The Budget Deficit, the Debt and the Dollar

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Dean Baker
Truthout, February 22, 2010

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The Wall Street-financed crew that is pushing to gut Social Security and Medicare is used to playing fast and loose with facts and logic to advance their agenda. Unfortunately, many of the reporters who cover these issues have little knowledge of economics so they are often suckered.

One of the favorite themes in the deficit hysteria is that foreigners hold close to half of the government’s debt, with the evil Chinese looming especially large in this story. Holding up the foreign menace to advance a political agenda is a well-tested tactic in American politics, but its proven success doesn’t make it any less reprehensible.

The reality is that insofar as we are concerned about foreign ownership of U.S. debt, then we should be talking about the trade deficit. This in turn brings us to a discussion of the value of the dollar, not the budget deficit. These topics get featured rarely, if ever, in the deficit hawks’ rants.

The logic here is very simple and should be familiar to those with any training in economics. The extent to which foreigners are able to acquire ownership of U.S. assets, regardless of whether it is government debt or private assets like stock and bonds, depends on the U.S. trade deficit. The trade deficit gives them the dollars they need to buy these assets. A trade deficit means that United States is sending more dollars abroad each year than are being used to buy U.S. exports. This difference allows foreigners to buy up U.S. assets.

This point is simple, but central. If the U.S. government were running a $2 trillion budget deficit, but its trade was balanced, then foreigners could not be increasing their ownership of the government’s debt, unless they were selling off holdings in U.S. stocks, bonds or other dollar denominated assets.

Conversely, if the country were running a $2 trillion trade deficit, but the budget was balanced, so we had no annual budget deficit, foreigners could increase their share of ownership of the debt. They could use the $2 trillion that they were acquiring each year as a result of the trade deficit to buy up the government bonds that had been issued to finance the debt in prior years.

In short, if someone is concerned about foreign ownership of the U.S. government debt, and not just looking to make cheap jingoistic appeals to advance their agenda, then they should be discussing the trade deficit, not the budget deficit. And the issue here really is foreign ownership of U.S. assets in general, not government debt. Foreign ownership of U.S. assets represents claims on future income. The interest, dividends and profits from these assets will be paid out to foreigners, not people living in the United States.

Even if there is some particular reason to worry about the share of the government debt owned by foreigners, then the focus should still be U.S. assets more generally. Our financial markets are hugely liquid. If a foreign investor or government owned $1 trillion of U.S. stock, corporate bonds or short-term dollar deposits, they could sell these assets tomorrow and buy $1 trillion in government bonds. There is zero reason that any serious person would ever be concerned specifically about the share of the government debt held by foreigners.

This brings us to the question of what determines the trade deficit. The simple answer is the value of the dollar. At any given level of GDP, the overwhelming determinant of our trade balance is the price of the dollar relative to other currencies. If the dollar rises by 10 percent against other currencies, then it makes foreign goods cheaper for people in the United States. It also makes U.S. exports more expensive to people living in other countries. A 10 percent rise in the value of the dollar is comparable to imposing a 10 percent tariff on all U.S. exports and giving a 10 percent subsidy to all imports.

The reason that the United States consistently runs large trade deficits is that its currency is over-valued. Unfortunately the deficit hawks are too chicken-hearted ever to talk about the over-valued dollar since they get much of their funding from Wall Street, which likes a strong dollar.

So, we can look forward to a lot more cheap jingoism from the deficit hawk crowd about the menace of more foreign ownership of the government’s debt. We can also expect that they will continue to ignore the real issue of an over-valued dollar that is making U.S. goods uncompetitive in the world economy. The deficit hawks are right to say that the system is broken. But the best evidence is that their jingoism is being taken seriously.


Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of The End of Loser Liberalism: Making Markets Progressive. He also has a blog, "Beat the Press," where he discusses the media's coverage of economic issues.