By Marcus Hutchins
Many years ago, I came across a cartoon which brought a smile. A door-to-door salesman peeked inside an open screen door and observed a frowning 10-year-old lad laboring at his piano practice. The placid peddler asked the boy, “Young man, would your mum be at home?” The lad’s eye turned to his baseball glove resting beside him on the piano bench and grumbled, “What do you think?”
Questions are often answered by observation. If this young fellow’s mother was not at home, she must have had a pretty good surveillance camera. Often we can learn much about our economic world, and dispel prevalent prevarications, by observing a few simple facts.
Last week we presented some facts regarding our national debt and the ownership of the debt. The total size of our federal debt has risen significantly since 2007, the starting point of the Great Recession. In addition, the non-U.S. ownership of the debt jumped substantially between 2000 and 2007, and again from 2008 to 2014, rising from about 15 percent to about 33 percent foreign ownership.
These are facts. What is the story behind these facts? How and why has the foreign ownership doubled?
One story most of us have encountered in the media suggests that America spends beyond its means, and now borrows from other countries to stay afloat. As such, we are on a collision course with bankruptcy, and soon to suffer the fate of Greece, Brazil, and the like.
We also observed last week that a person is entitled to one’s own opinions but not one’s own facts. Some notions are either verifiable facts or fabrications. Other notions have an element of uncertainty, and can be considered opinions.
The claim that the U.S. is a nation of prolific spenders which requires international capital to stay afloat is not an opinion. It is statement which can be ratified or repudiated by appeal to additional facts readily available in the Treasury International Capital database and the Federal Reserve Economic Data database.
We begin with Brazil. Our Portuguese-speaking neighbor to the south-southeast is suffering from poor fiscal management. At least three conditions accompany profligate public policies.
First, during the past 10 years, inflation has climbed from 3.6 to roughly 10 percent. Second, the value of the Brazilian real (the local currency, pronounced “ray-al”) has declined from 65 to 27 U.S. cents. Third, Brazilian 10-year borrowing costs are nearly 13 percent.
Each of these three conditions is typical of fiscal mismanagement. First, when a government inappropriately spends more than it taxes, inflation rises. This happens as a consequence of too much spending relative to the productive capacity of the economy. We shall take this up in more detail another week.
Second, if a business, an individual, or a government has borrowed beyond its means, additional lending comes at an ever-increasing price. The price of loanable funds is interest. Deadbeat debtors pay loan-shark lending rates.
Finally, when a national government is a deadbeat debtor, the currency that debtor creates becomes suspect. As such, international investors demand a deep discount in the country’s currency to be lured into lending a portion of their loanable loot. In other words, distressed debtors suffer currency declines.
With this background, let us examine the three measures of inflation, interest rates, and currency movements for the U.S. to see whether Uncle Sam fits the suit of a feckless financial rogue.
Inflation for the past year has been about one percent, half of what the Fed has targeted, and perhaps a quarter of what many macroeconomists would prefer. Interest rates, 10-year borrowing costs for the U.S. government, have fallen to 1.85 percent even at a time when the Fed is raising short-term rates. Further, the dollar has soared roughly 20 percent in the past few years against the common basket of major world trading partners.
These three facts make it impossible to accept the fabrication that the rise in the U.S. debt and the rise in foreign ownership have been a result of wanton and wasteful spending. Another story must underlie these twin facts.
As these are actually two stories, we will explain the rise in foreign ownership of U.S. debt today, and leave the rise in the debt itself for a rainy day.
International currency values are highly important in determining a nation’s competitiveness in world trade. For example, if the euro moves from 95 U.S. cents to 145 U.S. cents (as it once did), the cost, in the U.S., of a German BMW theoretically rises from, say, $45,000 to nearly $69,000. I say “theoretically” since, in practice, BMW tries to absorb much of the cost of the rising currency itself to maintain market share. But the company is not happy about it. Ascending currencies are the enemy of exporters.
A nation can usually hold down the value of its own money by selling large quantities of its currency in the foreign exchange market, in exchange for a target currency such as the dollar. During the period from 2000 to 2007, China did just that. They desired a competitive advantage in the exportation of their manufactured products. So China sold yuan to keep its currency cheap and accumulated a large dowry of dollars.
Chinese-held dollars were then invested in U.S. Treasury debt. Much of the rise in foreign ownership of U.S. debt from 2000 to 2007 can be traced to China’s currency manipulations.
During the next period, namely 2008 to the present, the rise of foreign holdings of U.S. debt includes an additional big player, and an additional motive with other players. The additional big player has been Japan.
Japan has suffered secular stagnation for a quarter of a century. When Shinzo Abe came into office, he promised progress against deflation. His first line of attack was his country’s currency, the yen. He engineered a drop from 1.3 to around 0.8 cents per yen, a huge percentage decline. He did this in the tried-and-true fashion: sell yen for dollars and park the dollars in U.S. Treasury debt.
During the period from 2008 to 2015, while China’s holding of U.S. debt doubled (again), Japan’s holdings more than tripled. Much of the rise in foreign ownership of U.S. debt can be explained by these two nations.
We mentioned another motive which explains nearly all of the rest of the rise. No country’s economy matches the size of the U.S. economy. All other countries are smaller. As such, prudent management dictates that nations hold foreign-exchange reserves.
When Ireland, then Portugal, then Spain, and let us not forget Greece, all suffered financial meltdowns, the euro was at the heart of each problem. In reaction, many central banks around the world shifted out of the euro and into the dollar as their reserve currency of choice. As they have moved into dollars, they have invested those dollars in treasuries.
This explains both why the dollar has strengthened, as well as why foreign holdings of U.S. debt has risen.
We have yet to tackle why the U.S. debt level has risen as much. The rainy day will come next week. In the meantime, I’ll be practicing my woodwinds.
(Marcus Hutchins is a former economist, treasury bond arbitrage trader, and hedge fund manager. He retired to Southport in 1997, where he resides with his wife, Andrea, and youngest daughter, Abbey. He welcomes feedback at coastaleconomist@me.com.)
