Wednesday, February 17, 2010

Too much hoopla over foreigners' holdings of US debt

The news of "a record drop in foreign holdings of U.S. Treasury bills in December" is not necessarily as bad as people are trying to make it.

China can't necessarily harm the U.S. economy by dumping a ton of its holdings of US Treasuries. If China continues to generate a trade surplus with us, but decides to a) sell some of its Treasury holdings and b) devote more of its dollar surplus to the purchase of debt from other countries, this does not guarantee at all that the U.S. economy will suffer. The most likely outcome of such actions would be to increase China's purchases of U.S. goods and services.

This is the key thing to remember: when country A sells more stuff to us than we purchase from them, then it ends up with dollars that can only be spent, ultimately, on something here in the U.S. The dollars that we spend on foreign imports never really leave the U.S. banking system, they simply change hands. Dollars are always spent here. A country that has a trade surplus with us must spend its dollars on a) our bonds, b) our stocks, c) our real estate, or d) deposit those dollars in a US bank account. Dollars that figuratively travel overseas to buy foreign goods are always recycled back to the U.S. economy in some form or other.

If the rest of the world decides tomorrow that they are all fed up with financing our profligate spending ways, then there is really only one thing that will obviously have to happen: if all the countries that have trade surpluses with us decide to stop buying Treasuries, then they will have to spend the dollars they earn from selling things to the U.S. on something else here in the U.S., or deposit those dollars in a bank account here. A big decline in Treasury purchases on the part of the rest of the world would most likely mean, therefore, a big increase in U.S. exports of goods and services. Higher interest rates on our bonds would coincide with a big increase in our exports. Is that a bad thing? I don't know, because the answer is not obvious to me. (Though I still think that higher interest rates would be a good thing, because they would signal a stronger economy.)

There are other considerations as well. It's not obviously in China's interest to dump tens or hundreds of billions of Treasuires, because that might depress the dollar and thus destroy the value of the trillions of U.S. assets it already holds. China is really between a rock and a hard place on this issue.

9 comments:

  1. Scott,

    What if foreigners took their dollars and instead of buying our goods, purchased much of the productive capacity of America and sent the profits back home....what impact would that have on our nation?

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  2. alstry,
    The productive capacity of America lies in the intellectual capital of its citizens, and thus cannot be purchased by outsiders. Take the iphone as an example. Americans creatd the concept. None of it is manufactured here, yet most of the value is added here, and the majority of profits are made here.
    If it is irrelevant whether a building or buisness located in Chicago is owned by someone in Illinois or Georgia, then it is likewise irrelevant if the owner resides in Canada or China.

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  4. If the US population saves more, the US government needn't be as reliant on foreigners for money.

    The US population is saving more so...

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  5. "A country that has a trade surplus with us must spend its dollars on a) our bonds, b) our stocks, c) our real estate, or d) deposit those dollars in a US bank account. Dollars that figuratively travel overseas to buy foreign goods are always recycled back to the U.S. economy in some form or other."

    Scott, I do not understand. What keeps the Chinese from exchanging dollars to Euros and investing in Audi or Porsche, both the cars and the factories, and Germans from investing in China or Brazil?

    What keeps our dollars from becoming a forgotten currency?

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  6. It's easy to understand how trade works if you assume just two countries: US and China. China sells us a TV for 1,000. Now what are they going to do with the dollars? They have the following choices: put the money in a bank deposit, buy Treasury bills, notes, or bonds, buy equities, buy real estate, or buy some goods or services from us. Let's say they buy Treasuries. Then tomorrow they decide they don't like what's going on in the US and they decide to sell the Treasuries. What are they going to do with the dollar proceeds of the sale? Their choices: a US bank deposit, equities, real estate, goods or services. They never have the option of just taking the dollars home with them, because you can't spend dollars in China.

    With multiple countries the analysis is more complex, because the Chinese can, as you say, trade the dollars for Euros and all sorts of permutations can occur. But eventually the analysis boils down to the US and the Rest of World. The dollars the Chinese don't spend must, at the end of the day, be spent by someone, somewhere in the world, and they must be spent on some US asset or good or service. If ROW wants out of our bonds, they have to buy something else from us.

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  7. But if ROW wants out of dollars so will we. Then all hell breaks loose and Everybody In the World (EIW) abandons the dollar, minimizing losses by acting fast.

    It would seem that the spare dollars you talk about are invested overseas at decreasing rates of conversion, ...the above phenomenon in slow motion.

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  8. If everyone wants out of dollars, then dollars become a "hot potato" and their velocity increases. This would be a prescription for much higher inflation, and it would be driven by declining demand for dollars/rising money velocity.

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  9. It's your comment that dollars can't disappear but simply reappear in American banks in a different form that I found novel and fun.

    It's true, I suppose. Dollars don't disappear but rather become digital ether. A little like delinquent mortgages counted as assets, also held in American banks.

    The conclusion that dollars are here to stay so not to worry probably comforts our administration.

    That CAN'T be good.

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