Fairy Tales of the Coming State of the Union: If We Keep Issuing Debt Our Main Creditors Won't Buy It
In "All Together Now: There Is No Deficit/Debt Problem,” I warned against the message calling for deficit reduction that the President will probably deliver in his State of the Union Address next month. I view the coming narrative as very likely to be composed of a number of fairy tales. In previous posts in this series I've analyzed and critiqued five of the fairy tales I expect the President to tell us in his coming State of the Union speech. In this post, I'll discuss a sixth fairy tale: the idea that if we continue to issue more debt, our main creditors: the Chinese, the Japanese, and our oil suppliers, may cease to buy our debt making it impossible for us to raise money through borrowing which, in turn, would force us into radical austerity, or perhaps even into insolvency, which would then be followed by radical austerity and repudiation of our national obligations.
As I've explained in previous posts, since we can deficit spend to whatever extent is desirable without issuing debt, if our creditors were to cease buying that debt it need not force us into insolvency or radical austerity and default. The idea that this will occur assumes that we must “fund” deficit spending with borrowing; but this is only true so long as Congress mandates this requirement. If it ceases to do so, the possibility of insolvency, austerity, and default goes away.
But it is important to realize that even if Congress continues to require debt issuance, the possibility that creditors will cease to buy our debt is very unlikely. To see why, we have to consider the choices faced by our major creditors. First, they've accumulated a lot of dollars. Second, many of these dollars were used previously to buy our bonds. Third, dollars that weren't used to buy bonds or goods, services, and assets for sale in dollars, are now sitting in reserve accounts at the Federal Reserve. Fourth, reserve accounts are like checking accounts. They don't earn any interest for the nations holding them.
Fifth, of course, these nations would like to use their money to benefit themselves. Sixth, so, generally speaking, here are their immediate choices. They can:
-- Buy our bonds and their USD can earn some interest;
-- Buy goods, services, or other assets available in USD (this will improve our balance of payments, produce income for US exporters, and produce increased tax revenues for the Government, lowering the deficit);
-- Trade USD for other currencies (this will lower the value of USD on the currency markets, reduce our imports and our creditors' exports, and our leakage of aggregate demand leading to increased stimulus in this country and higher tax revenues. If too much of our currency is dumped by our creditors, then they will suffer heavy losses in the value of their own USD holdings, so they are are very likely to divest themselves of USD only very incrementally over a period of years);
-- Leave their dollars in their reserve accounts (this alternative is very unlikely because it does our creditors no good)
You can see from these alternatives, that our creditors have no good choices if they don't want to invest in bonds. Their USD accounts have grown as large as they are now, because they want to export their commodities and manufactured goods in return for USD. They either can't consume all of them internally, or don't want to because they are following internal austerity programs with respect to consumption.
They can change their desire to have export-led economies. But they are very resistant to doing that. So, if they want to stop the accumulation of USD, then they have to find other nations they can export to whose currencies are more desirable. In the present world trade situation, there are no alternatives whose currencies are more desirable than USD who are also willing to run an economy that is not export-led.
So, if our creditors don't want to invest in our bonds, and want to keep an export-led economy, then they will keep accumulating USD, or will spend USD on our goods, services, and assets, balancing their exports with imports, or will trade our currency, which will lower the value of the USD they continue to hold. Importing things from us goes against their export-led economic policy, trading our currency weakens its value and therefore also has a negative impact on their export-led policy. So what's left for them: holding USD in a reserve account; or buying our bonds. Buying our bonds is often their best choice.
I understand that our creditors would like to get out of the box I've just outlined, and would like to diversify their currency and bond holdings. I expect that there will be periodic efforts to do that by trying to invest in the Euro and other currencies, and by discussions focusing on implementing a market basket of currencies replacing the dollar as the reserve currency. However, I don't think these efforts are sustainable.
The reason is that the Chinese, Japanese, Middle Eastern nations, and the Eurozone all want to have export-led economies. As long as they are committed to do that they will need to export goods to nations that are willing to have economies that are domestically oriented, and they have to be willing to accept the currencies of those nations in payment for their goods, and to accumulate those currencies.
Once again, the nation with a domestically-oriented economy with the strongest currency is and will be the United States for the foreseeable future, so there is no way for the other nations to get out of their box unless and until they decide to abandon their export-led orientation. When they do that, their USD holdings will dissipate over time, and we will be less able to sell our debt to them.
But on the other hand, since we will then be importing far less due to the lower value of the dollar, there will be less drain of aggregate demand to exports, more stimulus in the domestic economy, smaller deficits, and less need to sell debt even if Congress, in its infinite wisdom, still requires that we issue it.
Finally, I'd be remiss if I didn't say one more thing about this fairy tale. Specifically, the image this one conveys is that the US is like a borrower that periodically has to go to a bank to get a loan to fund its spending. This image is way out of kilter with reality. This is true first, because the US doesn't “fund” its spending with loan proceeds. It spends by marking up non-Government accounts.
And second, and even more importantly in this context, we can see that the US is much more like a Bank offering savings accounts to its checking account customers, than it is like a borrower begging for a loan. We can see this by noticing that China's reserve account at the Fed is like a checking account; and that it's securities account is functionally like a savings account in which China makes a time deposit. That is, China buys a bond and at the end of an agreed upon period its “savings” or bond account is marked down the face value of the bond, while its reserve account is marked up by the principal invested in the bond, plus the agreed upon interest.
So, the fairy tale says, we're always going hat in hand to China, Japan. Middle Eastern nations etc. and the reality is that these nations are choosing to shift money from checking accounts to low-risk savings vehicles we offer backed by the full faith and credit of the United States. Now, what's so alarming about that?