Foreign Debt Threatens Economy
Discuss how creeping inflation, high interest rates, and soaring oil prices threaten the economy and businesspeople will listen attentively. But turn the conversation to the current account deficit and a rapidly depreciating U.S. dollar, and watch their eyes glaze over.
Granted, currency exchange rates and net trade flows aren’t typical coffee shop chatter. But shifting global trade patterns hold the potential to cripple the current economic recovery. Just because your business lacks foreign customers and imported material doesn’t make it immune to the long arm of international trade.
The burgeoning trade imbalance and the resulting dependence on foreign lending has the potential to jolt your business, should financial markets unravel. Soaring inflation and interest rates could debilitate housing, the auto sector, and other interest-sensitive industries. The result: home prices fall, consumer spending evaporates, unemployment climbs and business investment retreats. Not a pretty scenario, and probably not likely. But possible.
The current U.S. account deficit is the broadest measure of trade balance. It includes the balance on both goods and services trade, and investment income between the United States and its trading partners. The deficit was $666 billion in 2004, or 5.7 percent of U.S. gross domestic product. The United States now imports 50 percent more than it exports.
Only in 1816, when U.S. imports surged after the War of 1812, has the current account deficit ever been in the 5 percent range. The United States is not alone in experiencing negative trade balances but few countries have such a high deficit in relation to national output. In fact, only Hungary, Bulgaria and the Czech Republic fall in this range. Those nations can hardly be considered economic superpowers.
Why is the Trade Deficit So Large?
How did the trade deficit become so lopsided? In 1990, for each additional dollar spent on consumer goods (excluding autos), 15 cents went for imports. That figure is now 45 cents.
Are Americans impulsively buying French wine, Swiss watches, Italian shoes and German cars? Hardly, but we do shop at Wal-Mart and send lots of dollars to Mideast oil producers.
One contributing factor to the trade deficit is the flight of American production overseas. American consumers may be buying the same type of clothing, furniture and appliances as a decade ago, but now these goods are made outside our borders.
U.S. parts suppliers are disappearing from the economic landscape as low labor costs allow Asian vendors to undercut prices. Asia has been a popular platform for foreign companies to establish operations. About 60 percent of China’s exports are produced by multinational corporations.
Weak foreign economies, particularly in Europe and Japan, impede the demand for U.S. exports, even though the declining dollar makes U.S. products less expensive. This year, the U.S. economy grew at a healthy 4.4 percent inflation-adjusted rate. But most economies in Europe remain sluggish.
Oil prices that approached and occasionally exceeded $50 a barrel bloated our import bill in 2004. Although the United States is less dependent on foreign oil than we were 25 years ago, the jump in the cost of crude can still deplete margins and raise producer and consumer prices as it moves through the economy’s pipeline.
Historically low interest rates are a key villain in the trade gap. Consumers prefer to spend rather than accept anemic savings rates. Higher rates that make savings attractive would help absorb consumer dollars that are headed overseas.
Why Are Interest Rates So Low?
Despite consistent quarter-point rate hikes by the Federal Reserve, the yield on long-term bonds has dropped, sustaining low mortgage rates and a housing market on steroids. Why are the long rates dipping despite the Fed’s commitment to elevate rates to a “neutral,” less stimulating level?
An unholy alliance links overseas investors with U.S. consumers and businesses. They finance our budget and trade deficit through their purchase of financial securities, keeping interest rates low. In return, Americans support growth in global economies by gorging on consumer goods at the expense of personal savings.
Central banks have an additional motive to buy U.S. dollars and dollar-denominated securities. A weak dollar makes imports more expensive for U.S. consumers. By aggressively intervening in currency markets through purchase of dollars, foreign central banks keep native currencies from rising to levels that make their exports less competitive.
How Long Can This Last?
Overseas creditors’ recent purchases of U.S. securities are enormous. Estimates are that foreign investors own over 40 percent of all U.S. Treasury securities. With the dollar’s steep drop in the past three years, foreign-held U.S. bonds and cash declined in value. Since the dollar is the most popular reserve currency, holding dollars has become a liability for foreign central banks.
The scenario that keeps economists awake at night involves a massive sell-off of dollars by central banks. At some point, the benefits of supporting export purchases by holding a currency that steadily declines becomes counter-productive. If central banks begin to gradually divest U.S. dollars from their foreign currency reserves, a meltdown could occur. Just as stockholders engage in a selling frenzy when their investment begins a free-fall, so central banks might be motivated to cut their losses from a downward spiraling dollar.
The United States would need to find other investors to fill the void left by fleeing central banks. Private foreign investors could step forward, but only if interest rates were high enough to provide a competitive return and also compensate for anticipated future declines in the dollar.
That required return would be much higher than current bond rates. A sudden and significant spike in interest rates would shake investor confidence.
The housing market, housing-related sectors, and other interest-sensitive industries would face setbacks. Inflationary pressures would result from both rising import prices and the ability of domestic producers to match those higher prices.
A More Optimistic Scenario
One would hope that by acting in their own self-interests, nations will prevent this doom-and-gloom scenario. Despite some challenges, the United States is the engine driving the world economy. Any action that hobbles the United States ultimately harms countries dependent on exports. A sell-off of dollars by foreign central banks sharply diminishes the value of foreign currency reserves.
A smaller U.S. budget deficit decreases dependence on overseas creditors. Gradual and predictable rate increases by the Fed should produce interest rate levels that spur consumers to save, thus decreasing demand for imports. And the weaker dollar should make U.S. exports more competitive overseas.
During the Cold War, “mutually assured destruction” emerged. Because the Soviet Union and the United States both had the capability to destroy each other, public officials assumed that no rational leader would launch a nuclear attack. Today, the United States and its overseas creditors are involved in a financial balance of terror. Each has the potential to seriously impair the other’s economy.
Recognizing this unhealthy cycle of mutual dependence, perhaps the U.S. and its creditors can gradually recalibrate the trade and financial imbalance and break this vulnerable cycle.
Scott Franklin is a principal at First Generation Consulting and holds a master’s degree from the London School of Economics. He develops seminars, speaks and writes about economic issues facing the business community. He can be reached at or 913-642-6951.
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