Debtor Nation: The rising risks of the American Dream, on a borrowed dime
Harvard Magazine July/August 2007
Debtor Nation: The rising risks of the American Dream, on a borrowed dime
by Jonathan Shaw
Consumerism is as American as cherry pie. Plasma TVs, iPods, granite countertops: you name it, we’ll buy it. To finance the national pastime, Americans have been borrowing from abroad on an increasingly stunning scale. In 2006, the infusion of foreign cash required to close the gap between American incomes and consumption reached nearly 7 percent of gross domestic product (GDP), leaving the United States with a deficit in its current account (an annual measure of capital flows to and from the rest of the world) of more than $850 billion. In other words, the quantity of goods and services that Americans consumed last year in excess of what we produced was close to the entire annual output of Brazil. “Brazil is the tenth largest economy on the planet,” points out Laura Alfaro, an associate professor of business administration who teaches a class on the current account deficit at Harvard Business School (HBS). “That is what the U.S. is eating up every year—a Brazil or a Mexico.”
Whether this practice is sustainable—and if not, how it might end—are questions that divide scholars and investors alike. We have borrowed so much from abroad—between half a trillion and a trillion dollars a year for the past six or seven years—that in 2006, our investment balance with the rest of the world (what we pay foreign investors on their U.S. assets versus their payments to us on our investments abroad, historically nearly equal) tipped to became an outflow for the first time in more than 50 years. We are a debtor nation swiftly heading deeper into debt.
Sidebar to this text:
* Not Your Daddy's Deficit
The global imbalances created by this dynamic of American borrowing and foreign lending appear stable for now, but if they slip suddenly, that could pose serious dangers for middle- and working-class Americans through soaring interest rates, a crash in the housing market, and sharply higher prices for anything no longer made domestically. Harvard economists and political scientists see possible threats to globalization (the opening of markets and trade that has made the economy a world phenomenon): the risk of rising protectionism; the potential for a world recession if market forces unwind the imbalances too quickly; and even the possibility that political considerations could trump shared economic interests, causing nations to use their international financial positions as weapons.
Photograph by Stu Rosner
Jeffrey Frankel
That last idea—that nations can wield power through their accumulation of currency reserves—is rooted in our own history. When President Dwight D. Eisenhower learned in 1956 that Britain, in collusion with France and Israel, had invaded Egypt without U.S. knowledge, he was infuriated. “Many people remember Suez,” notes Jeffrey Frankel, Harpel professor of capital formation and growth at the Kennedy School of Government (KSG), but few recall “the specific way that Eisenhower forced the British to back down.” At the time, there was a run on the pound sterling and he blocked the International Monetary Fund (IMF) from stabilizing the currency. With sterling on the verge of collapse, says Frankel, “Eisenhower told them, ‘We are not going to bail out the pound unless you pull out of Suez.’” Facing bankruptcy, the British withdrew. This incident, notes Frankel, “marked the end of Great Britain’s ability to conduct an independent foreign policy.”
Putting international politics aside for a moment, “When a country gets a capital inflow [such as the United States has now], generally speaking things are pretty good,” observes Jeffry Frieden, Stanfield professor of international peace. “It allows you to invest more than you save, and consume more than you produce. There is nothing necessarily wrong with that,” he notes. Firms do it all the time, and so do households. They borrow on the expectation that they will be more productive and better able to pay the money back in the future. The United States, for example, was “the world’s biggest debtor for a hundred years,” Frieden notes, “but the money was used to build the railroads and the canals and the factories and to improve the ports and to build our cities. It was used productively, and it worked. The question to ask now is not, ‘Is the country living beyond its means?’ The question is, ‘Is the money going to increase the productive capacity of the economy?’ Because if it just goes to getting everybody another iPod,” he warns, “then unless iPods make people more productive, there is going to be trouble down the road when the debt has to be serviced.”
Photograph by Stu Rosner
Jeffry Frieden
Trouble struck Mexico in 1995, Thailand, Malaysia, and other countries in 1997, and Argentina in 2001, after those countries borrowed vast sums in the international marketplace. Argentina before the crash had been a model developing nation and a darling of the IMF, closely following the fund’s economic prescription for integration into the global system of finance and trade. But even the IMF could not save the country from the destabilizing effects of international capital flows. When global investors realized that Argentina’s debt load was unsustainable, they sold their assets, called in their loans, and exited the country. Overnight the Argentine peso plummeted in value against the dollar, the currency in which debt had been issued, and staggering obligations suddenly became unpayable. Argentines who had financed their mortgages in dollars lost their homes. There was a run on the banks, and the government imposed a limit on cash withdrawals. In a country abounding with wheatfields and cattle ranches, starving people began raiding garbage bags in wealthy neighborhoods.
Paul Blustein, a financial reporter for the Washington Post who wrote And the Money Kept Rolling In (and Out), describes a vivid scene after the crash when a truck carrying Angus steers overturned on a highway: a crowd of machete-wielding shantytown residents slaughtered and butchered them, fighting each other for the bloody chunks of meat. He recounts stories of middle-class families riding a government-provided train into Buenos Aires each night to pick through garbage, searching for bottles, cardboard, and newspapers—anything that could be sold for recycling. This—in a country that had been prosperous, with no inflation and 6 percent annual economic growth.
Despite the differences between Argentina’s borrowing and our own (especially the fact that we borrow in our own currency, eliminating exchange-rate risk), Blustein finds unsettling “the manner in which the flow of foreign capital into the United States has rendered its policymakers complacent about the nation’s budget and trade deficits….” Official assurances “that foreigners will continue to provide the funding the United States needs as long as the country remains a good place to invest bear eerie similarities,” he writes, “to the logic employed by Argentine policymakers.”
Drowning in Liquidity?
Money flowing into the United States injects purchasing power into the economy unevenly—it affects certain sectors, such as housing, more than others. “Assume the world is divided into things that are tradable and things that are not,” says Jeffry Frieden. Hard goods, clothing, and most foods are tradable: they are transported easily across borders and are therefore subject to international competition. Haircuts, housing, medical care, restaurant food, and public transportation, on the other hand, are consumed where they are produced. Because these kinds of goods and services can’t be exported or imported, they are considered non-tradable. When foreigners are buying our currency, the dollar appreciates, making international goods relatively inexpensive. That leaves consumers with even more money to spend on non-tradables, such as housing and land. And because housing and land are not subject to foreign competition, their price goes up. Relative price indices from 1980 to 1985, a period characterized by large capital inflows resulting from the huge Reagan-era federal deficits, show that the price of industrial commodities, finished goods, and motor vehicles rose between 18 and 28 percent, but the price of non-tradables rose two to three times faster. “Relative price trends over the last seven years show a similar phenomenon,” Frieden reports.
“It drives me crazy,” he adds, “when I read in Business Week or the Wall Street Journal all the idiosyncratic reasons that people come up with to explain why the cost of housing has been going up. The reason is because the dollar has been rising” as capital has flowed into the country and kept interest rates down.
Copyright ©1996–2007, Harvard Magazine, Inc.
Link to Article Source
Debtor Nation: The rising risks of the American Dream, on a borrowed dime
by Jonathan Shaw
Consumerism is as American as cherry pie. Plasma TVs, iPods, granite countertops: you name it, we’ll buy it. To finance the national pastime, Americans have been borrowing from abroad on an increasingly stunning scale. In 2006, the infusion of foreign cash required to close the gap between American incomes and consumption reached nearly 7 percent of gross domestic product (GDP), leaving the United States with a deficit in its current account (an annual measure of capital flows to and from the rest of the world) of more than $850 billion. In other words, the quantity of goods and services that Americans consumed last year in excess of what we produced was close to the entire annual output of Brazil. “Brazil is the tenth largest economy on the planet,” points out Laura Alfaro, an associate professor of business administration who teaches a class on the current account deficit at Harvard Business School (HBS). “That is what the U.S. is eating up every year—a Brazil or a Mexico.”
Whether this practice is sustainable—and if not, how it might end—are questions that divide scholars and investors alike. We have borrowed so much from abroad—between half a trillion and a trillion dollars a year for the past six or seven years—that in 2006, our investment balance with the rest of the world (what we pay foreign investors on their U.S. assets versus their payments to us on our investments abroad, historically nearly equal) tipped to became an outflow for the first time in more than 50 years. We are a debtor nation swiftly heading deeper into debt.
Sidebar to this text:
* Not Your Daddy's Deficit
The global imbalances created by this dynamic of American borrowing and foreign lending appear stable for now, but if they slip suddenly, that could pose serious dangers for middle- and working-class Americans through soaring interest rates, a crash in the housing market, and sharply higher prices for anything no longer made domestically. Harvard economists and political scientists see possible threats to globalization (the opening of markets and trade that has made the economy a world phenomenon): the risk of rising protectionism; the potential for a world recession if market forces unwind the imbalances too quickly; and even the possibility that political considerations could trump shared economic interests, causing nations to use their international financial positions as weapons.
Photograph by Stu Rosner
Jeffrey Frankel
That last idea—that nations can wield power through their accumulation of currency reserves—is rooted in our own history. When President Dwight D. Eisenhower learned in 1956 that Britain, in collusion with France and Israel, had invaded Egypt without U.S. knowledge, he was infuriated. “Many people remember Suez,” notes Jeffrey Frankel, Harpel professor of capital formation and growth at the Kennedy School of Government (KSG), but few recall “the specific way that Eisenhower forced the British to back down.” At the time, there was a run on the pound sterling and he blocked the International Monetary Fund (IMF) from stabilizing the currency. With sterling on the verge of collapse, says Frankel, “Eisenhower told them, ‘We are not going to bail out the pound unless you pull out of Suez.’” Facing bankruptcy, the British withdrew. This incident, notes Frankel, “marked the end of Great Britain’s ability to conduct an independent foreign policy.”
Putting international politics aside for a moment, “When a country gets a capital inflow [such as the United States has now], generally speaking things are pretty good,” observes Jeffry Frieden, Stanfield professor of international peace. “It allows you to invest more than you save, and consume more than you produce. There is nothing necessarily wrong with that,” he notes. Firms do it all the time, and so do households. They borrow on the expectation that they will be more productive and better able to pay the money back in the future. The United States, for example, was “the world’s biggest debtor for a hundred years,” Frieden notes, “but the money was used to build the railroads and the canals and the factories and to improve the ports and to build our cities. It was used productively, and it worked. The question to ask now is not, ‘Is the country living beyond its means?’ The question is, ‘Is the money going to increase the productive capacity of the economy?’ Because if it just goes to getting everybody another iPod,” he warns, “then unless iPods make people more productive, there is going to be trouble down the road when the debt has to be serviced.”
Photograph by Stu Rosner
Jeffry Frieden
Trouble struck Mexico in 1995, Thailand, Malaysia, and other countries in 1997, and Argentina in 2001, after those countries borrowed vast sums in the international marketplace. Argentina before the crash had been a model developing nation and a darling of the IMF, closely following the fund’s economic prescription for integration into the global system of finance and trade. But even the IMF could not save the country from the destabilizing effects of international capital flows. When global investors realized that Argentina’s debt load was unsustainable, they sold their assets, called in their loans, and exited the country. Overnight the Argentine peso plummeted in value against the dollar, the currency in which debt had been issued, and staggering obligations suddenly became unpayable. Argentines who had financed their mortgages in dollars lost their homes. There was a run on the banks, and the government imposed a limit on cash withdrawals. In a country abounding with wheatfields and cattle ranches, starving people began raiding garbage bags in wealthy neighborhoods.
Paul Blustein, a financial reporter for the Washington Post who wrote And the Money Kept Rolling In (and Out), describes a vivid scene after the crash when a truck carrying Angus steers overturned on a highway: a crowd of machete-wielding shantytown residents slaughtered and butchered them, fighting each other for the bloody chunks of meat. He recounts stories of middle-class families riding a government-provided train into Buenos Aires each night to pick through garbage, searching for bottles, cardboard, and newspapers—anything that could be sold for recycling. This—in a country that had been prosperous, with no inflation and 6 percent annual economic growth.
Despite the differences between Argentina’s borrowing and our own (especially the fact that we borrow in our own currency, eliminating exchange-rate risk), Blustein finds unsettling “the manner in which the flow of foreign capital into the United States has rendered its policymakers complacent about the nation’s budget and trade deficits….” Official assurances “that foreigners will continue to provide the funding the United States needs as long as the country remains a good place to invest bear eerie similarities,” he writes, “to the logic employed by Argentine policymakers.”
Drowning in Liquidity?
Money flowing into the United States injects purchasing power into the economy unevenly—it affects certain sectors, such as housing, more than others. “Assume the world is divided into things that are tradable and things that are not,” says Jeffry Frieden. Hard goods, clothing, and most foods are tradable: they are transported easily across borders and are therefore subject to international competition. Haircuts, housing, medical care, restaurant food, and public transportation, on the other hand, are consumed where they are produced. Because these kinds of goods and services can’t be exported or imported, they are considered non-tradable. When foreigners are buying our currency, the dollar appreciates, making international goods relatively inexpensive. That leaves consumers with even more money to spend on non-tradables, such as housing and land. And because housing and land are not subject to foreign competition, their price goes up. Relative price indices from 1980 to 1985, a period characterized by large capital inflows resulting from the huge Reagan-era federal deficits, show that the price of industrial commodities, finished goods, and motor vehicles rose between 18 and 28 percent, but the price of non-tradables rose two to three times faster. “Relative price trends over the last seven years show a similar phenomenon,” Frieden reports.
“It drives me crazy,” he adds, “when I read in Business Week or the Wall Street Journal all the idiosyncratic reasons that people come up with to explain why the cost of housing has been going up. The reason is because the dollar has been rising” as capital has flowed into the country and kept interest rates down.
Copyright ©1996–2007, Harvard Magazine, Inc.
Link to Article Source
This entry was posted
on Tuesday, August 14, 2007 at 22:53.
