exceedingly low, and high inflation will be avoided by every stripe of policymaker the US is likely to appoint.
In this blog I will address the connection between trade deficits and foreign accumulation of treasuries, the interest burden supposedly imposed on our grandkids, and the possibility that foreign holders might decide to abandon the dollar.
Let us set out the framework. At the aggregate level, the government’s deficit equals the nongovernment sector’s surplus. We can break the nongovernment sector into a domestic component and a foreign component. As the US macrosectoral balance identity shows, the government sector deficit equals the sum of the domestic private sector surplus plus the current account deficit (which is the foreign sector’s surplus). Let me stress that this is an identity, beyond dispute. Even by those who are worried about the sustainability of continued budget deficits recognize the macro accounting identity (see here). We will put to the side discussion about the behaviors that got us to the current reality — which is a large federal budget deficit that is equal to a (smallish) private sector surplus (spending less than income) plus a rather large current account deficit (mostly resulting from a US trade balance in which imports exceed exports).
There is a positive relation between budget deficits and the current account deficit that goes behind the identity. All else equal, the government budget deficit raises aggregate demand so that US imports exceed US exports (American consumers are able to buy more imports because the US fiscal stance generates household income used to buy foreign output that exceeds foreign purchases of US output.) There are other possible avenues that can generate a relation between the US government deficit and the current account deficit (some point to effects on interest rates and exchange rates), but they are at best of secondary importance. To sum up: a US government deficit can prop up demand for output, some of which is produced outside the US-so that US imports rise more than exports, especially when a budget deficit stimulates the American economy to grow faster than the economies of our trading partners.
When foreign nations run trade surpluses (and the US runs a trade deficit), they are able to accumulate dollar denominated assets. A foreign firm that receives dollars usually exchanges them for domestic currency at its central bank. For this reason, a large proportion of the dollar claims on the US end up at foreign central banks. Since international payments are made through banks, rather than by actually delivering federal reserve paper money, the dollars accumulated in foreign central banks are in the form of reserves held at the Fed-nothing but electronic entries on the Fed’s balance sheet. These reserves do not earn interest. Since the central banks would prefer to earn interest, they convert them to US treasuries-which are really just another electronic entry on the Fed’s balance sheet, albeit one that periodically gets credited with interest. This conversion from reserves to Treasuries is akin to shifting funds from your checking account to a certificate of deposit (CD) at your bank, with the interest paid through a simple keystroke that increases the size of your deposit. Likewise, treasuries are CDs that get credited interest through Fed keystrokes.
In sum, a US current account deficit will be reflected in foreign accumulation of US Treasuries, held mostly by foreign central banks. The figure below displays the top foreign holders of US treasuries. While most public discussion has focused on Chinese holdings, Japanese holdings are of a similar size.
While this is usually presented as foreign “lending” to “finance” the US budget deficit, one could just as well see the US current account deficit as the source of foreign current account surpluses that can be accumulated as treasuries. In a sense, it is the proclivity of the US to simultaneously run trade and government budget deficits that provides the wherewithal to “finance” foreign accumulation of treasuries. Obviously there must be a willingness on all sides for this to occur-we could say that it takes (at least) two to tango-and most public discussion ignores the fact that the Chinese desire to run a trade surplus with the US is linked to its desire to accumulate dollar assets. At the same time, the US budget deficit helps to generate domestic income that allows our private sector to consume-some of which fuels imports, providing the income foreigners use to accumulate dollar saving, even as it generates treasuries accumulated by foreigners.
In other words, the decisions cannot be independent. It makes no sense to talk of Chinese “lending” to the US without also taking account of Chinese desires to net export. Indeed all of the following are linked (possibly in complex ways): the willingness of Chinese to produce for export, the willingness of China to accumulate dollar-denominated assets, the shortfall of Chinese domestic demand that allows China to run a trade surplus, the willingness of Americans to buy foreign products, the (relatively) high level of US aggregate demand that results in a trade deficit, and the factors that result in a US government budget deficit. And of course it is even more complicated than this because we must bring in other nations as well as global demand taken as a whole.
While it is often claimed that the Chinese might suddenly decide they do not want US treasuries any longer, at least one, but more likely many, of these other relationships would also need to change.
For example it is feared that China might decide it would rather accumulate euros. However, there is no equivalent to the US treasury in Euroland. China could accumulate the euro-denominated debt of individual governments-say, Greece!-but these have different risk ratings and the sheer volume issued by any individual nation is likely too small to satisfy China’s desire to accumulate foreign currency reserves. Further, Euroland taken as a whole (and this is especially true of its strongest member, Germany) attempts to constrain domestic demand to avoid trade deficits-meaning it is hard for the rest of the world to accumulate euro claims because Euroland does not generally run trade deficits. If the US is a primary market for China’s excess output but euro assets are preferred over dollar assets, then exchange rate adjustment between the (relatively plentiful) dollar and (relatively scarce) euro could destroy China’s market for its exports.
I am not arguing that the current situation will go on forever, although I do believe it will persist much longer than most commentators presume. But changes are complex and there are strong incentives against the sort of simple, abrupt, and dramatic shifts often posited as likely scenarios. I expect that the complexity as well as the linkages among balance sheets ensure that transitions will be moderate and slow-there will be no sudden dumping of US treasuries.
Before concluding, let us do a thought experiment to drive home a key point. The greatest fear that many have over foreign ownership of treasuries is the burden on our grandkids-who, it is believed, will have to pay interest to foreigners. Unlike domestically-held treasuries, this is said to be a transfer from some American taxpayer to a foreign bondholder (when bonds are held by Americans, the transfer is from an American taxpayer to an American bondholder, believed to be less problematic). So, it is argued, government debt really does burden future generations because a portion is held by foreigners. Now in reality, interest is paid by keystrokes-but our grandkids might decide to raise taxes on themselves to match interest paid to Chinese bondholders and thereby impose the burden feared by deficit hawks. So let us continue with our hypothetical case.
What if the US managed to eliminate its trade deficit so that it ran a perpetually balanced current account? In that case, the US budget deficit would exactly equal the US private sector surplus. Since foreigners would not be accumulating dollars in their trade with the US, they could not accumulate US treasuries (yes, they could trade foreign currencies for the dollar but this would cause the dollar to appreciate in a manner that would make balanced trade difficult to maintain). In that case, no matter how large the budget deficit, the US would not “need” to “borrow” from the Chinese to finance it.
This makes it clear that foreign “finance” of our budget deficit is contingent on our current account balance-foreigners need to export to us so that they can “lend” to our government. And if our current account is in balance then no matter how big our government budget deficit, we will not “need” foreign savings to “finance” it-because our domestic private sector surplus will be exactly equal to our government deficit. Indeed, one could quite reasonably say that it is the budget deficit that “finances” domestic private sector saving.
Yet, the deficit hawks believe the federal budget deficit would be more “sustainable” if foreigners did not accumulate treasuries that supposedly burden future generations of Americans.
OK, how could we eliminate the current account deficit that allows foreigners to accumulate treasuries? The IMF-approved method of balancing trade is to impose austerity. If the US were to grow much slower than all our trading partners, US imports would fall and exports would rise. In fact, our current “great recession” did reduce our trade deficit-although only moderately and probably temporarily. In order to eliminate the trade deficit and to ensure that we run balanced trade, we are going to need a much deeper, and permanent, recession. By reducing American living standards relative to those enjoyed by the rest of the world, we might be able to eliminate our current account deficit and thereby ensure that foreigners do not accumulate treasuries said to burden future generations of Americans.
Now, can the deficit hawks please explain why we should desire permanently lower living standards on their promise that this will somehow reduce the burden on our grandkids?
I think my grandkids would prefer a higher growth path both now and in the future, so that we can leave them with a stronger economy and higher living standards. If that means that thirty years from now the Fed will need to stroke a few keys to add interest to Chinese deposits, so be it. And if the Chinese some day decide to use dollars to buy imports, our grandkids will be better situated to produce the stuff the Chinese want to buy.
L. Randall Wray is Professor of Economics at the University of Missouri-Kansas City.
This post first appeared at New Deal 2.0.
Also see “What the PBoC cannot do with its reserves” from February by Michael Pettis, which also gives clarity to this issue. We highlighted the key paragraphs of that piece here: “Beijing is not Washington’s banker.”