Borrowing from abroad.
Lots of it. Almost unimaginably large amounts of it. At very attractive interest rates, thanks to the yen carry trade and our friends in the central banks of China, Russia, Saudi Arabia and a few others (Korea, Taiwan, increasingly Brazil and a host of small oil exporters). Emerging market central banks and oil exporters almost certainly added $550b to their existing stock of dollars (I’ll provide the details later) in 2006 – some of that directly financed the US current account deficit, some of that was held offshore where it indirectly financed the US deficit, and a tiny fraction was invested in the dollar denominated sovereign bonds of other emerging markets.
I actually think central bank reserve diversification out of the dollar -- or just a substantial reduction in central bank inflows -- would be scary. I just don't think it has happened. Not in aggregate. Russia's diversfication in 2006 seems to have been more than offset by rising dollar accumulation by others.
The huge ongoing flow of capital into the US is now taken for granted. The possibility that this flow would stop wasn’t even listed – a don’t think a passing reference to a falling dollar counts -- among the Nick Timiraos’ list of risks to “Goldilocks” in the weekend Journal. Protectionism – which would cut into business profits – was the main external risk cited. Not an inability to raise about $ 1 trillion net from abroad …
Never mind that returns on investment in the US have lagged returns on investment elsewhere for the past several years --- or that forecasts showing that the US external deficit isn’t that bad tend to assume that the US will continue to offer far lower returns than investment elsewhere. The money will still come in.
There isn’t much need to worry about US “asset protectionism” either. How did China respond when the US said no to CNOOC? By buying even more bonds …
Actually we don’t know this for sure, because the best US data on Chinese purchases comes with a big lag, but it seems quite likely. China needed to invest about $300b in foreign debt markets this year to offset its current account surplus and net FDI inflows. I would be surprised if much less than $200b went into dollar assets.
And how did Dubai and the UAE respond when the US said no to Dubai ports world. By spending 6 months studying whether to cut the dollar share of its reserves from 98% to 90%, and by buying (even more) US property. $2 billion worth. Wall Street may not like limits on the potential set of buyers for US companies, but, well, as long as the money continues to come in – even if a different form – the US can finance its deficit.
So far, I have to say, the result of the US invasion of Iraq has been far, far worse than I imagined could be possible. Midwifing a civil war isn't pretty. And the results of the United States growing dependence on imported savings – the flip side of the US current account deficit – have been far smaller than I thought likely.
But just as the US found getting into Iraq a lot easier than getting out, so too the US may find that getting into foreign debt is a lot easier than getting out. Or, to put it just a bit differently, it wasn’t that hard for most Americans (at least those who don’t make tradable goods) to get used to borrowing almost a trillion dollars a year from the rest of the world. And it won’t be easy to get rid of that need …
Most realistic projections show that the US will need to – barring a hard landing – borrow about a trillion dollar (or an equivalent amount of euros) a year for the foreseeable future. That is what happens if the trade deficit falls – and to be honest, I think forecasts showing a big fall in the US trade deficit in 2007 extrapolate the q4 data a bit too heavily -- just because the interest bill on the US debt will still rise. And it will have to refinance its existing stock of foreign debt as well.
I still worry that Floyd Norris may be right. The US may not quite realize how much it took the dollar’s financial hegemony for granted until that hegemony starts to go away. He wrote on Saturday (Time Select):
The United States has profited greatly by having a printing press for the currency the world wants. Efforts to protect that position — by slowing the erosion of the dollar and reducing the balance-of-payments deficit — are barely on the political radar. A generation from now, Americans may marvel at the complacency that assumed the dollar’s dominance would never end.
I would frame it just a tiny a bit differently. The world would change radically if the US actually had to offer foreigners approximately the same return (adjusted for currency moves) as other countries now have to offer …
But hey, I can detect a trend. Complacency is officially in. Worrying about complacency is out. After all, worrying hasn't made anyone much money recently.