One of the knottiest issues surrounding the U.S. national debt is that of growing foreign ownership of our Treasury bonds. Is there any danger in the fact we owe about a third of our national debt to entities outside our borders?
Historically, this was not a problem. Introductory economics textbook long argued that much public breast beating about the debt is misguided. One reason is that “we owe the debt to ourselves.”
For years, most Treasury bonds were owned by people or institutions within our borders. While current and future taxpayers must pony up money to service the debt, any interest and principal payments made also go to people in the United States. There is no flow of funds outside the country. This argument was almost entirely correct 50 years ago. But by 1980 foreigners already owned 18 percent of all U.S. Treasury bonds “held by the public.”
In the intervening two decades, that proportion continued to climb. As of a year ago, debt held by the public totaled $2.9 trillion. Some $1.3 trillion of this, or 39 percent, was owed to foreigners. Since flows of money in and out of a country generally balance out in the long run, for every $100 in Treasury interest payments, we must export $39 worth of goods or services to make foreign interest payments. Or we can sell foreigners $39 worth of U.S. assets.
Foreign ownership of any U.S. physical or financial assets scares many people, mostly unnecessarily. Attracting foreign investment is not necessarily a bad thing.
Many developing countries go to great lengths to attract outside capital. The U.S. used a great deal of foreign capital in the 1800s to build canals, railroads, mines and factories. Foreign investments in dollar assets can be risky for the investor. Japanese purchases of U.S. real estate are a good example. In the 1980s, Japanese investors bought large amounts of commercial property, largely in Hawaii and California. Indeed, buying by foreigners helped stoke a property price bubble. U.S. magazines ran cover stories implying that Japan was buying up the United States and, implicitly, would control it.
Fifteen years later, few remember the brouhaha. First, the property prices collapsed, particularly in southern California. When Japanese investors bailed out and tried to bring their money back to Japan, they were clobbered by a yen that was more expensive in dollar terms than when they had first sent their money to the United States. Between the lower property prices and an adverse exchange rate move, many ended up losing two-thirds of their money.
“Yes,” you may say, “but that was different than foreigners owning U.S. government bonds.”
It is and it isn’t. One important difference is that private Japanese firms made the real estate investments. Foreign central banks, rather than private sector investors, are the largest foreign owners of U.S. Treasuries. But such foreign ownership of U.S. bonds resembles the real estate experience in two important ways. Any large-scale move by foreigners to dump U.S. Treasury bonds would provoke the same double whammy that lacerated Japanese property buyers.
If the foreigners who own U.S. bonds all decided to sell them, the price of bonds would drop. As they converted the dollars they got from selling bonds back into their own domestic currencies, foreign exchange markets would be flooded with U.S. dollars and the dollar would weaken against whatever currencies the bond sellers wanted. They could get out of their U.S. debt holdings, but they would take a terrible bath.
The U.S. would not be unscathed. Dropping bond prices mean rising interest rates, which would slow consumer and business spending. The Fed could buy up enough of the bonds dumped by foreigners to hold interest rates down, but this would dramatically increase the money supply, increasing inflationary pressures.
Such a sudden, mass shunning of U.S. Treasury bonds is not likely to occur. One must ask why foreign central banks buy U.S. treasuries. There are two reasons. First, the U.S. dollar is a reserve currency. Many countries hold substantial reserves of the currencies of nations with which they trade with to ensure their ability to pay for imports or service debts.
Since the U.S. dollar can be traded for nearly any other currency, holding foreign exchange reserves in dollars simplifies the process. Moreover, as long as central banks have dollars, short-term U.S. Treasury IOUs will earn some interest.
Other countries manage billions of dollars of reserves in this way. They are lending money to the U.S. government, but this is a collateral effect of their foreign exchange management, not an objective in itself.
Some central banks buy dollars to keep their own currencies from gaining value relative to the dollar. This is clearly going on in Japan and China and neighboring countries right now. Members of Congress recently asked the Treasury Secretary to investigate if such exchange rate intervention in Asia hurts U.S. manufacturers.
Asian governments know that if the yuan, yen or rupee strengthens against the dollar, their firms will find it harder to sell in the United States. Their central banks buy surplus dollars to prevent this, just as the U.S. government long bought corn to keep U.S. farm prices up.
As for those countries simply managing their exchange reserves, if you are going to hold dollars you can earn interest by buying Treasuries. The central banks of Japan, China and other Asian exporters now hold hundreds of billions worth of U.S. Treasury bonds. Their objective is not to help the U.S. government, but rather to effectively subsidize their own domestic industries by keeping their currencies weak.
© 2003 Edward Lotterman
Chanarambie Consulting, Inc.