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.
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.