Obama: Yesterday, the Joy, Today the Hard Economic Reality

Now that Barack Obama is in the White House, his single greatest challenge is to restart the U.S. economy, to turn it away from its descent into depression, toward sustainable recovery. Unlike the period of the Great Depression of the 1930s, when Americans held their ultimate fate in their own hands, they no longer do. Whether he fully appreciates it as he sets out on his presidency, much of the ability of Barack Obama to carry out his economic agenda will depend on the decisions of foreigners.

In sharp contrast to the Great Depression of the 1930s when the United States was the world’s leading creditor nation, the U.S. is now the greatest debtor in the world. This places enormous constraints on the course the United States can pursue to cope with the economic crisis and with the broader foreign policy challenges that confront it.

Two forms of debt are particularly important to the external position of the United States: the U.S. government deficit and debt; and the U.S. current account deficit.

First, let’s look at the effects of the U.S. government debt, which presently amounts to $11 trillion and is set to soar much higher. The Obama administration’s economic recovery plan is driving the U.S. government’s deficit from $410 billion at the beginning 2008 to well over a trillion dollars a year. The administration projects that trillion dollar deficits will persist for years to come. The U.S. federal debt is financed in part by securities held by U.S. government accounts, among the most important, the Federal Employees Retirement Funds, and the Federal Old-Age and Survivors Insurance Trust Fund. At the beginning of 2008, 55 per cent of the debt was held the “public”, meaning those who purchased U.S. treasury bonds. Forty-five per cent of these “public” purchasers were made by foreigners, two-thirds of that total by foreign central banks. By far the most important of the central banks in making these purchases were those of China and Japan. When to the central banks of China and Japan are added to other purchasers from these two countries, about 47 per cent of the purchases by foreigners is accounted for. In total, foreigners have been financing about 25 per cent of the gigantic U.S. National Debt, a percentage that the Obama agenda could drive much higher.

Between them, the central banks of China and Japan hold over a trillion dollars worth of the U.S. securities used to finance the U.S. national debt They don’t buy them because they regard them as a good investment. Quite the contrary. They buy them to save the United States from the crippling consequences of its own internal weakness. This, they do, not as an act of generosity, but to safeguard their vitally important export markets in the U.S. and to prevent a global economic collapse.

Suppose the Chinese and Japanese central banks, along with about eight or ten other central banks, decided to reduce their purchases of U.S. Treasury bonds. The consequence would be a sharp decline in the value of the U.S. dollar against other currencies. A lower dollar would lead to a very substantial reduction of U.S. imports. Keeping exports flowing into the vast American market is what motivates Asian central bankers to buy trillions of dollars worth of U.S. Treasury bonds.

There is a limit to this willingness to serve as lenders for the deeply indebted Americans, however. The biggest money makers in China are foreign multi nationals that set up shop in that country to avail themselves of a highly productive and relatively inexpensive labour force. Those multi-nationals are earning a far higher return on their invested capital in China than the Chinese central bank makes sustaining the U.S. dollar through its purchases of U.S. Treasury Bonds.

The Obama administration will need to sell vastly more (the dollar total could more than double) Treasury Bonds to Asian and other central bankers. This will have two effects. First, it will substantially increase the downward pressure on the American dollar against other currencies. A renewed fall in the value of the U.S. dollar will serve as yet another disincentive in the path of central bankers and private investors buying up the bonds. Buying bonds denominated in a falling currency is a money loser, especially if the interest rates on the bonds are low. To sweeten the pot, the interest rates on U.S. Treasury Bonds will have to be substantially raised, both to slow the decline in the U.S. dollar and to increase the return to the buyers of the bonds.

This, of course, creates yet another problem for the United States. Higher interest rates on American bonds make the cost of financing the rapidly expanding U.S. national debt ever more dauntingly stratospheric. Thus, borrowing immensely more from foreigners to finance the administration’s stimulus program is an exercise that can only be described as fraught. The more expensive the cost of borrowing, the less effective will be the U.S. recovery program.

In principle, there is a way to reduce the volume of additional foreign borrowing. This would be to dramatically reduce the income and wealth gaps between the rich and the rest of the American population, in part by imposing much higher income and wealth taxes on the very affluent. While in theory, this could work, in practice this would necessitate such an enormous shift in the American socio-economic system that it is inconceivable under present circumstance. It remains only a theoretical possibility to be noted. The continuing dependence of the United States on foreign borrowing, and thus on the need to tie much of the world into an American centred geo-political system is rooted in the marked inequality that exists in the United States itself.

Adding to the problem is the rising current account deficit of the United States, which was running at an annual rate of $710 billion in the autumn of 2008. (The current account includes the trade in commodities, tourism, and the trade in services, including profits, dividends, and interest payments between the United States and all other countries over the course of a year.) To finance its gigantic current account deficit, which amounts to just under five per cent of the U.S. Gross Domestic Product of $14.3 trillion, the U.S. is forced to engage in immense foreign borrowing. This can take a number of forms. One of the most important is the inflow of investments by foreigners to acquire assets in the United States. During the 1990s, these inflows were occurring at a time when the U.S. was on the cutting edge of the global technological revolution. It was the age of the dot.com boom. Following the dot.com crash in 2001, though, much of the flow of new foreign equity into the United States halted. Indeed, over the next few years, if the U.S. dollar should drop significantly against other currencies, foreign investment inflows into the United States would likely be aimed at the acquisition, on the cheap, of American economic assets. This is hardly a prospect that the U.S. government and corporate sector can view with equanimity.

For any country to have a perennial current account deficit that runs in the range of five per cent of its GDP is a perilous exercise. For any country other than the United States to do it is unthinkable. The U.S., as those who believe that America can go on doing this indefinitely insist, has a special role in the global system which allows it the privilege of greater indebtedness than other countries. Among other reasons for this is the fact that the U.S. dollar remains the reserve currency of the world. This means that when the U.S. government borrows money abroad it does so in its own currency, so that even if that currency depreciates against other currencies, Washington does not have to assume the additional cost this would impose on other borrowing governments.

The merit of this argument has declined as the prospects for the further depreciation of the U.S. dollar have increased. The burden to be borne by foreign central banks has simply grown dangeriously large and it is about to become more enormous still.

The U.S. current account deficit---the extent to which the United States spends more abroad than it earns abroad---creates a paradoxical relationship for the U.S. with other countries. On the one hand, there is the vast American market on which China, Japan and other countries, including Canada, depend so much for the profitability of the enterprises based on their soil. (Manufacturing companies, because of the economies of scale they achieve as their sales and volume of production increase---as the ratio of fixed to variable costs falls---make as much as half of their profits on the last fifteen or twenty per cent of their sales.)

It helps to picture the size of the U.S. market for foreigners this way: each year the U.S. offers to foreign suppliers a market more than half the size of the entire Canadian market as a consequence of its deficit. This additional market exists on top of what the U.S. market could offer foreigners if Americans sold abroad as much as they buy. The paradox is that foreigners have to pay dearly to keep this market open and available to them. The bigger the U.S. current account deficit, the more lucrative it is to foreigners. But the bigger the U.S. current account deficit, the more burdensome is the weight of the unprofitable U.S. Treasury Bonds foreigners must buy to keep that market open.

There is an inherent instability at work here. It is the kind of arrangement that could only exist in the relationship between a declining empire, or hegemon, and its clients. When the United States was a rising empire---as it was even in the dark days of the Great Depression in the 1930s---it creditor status, its superior productive plant and ultimately its unexcelled military potential, ensured its ability to invest abroad on its own terms and to dictate its trade arrangements with other countries. Indeed, in the last days of the Second World War, in 1944, the United States, along with its allies established the rudiments of the post-war economic system at Bretton Woods, New Hampshire, placing itself at the centre.

The United States can be likened to a ballerina. When she is young she makes difficult feats look easy. When she is aging she has to settle for making easy moves look difficult.

At what point will foreigners conclude that the game is not worth the candle, that financing the foundering U.S. is more trouble than it’s worth? Since so many factors are at play, including the stresses so evident in the U.S. effort to sustain its geo-strategic position in the world, no precise answer can be given to this exceptionally important question. What is abundantly clear, however, is that the Asian powers and the Europeans could adopt economic strategies in which the role of the U.S. as a market of necessity (much more for the Asians than the Europeans) becomes far less important than it is today.

Although it would confront both countries with large, and quite different, challenges, China and Japan could set out to dramatically reduce their dependence on exports. Because of its immense population and the fact that only about one third of it has been raised above third world conditions (more than four hundred million people), China has a vast internal market to which it can potentially direct much more of its economic output. Instead of propping up the financing of the U.S. state, the Chinese central bank could redirect its energies toward this unequaled internal market.

This would be no simple matter. To date, China has benefited enormously from the investments of foreign firms, their know-how and their access to the mature markets of the West (especially the American market).

The socio-economic transition for China in a shift from exports to the internal market would be a highly stressful one. Wages in the advanced sectors of the Chinese economy, which have been rising could be driven down, as the giant country focused on internal demand. The well-being of the relatively prosperous segments of Chinese society would experience at least temporary dislocation during the transition. Over the longer term, however, the shift would likely lead to even greater prosperity in the advanced sectors since the pressure to keep labour costs low for the purposes of the export orientation would be greatly lessened.

As long as China regards sustaining a huge level of exports to the U.S. as critically important to its economy, Chinese wages have to be held down. As China develops, and the demand for greater domestic prosperity increases, labour prices are bound to rise in any case, and this will further drive the shift away from the concentration on the American market.

Japan’s situation, despite its reliance on exports to the U.S. is markedly different from that of China. Japan has an advanced economy and a high standard of living. The country’s aging population and its reliance on exports have held back the expansion of Japan’s domestic market. To put it the other way round, the failure of its domestic market to develop rapidly has made Japan’s high level of exports a matter of continuing importance.

The U.S. and Japanese economies have been depicted as having a symbiotic relationship. Japan is the saver and lender---it has been the world’s leading creditor nation since the mid 1980s---and the United States is the spender, borrower, debtor and importer. Japan needs the U.S. as an outlet for its surplus capital and a destination for its exports. The United States relies on Japan to help finance its debts, its propensity for living beyond its means and its thirst for high quality manufactured products.

Japan, like China, has been willing to lend enormous sums, at very poor rates of return to the United States to keep this symbiotic relationship alive. But there are limits to the Japanese willingness to bear even higher costs to safeguard the U.S. market outlet.

The scope for the Japanese to focus on the expansion of their domestic market is much more limited than is the case for the Chinese. Japan, however, is quite capable of shifting its lending and the destination of its exports away from the U.S. to India, Europe, Brazil, Nigeria, South Africa and other countries. Indeed, in conjunction with a drive by China to expand its domestic market, there would be an enormous opportunity for Japan to help finance China’s expansion and to shift the focus of its exports to its giant neighbour.

It is a cardinal error to believe that the United States will sustain its present role at the centre of the global economy and that it can continue the virtually unlimited access to foreign borrowing it has enjoyed in recent decades.

Although this has not been widely acknowledged in public discourse, the United States will have to navigate a wrenching economic transition. One cost, that is virtually certain to accompany this is a falling standard of living for the American people. Barack Obama has warned Americans that the road ahead will be a difficult one. Soon they will learn that the pain is much greater than they have yet imagined, a pain that grand speeches down the length of the Mall will do little to assuage.