How Dangerous Is U.S. Government Debt?

The Risk of a Sudden Spike in U.S. Interest Rates

June 2010

Facade of the Treasury Department in Washington, DC, on May 25, 2008. (AgnosticPreachersKid/Wikimedia Commons)

BY

Francis E. Warnock

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Overview

The dollar’s status as the world’s reserve currency has become a facet of U.S. power, allowing the United States to borrow effortlessly and sustain an assertive foreign policy. But the capital inflows associated with the dollar’s reserve-currency status have created a vulnerability, too, opening the door to a foreign sell-off of U.S. securities that could drive up U.S. interest rates. In this Center for Geoeconomic Studies Capital Flows Quarterly, Francis E. Warnock argues that a sell-off came close to happening in 2009. How the United States uses this reprieve will affect the nation’s ability to borrow for years to come, with broad implications for the sustainability of an active U.S. foreign policy.

Excerpt

Introduction

Source: BEA. Note all data are in BOP accounting terms (that is, outflows [-], inflows [+]).

Endnotes

[1]
Robert Triffin, Gold and the Dollar Crisis: The Future of Convertibility (New Haven: Yale University Press, 1961).
[2]
Henny Sender, “China to Stick with U.S. Bonds,” FT.com, February 11, 2009.
[3]
See http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/2008/02/23/the-euro-could-surpass-the-dollar-within%2010-years/.
[4]
The baseline CBO forecast must assume policies remain as they currently are, which means that temporary spending provisions are assumed to expire, even if in practice they are often extended. For a discussion of various deficit and debt forecasts, see Alan Auerbach and William Gale, “Déjà Vu All Over Again: On the Dismal Prospects for the Federal Budget” (Brookings Institution mimeograph, 2010), which notes that the main concern is not in deficits over the next year or two, but medium- and long-term deficits.
[5]
Laubach’s analysis is explicitly about five-year projections of deficits (and debt), so one should caution against using it to make statements about the impact of cyclical deficits. It is more appropriate for longer-term fiscal trends. See Thomas Laubach, “New Evidence on the Interest Rate Effects of Budget Deficits and Debt,” Journal of the European Economic Association, vol. 7, no. 4, pp. 858–885.
[6]
David Malpass, chief economist of Bear Stearns, quoted in “Their Money, Our Strength,” Wall Street Journal, August 5, 2004.
[7]
See Francis E Warnock and Veronica Cacdac Warnock, “International Capital Flows and U.S. Interest Rates,” Journal of International Money and Finance, vol. 28 (2009), pp. 903-19.
[8]
For a more eloquent discussion of salient features of the U.S. Treasury market, see Brian Sack, “Dollar Asset Markets: Prospects after the Crisis,” remarks at the ACI 2010 World Congress, Sydney, Australia, March 26, 2010.
[9]
See, for example, Jacques Delpla and Jakob von Weizsäcker, “The Blue Bond Proposal,” Bruegel Policy Brief 2010/03.
[10]
See Sack, “Dollar Asset Markets.”
[11]
These adjustments, developed by Charles Thomas, Francis E. Warnock, and Jon Wongswan in “The Performance of International Equity Portfolios” (NBER Working Paper 12346, 2006) and refined by Carol Bertaut and Ralph Tryon in “Monthly Estimates of U.S. Cross-Border Securities Positions” (FRB International Finance Discussion Paper No. 910, 2007), are updated each year on http://www.federalreserve.gov/pubs/ifdp/2007/910/default.htm.
[12]
The transactions center bias in the TIC data on long-term securities flows derives from the fact that the respondents are asked to identify the country through which the transaction was made, which can differ from the country of the ultimate buyer (in the case of inflows) or of the issuer (in the case of outflows). Liabilities data collected on a custodial basis can also have a bias if the custodian and ultimate investor reside in different countries. To see that the Federal Reserve adjustment is largely a removal of the transaction center bias, note that for Treasury bills, which are collected by the TIC system on a custodial basis, the discrepancy between TIC and BOP data is quite modest.
[13]
Note that even with all available information, there is nothing pristine about transactions-based international capital flows data collected for BOP purposes. A fundamental difficulty with such a data collection system is that it asks reporters to submit data that they would never collect on their own. A financial intermediary would not naturally care about the residency of the parties on either side of a trade, but that is exactly what BOP accounting rules ask them to do. More natural might be to obtain higher frequency reads on cross-border positions, something naturally collected by custodians, and use them to calculate flows.