JPRI Critique, Vol. X, No. 5 (June 2003)
The Economic Costs of American Imperialism
by Marshall Auerback
The U.S. today is a paradox:  it is both the world’s greatest power and its biggest debtor. This has allowed it to deploy guns and consume butter.  But the costs of this policy are coming home to roost: the U.S. current account deficit today is nearly 50 percent bigger than its defense spending. The trade deficit hit a record $435.2 billion last year and has deteriorated still further in 2003. With the current account deficit now approaching $600 billion, the US needs to attract around a net $2.7 billion of overseas capital every working day. Adding to this picture of profligacy, the Bush administration’s recently announced 2003 budget forecasts a $304 billion deficit, but this figure excludes the deficits of agencies that are guaranteed, backed or sponsored by the U.S. government (such as Fannie Mae or Freddie Mac), a bailout of which could render the final number substantially higher, even before adding in the cost of the Iraq war and any other new outlays required to sustain the new American imperium.
American taxpayers thus face record-breaking debt, record-breaking trade deficits, reduced government services, a crumbling and under-funded infrastructure, and three major public-sector programs—Social Security, Medicare, and Medicaid—that are expected to double in cost as a share of the economy, putting unimaginable pressure on tax rates, the economy, and the budget.  And that is before taking into account the financial burden of reconstructing Iraq, Afghanistan, and whichever other country is deemed to be next on the hit list.  It is a striking commentary on America’s current situation that Canada created 70,000 jobs during February and March while the U.S. lost half a million.  The Canadian corporate sector remained confident because it was not suffering from concerns about war and the legacy of corporate scandals during 2002.
The world’s financial markets are increasingly alarmed that the U.S. is embarking upon an imperialist foreign policy that will have unknown consequences for its fiscal position, foreign trade, and relationships with other countries. In the heyday of its empire, Britain ran large current account surpluses. There is no precedent for a country playing the role of global superpower with a large external payments deficit. During the Cold War, the U.S. was able to finance its defense spending in part through offset programs with other countries. The Bundesbank, for example, stockpiled dollars as a quid pro quo for U.S. defense spending in Germany. During the 1991 Gulf war the U.S. received large subsidies from Japan, Saudi Arabia, and other countries. Today, by pursuing a more unilateralist foreign policy, the United States will have to absorb all of the costs without help from traditional allies.
The recent rapidly accelerating decline of the dollar indicates that the financial markets are beginning to count the costs of the Bush administration’s newfound unilateralist zeal and are losing their respect for American financial policymakers. A loss of international financial confidence is a problem that America simply cannot afford at this juncture. The U.S. current account deficit is forecast to be in excess of 5% of GDP by the end of this year, and Wynn Godley of the Levy Institute tells us that this level will put the U.S. private sector past a dangerous threshold. In other G-7 countries, these sorts of levels have produced a major recession or, worse, a financial crisis. When he was chief economist of the World Bank, former Treasury Secretary Lawrence Summers warned that close attention should be paid to a current account deficit of 5% of GDP. During his time at the World Bank, Summers closely studied debt trap dynamics, and recognised that the lower a country’s rate of economic growth, the more likely its external debt will prove to be explosive. Thus, should the current account deficit persist, the U.S. may be in big trouble, and the current military plans simply exacerbate this and make the risk of debt-trap dynamics even greater.

Debt-Trap Dynamics

What are debt trap dynamics? In essence the concept is very simple. If the interest rate on a country’s debt exceeds its long run growth rate, its external debt tends to rise inexorably relative to GDP. We can illustrate this with a country with a trade account that is in balance but an external debt inherited from the past (prior trade deficits, war reparations, etc.). Without a trade surplus, it cannot service the interest on its debt with foreign exchange earnings; it must borrow to meet payments on interest due. Therefore, its external debt will compound at the rate of interest. If this interest rate exceeds the country’s long-term growth rate, the country’s external debt will grow more rapidly than the country’s GDP and its external debt-to-GDP ratio will rise inexorably.
A prominent example was the so-called “Third World debt crisis.” That began in 1973, when the rise in oil prices and a concomitant need to recycle petro-dollarsgave the go-go bankers of that period a field day.  The resultant lending binge, notably to the countries of Latin America, led many to develop large current account deficits and large external debts.  When then U.S. Federal Reserve Chairman Paul Volcker raised U.S. interest rates sharply at the end of 1979, an external debt crisis became almost inevitable.  Yet, virtually nobody—bankers, multilateral institutions, academic economists—noticed until three years later, when Mexico defaulted on its debt, and the first of many developing world debt crises erupted.  It took most of the decade of the 1980s to “work out” the debts of the afflicted countries
Of course, if a country’s external debt is not large, if the excess of the interest rate it pays on its external debt over its long-run economic growth-rate is small, and if it has a trade balance or only a modest trade deficit, its external debt will grow slowly. More important, only a small adjustment sufficient to throw the trade account into surplus will allow the country to service its external debt out of foreign exchange earnings and thereby arrest the “explosive” external debt dynamics. 
Let us now consider the case of the United States. At present, it has a significant net debt (around 28% of GDP by the end of this year), a large trade deficit, a large current account deficit (almost 6% of GDP), and a real interest rate on its debt of 3% to 4%, thus exceeding slightly its real growth rate of 2.2% to 3%.  The large trade deficit alone will tend to raise the U.S.’s external debt-to-GDP ratio by a few percentage points per year, but it alone will not cause that ratio to rise inexorably or “explosively.”  If the U.S. did not have to borrow to pay interest on its debt, the ratio of the trade deficit to GDP would likely remain manageable.
Unfortunately, the U.S. is a country with a trade deficit and must also borrow to pay the interest on its debt. Because the interest rate on that debt exceeds the U.S.’s growth rate, the compounding of capitalized interest payments alone will tend to raise the nation’s relative indebtedness. Because the U.S. is such a vast economy, it cannot eliminate its current account deficit as readily as a smaller economy.  When it tries to improve its trade balance through devaluation or through restrictive demand management, its sheer size affects the economies of its trading partners adversely and to an appreciable degree. Understandably, they object and resist. When foreign economies resist dollar devaluation and the dissipation of their current account surpluses, the U.S. may have toraise interest rates in order to induce creditors to continue financing its debt build-up.  For this reason, I expect that the chronic U.S. current account deficit and mounting external debt will ultimately raise long term U.S. interest rates.  And this, in turn will speed up the compounding of the interest due on the U.S. external debt and will make the debt trap dynamics even more vicious.  At that point, what author Charles Kindleberger (Manias, Panics, and Crashes, Basic Books, 1989) calls a “credit revulsion” might ensue, producing a catastrophic outcome for the U.S. economy not like that of the early 1980s, the 1994 Mexican crisis, or the Asian financial crisis of 1997/98.

The China Factor

The key to this looming problem is China. While the U.S. currency has declined against the euro and the yen, it has not fallen against the currency of the nation that accounts for the largest—and most rapidly growing—segment of its trade deficit, China. Since 1994, China has effectively linked its currency, the yuan, to the dollar. The government essentially guarantees that it will buy the local currency for dollars within a fairly narrow band. By keeping the yuan tightly aligned with the dollar, China perpetuates the cost advantage it has over the United States as a manufacturing center. When the dollar weakens against the euro and the yen, the yuan weakens by roughly the same proportion. As a result, U.S. consumers will not find Chinese-produced goods to be any more expensive today than they were a year ago. Perhaps more significantly, a U.S.-produced dishwasher will not seem any cheaper to European or Japanese buyers than similar products made in China.
In theory, dollar depreciation should improve the U.S. trade deficit, although with a lag, since a falling dollar exchange rate means higher dollar prices for imports. This initially deepens the trade deficit, until domestic consumers, wholesalers, and producers react to higher import prices by either curtailing their purchases of imported products or switching their expenditures to domestically produced substitutes. If foreign producers lower their prices in their home currencies to offset the currency effect to the final purchaser of their products (as China effectively is doing by virtue of pegging the yuan against the greenback), then there is no effect.
Perhaps, if the U.S. private sector were financing its savings deficit by issuing equity shares, matters might not be so grave. When private borrowers obtain the funds they need through equities, these are perpetual claims that require no fixed repayments, and borrowers who rely upon them can weather a considerable storm. But there is no way borrowers can weather having the plug pulled on them by their lenders. In the U.S. today, with virtually no precedent in the history of capitalist economies, corporate bond sales, not equity issuance, are soaring at record levels. The situation is even worse than Asia during the latter’s financial crisis in 1997 and 1998.  There are in fact no parallels in the history of the industrialized world for such large and possibly very vulnerable profligacy in both the private and public sectors. 
What should we conclude?  History tells us that under conditions of extreme economic prosperity or depression, psychological factors cause economic agents to behave in ways that depart from the “norm.” In Japan today, a negative psychology engendered by the bursting of the Japanese asset bubble of the 1980’s and the prolonged economic stagnation that followed in its wake has created a self-feeding pessimism about the Japanese economy. The virtual cessation of public participation in the stock market, the build up of non-performing loans in the commercial banking system, and the total policy paralysis on the part of Japan’s financial and monetary authorities are all symptomatic of this malaise. 
Similarly, but in a reverse fashion, a decade of economic growth and an unprecedented credit bubble in the U.S. have created a psychology of euphoria that now causes some economic agents to assume astounding risks. This economic adventurism is the domestic counterpart of an increasingly reckless foreign policy. In the long run, any indebted country that is caught in explosive debt trap dynamics—even if that country is the issuer of the world’s reserve currency—will prove to be an untenable borrower.  For all of America’s perceived unilateralist military strength, the country’s debt position renders it an economic multilateralist by necessity. France, Germany, Russia, China, and Japan do matter in this context. President Bush may continue to view them as a troublesome irrelevance, but he is likely to be forced to change his mind if these countries stop viewing the U.S. as a stable guarantor of the world’s monetary system and instead start seeing it as the world’s greatest profligate. Of course, there is no precedent to go by, for there has never been a reserve-currency issuer that turned into a profligate debtor. No amount of success in Iraq will alter this fundamental Achilles heel in the American economy.
MARSHALL AUERBACK is a British-based international portfolio strategist for David W. Tice & Associates, a global fund management firm.   

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