Deep Throat is no longer Washington’s best kept secret, the ten-year Treasury note yields less than 4% and Stephen Roach is a (reluctant) bond bull. The currency of a country with a 6.5% of GDP current account deficit is rallying ...
So it is least worth asking whether the US is taking on the right amount of external debt. After all, what’s the point of having the world’s reserve currency if you don’t use it?
There is little doubt the US external debt to GDP ratio is set to rise sharply in 2005 -- probably to well over 30% of US GDP and 300% of US exports. That is what a 6.5% of GDP -- maybe more this year, and certainly more in 2006 if the dollar stays strong -- current account deficit does, particularly if the value of your existing external assets is falling (big time). Technically, what matters is the trade and transfers deficit, not the current account deficit, but with net interest payments on US debt still fairly low, they are pretty close to the same thing, at least for now.
Rising external debt has an obvious domestic counterpart. Rising household debt. Justin Lahart noted in his Tuesday Wall Street Journal column:
"In last year’s fourth quarter, the debt-to-income ratio of US households came in at an all time high of 1.2-to-1, according to the Federal Reserve. A decade ago it was 0.9-to-1. Household debt as a share of household assets is near an all-time high -- a tough trick considering how much of the value of household assets has been juiced up by rising housing prices. ... it seems safe to say that American households have been employing more financial leverage. Put another way, they’ve been taking on more risk."
Lahart’s twist? Maybe households are not taking on too much risk now, but rather they were taking on too little in the past.
"It could be that they were not taking on enough risk in the past, and lost opportunities because of it. It could be that, because the Fed as learned to more skillfully manage the economy, taking on more risk isn’t all that risky."
Lahart doesn’t fully buy that argument -- since the sustainability of a higher debt to income ratio hasn’t been tested by a shock. I don’t either. I am not persuaded by the commonly made argument that that rising household debt doesn’t matter, because household assets are rising even faster. Brian Wesbury of Claymore Advisors is the latest to make this argument on the Journal’s oped page. Houses were worth $17.2 trillion at the end of 2004; mortgage debt was only $7.5 trillion.
Where is the problem? Simple. Folks like my parents who bought a house a long time ago have lots of home equity and very little debt. They could weather a housing slump, no problem. But folks who bought in recently -- particularly with an interest only mortgage -- have lots of debt and little (or no) equity. If prices were to fall, there mortgage debt might exceed the price they could sell their home. That is a potential problem.
But what of the US writ large? Did the US, which was a net creditor for most of the post-war era, and had roughly equal external assets and external liabilities until quite recently, fail to take on enough risk during this period, and lose opportunities as a result? Did the US, for example, make a mistake by not financing the cold war by running up its external debt? If so, we sure don’t intend to repeat that mistake in the war against terror.
One thing is clear. The external side of the US economy is now much more leveraged that it has been in the last. Back at the end of 2000, net external debt was around 10% of GDP, a bit under 100% of 2000 exports. It is 25% of US GDP now, and, as noted earlier, set to be well over 30% of US GDP, or 300% of exports, at the end of 2005. That number though is a bit misleading, since the US is on a trajectory that implies significant further increases in its external debt. Nouriel and I have consistently noted that the trade and transfers deficit is now so large than even if it starts to fall by a half a percent of GDP a year, it will remain at levels that imply rising external debt to GDP ratios for some time. Consequently, in a gradual adjustment scenario, US external debt rises to over 50% of GDP -- and even if the trade deficit is closed by increasing exports to around 15% of GDP, not by reducing imports to 10% of GDP, the US debt to export ratio will rise toward 400%. If the US cannot grow its exports fast enough, and adjustment comes through falling imports, the US debt to export ratio will be even higher.
That is quite leveraged by international standards -- and I don’t buy the notion that external debt should be compared to domestic assets, rather than external assets. Lots of domestic assets -- think houses -- don’t generate external income.
If net external debt is 50% of GDP, even a 5% interest rate implies 2.5% of GDP in net interest payments. Since net debt will be the difference between say external assets of 50% of GDP and external debts of 100% of GDP, the US just might earn enough "carry" from higher returns on its external assets than it pays on its external liabilities to offset some of this -- but net interest payments are likely still to be around 2% of GDP, even in a rather benign scenario. Positive interest differentials may support the dollar, but they also increase the interest bill on US external debt.
Of course, if the US trade and transfers deficit keeps expanding US external debt will rise to an even higher level, assuming that the adjustment process is still gradual. More leverage. More opportunity to spend more than we in the US earn. More risk? Or a recognition that the US has not used the dollar’s reserve currency status as much as it should have the past, and thus failed to take advantage of an obvious opportunity? We are about to find out.
The deep irony, of course, is that much, if not most, of the financing that the US is relying on to cover current costs of the "fight for freedom" comes from countries that themselves are not free. China. Saudi Arabia. Putin’s Russia. All have large current accounts surpluses, and spare dollars that ultimately get lent back to the US, either directly or through intermediaries ...