Re-evaluating U.S. Debt

The U.S. budget deficit is financed by borrowing. More and more of that money comes from China, now the United States' second-largest lender, after Japan. China's investment in U.S. government debt has more than tripled in the past five years, from $71 billion in 2000 to $242 billion in 2005.

Is that a problem? No, says the director of the Congressional Budget Office, Douglas Holtz-Eakin. "Dollars all look the same," he added. "Their ultimate source doesn't matter."

Under pressure to pay for hurricane recovery, the war in Iraq, a costly transportation bill, tax cuts, and a new prescription drug program, Congress and the president have been unwilling to raise taxes or make deep spending cuts. The only alternative is to borrow.

And foreigners are awash in U.S. dollars. Americans buy goods from abroad. Foreigners use the cash to buy U.S. debt. That keeps U.S. interest rates low, which makes the foreigners happy because it means Americans can continue to buy their goods.

In the view of Albert Keidel of the Carnegie Endowment, "It's not a problem." The Chinese, he added, "are becoming increasingly reasonable members of the world financial community. They don't want to be seen as irresponsible or vindictive."

According to Dominic Wilson, global economic analyst for Goldman Sachs, the Chinese "have no great interest in destabilizing either the U.S. bond market or the U.S. economy. This is a major export market. For China, it is the largest."

But isn't there something worrisome about Communist China financing the U.S. government? Wilson acknowledged some concern. "It is a situation that makes the U.S. more vulnerable to decisions of overseas governments and the decisions of overseas investors," he said. "That is not a situation that, over the long run, you want to be in."

Japan is still, by far, the largest U.S. lender, with $683 billion in U.S. debt, nearly three times as much as China. But the source of Japanese lending has shifted. About 18 months ago, the Japanese government began to move away from the large-scale purchase of U.S. securities, and its private sector stepped in to fill the gap. In China, however, it's the government that's lending money to the United States. Is that better or worse for the United States?

A government is more likely to be a stable investor. Private investors could be inclined to stampede or panic. But the Chinese government's investment in this country does give that government a lot of potential bargaining power. As Wilson of Goldman Sachs put it, "If you are thinking about the leverage that it gives to the Chinese government, that is obviously an easier bargaining chip to play when those securities are in the hands of government rather than the private sector."

If the Chinese decide to cut back their investment, that decision could drive U.S. interest rates up. The Carnegie Endowment's Keidel isn't too worried about that either. "The force that manages U.S. interest rates is the Federal Reserve," he pointed out. "The U.S. Federal Reserve has enormous resources. What the Chinese might do can't really compete with what the Fed would do."

Meanwhile, U.S. manufacturers want the Bush administration to put more pressure on China to increase the value of its currency. Small U.S. manufacturers face increased competition from China and want to make imports from China more expensive in the U.S. market. They favor legislation that would define Chinese "currency manipulation" as an unfair trade practice and impose penalties for it. "I don't want to bow to China in my lifetime," a manufacturer of industrial steel floats told The New York Times. "I do not want to see them taking over in every area of manufacturing."

China did raise the value of its currency slightly in July and has promised further revaluations. The Bush administration favors putting gradual pressure on China rather than imposing stiff sanctions. One reason is that rapid revaluation could negatively impact Chinese investment in U.S. government debt. With revaluation, Wilson said, "their need to buy U.S. Treasuries and U.S. dollar assets will naturally go down."

Speculators who have been betting on revaluation will say it's time to cash in. "You will see, not continued inflows that will require the Chinese to buy Treasuries, but sudden outflows," Keidel said. "They would have to come up with the liquidity that they would need to have the money flow out." China would have less cash to invest in U.S. debt.

One former U.S. policy maker sounds worried. "Every single day of the year, our government goes into the market and borrows money from other countries to finance Iraq, Afghanistan, Katrina, and our tax cuts," former President Clinton said on ABC News' This Week. "We have never done this before."

Actually we have, economists say. The French helped to finance the American Revolution and the War of 1812, and the United States has borrowed from international financial markets throughout its history—but never on this scale. In Keidel's view, "The real issue now is not where the money is coming from, but is this size deficit healthy for the U.S.?"

Economists argue that the problem is not the lender. It's the borrower. "In terms of the dependence on foreign borrowing, I think the simple solution is that the U.S. needs to save more," Wilson said. If Americans were to save more, they could borrow the money from themselves, not from foreigners.