Earlier this month, the premier of China gave a speech in which he expressed concern about the management of the U.S. economy. In the context of his country's holding of over a trillion dollars in U.S. Treasury securities, the remarks were widely seen as saying, in effect, "We own you now. Do what we tell you or we'll cut you off. Then you'll really be in trouble."
Despite plenty of evidence that the Chinese leader's comments were bluster and aimed at his domestic political audience, this story has gained some currency in the U.S. The comments were immediately seized upon by U.S. pundits, politicians, and others to support their contentions that U.S. fiscal policy must become more "responsible" by reducing U.S. deficits and debt as soon as possible. Shortly after his remarks were reported here, I attended a conference on budget policy in which people discussed the "warnings" as if they were important. Last night, by chance I watched a few minutes of Fareed Zakaria's new talk show on CNN, in which he again quoted China's leader and asked how bad the situation is. (That one of his panelists was Nicholas Kristof of the New York Times, who is completely unqualified to speak on the subject, is a different matter.) Even though Zakaria's guests did not speak in panicked tones, the very discussion of the Chinese leader's remarks imparted to them an importance that they do not deserve. As usual, the conventional wisdom regarding deficits has it mostly wrong.
Why do we borrow from abroad at all? In any given year, any economy will generate some amount of saving that can be used to finance investment. The domestic government (if it is running a deficit) and domestic businesses (if they are well run) will want to borrow money to finance their purchases. Under the standard story, if the government is running a deficit, the money that it borrows "crowds out" borrowing by private businesses, preventing factories from being built, machines from being purchased, etc. If, on the other hand, the government finances its deficit by borrowing from abroad, domestic businesses are not forced to reduce their borrowing and thus are able to invest as they would have if the government had not run a deficit. The cost of this, of course, is that foreign bondholders are owed interest on U.S. debt, which means that even though we have built more factories, etc., we must divert some of our profits from those factories to pay our foreign lenders.
As an initial matter, therefore, the choice of borrowing from abroad allows us to invest in capital in the U.S. that we would not otherwise be able to afford. If the capital earns a higher rate of return than the interest on foreign debt, then we are ahead. Given that the decisions to invest are pegged to the interest rates that businesses must pay, we typically have good reason to believe that they will invest up until (but not past) the point where their projects are equal to the cost of borrowing. In short, the ability to borrow from abroad allows us to build some things that we would not otherwise build, with the concomitant job creation, etc., in this country and the likelihood that the investments will in the aggregate pay off at higher rates than we are paying on our debt.
Any concerns about foreign borrowing, therefore, must be based on political concerns that we are giving foreign lenders the ability to affect our economy in ways that they could not if we did not owe them so much money. The reality, of course, is that being a creditor to the U.S. is still so attractive that the bonds that we issue fetch very high prices (which is the same thing as saying that they pay very low interest rates). If a bondholder were to engage in a deliberate attempt to punish the U.S. for its fiscal policies, the only thing it could do is to sell U.S. Treasury securities. Because prices fall when supply rises exogenously, the holders of debt would see the value of their assets fall. The more U.S. debt one holds, the more of a loss one suffers from U.S. debt becoming less valuable. More simply, punishing us by making us pay higher interest rates also punishes our lenders by making their investments go down in price.
Of course, the legitimate concern is that lenders will rationally pull back on future purchases and will not re-lend money to us when current securities mature. On the margin, U.S. policy must be set in a way that takes into account the likely reactions of all potential lenders to U.S. fiscal policies. This is quite different, however, from saying that foreign borrowing is going to allow the Chinese government to dictate terms to the U.S. government. In the current vernacular, the U.S. is "too big to fail," and our lenders know it. As I discussed the other day in the context of monetary policy, what China and every other lender (foreign and domestic) want is a healthy and rich U.S. economy that can service its debt payments and buy and sell goods and services in a well-functioning global economy. The surest path to that outcome is for the U.S. to engage in fiscal, monetary, and regulatory policies that will end the recession. Following that path will be much easier if we do not allow ourselves to be distracted by the politically-motivated comments of a foreign leader -- even (or especially) one who is counting on us to pay interest on a trillion dollars in securities that his government counts as an asset.
-- Posted by Neil H. Buchanan