TCS Daily

Economic Limits to Empire

By Desmond Lachman - October 4, 2004 12:00 AM

One has to regret that the current presidential debate is not more focused on those economic issues that will ultimately determine the United States' ability to sustain its supremely dominant role in international affairs. For while President Bush and Senator Kerry continue to square off on the war in Iraq, the Commerce Department recently reported on the alarming and record rate of US dependence on foreign central banks to finance both its ballooning external payments gap and its very large budget deficit. Failure to adopt corrective measures soon to wean the US off this dependence will in time almost certainly undermine its ability to continue policing the world.

In his recent book Colossus: The Price of America's Empire, Niall Ferguson notes that in the heyday of the European empires, the dominant global power was supposed to be a substantial creditor nation that invested its savings in the economic development of its colonies. He reminds us that when Britain bestrode the globe one hundred years ago, capital exports were one of the foundations of its power.

Not only did the City of London make large loans to the colonies, but it channeled large amounts of capital into the colonies' mines, plantations, railways and general public infrastructure. In fact, between 1870 and 1914, net capital out of London averaged between 4 and 5 percent of GDP a year. Similarly, when the United States was globally asserting itself in the first half of the twentieth century, it was able to engage in dollar diplomacy because it was a substantial capital exporter.

As the Commerce Department reminded us, those days are long over. Indeed, in the second quarter of 2004, the US was running an external current account deficit at the staggering annual rate of $650 billion, or the equivalent of almost 6 percent of its GDP. At the same time, far from being a creditor nation, the United States has become the world's largest debtor nation with a net external debt that now amounts to around 28 percent of GDP. In reflection of that status, we now have a situation where a group of Asian central banks, predominantly those of China and Japan, finance over 40 percent of the US external deficit and own over $1,000 billion in US government paper.

Sober economic analysts project that on present trends and at the current dollar exchange rate, the US external current account deficit could very well rise by $100 billion a year to $1000 billion, or around 9 percent of GDP, by 2010. They also project that by then the US net external debt could rise to over 50 percent of GDP, while Asian central banks' holdings of United States government paper could swell to over $2,500 billion.

Earlier dollar crises, like that which occurred in the mid-1980s when the US external current account deficit was only half its present level, should remind us of the limited tolerance that markets have for high external deficits. For a point will be reached where market participants will no longer wish to hold dollars at the current dollar exchange rate for fear of the risks to which a growing external deficit exposes them. This would not only cause the dollar to depreciate substantially but it could also cause US interest rates to rise as investors shied away from buying US dollar assets.

Painful past experiences of a falling dollar and rising interest rates should also remind us of the large leverage that foreign central banks could exercise over US foreign policy by virtue of their large holdings of United States government paper. For these central banks now have considerable ability to disrupt US financial markets by simply deciding to refrain from buying further US government paper and to sell any significant part of their existing holdings of such paper in the market.

The time to begin weaning the United States off its excessive dependence on foreign financing could not be too soon. This is particularly the case since any delay in that process only increases the size of the US external debt, which raises the corresponding interest payments on that debt and which further increases the external deficit.

Any serious effort to reduce the US external deficit will involve persuading foreign central banks in general and those in Asia in particular to get out of the way of a substantial further depreciation of the dollar. Specifically, they would need to be persuaded to stop preventing their currencies from appreciating in value by purchasing large amounts of dollars in the markets as they do now. This would be needed to make US exports competitive abroad and US imports expensive at home.

Beyond having the US dollar depreciate, narrowing the US current account deficit will also require limiting the chronic dis-savings of the US public sector that presently lies at the heart of the US external deficit. As a minimum, one would think that over the next few years the budget deficit would need to be at least halved from its present level of around 4 ½ percent of GDP in order to make room for the improvement of the US external accounts.

It is never pleasant for presidential candidates to talk about the real sacrifices that might be needed to put the country's external finances on a sounder footing and to reduce dependence on foreign financing. However, on the basis of all too many precedents, one must fear that failure to begin the process of correcting the US external deficit soon runs the very real risk of another dollar crisis with all its attendant disruptions to US financial markets and the US economy.

The author, a TCS contributor, is Resident Fellow, American Enterprise Institute.


TCS Daily Archives