The falling dollar, Social Security and foreign debt

By Brad Setser

brad_setser@msn.com

Q. Facing a huge foreign debt, what should the government do?

Q. Why is the U.S. running a large trade deficit, and who is financing that deficit?

Q. Why are foreign central banks investing in the U.S., if not for high returns?

Q. When will foreign central banks stop financing the U.S.?  When will the tipping point occur?

The best thing we can do is to reduce the budget deficit. Every dollar the deficit is lowered is a dollar that we as a country don't need to borrow from abroad. A smaller deficit would free up private US savings rather than the government to finance domestic investment. The budget deficit is not as large in relation to gross domestic product as in the 1980s, but it is large in relation to our tiny current savings rate. Remember, we save less now than we did in the 1980s.

That means that policy proposals like the partial privatization of social security, which almost certainly would require that we issue more government debt, are potentially risky.  We are already buying too much on credit; I doubt we can afford to buy private accounts on credit as well.

The dollar also needs to fall, and not just against European currencies. A falling dollar reduces demand for imports and increases demand for our exports, and it will encourage firms to invest in the US rather than shift production out of the US.

But even if we start to cut the budget deficit and import less and export more, we will still depend on foreign central banks for some time. At a minimum, we need the foreigners who already have invested lots in the US – the Bank of Japan and Japan’s Finance Ministry probably have together lent the US over $700 billion and the People’s Bank of China probably has lent the US over $400 billion – to hold onto to their existing holdings of US bonds.  

But we actually need central banks to do more than just hold on to renew their existing credit lines to the United States. We also need the world’s central banks to keep on increasing our credit line so that we don’t have to go cold turkey and reduce our trade deficit from $600 billion to zero over night. We have dug ourselves into a real hole and simply cannot reduce either our trade deficit or our need to borrow savings from the rest of the world too quickly without a severe recession. We should take steps to reduce the amount of new money we need to borrow from the rest of the world, and from foreign central banks. But we also don’t want to be forced to stop all new borrowing too quickly.

That is the real challenge: we cannot end our dependence on foreign central banks suddenly, but we clearly need to take steps to reduce it over time. Conversely, our trading partners need to take steps to make sure that their economies do not depend solely on exports for growth. Otherwise, a slowdown in US demand for imports will undermine their growth and cause a global economic slowdown.

Brad Setser is a research associate at the Global Economic Governance Programme at University College, Oxford and a blogger. E-mail: brad_setser@msn.com

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