Who pays for Uncle Sam’s deficits?

[Expanded May 27. 2018]

I have reviewed this subject a lot, but some people, unfortunately, still don’t get it. Econ 101: Trade deficits

On May 18, (last week) the U.S. public debt was 21.1 trillion dollars or 109% of our total output (GDP).  Of that, 15.4 trillion was held by the public (the rest was held largely by the Federal Reserve Banks and the Social Security Trust Fund.  The government paid $458.5 billion in interest on its debt outstanding in the most recent fiscal year (2017).  As interest rates rise over the next few years, this will at least double over the next decade.  China holds about $1.2 trillion of this debt, meaning that it has helped the U.S. government finance its debt to that extent.

Switching from debt (the outstanding stock) to deficit (the flow of new debt per period) the U.S. fiscal deficit for the Financial Year 2017 (which ended in September) was $666 billion or 3.5% of GDP.  If our budget balances over the business cycle as it should, we should have had a surplus of about that much at this point as the economy is fully employed.  The forecast deficit for 2019 and beyond is one trillion dollars per year as far as the eye can see (and this from a Republican Congress and Administration!!!).  This is not sustainable and will eventually collapse of it’s own weight.

The question that I want to review here is who pays for these government expenditures not financed by tax revenue—who finances our deficits?

Taking broad categories there are four potential sources of such financing.  The first is the Federal Reserve.  Our central bank buys (finances) government debt when it wants to increase the money supply.  During the great recession the Fed bought a huge quantity of debt (around 4 trillion dollars) but paid interest to banks that keep their “excess reserves” at the Fed to keep the base money issued from increasing the broader money supply (public deposits at banks) as much as such purchases would normally produce.  The Fed has now started a program of gradually selling most of that debt back to the market so it will not be a source of debt finance for many years.

The second source of financing could come from the general public spending less and saving more (in the form of treasury debt purchases).  In the three years before the great recession (2005-7) the personal savings rate was about 3% of GDP. That jumped to 6% in 2008 but is now (2017) back down to 2.4%.  So increased saving did not finance the government’s $666 billion deficit in 2017.

The third source of financing could come from reduced private investment.  When investment falls in order to finance government spending it is called “crowding out” and obviously reduces the economy’s output in the future.  At the bottom of the great recession (2009) gross private domestic investment was 1.9 trillion dollars rising steadily to 3.2 trillion in 2017 with a very slight dip in 2016.  Thus government deficits were fortunately not financed by a reduction in private investment (thanks to foreigners as explained next).

So who put up the money to pay for our government’s spending in excess of its tax revenue?  Foreigners, including China.  How do foreigners get the dollars they need to invest in the U.S. including in U.S. treasury debt?  To accumulate these dollars foreign countries must have a trade surplus (sell more to the U.S. than they buy from the U.S.) and/or they must receive investments from the U.S. (a capital outflow from the U.S.).  In fiscal year 2017 the U. S had a trade deficit of around 550 billion dollars (in 2016 it was 502 billion).  Its fiscal deficit this last year was 666 billion dollars (in 2016 it was 585 billion).  Thus most of the financing of our fiscal deficit came from our trade deficit with the rest of the world.

If President Trump wants to reduce our trade deficit with the rest of the world (bilateral deficits, such as with China, are irrelevant—only the global total matters), he and our spendthrift congress should reduce our fiscal deficit.  This is badly needed whatever our trade deficit is.  Our economy adjusts at all margins (interest rates, exchange rates, etc.) until the governments financing needs are met.  In fact, as I’ve noted earlier, we should actually be running a fiscal surplus in this full employment phase of our business cycle.

You might wonder why investors in the rest of the world are so eager to invest in the U.S. when U.S. interest rate are so low.  Ten-year government bond rates in the U.S. are currently (May 25, 2018) around 2.9%, in Mexico 7.7% and in Brazil 11.0%.  In part this is because U.S. bonds are still considered safer (less exchange rate and default risks) than those of Mexico and Brazil.  With U.S. federal debt at 109% of our GDP and rising this low risk premium will not last forever.  In Canada, where the government debt to GDP ratio was a modestly more respectable 89.6% at the end of 2017, its ten-year bond rate is 2.35%.

A more important source of foreign demand for U.S. debt derives from the dollar’s role as the primary foreign exchange reserve asset. Because so much of world trade is priced and paid for in U.S. dollars, individuals, firms and governments hold precautionary balances of dollars just as we hold balances of dollars in our bank accounts or piggy banks in order to make payments between pay checks.  Official foreign exchange reserves alone (those held by governments and their central banks) currently amount to 11 trillion dollars, over 60% of which is in U.S. dollars.  These dollar foreign exchange reserves are invested in the U.S. largely in “relatively” safe U.S. government securities.

While governments generally accumulate foreign exchange reserves for normal precautionary reason, it is also true that some have accumulated more than can be justified for precautionary purposes.  In the early 2000s China intervened heavily in the foreign exchange market to prevent its currency from appreciating, which would have made China’s exports more expensive and its imports cheaper in U.S. dollar terms.  By 2007 China had current account surplus that was 10% of its GDP. As a result of this mercantilist, export promotion policy China’s foreign exchange reserves skyrocketed from less than $0.2 trillion U.S. in 2000 to around $4.0 trillion in 2014.  As a result of large capital outflows from China last year its foreign exchange reserves fell from $4 trillion to $3 trillion by the beginning of last year as it intervened in the reverse direction (to prevent its currency from depreciating).  In fact, in the first quarter of this year China had its first current account deficit since joining the World Trade Organization in 2001.

In addition to strengthening the rules of the WTO, the international monetary system would benefit from replacing dollars with the IMF’s Special Drawing Rights (SDR) in international reserves. http://www.compasscayman.com/cfr/2010/01/05/Do-we-need-a-new-global-currency-/%C2%A0 and https://works.bepress.com/warren_coats/25/

About wcoats

Dr. Warren L. Coats specializes in advising central banks on monetary policy, and in the development of their capacity to formulate and implement monetary policy. He is retired from the International Monetary Fund, where, as Assistant Director of the Monetary and Financial Systems Department, he led missions to over twenty countries. Before then, he served as Visiting Economist to the Board of Governors of the Federal Reserve System, and to the World Bank, and was Assistant Prof of Economics at the Univ. of Virginia from 1970-75. Most recently he was Senior Monetary Policy Advisor to the Central Bank of Iraq; an IMF consultant to the central banks of Afghanistan, Kenya and Zimbabwe; and a Deloitte/USAID advisor to the Government of South Sudan. He is currently a member of the Editorial Board of the Cayman Financial Review and until the end of 2013 was a member of the IMF program team for Afghanistan. His most recent book is entitled "One Currency for Bosnia: Creating the Central Bank of Bosnia and Herzegovina."
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2 Responses to Who pays for Uncle Sam’s deficits?

  1. Mike Burnaugh says:

    Thanks again, Dr. C! And what kind of atrocity will the Senate give us this fall, as they fail to pass, or even consider any regular order appropriations bills?Oh, please shut down the Govt.! First casualty should be the paychecks of Congressmen and Senators. Since they don’t do their jobs, who needs them?

  2. Jim Roumasst says:

    Thanks, Warren. So, roughly speaking, the fiscal deficit drives the trade deficit, which is balanced by a capital market surplus. This means that the share of American wealth held by foreigners is gradually rising. That is what makes the situation unsustainable. But long before foreigners own our country, they will impose conditionalities on its management. As national sovereignty is eroded, government by the people will perish from the earth.

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