Debtor Nation, another view

Debtor Nation, Without Rhetoric
By Thomas Nugent
Feb 24. 2004

In the world of economic analysis, fundamental truths are sometimes
lost to rhetoric. For example, it is fact ? not theory ? that
government budget deficits add exactly that amount to the savings of
financial assets that the rest of us hold. Yet politicians and
economists have attacked the federal budget deficit on the premise
that it reduces savings. Few media moguls pick up on the fact that
expansive fiscal policy (the budget deficit) has been directly
responsible for the recent increases in non-government savings, just
as they overlooked the fact that the Clinton surpluses reduced our
savings.

Along with errantly berating budget deficits as draining our savings,
the media make an equally illogical error regarding the trade deficit.
Within the Beltway, a trade deficit means that U.S. consumption is at
the mercy of foreign lenders, and the U.S. Treasury is beholden to
foreign owners of its securities. The image is that of the U.S.
government and American consumer going hat-in-hand around the world
begging for credit to fund expenditures, with the United States also
at risk of meeting its foreign "obligations." We are presumed to be
suffering the consequences of being a debtor nation.

Fortunately, the truth is far from the mythology. To expose these
myths, all that's needed is a closer look at what's really happening.
First it's the U.S. consumer who is funding foreign savings, and not
foreign savings that is funding the consumer. Second, U.S. Treasury
issuance has to do with alternative accounts at the Federal Reserve,
and is not the precursor of financial stress.

What occurs when a U.S. consumer purchases a German-made car? If the
consumer pays cash, the consumer's checking account in a U.S. bank is
debited and the German car maker's account is credited, thereby
increasing foreign savings of U.S. dollars. Total deposits in the U.S.
banking system remain the same. (By the way, there is no cargo ship in
New York harbor taking dollars back to Germany. All that occurs is a
change in holders of U.S. dollar deposits in the banking system.)

When the consumer borrows to buy the car rather than using cash in his
bank account (a more likely option), the bank makes a loan to the
consumer, creating a loan on the asset side of the bank's balance
*** and a new deposit on the liability side. (Loans create
deposits.) After the car is paid for, the German car company has the
new bank deposit. Note that consumer borrowing increased total bank
deposits and funded foreign deposits (savings) of U.S. dollars. The
widely held causal myth is that foreigners are funding U.S. consumers.

That's what the trade gap is all about -- the desire of foreigners to
net save U.S. dollars and to sell goods and services to the U.S. to
obtain those assets. If foreigners did not desire to save U.S.
dollars, they would instead [use their dollars to] buy goods and
services from the U.S. and there would be no trade deficit.

Following the above transaction, the foreign holder of U.S. dollar
bank deposits may decide to invest in U.S. Treasury securities rather
than hold a bank deposit. At the time of the German car company's
purchase of these securities, the seller of the Treasury securities
becomes the new holder of the bank deposit, and the foreigner the new
holder of the Treasury security. (If the foreigner buys securities
directly from the Treasury the result is the same.)

When foreigners hold Treasury securities, the U.S. government is said
to have foreign creditors, and the U.S. is said to be a debtor nation.
While this is true by definition, a look past the rhetoric at what the
U.S. government actually owes the holder of Treasury securities is
revealing. The government promises that, at maturity, the foreigner's
security account at the Fed will be debited, and his bank's reserve
account at the Fed will be credited for the balance due. In other
words, the U.S. government's promise is only that, at maturity of the
Treasury security, a non-interest bearing reserve balance will be
substituted for an interest bearing Treasury security. This
transaction is not a potential source of financial stress for the
government. Remember, the U.S. is no longer on a gold standard meaning
that the dollar is not redeemable at the government for gold or any
other good or service. Holders of deposits or Treasury securities
can't demand the surrender of our national parks, or any other U.S.
asset.

Understanding that government deficits add to savings and that U.S.
consumers fund the desires of foreigners to save is a good way to
start seeing through the media's economic mythology.

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