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The Debt Wolf at the Door

Author: Bruce Stokes
July 3, 1999
National Journal


When the fabled shepherd boy cried "Wolf!" before the predator was actually attacking his sheep, he forever became the ignominious symbol of the consequences of raising a false alarm. But in one way, the boy got a bad rap. Although he misled the villagers twice, the wolf eventually did come. In retrospect, perhaps this children’s tale has two morals: not just the perils of "crying wolf," but also the dangers of ignoring warnings.

In that revisionist spirit, we should listen to Robert A. Blecker, a visiting fellow at the labor-funded Economic Policy Institute in Washington, who in a paper released this week became the latest in a long list of economists—from Martin Feldstein, former head of the president’s Council of Economic Advisers, to C. Fred Bersten, head of Washington’s Institute for International Economics—to warn of the economic troubles that could ensue from America’s rising indebtedness to the world. Once the world’s largest creditor, the United States is now its largest debtor, owing foreigners $1.6 trillion, according to figures released this week by the Commerce Department. This means that foreign investors hold a lot more U.S. liquid assets, such as corporate stocks and government securities, than we own of theirs.

"If present trends continue," said Blecker, "the growth in U.S. international debt will not be sustainable in the long run. No country can continue to borrow so much from abroad without eventually triggering a depreciation of its currency and a contraction of its economy."

Few economists would dispute that warning. But the problem, as the shepherd boy learned to his chagrin, is that repeated warnings of doom and gloom that don’t immediately come true are rapidly ignored. Similar prophecies of an economic hard landing appeared in the early 1980s, when the United States first became a debtor. But the recession in the early ’90s had other causes besides foreign debt. Now in the flush 1990s, deadbeat America has still somehow avoided its comeuppance, and anyone trying to get Washington to worry about this "problem," let alone take some precautionary action to deal with it, is listened to about as closely as the boy crying wolf.

U.S. international indebtedness is the cumulative consequence of running trade deficits every year since 1976. Because Americans consume more than they save, the economy has to borrow to make up the difference. Blecker estimates the debt was 18.3 percent of the gross national product in 1998. And if the current trends continue, by 2006 it could exceed $4 trillion, which would equal more than a third of the GNP by that time.

Since 1997, foreigners have also earned more in interest and dividends here—and taken them home—than Americans have earned abroad, with this cash outflow totaling $66.4 billion last year. As a result, Washington finds itself borrowing both to cover its obligations and to cover the interest on its previous borrowings, an unenviable trap in which the debts compound rapidly. "It is simply inconceivable that these variables could continue to increase indefinitely without engendering an investor reaction at some point," said Blecker.

If U.S. growth slows and rates of return look better in other parts of the world, if the Wall Street bubble seems about to burst, or if the dollar appears to be weakening against other currencies, the foreign money gush could rapidly change to a trickle. With the supply of foreign cash curtailed, U.S. interest rates would rise, growth would slow, and the dollar would plummet.

"Once the system got into a crisis," said Wall street investment advisor Richard Medley, "our foreign debt would be an accelerant into a devastating crisis."

Yet experience over the past 15 years suggests this danger is remote, thanks to the continued strong performance of the U.S. economy; to the breadth and depth of U.S. financial markets, which offer investors safety they won’t find elsewhere; and to the insatiable global demand for the dollar as the world’s principal reserve currency. "At some time it will be necessary to narrow the [debt]," said William Cline, chief economist at the Washington-based Institute of International Finance, "but I don’t think you can characterize it as a Damocles sword."

And in Washington, no sword, no action. In fact, the current debate over how much the Federal Reserve should raise interest rates, after a quarter-point rise this week, has largely ignored this rise’s implications for the foreign debt. It could cut either way. A higher rate will increase the cost of servicing the debt and could strengthen the dollar, which would worsen the trade deficit. Or, it could slow U.S. growth, which would slacken the thirst for imports and narrow the trade deficit.

Blecker’s study is organized labor’s effort to belatedly inject the foreign debt into current policy debates and to argue for weakening the dollar now, among other things, to effect a soft landing next time the economy dips.

But when other economists have cried wolf too often and too early about the foreign debt, Washington has turned a deaf ear—perhaps understandably, given the lack of immediate economic impact—and Blecker is likely to share the same fate. His warnings, like the shepherd’s, won’t be taken seriously until the wolf arrives, and then it will be too late.

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