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Home Publications Blogs Beat the Press Correcting Robert Solow: Debt Owed to Foreigners Is Determined by the Trade Deficit, not the Budget Deficit

Correcting Robert Solow: Debt Owed to Foreigners Is Determined by the Trade Deficit, not the Budget Deficit

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Thursday, 28 February 2013 05:49

I hate to have to correct Nobel prize winners (okay, that's not true), but Robert Solow does get one item somewhat wrong in an otherwise useful column on the government's debt. Solow notes that close to half of the publicly held debt is owned by foreigners. He then tells readers:

"This part of the debt is a direct burden on ourselves and future generations. Foreigners are entitled to receive interest and principal and can use those dollars to acquire goods and services produced here. If our government had used borrowed money to improve infrastructure or to improve the skills of workers, the resulting extra production would have made repayment easier. Instead, over the last decade, it used the money for wars and tax cuts."

This is somewhat misleading. Suppose that the United States had been running balanced budgets for the last three decades, so there was little or no public debt for foreigners to buy, but we had run the same trade deficits over this period. In this case, foreigners would own the same amount of U.S. assets, except they would be private assets like stocks, bonds, and real estate. The income from these assets would be:

"a direct burden on ourselves and future generations. Foreigners are entitled to receive interest and principal and can use those dollars to acquire goods and services produced here."

In other words, the fact that we have given foreigners a substantial claim to our future income is the result of our trade deficits, not our budget deficits.

There is an argument that the budget deficit has contributed to the trade deficit, but it is not as simple as many people in policy debates seem to believe. If a budget deficit provides a boost to the economy, as the stimulus did in 2009-2010, then it will increase the trade deficit. The logic here is simple. If the economy is bigger, then we buy more of everything, including more imports.

In this argument, if we cut our budget deficit, we can reduce our borrowing from abroad by shrinking the economy. This is true, but it seems like a rather dubious argument. Do we really want to have millions more people out of work just so that we can deny foreigners a share of our future income? It is also worth noting that an increase in private sector investment or consumption would have the same impact in increasing the trade deficit.

When the economy is below full employment, anything that raises GDP will lead us to purchase more imports. This includes budget deficits.

The other way in which the budget deficit can lead to a higher trade deficit is by causing the dollar to rise. The logic here is usually that larger budget deficits mean higher interest rates, which in turn will raise the value of the dollar. However the exact mechanism does not matter, the point is that the proximate cause of the larger trade deficit is a higher valued dollar, not the budget deficit. If the deficit does not cause the dollar to rise, then it would not have an impact on the trade deficit.

The other implication of this line of reasoning is that if we are concerned about our growing indebtedness to foreigners then we should be concerned about the over-valuation of the dollar. Whatever steps we take to reduce the value of the dollar will increase the competitiveness of U.S. goods, reducing imports and increasing exports. This means that those who are troubled by the extent to which foreigners will have a claim on future income should be concerned about the value of the dollar, not the budget deficit.

If we lower the budget deficit without lowering the value of the dollar, then it will not improve our trade deficit (except to the extent that the lower deficit reduces GDP). On the other hand, if we can lower the value of the dollar without reducing the budget deficit then we will have addressed the concern about foreigners buying up U.S. assets and thereby getting claims to future income. 

 

Note: Typo corrected -- thanks John.

Comments (7)Add Comment
...
written by John, February 28, 2013 7:56
". . . Do we really want to have millions more people out of work just so that we cannot deny foreigners a share of our future income?"
You meant ". . . so that we can deny foreigners a share of our future income", right? (I hate to correct you.)
...
written by skeptonomist, February 28, 2013 9:19
Sokolow also says "The real burden of domestically owned Treasury debt is that it soaks up savings that might go into useful private investment." In practice this was not a problem after WW II, when debt reached 120% of GDP. This is another instance of how the "theoretical" predictions of conservative economists were falsified in that era. Private investment was largely crowded out during the war, but came back immediately afterwards. Very likely the enormous buildup of demand during the war counteracted any deficiency of capital due to absorption of savings in government bonds. There is certainly no lack of private capital at present - the problem is lack of demand. Not even conservatives are complaining of capital starvation.
...
written by Chris Engel, February 28, 2013 11:59
Dr. Baker,

Have you thought through a comprehensive plan for a more competitive dollar?

I was thinking instead of all these liquidity swaps the Fed does, why not get the Fed involved with outright Foreign Currency purchases so that we have a portfolio of foreign currency assets that can be used to counteract a selloff or at least soften the inevitable revaluation of the dollar?

This will become a major reality once the Remnimbi becomes a non-capital-controlled currency that has big international demand.

They're taking small steps to increase foreign remnimbi holdings (under fairly strict controls) but in a couple years when they fully open the spigot, that's when there will be serious dollar pressure downward.

This is when the debt will _actually_ become a problem, when there's a viable alternative for international holders who actually wouldn't mind taking a hit in FX value in order to achieve an advantaged trade position with China instead of the US ( this depends heavily on multiple variables in China such as their consumer and demographics ).

so once that becomes an issue then the dollar will probably weaken significantly and there could be more upward rate pressure as well depending on how strong domestic demand would be to gobble that up (the Fed has the firepower to mop up that demand for example).

The only problem is that there has already been premature talk of "currency wars" and stuff, so the PR effect of the Fed building an FX portfolio would be nasty.

Anyway it would be interesting if you developed this more. You've written about different options for how to handle a rate increase, but i'm more curious how American policymakers could address the inevitable correction on the dollar that goes along with rising international alternative currency-denominated assets (i'm looking mostly at China).

Maybe my ideas are naïve but I think if the Fed openly forces the dollar down by purchasing foreign currencies that would help soften what would be an inevitable correction once the current account deficit begins to "normalize" (whatever that means). Perhaps you have an alternative way to address this?
Publicly held federal debt
written by Charlie, February 28, 2013 12:30
other than that held by the Federal Reserve has been steady or slightly declining as a fraction of GDP the past couple years. This year, if the FED continues asset purchases, and particularly if the sequester cuts follow through, the nominal debt held outside the Federal Reserve will likely decline.
just a note
written by Eclectic Observer, February 28, 2013 1:30
I think the column would also have been improved by dispatching the notion that our economy is put at risk by any one country. Your post is correct in that there isn't much difference between a debt claim on US domestic economy for private or public but selling that debt also affects currencies and thus balance of trade. We have way too much discussion about how the Chinese own us thru debt.
Retired Economist
written by Mitchell Harwitz, February 28, 2013 2:34
The column is much ado over two words.The words are "borrowed money." If Professor Solow had written "If our government had used imports to...." there would have been absolutely nothing to fuss over. As the column was originally written, there still wasn't much, as Dean Baker admits!
...
written by watermelonpunch, March 01, 2013 1:18
Important topic. Many average people (like me) have a hard time understanding these seemingly subtle but apparently important distinctions.
And frankly I read this page twice, and I feel kind of sick, and I don't think it's just rhinovirus. This is a confusing topic!

The other implication of this line of reasoning is that if we are concerned about our growing indebtedness to foreigners then we should be concerned about the over-valuation of the dollar.


That stands out to me because it seems I often notice the people who worry most about the indebtedness to foreigners also being the people who fret furiously about the US dollar declining in value.
???
And this is not just the people who harp on about gold, have a stockpile canned food & bottled water in their basement, and spend their vacations visiting places where visions of Mary have appeared.

I think it's a widespread disconnect that deserves more scrutiny, and better awareness.

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.

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