If US stays attractive, its debt won't be a threat
Oct 15, 2004
Hilton Root
Publisher: The Straits Times

The Straits Times

Political and expert opinion in the United States share a concern that the growing trade deficit and global borrowing binge are a threat to America's future and, in turn, to global stability. But the rhetorical posturing of the candidates is leading to unrealistic and even dangerous proposals that may precipitate the cataclysmic forebodings the candidates are trying to avoid.

Many of the world's most influential economists, the International Monetary Fund, and business leaders, including Mr. Peter Peterson and Mr. Warren Buffet, believe that US fiscal policies and the country's US$500 billion (S$840 billion) trade deficit threaten global financial stability.

Politicians, spreading fears that the US economy will be left to the mercy of foreign investors, have urged protectionist policies that will likely prompt new rounds of anti-Americanism and stall future steps towards global integration. But will these shortsighted fiscal policies, as critics suggest, truly lead the world economy to disaster?

Despite the misgivings of experts, global demand for the US dollar remains strong. Indeed, big budget deficits created by the US government hike up interest rates, thus attracting foreign capital to the US. More importantly, there is a continuing trust in the dollar.

A nation's fiscal capacity relies upon more than its savings rate. It also depends on the reputation of its political institutions and the stability of its social organisations. Before issuing loans, foreign lenders evaluate the likelihood of repayment by assessing whether debtors' political institutions are healthy and supported by social consensus.

Many critics believe the underfunded US social security and medical care systems threaten future US financial stability; this debate politically divides the US population down the middle. But a resolution of these current divisions can be accomplished within the context of those institutions. None of the parties is likely to take up arms or demand a new Constitution to see that its interests are protected.

Long-term global comparisons among world regions reveal there is, in fact, no substitute for the relative health and stability of the US economy.

In Europe, an overburdened public sector slows growth and diminishes the appeal of European assets. For it to contend for a larger share of international capital flows, the policies that are currently the basis of political stability must change. Europe's citizens would have to modify their social organisation to reduce social claims on the state, integrate immigrants and strengthen regional political institutions by diluting domestic independence.

Asian economies suffer from ill-defined relationships between the state and the private economy. In China, weak institutions have facilitated growing deficits and fiscal uncertainty. Though the government needs help to fund its expansive policy of public investment and support for state-owned industries, the wealth of the growing private sector remains untaxed.

Similarly, East Asia's tiger economies, Japan included, suffer from cultural ambivalence about the government role in industry regulation. Many citizens, undecided about public protection of the workforce, fear substituting the role of the state for the family. Labour markets, as a result, suffer from rigidity. The Middle East does not seem likely to change its ways either.

Latin American governments suffer from an inability to reach a consensus about spending priorities. Governments cannot collect adequate revenue because the poor refuse to pay taxes for undelivered services, and the rich have no incentive to pay for services they do not use. None of the region's governments feels sufficiently self-assured that increasing taxes will not jeopardise institutional stability. Thus, most Latin American states are in a permanent fiscal crisis, while their citizens' savings are safely harboured overseas.

The damaging impact of political instability is always a possibility in China or Latin America when questions concerning public programmes funds are raised. In the US, raising taxes, although politically unpalatable, will not provoke an institutional crisis. Despite the strong differences expressed by this year's presidential candidates, whichever position is eventually enacted into law will be reliably funded by Congress. A resort to military action will not occur because one side disagrees with the electoral outcome. Even if a new political party comes to power, it will continue to honour the liabilities incurred by its predecessor. Moreover, the additional funds that must be raised for agreed-upon programmes will not engender insurrection by the dissenting party.

So, what of the US' growing debt? Historically, there have been several examples of the world's greatest power being the world's greatest debtor. The rise of Holland in the 17th century and England in the 18th century can be attributed directly to their ability to borrow at comparatively low interest rates. Both countries borrowed a larger percentage of their national income than did contemporary rivals, such as France, Russia and Spain.

Being able to borrow at lower rates of interest can be a source of strength, but it can also be a liability. Should the rates suddenly shift due to unexpected terms of trade, the strong parties' burden might be magnified beyond the means of repayment. Politically strong nations face the peril of overextending their fiscal reach by being too attractive to the savings of their neighbours. People will send their money to a country that appears to be politically strong, thus allowing that nation to live beyond its means. Should a short-term disruption occur in the ability to repay or borrow, a major financial crisis can ensue. The consequences of a sudden disruption of capital flows can be devastating, even to a sophisticated financial system. This is precisely the danger that the next US president must address.

Ironically, critics view extensive overseas borrowing by the US as a threat to globalisation. One could easily make the opposite argument: Exposure to the US economy gives international investors a stake in the successful management and prosperity of the US.

US policymakers should encourage private savings and discourage government spending, but new domestic fiscal policies will not be enough to shift the flow of international capital to those parts of the world that are most in need. The credibility of US domestic political institutions gives the country a strength that makes dollar-denominated investments attractive to foreign investors. For the foreseeable future, instead of unrealistic rhetoric about drastically cutting the trade and fiscal deficits, politicians might be wiser to implement a well-planned investment policy. One based upon solid long-term investments in education, technology and social equity will pave the way to economic growth. Abundant dividends in the future must be the objective of funds borrowed today.

America's long history of budget and trade deficits and excessive federal spending have not deterred capital flight from developing nations. The capital flight from developing nations to the US stems largely from domestic governance failures that cannot be corrected by the US administration. Capital does not end up in the country that needs it most, but in the one that treats it best.

The writer was a senior adviser to the Treasury Department and is now Freeman Visiting Professor of Economics at the Claremont Colleges and Senior Fellow at the Milken Institute.