Returning Dollars

An interesting question about foreign holdings of U.S. Treasuries was asked in the comments section of last week's post, Fun With the Public Debt - it deserves a little more attention. Whether any of the answers are correct is anyone's guess - surely it will become clear in the coming years, and maybe there is something to be learned by talking about it.

Q. What else are the Japenese and Chinese gonna buy besides US securities?

A1. chubbyray said... Better investments have existed for a while. The Chinese are aggressively pursuing energy and commodities WW. Tipping point will come when that is widely perceived as the place to park money. Can't buy earthquake insurance during the earthquake.

A2. Tim said... Buying commodities and investing in natural resource companies are at the top of the list. The question of when will Asia stop taking those dollars and lending them back to us is really the question of the decade.

It should really be viewed not as "investing" the money, but as "what can they do with the dollars that would serve their interests best?" Right now, their interests are best served by keeping the U.S. budget deficit funded and continuing to loan money for U.S. housing in order to keep our economy going and their exports going.

The problem for the U.S. is that, what is in one's best interest changes over time - the U.S. has become overly dependent on borrowing money from abroad.

A3. Anonymous said... I figure China see their hoardings of dollars as a sort of weapon in reserve, which they can drop on the market when and if the US should ever seriously annoy them. The financial loss they would thus inflict upon themselves has surely already been written off.

Here's the same chart that was used for last week's post showing the dramatic increase in foreign Treasury holdings for the last ten years, and in particular the last five years. A similar pattern would be apparent when looking at foreign holdings of mortgage backed securities.


Click to enlarge

The Current Arrangement

So, U.S. dollars used to purchase goods from Asia get recycled back into U.S. debt in the form of U.S. Treasuries and residential mortgages. This keeps bond prices up and hence long term interest rates down, which has been a major factor in sustaining the housing boom of recent years that has helped to fund much of consumer spending through home equity extraction, which has kept Asian exporters busy.

Asian fiat currencies are pegged to the dollar either implicitly or explicitly), which helps to keep import prices from rising in dollar terms (as they should in response to the huge trade deficit), and life goes on - the imbalances grow and the debt grows, manufacturing and service jobs are created in Asia, while real estate related and consumer spending related jobs are created here.

Many people believe that things can continue this way indefinitely.

With the intractable problems of federal budget deficits and both lackluster job creation and wage growth amidst rising consumer prices for everything that is not imported from Asia, both the U.S government and the U.S. consumer are highly dependent on ever more debt to continue spending at current levels.

With consumption such a large share of GDP, if there were to be a significant pull-back in consumption, growth rates would quickly plummet, perhaps causing a cascading series of contractions around the world, the worst of all scenarios.

What Happens If Dollars Stop Returning

Should dollars stop returning to the U.S. to purchase new U.S. government debt, there would be little choice other than to monetize the new debt. That is, to print money "out of thin air" in order that the government can pay its bills (see U.S. Monetary Authority in the chart above). Rapidly increasing monetization of U.S. debt, when viewed by the rest of the world, would likely cause a panic/loss of confidence in the dollar in some ways similar to the problems in Argentina in the 1990s.

Should dollars stop returning to the U.S. to purchase mortgage securities, long term interest rates (set by the bond market) would naturally rise, making housing even more unaffordable, likely causing home prices to decline precipitously, bringing to an end the housing-ATM financed American consumption that has fueled global growth in recent years.

No one has an interest in stopping dollars from returning to the U.S. as debt - not Asia, and certainly not the U.S. - but, at some point a rebalancing must occur.

It is naive to think that it won't - it's just a matter of the timing.

Two Scenarios

It seems there are two scenarios here - one that is rosy for the U.S., one that is not so rosy.

The rosy scenario is that somehow, Americans start innovating more and maybe spending a little less. It has long been said that we are the great innovators - they sweat, while we think. Unfortunately, the biggest innovations in recent years have been in mortgage finance, while what is needed is something like the 1990s technology boom to once again separate the U.S. from the rest of the world by providing high paying service jobs to justify the lifestyles to which we have become accustomed.

In this scenario, Americans will continue to benefit from the combination of inexpensive imported goods, while at the same time earning good wages for jobs that must somehow remain in the U.S. - not an easy thing to achieve, but possible. Falling behind the rest of the world in education, as discussed often by Alan Greenspan recently, does not make this task any easier.

The not-so-rosy scenario is that Asia emerges as the next economic superpower in the coming years and decades, much as the U.S. emerged as a superpower after Britain in the last century. In this scenario, surely the Asians would not accept this same arrangement when it comes to recycling U.S. dollars for debt.

Many believe that this is the nature of empires, that they rise and then slowly decline - that this will be long tortuous process for the U.S. where Asia exerts increasing clout in the rest of the world, slowly weaning itself off of its reliance on exports to the U.S., developing a robust consumer society for its manufactured goods to ensure continued demand regardless of the what happens in the U.S.

Which scenario will it be?

Who knows.