Deficit 3 – At the Water’s Edge
The US government is running a chronic deficit, going deeper and deeper into debt. The US public is running a deficit, going deeper and deeper into debt. So where is the credit coming from? The short answer is that it’s coming from nearly everyone who isn’t an American and isn’t dirt poor.
The longer answer is that the US has been able to tap into a river of foreign credit by virtue of the third deficit: the trade deficit. Foreigners, in the aggregate, sell about $2 billion per day more of goods and services to Americans than they buy from Americans. The Americans, in the aggregate, make up the difference by selling investments to foreigners, most conspicuously US Treasury bills. Chart 3 illustrates this two-way street and shows how rapidly the traffic has been growing.
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Why This Can’t Go On
If you have a very good credit rating, you may be carrying credit cards with limits of $10,000, $20,000, or perhaps much more. But however good you may look to lenders, there is a limit to how much they are willing to lend. And however good the US may have looked to lenders in the past, there always were limits to what it could borrow. The difference between then and now is that today the US is straining those limits.
Two elements determine how far foreigners will go as lenders to the US. The first is akin to a credit test. The second is a portfolio consideration. It is becoming increasingly difficult for the US to satisfy either of them.
Foreigners will accept T-bills and other dollar-denominated IOUs only so long as they believe US borrowers can make good on their debts. The concern is not primarily about explicit defaults. It is about the likelihood of a slow-motion default via inflation. It is a concern about the future value of the dollar. Confidence that the dollar will hold its value is strained with every increase in the US budget deficit (which increases the US government’s incentive to inflate) and with every increase in the overall level of US debt to foreigners (which encourages the public’s tolerance for inflation).
It would take a phenomenally slow person, say, a central banker, to have much faith in Uncle Sam’s good credit when the US can’t pay its current bills by a very wide margin – and has trouble saying “no” to new spending plans. But even the faith of a central banker must have its limits.
Perhaps the central bankers haven’t yet seen Chart 4, showing the Government Accounting Office’s latest projections of US federal government red ink. Based on straightforward assumptions that (i) regular income tax rates continue; (ii) the alternative minimum tax is adjusted; and (iii) discretionary spending grows with GDP, the projection for spending, and thus the budget deficit, flies off the map. By 2040, the yearly deficit grows from the current 3% of GDP to 40%!
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The second element in the calculations of foreign lenders is a portfolio consideration. Owning too much of anything is worrisome. So even if the risk of the dollar losing its value were modest (which it no longer is), as foreign holdings of dollar-denominated securities grow, the risk eventually becomes intolerable.