Now let’s consider the U.S. position. The current account deficit in 2006 was $856.7 billion, 8.2 percent higher than the year before and 5.8 percent of GDP. This deficit means we effectively borrowed $856.7 billion from non-U.S. parties (who are outside the tax realm of the U.S. government).
They were content to take our promissory notes in the form of long-term U.S. securities such as stocks, corporate bonds, U.S. Treasuries, and Agency paper. Every month we watch the Treasury report on these flows with bated breath. In December, the inflow was a hideously low $14.3 billion (revised), but in January, it came back at a whopping $97.4 billion. December and January together are sufficient to offset the trade deficit, and on we go.
It’s a good deal for the U.S. We get “stuff” and they get promissory notes. But something else is starting to happen. Americans are starting to buy foreign securities, too. In the fourth quarter of 2006, U.S. investment in foreign securities was a record $115.7 billion, more than double the Q3 level of $54.4 billion.
Of that, foreign stocks were the main component — $60.2 billion from $10.3 billion in Q3 — with U.S. buying of foreign bonds up to $55.5 billion from $44.1 billion. Remember all those brokerage ads on TV about optimizing your portfolio and reducing risk with diversification? Well, the American public listened, and they are buying foreign paper — and you can’t put that genie back in the bottle, either.
International trade is not really financed by long-term capital flows to securities. Trade is financed by banks and exporters. But their willingness to extend credit to importers is in part based on confidence that they will be paid and the payment will be in a stable currency so it doesn’t lose a lot of value between the time an export good is priced and the time payment is actually received, say 90 days. Another rung in that ladder is the willingness of the foreign government to buy from the exporter all the dollars it earns. This is how Japan acquired its own stash of dollars (almost $1 trillion), second only to China.
We usually dismiss scare stories about foreigners suddenly deciding to dump dollar investments, including reserves, in favor of euro-denominated paper or other currencies. The world’s reserve currency is always the currency of the military superpower of its day — Venice, Spain, Britain. But the dollar can remain the world’s reserve currency and yet be held in lesser amounts than before, if only because technology allows near-instantaneous switching from security to security and currency to currency. Global liquidity is stupendous.
Governments in places such as Japan, Taiwan, and South Korea are not going to be quick to diversify out of dollars. They are unequal allies, depending on the U.S. for defense. Even Europe depends on the U.S. for defense. However, some large countries, while technically under the U.S. defense umbrella, are not actually at risk (e.g., nobody is threatening to invade Brazil).
The status quo will remain in place for some time to come, if only because of back-door diplomacy and the community of self-interest. As Chinese officials themselves say, they do not want to destabilize the global financial markets. It’s not in China’s best interest for the dollar to devalue dramatically, for example.
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