About my post on how our forex reserves are hurting us, Nitin sends me a Rediff link which says that it is also helping the US, because every dollar we keep in the reserve is a loan to the US (in the same sense that keeping a rupee in the bank is a loan to the bank).
Quite right. I got into a long argument the last time I made such an statement, It is a long story and deserves to go down as one of The Examined Life classics. I was fisking a truly awful piece by S Gurumurthy which essentially claimed that a) The US is surviving on the savings of other countries like India and Japan, b) That is a horrible thing to do and hence c) We should save [and because he pointed out that saving by India is equivalent to investing in an undeserving country like the US, we should continue to do the same stupid thing even more]
That was when I started realising that most people’s knowledge of Economics rested on a very shaky foundation.
Here’s another piece from AWSJ – it requires subscription so I’m posting excerpts:
Foreign-Cash Reliance May Hurt U.S – Greg Ip
AS THE U.S. has grown ever reliant on foreign central banks to finance its trade and budget deficits, the question arises: Could foreign governments, like China’s, one day use this clout to influence U.S. foreign policy? Most experts say it’s far-fetched. But some look at history and the state of modern markets and are worried.
“There is surely something odd about the world’s greatest power being the world’s greatest debtor,” Lawrence Summers, Harvard University president and former U.S. Treasury Secretary, said in a recent speech. He calls it “troubling” that the U.S. depends so much on “inevitably political” entities to finance its foreign debts.
Last year, the U.S. ran a $541 billion deficit in its current account — the balance of goods and services trade and investment income between the U.S. and the rest of the world — which had to be financed by selling stocks, bonds, and other assets to foreigners. The U.S. has run such deficits for years, but most of the time they were financed by private investors and their purchases were seen as a sign of confidence in the U.S. economy. But in recent years, private inflows haven’t kept pace with the growth in the current-account deficit and foreign central banks have stepped into the breach, buying more than $200 billion of U.S. assets, mostly Treasury bonds and bills, last year. They do this to hold the dollar’s value up against their own currencies, which makes their exports more competitive.
At present, foreign central banks, led by China’s and Japan’s, now hold close to $1 trillion of Treasury bonds and bills, almost a quarter of the publicly-held U.S. debt. That dollar hoard serves their economic interest, but it also gives them a potential financial lever.
IMAGINE A standoff between the U.S. and China over Taiwanese independence. What would happen if China stopped buying U.S. bonds, or sold them outright? As bond prices fell, their yields, which move in the opposite direction, would rise. Mortgage rates would rise, depressing home sales and weakening the economy.
How vulnerable is the U.S.? Not very, argues Federal Reserve Chairman Alan Greenspan. Although foreign central bank holdings are large, he says, they are small compared with the total trading volume in U.S. debt markets, and their sales could be easily absorbed. Furthermore, most of their holdings are short-term bonds, of two years maturity or less, whose yields, unlike those on 10-year bonds, tend to be influenced more by the Fed’s monetary policy than day-to-day buying and selling.
Still, if central banks stopped buying, someone would have to make up for the loss. Bond prices fell in mid-March on news reports that Japan might stop buying dollars to hold down the yen. There are also many instances of foreign buying and selling aggravating movements in U.S. bonds. Last summer’s dramatic run-up in bond yields, usually blamed on fumbled communication by the Fed about deflation, may have begun when Japanese investors sold Treasurys to make up for losses in the Japanese bond market.
Other economists argue that other nations wouldn’t want to destabilize U.S. markets, because they would be hurt so much in the process. If China stopped buying dollars, its currency would rise, hurting exports. China’s leaders “hear from exporters who don’t want to have a revalued currency because it might cut into their export sales,” says Nicholas Lardy, a China expert at the Institute for International Economics. “They are very concerned about political stability, which they think is a function of job growth.”
Mr. Summers concedes this, but adds, “It surely cannot be prudent for us as a country to rely on a kind of balance of financial terror to hold back [dollar] sales that would threaten our stability.”
ECONOMIC HISTORY shows a number of times when countries subordinated their economic interests to political goals. In both 1967 and 1973, Arab countries embargoed oil deliveries to the U.S. because of its support of Israel, even though the action hurt their own economies by depriving them of revenue (though in 1973 that was initially compensated by the simultaneous leap in oil prices) and by ultimately encouraging the West to become more energy efficient and to develop alternative supplies.
Nor is there anything new about countries using financial clout to further geopolitical goals. Indeed, the U.S. took that route during the Suez crisis in 1956, notes former Clinton aide Rahm Emanuel, now an Illinois Congressman. To force Great Britain and France to remove their troops from Egypt, the U.S. refused to supply them with emergency oil supplies and blocked the International Monetary Fund from helping Britain defend its currency. Now, Rep. Emanuel worries, the U.S. has given China “veto power over our economic and security independence.”
In 1999, two Chinese Army colonels, Qiao Liang and Wang Xiangsui, praised “financial warfare” in a sometimes rambling book on new ways to wage war, called “Unrestricted Warfare.” They note the damage that capital flight had wreaked on Southeast Asia’s and Russia’s economies. Had China devalued its currency then, a “cataclysm” on world markets would have ensued, inflicting “heavy economic losses” on the U.S. “Such an outcome would certainly be better than a military strike.”
Unfortunately, the U.S. dependence on foreign lenders, like its dependence on imported oil, has become woven into the structure of its economy and is not easy to change. It requires either much stronger foreign demand for U.S. exports or much weaker U.S. demand for imports — neither of which is likely to happen. A weaker dollar will help, but the depreciation to date is likely far from adequate. The International Monetary Fund has another idea: a faster reduction in the budget deficit than the Bush administration now contemplates. That would reduce U.S. demand for foreign savings and insulate it from the moods of foreign investors — political or otherwise.
(c) 2004 Dow Jones & Company, Inc.
That was when I started realising that most people’s knowledge of Economics rested on a very shaky foundation.
You mean, austrian economics??? 😉
No Ramnath,
I meant basic economics. In this case most people wouldn’t realise that Gurumurthy was incorrectly extrapolating from guidelines for individual savings to guidlines for national savings.