Balancing act

It’s not hard to imagine a tipping point, though, when private investors balk at the vast U.S. external debt. Every major economist (including ex-Fed Chairman Alan Greenspan) expects that at some point, foreigners will have as much U.S. debt as they really want to hold. And it’s private investors who are now providing most of the incoming capital flow. In January, it was $102.7 billion (from a mere $24 billion in December). Official purchases of U.S. securities were a measly $12.3 billion in January (from $24.9 billion in December).

The U.S. buys more from abroad than it can sell abroad, creating the deficit. The U.S. government spends more than it can get back in taxes for a score of years — longer, unless the Iraq war ends soon and somebody comes up with a clever solution to the demographic time bomb of 75 million baby boomers all retiring and expecting Social Security checks over the next three to eight years.

So, the U.S. government already has a cumulative debt to foreigners of about $6 trillion, and presumably intends to add the cost of the baby boomer retirement to that. If the dollar is not the store of value it once was — and commodities are taking its place, at least to some extent — there are only two solutions.

The first is massive dollar devaluation, which of course quickens the stampede of private investors away from U.S. investments. No amount of variety, liquidity, and legal safety — the usual reasons why dollar investments are the gold standard — can overcome a crashing currency.

The second is to put the economy on a sounder footing, which means raising taxes, balancing the government budgets, and raising interest rates until they become overwhelmingly attractive to foreigners. Vastly higher rates would also cause a restructuring of private credit, from consumer spending and housing to business spending on productivity improvements. Recession would be inevitable.

The refusal of foreigners to hold dollars has another consequence: As the dollars come right back to the U.S. in the form of cash, money supply rises by definition. Unless the Federal Reserve finds a way to neutralize it, inflation ensues. Other governments (including China’s) neutralize excess money supply growth by issuing domestic bonds and pretty much forcing domestic financial institutions to buy them.

By raising reserve requirements, the central bank ensures that money doesn’t leak back out into the economy and feed inflation through the multiplier effect. Neutralization is only ever partly successful, though. And inflation is always and everywhere a monetary phenomenon.