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The prospect of US dollar becoming worthless is pretty scary

The prospect of US dollar becoming worthless is pretty scary

US debt and China: a tale of two deficits - Deficit hawks are manipulating mistaken fears about the dollar and the US trade gap to push a highly partisan cuts programme

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In the movie Philadelphia, the lawyer played by Denzel Washington is shown repeatedly telling his clients to explain their case to him as though he were a 9-year-old. This is a good rule to follow in explaining issues to economists and policy analysts, since they seem to get confused easily in discussing economics.

One of the lines frequently repeated by the deficit hysterics is that if we don't get the deficit under control, then there could be a run from thedollar. This is a great line for getting little boys and girls and reporters at elite news outlets very scared. After all, the prospect of the dollar becoming worthless is pretty scary.

One of the other lines pushed by this same crew is that we are borrowing hundreds of billions of dollars from foreigners, with the Chinese also being cited for special mention. The prospect of the Chinese holding trillions of dollars of US government debt is also scary to little boys and girls and reporters at elite news outlets.

The problem with these two scary stories is that they actually are in direct contradiction to each other. The only plausible way that we can stop borrowing hundreds of billions of dollars a year from those nasty Chinese is by having the dollar fall in value against the currencies of our trading partners. This decline probably would not take the form of a scary run that ends in the dollar being worthless, but more likely a substantial and sustained decline that makes US goods much more competitive in international markets.

The reason that we are borrowing from abroad every year is that theUnited States has a trade deficit of the order of $550bn a year, or just under 4% of GDP. This trade deficit is financed by foreign borrowings. The logic is simple. If the United States buys more than it sells, then it must borrow the difference.

Note that this has nothing to do with the budget deficit. If the United States buys $500bn more from other countries than it sells to other countries, then it must borrow $500bn a year from them, regardless of whether the United States is running a budget surplus or a budget deficit. Foreign borrowing is determined by the trade deficit, end of story.

There are two ways that reducing the budget deficit can affect this picture. First, cutting spending and/or raising taxes can slow the economy, as will likely be the result from the cuts recently pushed through by Congress. If the economy is smaller, then we will buy less of everything, including fewer imports. In other words, if cutting the deficit makes the downturn deeper, then we will have a lower trade deficit. This means that the deficit hawks can reduce our borrowing from bad guys – if their intention is to throw the economy into a severe and prolonged downturn.

The other route through which reducing the fiscal deficit can lead to a lower trade deficit is if it results in a lower-valued dollar. The argument here is that if we get the deficit down, then interest rates would fall. Lower interest rates would make foreigners less interested in buying dollar-denominated assets, like US government bonds.

If foreigners investors are less interested in buy dollar-denominated assets, then they have less need for getting dollars. The reduced demand for dollars would cause the value of the dollar to fall. A lower-valued dollar will then make US goods more competitive in international markets, leading us to buy fewer imports and to increase out exports.

However, this channel for reducing the value of the dollar is not working right now, since many governments – most importantly, China's – are deliberately propping up the value of the dollar against their currencies. They are doing this to sustain their export markets in the United States.

It is very difficult to see why China would be less interested in sustaining its export market in the United States if we reduced our budget deficit. Does anyone believe that President Hu is going to decide that China no longer needs its export market in the United States because we have reduced our budget deficit?



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