What if foreigners quit lending the US so much money?

by Philip Brewer on 8 April 2008 7 comments
Photo: Philip Brewer

One of the bugaboos of the financial doom-and-gloom crowd is the worry that foreigners (China in particular, but also oil exporting countries in the Middle-East, and others) might quit buying so many US Treasury securities.  If that happened, they say, the value of the dollar would plummet, interest rates would soar, and the US economy would be in terrible trouble.  I say:  Bring it on!

I'm not the only person who isn't worried about this.  Quite a few people take some comfort in the idea that dumping Treasury paper would hurt the major foreign holders worst of all, and that they'd never shoot themselves in the foot that way.  The doomsters retort that, given the inflation rate, the exchange rate, and the prospects for the US economy, it may well amount to the same thing either way, but that by selling, foreign holders of US paper could at least get something.

My own take is that the whole analysis is wrong.

What would happen?

Remember that the US isn't a bank--the government sells bonds, it doesn't take deposits.  Foreign holders of dollars can't show up and demand their money back.  All they can do is sell the securities they've got.  (And, of course, quit buying more.)

Interest rates

Obviously, if major holders started unloading their treasury paper, the prices would plummet and interest rates would soar.  That would make it expensive for the US to borrow new money, but it wouldn't affect the government's cost for the money they've already borrowered.  In any case, borrowing large amounts of money is just a policy decision by the Bush administration and the Congress.  As recently as 2000 the US government was running a surplus.  With the economy slipping into a recession, it would be harder to run a surplus now, but the current large deficit is entirely optional.

Besides making it expensive for the government to borrow large amounts of money, higher interest rates would make it more difficult for everyone else to borrow money as well.  On the other hand, it would make it quite profitable for people to save and invest money.  In fact, once the government got its fiscal house in order (something that wouldn't really be optional in this scenario), we'd see the exact reverse of what the doomsayers predict--treasury paper would become a highly prized asset.  People who bought it cheap when foreign governments dumped it would make huge profits.

Exchange rates

You'd see similar results in the foreign exchange market.  The value of the dollar would drop, making imports more expensive, but making exports more competitive.  

The US (because it is large and well-endowed with both natural resources and skilled workers) could actually produce most of what it needs domestically.  The only reason it doesn't do so is that imports from low-wage countries are so much cheaper.  

Of course, producing more of what we use would cost more--the consumer has had it great over the past 30-odd years of globalization, getting all sorts of cheap stuff that would cost a lot more if it weren't imported from low-wage countries.

The result would be lower standards of living, but it wouldn't be a catastrophe.  And, there would be winners as well as losers.  Manufacturers would come out ahead, as would farmers and workers.

As the US dollar falls, the price of everything that trades in global markets (for example, corn, wheat, and soybeans) rises.  (We see that already.)  Since we grow a lot of those commodities, we benefit in about equal measure to our losses--the raw materials cost more, which means the stuff we buy costs more, but the producers earn more, so they have more money to spend.  

One major exception, of course, is oil, where we use far more than we produce.  The price of oil would obviously soar in this scenario, hurting everybody.  But that's going to happen anyway.

Positioning yourself

I don't think this is a likely scenario, simply because (as I described at the beginning), dumping treasury paper would hurt the foreign holders of it most of all.  Still, it's not an impossible scenario, so it's worth looking at how you'd want to position yourself against such an eventuality.

  • First, you'd want to be sure not to be in debt, especially not variable-rate debt.  Interest rates would shoot up, making debt even more expensive than it is now.
  • Second, you wouldn't want to be in a business that depended on cheap imports.  (At the moment that's most businesses.  Some, though, could quickly move to local sourcing of their inputs, while others would find that difficult or impossible.)
  • Third, you'd want to minimize your household's dependence on the sort of imports that would become much more expensive.  The hard one here is fuel.  (Your house or apartment is probably full of imported goods, but you've already got them and won't be harmed if their price soars.)  I've talked before about preparing for higher fuel prices.
  • Finally, expect a lower standard of living.  Americans have enjoyed a high and rising standard of living for years, through a combination of individual borrowing (especially against homes), government borrowing (which has let the government fund an expensive war while lowering taxes), and globalization (importing goods from low-wage countries).  This scenario would just mean that they'd come to halt abruptly, but they're coming to a halt in any case.

Regular Wise Bread readers will have noticed that these are generally the same recommendations that we make anyway.  That's the reason for my somewhat flippant call to "bring it on!"--we're already ready.

A quick transition to a world where everyone had to live within their means would be rough--homes would be lost, jobs would be lost, businesses would be lost.  But we're heading there anyway, so it's just a matter of whether the transition will be fast or slow.  As individuals, we have the opportunity of starting the transition now--ahead of everyone else.

I suggest you make the most of it.

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Guest's picture
Curt

I love the topic. I think we need to start talking about this. This is getting closer to reality every day.

The Fed minutes yesterday, said the economy could be in for a "Severe Downturn". That downturn could start as a recession and turn into a depression. The entire world is getting pulled into the downturn. Foreign markets are already down 20% this year and the realy bad news is still to come. I know ... doom and gloom.

If (or when) the foreign investors lose faith in the US markets, the dollar will sink like a rock in a river. The dollar is already at risk, which puts savers like us at risk. If dollars dropped in value by half and inflation gobbles up another x% per year, the savers could lose the most. A friend of mine does not own a home and has no assets and a steady income with his own business. He has nothing to lose, but I could lose a lot. So, I'm not sure who I would rather be, as we face the coming downturn.

Some say to invest in foreign currencies, but they are also losing value as their central banks are printing money to keep from losing against the dollar - is order to keep their economies from completely stopping. All equity markets and currenies are very risky right now, leaving the commodities to hedge against the dollar as the best choice to protect a saver wealth.

Guest's picture
Kelja

The collapse of the dollar and resulting super-high inflation isn't something to take lightly. Expect all those necessary things: food, clothing, energy, to take big price hikes. This hurts low earners the most. Tax revenues will drop precipitously and perhaps some government programs will be cut.

The enormity of the financial crisis is understood by very few people on main street. The entire financial system is teetering on the edge right this moment. The Fed themselves came out just a couple of weeks ago and said the entire financial system was in danger of collapse within 24 hours! This was the reason given as they bailed out Bear Stearns. The Fed wasn't lying.

Think Bear Stearns was the only problem, the only major bank in trouble? Think again. At this moment, there are thousands of fingers in the dike holding back the deluge. And I'm hoping for the best but prepared for the worse.

Most of the money men and women on Wall Street are very, very frightened. Make sure you're protected.

Guest's picture
Jonny

Aghhhhh!!!! NOooooo!!!

Listen, the Fed cries "systemic meltdown" everytime they charge off to the rescue of Wall St. Look at S&L, LCM, etc. etc. Helloooooo, where do you think these people come from and go to after their Fed jobs?!?

This is just socialism for the rich and capitalism for the poor. Let the market deal with it...The cost of this so call rescue will be more then the reason for doing it in the first place!!!

Folks on Wall St. are afraid all right, afraid of losing their job after a bull market of lose credit that got us into this mess...

Philip Brewer's picture

Hyperinflation is probably the second-worst thing that can happen to an economy (after a war or natural disaster actually destroying productive assets).  But I don't think hyperinflation is the most likely scenario, simply because too many rich, powerful people have lots of money.  In a hyperinflation, they're the losers.  Since they're also the people in a position to make sure that things don't go that way, I don't think they will.

I could be wrong.  Maybe rich, powerful people are more heavily leveraged than I realize (in which case they, like other debtors, come out ahead in a hyperinflation).  Also, even if hyperinflation isn't a goal, it's possible to cause one by mistake:  Meaning to create a "just a little inflation"--enough to grease the wheels of the economy--the central bank could, through a series of errors, destroy the value of the money.

The thing about inflation is that it's easy to stop.  There are now many instances of runaway inflation brought to a halt before the currency is destroyed.  That may make central banks prone to be a bit reckless.  Right now the Fed is tolerating an inflation rate that's running 4% and rising.  We can assume that they're betting they can stave off systemic financial problems without inflation rising more than a point or two.  If they're wrong, inflation might surge to 6%, 8%, 10%.  But at any point during that progression, the Fed can say, "That's it--we've reached the point where inflation is the greater threat," and bring inflation back down. (At the cost of a recession and terrible trouble for debtors, of course--but that's where they're starting anyway.)

Guest's picture
Gates VP

Look, there are lots of opinions out here, and outspoken financial gurus are notorious for being a little crazy and hard to understand.

I like this article b/c it moves toward bridging that gap. Most people don't understand "what" the federal debt it, they just know it exists and that it has lots of zeros. This article doesn't quite speak to those people, but it's getting there, so congrats.

Me, I'm going to cut straight to the quotes:
All they can do is sell the securities they've got.
Yes this is true (I guess they can trade them too) and you use this to segue into interest rates. But there's something else here: this stuff needs to be cashed in for services or commodities at some point.

Right now there are hundreds of billions of dollars in money still waiting to be cashed in for stuff. You talk about exchange rates, but right now it's a game of chicken in terms of exchange rates. The US dollar is being held afloat because:
1. Everyone has them
2. They're the unit of trade for oil
It's a game of chicken b/c everyone wants to get the most real value from their little IOUs. But if everyone decided to try and cash in all of their US debt notes, the economy would just collapse and inflate away the rest of the IOUs.

Now, without any real stretch I think that it can be generally agreed that the average US standard of living will go down in the next few years (not up). There are simply more powerful downward forces than upwards forces right now.

And so I really like this comment: Finally, expect a lower standard of living. b/c it's not generally expected right now. In fact, most people expect the "infinitely expanding" standard of living which is really part of the money problem we're having.

So kudos, but I think there is one issue with which I will disagree completely:
The US (because it is large and well-endowed with both natural resources and skilled workers) could actually produce most of what it needs domestically.

This is utterly false. I'm a Canadian currently living in the US and I know this to be simply untrue. The US can clearly produce enough food for your its purposes, but the US cannot produce enough oil, gas, lumber or energy to support itself right now.

Lumber:
All told, those imports fed nearly one-third of the 65 billion board feet the U.S. consumed, according to statistics from U.S. Census Bureau's

Energy:
35% of the energy in the US is currently imported. And that demand is growing, who remembers rolling blackouts in California?

The US cannot power its long-term energy growth right now. The reason these numbers are very important is that the current US economy is founded on the concept of inexpensive access to energy sources. I live in KC right now and most people don't live anywhere close to work. There's no good public transportation, so people expend tons of money just getting to/from work. And most of the shopping is done on these multi-mile major thoroughfares filled with shops. These shops are completely inaccessible to people without personal vehicles. There's a whole major shopping center (Legends) that's like 30-45 minutes drive from where basically everyone lives. It's just "out in the middle of nowhere" off the interstate, but everyone merrily piles into the car on the weekend and drives out!

And that's just the tip of the energy iceberg: constantly increasing personal square footage over the last decades requires extra heating/cooling, bigger TVs, bigger fridges, more powerful computers...

Of course, I guess it all gets back to your last point: expect a lower standard of living and expect that lowered standard to include a lot higher valuation on location and "local living". Not being accessible by public transportation is going to hurt some businesses who long ago exchanged "cheap land" for my gas and time.

Philip Brewer's picture

I think you're absolutely right about energy, but I think that's almost divorced from the financial issues:  Oil prices would be going up even if the dollar weren't in such trouble.

I'm much less worried about other stuff, such as lumber.  The US has something like two-year's supply of unsold houses, so we could get along with a lot less lumber.  (Granted, it's also used to build other things, make paper, etc.  But, still--surging prices for lumber would hurt many businesses, but would not be a major factor for most people.)

But you're right--what we're going to see is surging prices for everything.  Some of that surging price is going to be inflation (the money becoming less valuable, as people want to hold less) and some of it is going to be a falling standard of living (as the prices of everything that trades in global commerce rise, not just in dollar terms, but in real terms).

It's not going to be any fun, but the hard parts are set to happen anyway--no matter what foreign holders of US treasury paper do.

Guest's picture

Well, the U.S. is mortally bound to its major creditors, especially China. The entire system we live in is designed around borrowing and debt, so the question is "how far does the rubber band stretch?" It seems we are pretty maxed out right now. I propose we cut WAY back on military spending, and focus more on domestic matters, and stay out of other countries quabbles. If we can eliminate the wars in Iraq and Afghanistan, among others, we can regain our ability to pay of our major creditors, thereby alleviating our debt and the dollar will regain ground. We cannot foresake our own people to fight foreign disputes and then let the country go to China and say "hey, we have another trillion dollars of debt, want to buy some more US Govt bonds?" We have to stop with this vicious cycle. This will plunge us into the 3rd world, really fast.