The Economy January/February 2004

America's "Suez Moment"

The growing trade deficit threatens U.S. living standards and makes the country dangerously vulnerable to economic extortion. The way out is to make foreigners act more like us

Despite its unchallenged military might, the United States has an Achilles' heel: its economy depends on foreign capital. Though hardly anyone acknowledges this publicly, China and Japan already hold so much American debt that, theoretically, each could exert enormous leverage on American foreign policy. So far, the economic dependence of these countries on American consumers has kept them from exercising such power. But what would happen if, for instance, Washington changed its one-China policy and officially recognized Taiwan? Or if the Bush Administration threatened to invade North Korea? Simply by dumping U.S. Treasury bills and other dollar-denominated assets, China—which holds more federal U.S. debt than any other country—could cause the value of the dollar to plummet, leading to a major crisis for the U.S. economy.

China and Japan wouldn't have to be consciously hostile to wreak havoc; they could create a currency crisis by accident, through either bad policy decisions or instability in their own economies. Both countries have weak banking systems that are burdened by bad loans that will never be repaid. Economists have long warned that the collapse of Japan's banking system could devastate the United States. A Chinese banking crisis could cause equally severe problems.

America is like no other dominant great power in modern history—because it depends on other countries for capital to sustain its military and economic dominance. In comparison, consider the British Empire. At the height of its imperial reign, in 1913, Britain was a net exporter, or investor, of capital; it invested the equivalent of nine percent of its gross domestic product in foreign countries that year, helping to finance the infrastructures of the United States, Canada, Australia, and Argentina. Even long afterward Britain was able to retain a prominent international role in large part because it earned interest and dividends on the enormous investments it had made during its heyday. In contrast, the United States today is a net importer, or borrower, of capital—not only from China and Japan but also from Europe and emerging economies, at a rate of more than $500 billion a year, or approximately five percent of our GDP.

The British Empire eventually declined, of course, and in 1956 it endured the humiliating demise of its great-power status in a clash over the Suez Canal. U.S. policymakers should take note: Britain was brought to its knees not by a military defeat but by an economic one—specifically, America's refusal to support the British pound, which created a monetary crisis for the British government, forcing it to call off its ill-advised campaign with France and Israel to recapture the Suez Canal after nationalization by Egypt. As its international debt grows, the United States becomes ever more vulnerable to its own Suez moment.

Our "Co-Dependent" Economy

The United States has so far been able to slow its relative global economic decline because of its unique role in the international economic system as the consumer of first and last resort. Other countries have been willing to lend us money (generally by buying U.S. assets and Treasury bills) not because investing in America has been so profitable but because we provide a market for the goods produced by their industrializing economies.

America is the world's only consumption superpower. As such, it deserves a great deal of credit for the recovery of European economies in the 1950s and 1960s, the Asian export miracle of the 1980s and 1990s, and the recent commercial rise of China. American consumers have powered the Keynesian engine that lifted the world economy out of its past three recessions, in 1982-1983, 1991-1992, and 2001-2002. The problem, however, is that with each turn of the global economic cycle, America has gone deeper into debt to the rest of the world. Today we owe almost $3 trillion—close to 30 percent of annual GDP—in international debt.

This problem is largely a result of our propensity to live beyond our means; Americans save too little and consume too much. But it is exacerbated by the behavior of our closest trading partners in Asia and (to a lesser degree) Europe, who are our fiscal mirror opposites: they save too much and consume too little. America and its trading partners are locked in co-dependency. In the short term this co-dependency has actually worked reasonably well: our principal trading partners lend us money to buy their cheaper goods with a strong dollar. In return they have access to a stable market for their products, enabling their economies to grow at an impressive rate.

But for the United States this relationship has significant costs that are only now beginning to be felt. For one thing, the availability of cheap foreign goods and services has led to the erosion of America's productive capacity. More important, now that the United States depends as heavily as many developing nations on borrowing from abroad, our standard of living and our dominant position in the world are at risk.

American policymakers have been slow to grasp this, however, because the initial effects of our growing debt burden have been more positive than negative. But eventually our growing international debt will produce more- painful consequences. If foreign investors become reluctant to lend to us, as they will if they foresee that we can't keep up with our mounting obligations, the dollar will fall, driving up interest rates and increasing the cost of living for most Americans. The modest decline in the value of the dollar over the past six months may be a harbinger of much steeper declines to come.

Some "new economy" theorists argue that in today's borderless world economy, the current-account deficit—the broadest measure of our negative balance of payments with the rest of the world—no longer matters, because we can endlessly borrow and attract capital from outside the United States. But current-account deficits and international debt do matter; they represent real claims on U.S. assets by foreign individuals and corporations—claims that will eventually need to be repaid. If China, Japan, and Europe are today subsidizing our national standard of living at a rate of more than five percent of GDP a year, then at some point we will need to subsidize theirs—and we will need to do so by an even larger amount, because of interest on the debt (and dividends on the assets) they own. Moreover, if the dollar declines, we will have to pay other countries more for their goods. This will lead to declining standards of living for most Americans.

The U.S. standard of living may at first seem to have little direct connection to our country's global military standing. But will taxpaying American voters be willing to spend ever larger sums of money to sustain our military position and assume responsibility for nation-building in dangerous parts of the world even as their standard of living is falling? The current debate over the growing price tag of the occupation and reconstruction of Iraq, which cuts across party lines, suggests not.

Building a Global Middle Class

How to escape this predicament? The United States cannot, of course, undo its debtor position overnight. But there are steps that it can take to keep the current-account deficit from getting worse, and to begin to wean our economy from its unhealthy relationship with Asian exporters. Essentially, we must begin to reverse the pattern of overconsumption by Americans and underconsumption by Asians that now characterizes the U.S.-Asian relationship. The first step, if we want to stop accumulating international debt, is to begin producing more than we consume—and to do that we must increase our national levels of saving and investment.

But that in itself could cause a global economic crisis: if American consumers stop buying, the world economy might sputter and collapse. Thus we must also encourage other societies to consume more, particularly more U.S. goods and services. There are inherent limits to how much the aging societies of Europe and Japan will be able to absorb from American producers, so the fastest route to decreasing the current-account deficit while growing the global economy lies in building a middle class of consumers in the emerging economies of Asia, Eastern Europe, and Latin America. The way to do this is to encourage Europe and Japan to invest their surplus savings in countries such as South Korea, China, Taiwan, Brazil, Malaysia, Turkey, and Mexico. Such an influx of investment would allow those emerging economies to both consume more and invest more, helping to produce what might be called middle-class-oriented development.

How would middle-class-oriented development work? The American experience in creating mass affluence in the twentieth century offers a model. The United States grew rich not by exporting its wares to Britain and France but by creating a large domestic market for American-made goods and services. This market was created in part by establishing a system of credit that allowed millions of Americans to get thirty-year mortgages to buy or build their own homes; by establishing a municipal and state bond market that allowed local governments to build new schools and roads and to finance modern electricity and water systems; and by developing loan programs that allowed entrepreneurs to provide needed services to new homeowners and growing businesses. All these activities helped to create millions of jobs for architects, engineers, plumbers, electricians, bricklayers, and others—along with enough demand to encourage ever more investment. Even today homeownership remains one of the cornerstones of American prosperity; and the home-mortgage market is one of the pillars of the U.S. financial system. To promote middle-class development in their emerging economies, therefore, governments should aim not simply at boosting manufactured exports but also at expanding domestic consumption, homeownership, and public infrastructure. They could begin to do so (with the help of the international financial community) by creating the equivalent of Fannie Mae and Freddie Mac, two quasi-governmental institutions that have helped make homeownership possible for millions of working Americans, and by creating local and state bond markets to finance new roads, schools, and water systems.

Unfortunately, over the past several decades the United States has all but ignored the success of its own middle-class-oriented development in formulating international economic policy, choosing instead to push developing countries to export in a way that has served the interests of neither its middle class nor aspiring middle classes in emerging economies. If the United States is to regain long-term international solvency without provoking a global economic crisis, it will only be by urgently promoting middle-class-oriented development worldwide.

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