(This guest post previously appeared at NewDeal2.0.)
U.S. public debt as of July 8, 2010 was $ 13.192 trillion against a projected 2010 GDP of $14.743 trillion. As of April 2010, China held $900.2 billion of US Treasuries, surpassing Japan’s holding of $795.5 billion. As of 2007, outstanding GSE (Government Sponsored Enterprises like Fanny Mae; Freddy Mac) debt securities (non-mortgage and those backed by mortgages) summed up to $7.37 trillion.
Does this mean disaster for the US? Conventional wisdom is misleading, as the case of China illustrates.
Former Treasury Secretary Hank Paulson revealed in his recently published memoir that in August 2008, while attending the Olympics in Beijing, he was informed by Chinese officials that “Russian officials had [earlier] made a top-level approach to the Chinese suggesting that together they might sell big chunks of their GSE holdings to force the U.S. to use its emergency authorities to prop up these companies.” Paulson said while “the Chinese declined to cooperate”, the report was nonetheless “deeply troubling,” as “heavy selling could create a sudden loss of confidence in the GSEs and shake the capital markets.”
In an Op-Ed article in the June 14, 2010 edition of Foreign Affairs by Benn Steil, Senior Fellow and Director of International Economics, and Paul Swartz, Analyst, centre for Geoeconomic Studies, the authors suggest that “with the U.S. needing to sell another $1.3 trillion in debt in 2009, the risk Paulson describes is certainly real.”
They point out that over the past decade, foreign ownership of U.S. debt has increased dramatically. Foreign holdings of Treasurys have risen from 29% to 48% of the outstanding stock, while foreign holdings of U.S. government agency and GSE backed debt have increased from 6% to 16%. Virtually the entire increase in both has been accounted for by foreign governments, as opposed to private investors. And one government dominates: China. By the authors’ estimates, China has accumulated an astounding $850 billion in Treasuries and $430 billion in agency debt over the decade — almost half the total foreign government accumulation. (As of April 2010, China held $900.2 billion of U.S. Treasuries, ranking top surpassing Japan’s holding of $795.5 billion.)
The authors report that to some, the fear that the Chinese might dump U.S. debt is misguided. “It would be very much against their own interest to do so,” Federal Reserve chairman Ben Bernanke said back in 2006. Heavy selling would precipitate precisely the fall in the dollar’s local and global purchasing power that the Chinese fear. So the Chinese would not cut off their noses to spite their faces. But the same faulty argument can be made about anyone caught in a Ponzi scheme, the authors warn. No one who finds himself in a Ponzi scheme wants to see it collapse, yet he will still sell because he knows he will be worse off if others sell first.
So, the authors ask, how serious is the risk of strategic, coordinated foreign selling, of the type that could destabilize financial markets? They answer that “Here is where Paulson drops the ball. He tells us only that China rejected the Russian scheme to coordinate the mass dumping of GSE debt. Yet large-scale near-simultaneous selling is precisely what happened. By our calculations, Russia sold $160 billion worth, virtually all of its holdings, over the course of 2008, while China sold nearly $70 billion worth between June 2008, when its holdings peaked, and the end of that year.”
And while the fire sale went on, the yield spread between GSE debt and U.S/ Treasury debt soared. From 2003 to 2007 it averaged 34 basis points. When Russia started selling GSE debt in January 2008, it stood at 57 basis points. When China started selling in July, it hit 86 basis points. As GSE debt was widely used as collateral in the U.S. repo market, the rising spread forced U.S. financial institutions to pony up more and more securities to support their borrowing. The government put the GSEs into conservatorship in September. Yet Chinese and Russian dumping of GSE debt accelerated into the fourth quarter of 2008, as did spreads, which peaked in November at over 150 basis points.
This episode highlights the clear risks to the U.S., and indeed the wider world, of growing American dependence on foreign government lending, the authors conclude.
But this is the wrong conclusion. Why? Because the U.S. owes no foreign debt denominated in foreign currencies.
The authors did not ask why the U.S., while vulnerable, is not critically over a barrel by massive foreign holdings of U.S. sovereign debt. The reason is because U.S. sovereign debts are all denominated in dollars, a fiat currency that the Federal Reserve can issue at will. The U.S. has no foreign debt in the strict sense of the term. It has domestic debt denominated in its own fiat currency held in large quantities by foreign governments. The U.S. is never in danger of defaulting on its sovereign debt because it can print all the dollars necessary to pay off foreign holders of its debt. There is also no incentive for the foreign holders of U.S. sovereign debt to push for repayment, as that will only cause the U.S. to print more dollars to cause the dollar to fall further in exchange rates.
In this situation, the borrower enjoys market power over the lender. This advantage that the U.S. enjoys comes from dollar hegemony, a peculiar condition in global finance in which the dollar, a fiat currency that the U.S. can issue at will, is recognised worldwide as a reserve currency for international trade because of U.S. geopolitical power with which to force the trading of critical basic commodities to be denominated in dollars. Everyone accepts dollars because dollars can buy oil and every economy needs oil. Granted, one can buy oil also with euros and yen, but only because these currencies are freely convertible to dollars, and therefore they are really derivative currencies of the dollar.
But this is not quite a free ride. Although the US is getting low-price imports paid for with paper dollars that it will never have to buy back with gold, this type of trade comes with is a penalty of losing low-paying manufacturing jobs overseas, mainly to China. In recent months, as the Chinese government realises that a low-wage economy is an underdeveloped economy, it has encouraged Chinese workers to demand higher wages through collective bargaining and strikes. Low-wage jobs then will move by transnational corporations to other underdeveloped low-wage economies such as Vietnam, Indonesia and some countries in Central and Latin American.
But this type of trade globalization through cross-border wage arbitrage also pushes down wages in the US and other advanced economies, causing insufficient consumer income to absorb rising global production. This is the main cause of the current financial crises which have made more severe by financial deregulation. But the root cause is global overcapacity due to low wages of workers who cannot afford to buy what they produce. The world economy is plagued with overcapacity as a result. It is not enough to merely focus on job creation. Jobs must pay wages high enough to eliminate overcapacity. Instead of a G20 coordination on fiscal austerity, there needs to be a G20 commitment to raise wages globally.