Should Americans Worry That Foreigners Hold Lots of Dollar Assets?

by Don Boudreaux on November 30, 2007

in Balance of Payments, Trade

I don’t worry about foreigners holding lots of dollars and dollar-denominated assets.  I explain why here.  And below is a clip:

Might Beijing’s motive for acquiring large holdings of dollar assets be the sinister one of eventually dumping these assets simply to disrupt American economic growth? It’s possible. But if so, the American economy enjoyed huge benefits to offset any problems springing from the later disruption.

During the time that the government in Beijing was accumulating dollar assets — accumulating these assets by paying for them prices higher than they are really worth – Beijing transferred wealth to Americans.

To see why, suppose that an evil businessman seeks to disrupt the economic future of innocent Ms. Jones. This businessman reasons that if Ms. Jones unexpectedly is fired from her job, she will suffer.  And she will suffer even more grievously if any new job that she finds pays her less than the job she lost. So Evil Businessman hires Ms. Jones at a salary well above her true market value. For several years Evil Businessman keeps paying Ms. Jones a salary much higher than she would command on a market not poisoned by the uneconomic motive of Evil Businessman.

And then one day, suddenly and unexpectedly, bam! Evil Businessman fires Ms. Jones, who then discovers that the best new job that she can get pays her an annual salary that is $100,000 less than she “earned” while employed by Evil Businessman.

Without doubting the disappointment and inconvenience Ms. Jones suffers when she is suddenly fired, we can nevertheless doubt that Evil Businessman really hurt Ms. Jones on net. During all the time that he employed her she earned more than she would otherwise have earned. And during this same time, Evil Businessman was paying the price for the later privilege of disrupting Ms. Jones’ economic life by firing her.

Rather than “Evil Businessman,” he really should be called “Stupid Businessman” — and the U.S., like Ms. Jones, should count its blessings if it’s really true that Beijing or any other wealthy entity consistently overpaid for American assets.

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Dale November 30, 2007 at 8:43 am

Yes, but did Ms. Jones take the premium she earned in and invest in quality equities or did she spend it all and then some while running up large credit card balances?

If companies and individuals invested and otherwise utilized their earlier wealth wisely, then the blow after Evil Businessman pounces is softened. But if this kind of forethought (save and invest for a rainy day) wasn't used…

Unfortunately, all the stats you see out there today is that it doesn't seem to be an issue of poor earnings by Americans. It seems we have a problem with overspending and undersaving.

That said, I don't buy into the "Evil China" conspiracy either because it doesn't align with their incentives to "punish" America.

John Dewey November 30, 2007 at 9:15 am

Dale,

Regardless of the consumption or investment choices Ms. Jones made, she was still far better off for all of those years she was overpaid.

Regardless of the consumption or investment choices made by Americans the past decade, they were still far better off for all those years they underpaid for imported goods. They were still far better off when Asian foreign overpaid for U.S. financial assets.

Dale November 30, 2007 at 9:46 am

John, I agree with what you are saying and I picked up on that theme when I read Don's post. I'm just saying that a lot of that wealth enjoyed by "Ms. Jones" has been squandered due to over-consumption by many, many individual Americans. Therefore, if Evil Businessman all of sudden put the economic hammer to the U.S., the cushion provided by a personal rainy day fund isn't available for a lot of the Ms. Joneses. I agree that up UNTIL the present, America has benefitted, but that won't be much comfort to those who haven't buried a few acorns for the winter if it comes.

John Dewey November 30, 2007 at 10:02 am

Dale,

I understand and I agree. What will really chap my backside will be the government taking some of my acorns to "comfort" those who partied night and day the past 6 years.

Chris November 30, 2007 at 10:10 am

Don, the article says:

In other words, any large sell-off of dollar assets would be much more the result of the dollar losing its value than the cause of the dollar losing its value.

Isn't there a risk that there'll be a snowball effect? The dollar drops some, foreigners sell off some dollar-denominated assets which drops the value of the dollar even more, which pushed more foreigners to sell, and so on….

kebko November 30, 2007 at 10:46 am

I don't find this very comforting. One of the problems of applying economics is that people's expectations change with their situation, so that people's moral standards reflect their best current position, and they find it much harder to adjust backwards than forwards. I mean, wasn't this one of the main problems leading to the Great Depression? Labor supply is sticky. What's the difference between an ill-advised tariff & a market adjustment in foreign-owned assets if they both lead to a sharp decline in gains from trade. It seems like they will both lead to social unrest and economic downturn.

I agree with many of the values espoused here, but this doesn't seem like an optimistic post to me.

John Dewey November 30, 2007 at 10:47 am

Chris,

That makes sense, but what does it really mean? In order for there to be a large sell-off, doesn't there have to be an equally large buy-in? At some point in the dollar decline, some investors will decide it has reached a bottom and begin to buy. At some point in the dollar decline, foreigners will start to buy more American goods and start to travel to the U.S. Snowballs don't roll forever, do they?

Randy November 30, 2007 at 10:53 am

Yes, the situation could change due to the hostile actions of a foreign power and we would be worse off because of it. But in that event we'll have bigger problems than more expensive toys and gadgets – like we'll probably be at war with the hostile power.

But the bottom line as far as I can tell is that this whole issue is just back door propoganda from the unions. They're the only loser from foreign competition – and they're loss is from the power position which they exercised over consumers for decades prior to the advent of foreign competition.

John Dewey November 30, 2007 at 10:59 am

Kebko,

First, why should we believe it will be a sharp decline? Why not just a gradual decline?

Second, if we are still gaining from trade, but gaining less than before, why would that lead to "social unrest and economic downturn"? What really happens when the dollar changes value? Our imports cost us a little more and our exports cost foreigners a little less. Those who buy imports will change their consumption patterns. Those who produce goods for export may hire a few more workers. Yeah, there will be gainers and losers. but the term "social unrest" just seems a little too strong.

Nathan Bowers November 30, 2007 at 12:40 pm

Even if China somehow wanted to "punish" us economically it would hurt them much more than it would hurt us. What's their upside in buying American assets and then trying to devalue those assets? Why would they want us to be unable to afford what they churn out in factories?

I think worrying about this kind of stuff is just another example of anti-foreign bias.

Jeff H. November 30, 2007 at 1:12 pm

Is the analogy really that Evil Businessman pays more than market value for Ms. Jones and then fires her, whereupon she can only earn her true market value?

Isn't the argument something more akin to Evil Businessman paying fair market value for Ms. Jones, but then firing her in such a dramatic display that no other employer finds confidence in her?

This is not to say the argument is necessarily valid. But it's a lot more like the argument I hear made, at least.

kebko November 30, 2007 at 1:15 pm

John,
Maybe my comment was a little strong, but my point is that people aren't going to react like we'd hope they would. We all know how deep the capacity for poorly conceived responses runs. The oil market is a good example of a very free & liquid market which is highly dependent on centrally controlled foreign actors. The market in oil is a bit nuts as a result, and lots of nutty plans to "fix it" are discussed & hatched that generally make us all worse off. I imagine nonsense like "energy independence" in a wider context like trade with China, and I can imagine a domino effect of market corrections and bad government responses to them.

I guess it just seems to me that it misses the point to explain how a rational world would deal with the market in dollars. The point is how is the irrational world going to deal with it, and this post doesn't give me any hope that the world will deal with it well.

mcwop November 30, 2007 at 1:25 pm

Why do people ignore the large amounts of foreign stocks, and debt owned by the U.S.? How about the foreign profits of our multinationals (e.g. GE)?

Why would one even expect there to be only "one" currency? There will be more developed economies than ever, and a larger choice in currencies. With increased trade, the world markets will just need to figure it all out, and I expect that to take time. The US Dollar may at some point not be the one and only reserve currency. If that happens, I do not expect the sky to fall. Many other countries seem to exist just fine where their currencies are not the top reserve choice, and they also live with high foreign ownership.

If it scares you then hedge.

Dave November 30, 2007 at 2:08 pm

This sounds like a case of "ignoring sunk benefits." We shouldn't embrace a potential problem just because we have benefited in the past.

It is similar to saying, "I found a $100 bill on the street yesterday, so I shouldn't care about losing a $20 bill today." Two days ago, I'd be happy to find $100 and then lose $20. But given that I already found the $100 bill, if I lose some money later today, I will be worse off.

John Dewey November 30, 2007 at 3:30 pm

Dave: "This sounds like a case of ignoring sunk benefits."

What does that mean? American consumers are receiving ongoing benefits from low prices for Chinese goods. They are receiving ongoing benefits from low interest rates because foreign governments are buying U.S. government debt.

Dave: "We shouldn't embrace a potential problem just because we have benefited in the past."

Who is embracing any problem at all? American consumers are just buying goods at low prices. Someday those prices may increase and American consumers will stop buying as many foreign goods. Where is the problem that anyone is embracing? Sorry that I don't understand. Can you explain the problem?

John Dewey November 30, 2007 at 3:39 pm

kebko: "The market in oil is a bit nuts as a result"

How is the market for petroleum nuts? It seems to respond very well to changes in supply and demand. Granted, the demand is probably inelastic in the short run. But not in the long run. Inelastic short run demand seems to represent perfectly rational behavior to me.

Despite all the claims about oil production peaking, the supply of petroleum made available to refiners has increased as increased demand pushed equilibrium prices higher.

What is nuts about the market for petroleum?

vidyohs November 30, 2007 at 4:32 pm

Yes, but did Ms. Jones take the premium she earned in and invest in quality equities or did she spend it all and then some while running up large credit card balances?
Posted by: Dale | Nov 30, 2007 8:43:55 AM

Talk about immediately running off the reservation! As a response to Don's post, this is an amazing comment! Much to clever by half.

And totally pointless. The assumption that Mrs. Jones could/would/should run up large credit card balances in Don's scenario is Dale's and serves no purpose to confirm or deny the fact that Mrs. Jones, in Don's scenario, was better off for having been "punished" by evil businessman.

Greg November 30, 2007 at 4:33 pm

Now as the $ is cheap (and might get cheaper), US companies gets cheaper.

Some would see this as a negative thing that foreigners will buy more US stocks and own more the US assets. Others would see it as a great thing, global trading, preventing conflicts.

However, if I was in China's shoes, I would use most of those US bonds to buy up US assets and other assets traded in US$.

Chris November 30, 2007 at 5:00 pm

John Dewey –

Well, I agree that there has to be a bottom to it. And, I also agree that at some point, foreigners will be willing to jump through all of our post-9/11 hoops to get bargains on tourism.

However, I don't think that the US gained all that much by why you call "buy-in." A tremendous amount of that money was just wasted.

In the end, our economy will be hurt not by decisions that the Chinese made, but by the cumulative effect of the poor decisions our Congress has made over the last 40 years.

andy November 30, 2007 at 5:16 pm

I have looked at the discussion with Peter Shiff on Fox business news….do you know what's odd? Every single thing is bad – high inventories, falling home prices, credit problems…and it is not a problem. What would have to happen so that you would call it a problem?? Unemployment? Unemployment is caused by inflexibility of the labour market. You CAN have inflationary recession with full employment!!! I have not seen the data for 1836 deflationary recession, but I would bet there was pretty low unemployment during that time.

Anyway, look at it (it's the newest one on the europac.net pages) – Schiff addresses exactly the problem of selling the assets. It seems to me that because of certain US policy the citizens had huge incentives to get indebted and sell their assets to the foreigners.

Do you find government regulation that creates such incentives a good idea? If not – how could you consider the result of such policy – selling assets to foreigners – good?

kurt November 30, 2007 at 5:28 pm

Can anyone explain why the UK added $200 billion of treasury notes in just one year? http://www.treasury.gov/tic/mfh.txt

John Dewey November 30, 2007 at 5:45 pm

Andy,

U.S. citizens own something like $60 trillion in assets. That number increases almost every year – I think 2001 was the exception. It's not a case of U.S. citizens giving up their part of the pie. The U.S. asset pie is growing and growing.

Many assets in the U.S. owned by foreigners were created by foreign investment. The $2 billion BMW plant in Greer, SC, is one example. The $3.7 billion steel mill to be built by ThyssenKrupp in Alabama is another. When foreign companies make these sort of investments, it's very good for the U.S. economy and the U.S. citizens.

U.S. retirees liquidate their investments made during earning years. If foreign investors rather than U.S. investors choose to purchase some of those investments, does it make any difference to anyone?

I do not see anything wrong with foreigners owning assets in the U.S. or owning assets anywhere that formerly belonged to U.S. citizens.

pauld November 30, 2007 at 5:49 pm

I think the point of the analogy is that hoarding dollars is not a good long-term strategy for hurting the US.
I think there is an even better analogy. Let's say I am an extremely rich person such as Warren Buffet, who wants to teach Bill Gates a lesson. So I slowly buy Microsoft stock over a period of years, causing its price to be above what the market would otherwise be. Then all at once, I sell all of my stock to cause Microsoft stock to plummet. Boy, that will really stick it to Bill Gates, won't it?

andy November 30, 2007 at 6:05 pm

John, you still assume that this happened on a free market based on reasonably good price information. It did not.

My argument is: the US government made incentives for the people to get indebted and then sell assets to the foreigners.

The real analogy would be:
You own a company. Bill Gates gives you a loan with interest rate at 1%. Behind scene, Bill Gates manipulates the prices of your costs, which causes you to incur losses. You have to sell your company to Bill Gates.

Do you think there is no problem in Bill Gates owning your company now? I am not referring to Bill Gates losing a lot of money on this operation. I am referring to YOUR situation. Do you think there is no problem?

John Dewey November 30, 2007 at 6:53 pm

Andy,

I don't have time to spend speculating about your hypothetical.

I thought you asked if U.S. citizens selling assets to foreigners was good. I say I don't care. It's neither good nor bad.

I agree that the Federal Reserve kept interest rates below historical levels for much too long. But the federal government didn't put a gun to anyone's head and force them to borrow more than they could afford. The federal government didn't force lenders to ignore the creditworthiness of loan applicants. The federal government didn't force investors in mortgage securities to ignore the risks in their investment.

Are you blaming the federal government for the stupidity of consumers, lenders, and investors?

andy November 30, 2007 at 7:10 pm

John – first I force you to use my money. Then I manipulate this money (at your expense of course), thus I create a big incentive for you to get indebted.

Then I blame you as irresponsible for not resisting long enough my incentives while taxing you for your resistance.

Of course it is consumer irresponsibility! Responsible consumer would definitely spend 2 years studying monetary policy trying to find out which price did the government distort this time, so that he could avoid irresponsible decision based on market prices.

It is the same as saying that the government is not responsible for shortages when it introduces price ceilings. Nobody forced the consumers to buy excess amount of product and the producers to cut production. The shortages are purely irresponsibility of consumers and producers.

Mesa Econoguy November 30, 2007 at 8:01 pm

I think this a fairly ludicrous argument, but I’ll bite: US investors own large amounts of foreign interests and vice versa. This is truly a global economy, and there is nothing wrong with net foreign investment in this country, due to weakening currency, stability of debt issuance, or otherwise. [Obviously there are various national security interests involved, but most of those can be avoided via third party intermediaries.]

Look at Great Britain – the British Pound is still one of the most “powerful” [high-value] currencies in the world, and their economy is less than 20% the size of ours.

This is nearly the same amateurish argument as “we’re now net consumers, instead of producers” [wrong], and “the trade deficit is too big, and we don’t build anything anymore here” [also wrong, not a deficit, yada yada yada].

andy November 30, 2007 at 8:39 pm

Don…I think I see the fallacy in your reasoning.

People mostly avoid doing stupid voluntary transactions. Thus, on free market the overwhelming majority of transaction will not fall into category "totally stupid decision". But you seem to imply that because some transaction was done voluntarily, it is not stupid. I think that is non-sequitur.

Given the growth of the monetary aggregates it is plausible to assume that the information conveyed in prices is biased. Thus, people may tend to enact voluntarily more stupid transactions then you would expect. Actually, if you look into the mortgage crises a lot of people DID act this way: they expected rising home prices, low interest rates and low inflation. Today there are lower home prices, higher interest rates and higher inflation.

I don't see how one could endorse obviously bad decision as good just because it is voluntary. Yes, people tend to avoid bad decisions when they act on the free market, but from that does not follow that this one particular transaction is good. Or a group of transaction however large that group of transactions is.

pauld November 30, 2007 at 10:07 pm

I am not aware that any economists who has asserted that because a transaction was done voluntarily, it is not a stupid transaction. Of course such an assertion is a non-sequitor.
I think it would be fair to say that in a free market, people who engage in stupid transactions bear the costs of their stupidity. This tends to be a strong, although not perfect, disincentive to doing stupid things with money.

Mesa Econoguy November 30, 2007 at 10:32 pm

Correct, pauld. This leads to economically rational behavior, hence the tautology.

G December 1, 2007 at 12:56 am

I think lending money is a bit different. In my opinion, there are externalities present in fractional reserve lending that create incentives for banks to lend when the Fed creates more credit. The bank does not bear the full costs of a bad loan, because the reduction in the money supply which results from a loan defaulting effects the lending industry as a whole. So it is advantageous for each individual bank to lend out money as interest rates drop, even if this action harms the entire lending industry.

Also, the presence of excessive liquidity makes these seemingly stupid lending decisions seem less so. Liquidity enables flipping, and bad mortgages can be flipped at a profit in the same way a home or dot-com stock could be. So the behavior is only stupid for those who get stuck with the worthless property after the music stops (which of course, is very hard to predict).

ben December 1, 2007 at 3:51 am

I don't buy the story that foreign-held securities pose a risk for the US, but I think this example is incomplete: the story hinges on the size of the premium China pays, but

a) it is not clear China has paid any premium, and

b) even without a premium the US is still almost certainly better off with China's investment than without.

If China has paid a premium, its gravy for the US (great), but this isn't a general reason to borrow from foreigners.

Mesa Econoguy December 1, 2007 at 9:43 am

No, that is a fundamental misunderstanding of economics, financial markets.

China has paid a premium in the form of lower yields, which lowers overall cost of borrowing (depressing effect on long end of yield curve), which frees up that money for other “more useful” purposes.

You can argue that it encourages bad government spending habits (which have always been bad), but there has been a clear benefit to US economic participants in the form of lower interest rates.

Gary Rogers December 1, 2007 at 10:34 am

Is there anything sinister in foreighn-held securities? No, they were earned in trade and it was considered a better investment to buy securities (loan us back the money) than to buy U.S. goods, services or assets with the dollars taken in trade.

Will countries dump their dollars to punish the United States? No, because it would hurt them more than us. We already received the benefit of the trade in the original transaction.

Will selling dollar securities hurt us? Only if it happens all at once. Selling dollar securities means the dollars must purchase something and that will most likely be U.S. products services or assets. Buying U.S. products and services helps our exports. Selling our assets hurts, but that is the deal we made.

Why might there be a mass sell-off of dollar denominated securities? There are two primary things that make dollar denominated securities valuable. First, the dollar has historically been a very stable currency that holds its value. Second, there is confidence that these securities are redeemable. If confidence in either is lost the value drops quickly, as we have seen with mortgage securities. The big risk is a sell-off that feeds on itself.

Am I worried about a mass sell-off of dollar securities? Absolutely! The dollar has been falling steadily since August, shaking the confidence that the historically stable dollar will continue to hold its value. At the same time, the sub-prime situation is making it clear that we are borrowing to the limit and have shown no signs of stopping. The consequences of losing confidence in the dollar are many times worse than a resession. Confidence must be built over time but can be lost in an instant, and once lost is not easily regained. I appreciate the Fed's desire to keep the economy humming by lowering interest rates, but right now it is more important to maintain a stable dollar. I think that cutting interest rates right now is a very dangerous move.

What caused the problem? Years of deficit spending that made it more attractive for foreign entities to loan us back dollars than to use them to buy U.S. goods and services. We do not need to pay back all of our debt right now, but we are reaching a point where we need to prove to the world that we are not going continue borrowing forever. Unfortunately this comes at a time when the baby boom generation is reaching retirement, we are winding down an expensive war and we have spent our reserves.

Barkley Rosser December 1, 2007 at 11:56 pm

To follow up on Gary Rogers, much of the discussion here has been off base because it is ignoring some rather basic facts. Don B. is perfectly right that the Chinese do not want the dollar collapsing and are willing to pay a premium in lower returns to buy up various US assets to prop it up so that they can continues to sell us and the Europeans stuff so that they do not get riots in the streets from their unemployed.

The problem is that the long-running decline of the dollar is getting out of hand. The worst sign of this is the tidbit posted by Brad Setser, the sudden stop of private foreign direct investment flowing into the US. That means that it is now much harder for the Chinese central bank to prop the dollar. It is not that they are going to dump the dollar to punish us. It may be that they will lose the ability to keep propping it up.

andy December 2, 2007 at 7:58 am

I am not arguing that there is something bad per-se on foreigners buing US assets. What I am arguing is that because of lower interest rates the consumers were motivated to get indebted which eventually leads to them losing the assets.

If an indebted person sells his assets to get out of debt – no there is nothing bad in that. The person shouldn't have got indebted in the first place, he wouldn't have to sell his assets and he would be much wealthier. That does not mean that for the borrowed money he didn't buy a lot of consumer goods….but it says he won't be able to buy more consumer goods in the future.

Will countries dump their dollars to punish the United States? No, because it would hurt them more than us. We already received the benefit of the trade in the original transaction.

This is nonsense. What makes the dollar worth? The possibility to BUY something for the dollar. What you say is, that they will not try to dump the dollars (= buy something for the dollars), because they would not be able to buy what the dollar is worth. That actually means that the dollar is worth not what the market currently thinks it is worth and they should try to buy at least something for it before it gets realized by 'the markets'.

Gary Rogers December 2, 2007 at 12:11 pm

Andy:

I probably did not explain my thoughts very well, and maybe missed something myself. I use these blogs as an opportunity to try out ideas and sometimes find that when I put them in words there are flaws in my logic. If this were easy to understand we would not have so many smart people in disagreement.

You are correct that a dollar is worth what it can buy. However, when you hold dollars you do it based on the expected future value of the dollar and the interest rate that can be earned on the money. Right now China is holding about 1.5 trillion dollars in their reserve accounts. If they decide that the dollar is going to continue to fall and they are not earning enough interest to make up for this risk, they are going to sell. Unless someone else is willing to hold these dollars in accounts they will be actively buying goods and services. Normally this is not a problem, but when talking trillions it can have a serious effect on the value of the dollar.

When I suggested that a sell off can feed on itself, consider that Japan has another trillion dollars in their accounts. When they see the dollar falling at a faster rate as a result of China's selloff, they too begin to sell. This would also be true for the countries in the Middle East. Nobody wants to see the dollar collapse, but those that sell early sell at a higher price. We have seen this recently with the Mexican Peso, the Russian Ruble and the Thai Bhat. It follows basic monetary theory only the dollar is no longer controlled by the Federal Reserve through the central banks. The money held in overseas accounts now eclipses the old M1 and M2 indexes that we used to track. We can still control this through interest rates, though, and for the short term must make sure that a mass sell off does not start. We will also have help from foreign countries that recognize the danger of a collapse. We also need to start balancing our budget.

The good news is that for anyone who has something to sell there are lots of dollars looking for something to buy. This is good news for exporters.

andy December 2, 2007 at 12:42 pm

Gary, I am not entirely sure whether long-term dumping of US dollar would be less dangerous then short-term one. I tend to think that long-term dollar decline is impossible on free market.

However, when you hold dollars you do it based on the expected future value of the dollar and the interest rate that can be earned on the money. Right now China is holding about 1.5 trillion dollars in their reserve accounts.

This works for individual consumer. It does not apply to government officials. Because they don't care how much money they lose, they may as well hold it just because they believe in some stupid monetary theory. In this case, that having fixed exchange rate with US dollar is somehow better then floating exchange rate.

If you consider all players on the market as owners of the assets, such thing is impossible. You will not persuade private individuals that although long-term they will lose while holding dollar, they really should not sell it now. Why should they?

The money held in overseas accounts now eclipses the old M1 and M2 indexes that we used to track. We can still control this through interest rates, though, and for the short term must make sure that a mass sell off does not start.

I am not sure about this…how would it work? I *guess* it is this idea: Government issues bond, receives 100, is expected to pay 102 in a year. The Fed buys the bond and sells it to China to obtain the dollars for 90. You may have postponed the problem, but you have printed 10 in the meantime which worsens the problem in the long run.

Alternatively the government issues bonds directly with high interest rate which causes higher taxes in the future, which might solve one problem and cause another?

I might have missed something, but how exactly should the higher interest mechanism save the dollar?

The good news is that for anyone who has something to sell there are lots of dollars looking for something to buy. This is good news for exporters.

That is great news for exporters and bad news for ordinary citizens. The industries that used to produce for domestic market will produce for export. Imports will diminsh. The domestic consumers obtains less product.

Gary Rogers December 2, 2007 at 7:36 pm

Andy:

I think we are close to agreement on most of this.

1. I give governments more credit than you in expecting them to act rationally. However, governments often do behave otherwise and that could certainly change the answer to the original question.

2. I think we are saying the same thing about interest rates. We would have to increase interest rates (or at least not drop them any more) to maintain the value of the dollar and this means more of our taxes go to paying interest on our debt. With a debt of somewhere over nine trillion dollars this is nothing to trifle with. On the other hand, a dollar collapse means hyperinflation followed by even higher interest rates. We want to keep interest rates as low as possible without creating a sell off and that is a difficult balancing act.

3. I think you summed things up very well in your last paragraph. Great news for exporters is not good for ordinary citizens. If you have ever seen anyone go over their head in debt, you will see that going into debt is pleasant while paying it back is painful. I am talking about the pain here.

4. Your earlier comments mention the government creating incentives that encourage people to go into debt. I agree with that and would add that the government debt itself is the primary thing that put us in this situation. The problem is that we are where we are and need to make the best of the situation. The best case scenario is that we do not go too far in trying to lower interest rates to stave off a potential recession and we start paying off some of our debt. The less debt, the more options we have.

Slocum December 3, 2007 at 7:49 am

But Ms. Jones's 'market value' is not fixed quantity — did Evil Businessman pay Ms. Jones a large salary for doing something that required little or no skill? And did he do it long enough that Ms. Jones didn't bother with upgrading her skills for decades while she was going grey? And did she find herself without a job at a point in her career where the retraining needed to realize her 'true' market potential would be difficult or impossible?

This isn't even hypothetical — think unskilled unemployed ex-assembly line workers from Big 3 auto plants.

Now comparing whole economies to single workers is problematic anyway, but there are problems with the analogy. And to an extent, my objections apply to economies as well as individuals–some productive capabilities, once lost, are very difficult to recreate. It would be relatively easy to recreate a domestic textile industry if it became cost-competitive to produce textiles here again. But it would be extremely difficult to recreate a Caterpillar or Boeing.

John Dewey December 3, 2007 at 8:59 am

slocum: "some productive capabilities, once lost, are very difficult to recreate …. it would be extremely difficult to recreate a Caterpillar or Boeing."

Why do you think it would be difficult? It recently took Kubota less than one year to build a tractor implement plant in Gainesville, GA. That plant will augment the small tractor and mower factory Kubota built in Georgia in 1988.

I don't think Komatsu had any trouble opening the five equipment plants it operates in the U.S. Komatsu's U.S. plants produce 60% of the equipment and vehicles it sells here. Komatsu's Rolling Meadows, IL, plant is currently exporting mining vehicles to China.

Frederick Davies December 3, 2007 at 5:15 pm

I believe there is a confusion on motives here: Evil Businessman is not trying to harm Ms Jones in an economic way, but in a political one; harming her self-belief and confidence. China is not going to do long-term economic harm to the US by suddenly dumping all her dollar reserves (as pointed out in the example, whatever economic damage the dumping does can be seen to have been offset by all the previous benefits), it is going to do political damage. Imagine a US President is about to recognise Taiwan as an independent state; if China threatens to dump all her US dollar reserves to engineer an economic crisis in the US, it will put that President in a very uncomfortable situation: if he goes ahead, he will have to explain to the US public why their dollars are not worth as much, making them all suddenly poorer. He could try to reason with the public about the fact that they are not really poorer, since whatever pain they are suffering now should have been compensated by the good times they had earlier; but as Bryan Caplan explained in "The Myth of the Rational Voter", thinking the voters are going to behave rationally in economic matters is a bit of a stretch. China is not playing an economic game here: this is political through-and-through; and from a political point of view, China's US dollar reserves are inherently undesirable.

Slocum December 3, 2007 at 6:23 pm

Why do you think it would be difficult? It recently took Kubota less than one year to build a tractor implement plant in Gainesville, GA.

Yes, well obviously it's not difficult for an existing company to build another plant. But it's difficult to recreate a company like Caterpillar or Boeing once they've disappeared (or, say, exited the commercial airliner industry). The barriers to entry in some markets can be prohibitively high.

cpurick December 6, 2007 at 8:53 am

Don,

I'm inclined to agree with your rationale, but principle forces me to ask if you've applied this test to your thinking (since we apply it to the other side's arguments all the time):
Have you considered that the people who benefit from the trade deficit now are not the same people who will be imposed on by the upcoming surplus? To the extent that a worker enters the labor market (or is born) after the trade deficit, and lives more poorly without realizing the benefits we've been enjoying, is there an externality?

John Dewey December 6, 2007 at 9:05 am

cpurick,

Why would a worker live more poorly?

cpurick December 6, 2007 at 10:34 am

The theory is that a prolonged period of shipping dollars overseas in exchange for cheap goods has left overseas parties with a lot of cash for buying American goods. Going forward, American consumers will have to compete with foreigners who have many dollars. This will manifest itself in the form of increasing American exports, but what it also means is that we consume less than we produce as we share the fruit of our labor with people who have been accumulating our dollars for years.

It will result in a declining living standard, and presumably some of the people who will live less well as a result were not among those who benefitted from the original cheap goods.

John Dewey December 6, 2007 at 3:08 pm

cpurick,

Let me see if I understand this theory. Because foreigners rather than Americans bought U.S. government securities, future Americans will have more competition for goods. Is that right?

So what would have happened to those future Americans if Americans had purchased the U.S. government government securities? Wouldn't those future Americans still have many dollars chasing the same amount of American output? Wouldn't American consumers face exactly the same decline in standard of living?

I may not understand this perfectly, but it just seems like the problem isn't that China buys our debt. Rather, it's that U.S. voters, through their representatives, have made a claim on the income of those future Americans.

cpurick December 6, 2007 at 6:09 pm

No, it's not a debt thing; it's a trade deficit thing. Because we've been buying foreign goods (imports) and exporting very little in return, there is an abundance of dollars in foreign hands. Those dollars are worth the most here, particularly now, and that's why US exports are climbing.

The effect is such that we've been living beyond our means at China's expense, and now everytime you go to buy something anywhere in the world (including here) you'll have a bidding war with someone from another country who also has dollars.

If you took advantage of the situation when we were importing, then this is just turnabout. But my question pertains to people who never benefitted from that, but who will now work to create exports, and who will now have to shop more carefully because American dollars are so plentiful everywhere.

John Dewey December 7, 2007 at 5:37 am

cpurick,

It is exactly a debt thing. It is U.S. government debt that foreigners are holding that bothers you so much.

If foreigners gain dollars through trade, they can use those dollars:

- to buy U.S. goods;
- to invest in the U.S. through direct investment (building plants);
- to invest in the U.S. through U.S. equities;
- or to exchange for native currency with their central banks which then buy U.S. debt.

Only the last one is truly "holding U.S. dollars".

cpurick December 7, 2007 at 10:28 am

Then I'm specifically thinking about the effect on workers when dollars in the last case are cashed out to buy the goods referenced in the first case.

This increases our exports, but it also means that Americans producing those exports are necessarily consuming less. A previous post here presented that as turnabout in a world where we've been living well off of other countries' labor, but I'm wondering if it's acceptable to people who never really benefitted from that.

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