The Privilege of American Debt

By Philippe Martin
Libération

Monday 06 February 2006

Starting in 1982, the United States began to accumulate external deficits that have increased significantly during the last five years. These deficits may represent the greatest threat to the global economy, but President Bush was silent on the subject during his State of the Union speech last week. Accounting for these deficits is rather simple at first glance: Americans consume and invest more than they produce. In order to do that, they import more goods than they export, and every year they therefore have to borrow more from the rest of the world. Americans don't want to save (the household savings rate is negative!), and the rest of the world does it for them. For 2005, the current account deficit - and therefore the increase in external debt - exceeded 6% of American GDP. That means that in 2005 alone, external debt increased over 6,000 Euros [$7,200] per household! The total of these accumulated deficits brings the net debt to the rest of the world to about 25,000 Euros [$30,000] per household. The natural counterpart is that practically every other country in the world - industrialized countries and even countries that are still relatively poor like China and emerging Asian countries - lends to the United States. No other country could allow itself to take such a debtor position without lenders either demanding a risk premium or packing up their bags - which would cause the currency to fall. It is difficult not to make a connection with the idea that the United States enjoys an "exorbitant privilege," the expression attributed to de Gaulle in 1965 (but in fact pronounced by his Finance Minister, Giscard d'Estaing). In a recent article (on the site www.cepr.org), Pierre-Olivier Gourinchas and Hélène Rey, two French economists teaching in the United States, have analyzed the nature of this privilege that has allowed the United States to go into debt without (so far) having to pay for all the consequences. One would expect that a country indebted to the rest of the world would have to pay interest on that debt. That is not the case: with the exception of the last trimester of 2005, the United States has always received more interest and dividends from the rest of the world than it has paid out. How is that possible? Net American debt is the difference between all foreigners' assets in the United States (the liability side of the US balance sheet) and American assets elsewhere in the world (the asset side of the balance sheet): the former represent about 12.5 trillion dollars, the latter 10 trillion, so a net debt of about 2.5 trillion dollars. But the assets and liabilities differ fundamentally. US liabilities are mostly Treasury Bills (often purchased by Central Banks) and loans from foreign banks. These loans are more and more short-term with low interest rates. On the asset side, the predominant categories are stocks holdings on foreign exchanges and direct investments by American multinationals. Riskier, those assets have higher rates of return. Therefore, Americans borrow at low cost to consume, but also to invest in higher risk and more profitable assets in the rest of the world. According to Gourinchas and Rey's expression, the United states has therefore become a capital investment business and pockets a fat margin along the way: with the difference between the rate at which it borrows and the return on its investments over 3%. This margin may be interpreted in different ways. The first is that Americans are most gifted investors and enjoy unprecedented margins. In that case, the deficit is less serious than it seems, because the income raked-in thanks to risk capital activity reduces the deficits by as much. The second interpretation is that the scope of the phenomenon is temporary and related to weakness in global interest rates. Their increase will increase the United States' cost of borrowing by as much. Therefore, the time is not far off when the US will have to begin to pay out: in fact, that was already the case for the last trimester of 2005 and will certainly be the case for 2006.

American privilege doesn't stop there: thanks to the hegemony of the dollar, they borrow in their own currency, but around 70% of their foreign assets are in foreign currencies. When the dollar depreciates, the net debt is automatically reduced. The payoff is substantial: a depreciation of 10% leads to a transfer of close to 6% of American GDP in favor of the United States, i.e., the amount of the annual trade deficit! For any other country, debt reimbursement would force it to consume less and produce more for the rest of the world. Because foreigners have agreed to lend to the United States in dollars, the adjustment through depreciation of the dollar is rendered less painful.

The problem with this exorbitant privilege is that it's naturally tempting to exploit it. By getting too far into debt, the United States could endanger the role of the dollar and the stability of its financial markets, both at the very source of its exorbitant privilege.

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Philippe Martin is a professor at Paris-I and a researcher at the CNRS [French National Center for Social Research].

Translation: t r u t h o u t French language correspondent Leslie Thatcher.