More on Abusing America’s ‘Exorbitant Privilege’: Will the Bond Market Turn on the US at a 100% Debt-to-GDP ratio?

17 June 2012, 1558 EDT


As part of a now lengthy chain (one, two, three, four) on US allies and the likelihood of US retrenchment, I argued that American hegemony, despite America’s huge debt and deficit, is more financially stable than almost anyone expected. Because foreigners’ appetite for dollars seems unquenchable and because we print the global reserve currency, borrow in it, and face no serious reserve challengers (the euro and RMB maybe, see below), US can exploit this ‘exorbitant privilege’ far worse than anyone ever thought.

For example, I think almost everyone expected the bond-market to turn against the US in the last decade given: exploding debt and deficits, huge welfare state expansions like Medicare part D and ObamaCare, the expensive and financially-unplanned GWoT, China’s relentless ascent, the Great Recession, and two rounds of quantitative easing. Wow – that’s a helluva list. Despite all that, interest rates and inflation are low, because we can exploit (and have) that exorbitant privilege. Stein’s Law says there must be a limit, but I think almost everyone is amazed at just how deep confidence in the dollar goes.

More simply put, foreigners so want dollars, that America can just print more and more dollars without consequent inflation, and borrow a lot from foreigners very cheaply (because they want those dollars so much). This means America can borrow and/or just print huge amounts of money at very low interest and inflation rates. That is ‘exorbitant,’ I presume, because no one else can do that without Greece-style financial trouble. We can borrow at low interest rates (the rate on the US ten-year bond is around 1.5% right now) and print lots of money (the recent quantitative easings, e.g.) without suffering like so many others who over-borrow and run the printing press. I find Barry Eichengreen’s book on this is helpful.

Vikash gave such good commentary on this tangle, that I have reposted our full debate on US borrowing and hegemony below. It gets fairly wonky, so please read the OP. Also, comments from anyone in IPE is much desired. Specifically, can someone tell me please when the US will finally hit the ‘soaring’ inflation and interest rates regularly predicted by deficit hawks at the WSJ or CNBC? This is what Romney means when he says we will become Greece, but I just don’t see any evidence of that. Does anyone have a good guess on the timeline for exploiting the exorbitant privilege? When does it finally give way? When do foreigners turn against us in the bond market? As I said in the OP, I think it (super cheap US borrowing) has gone on already far longer than anyone expected. But I also think that a 100% debt-to-GDP ratio might be the bond-market turning point. That is a pretty big psychological benchmark. And we’ll probably get there before the end of the decade.
So here is our debate on this:

Vikash Yadav: “While I generally agree with your argument about America’s exorbitant privilege (and I can just see DeGaulle and D’Estaing spinning in their graves) there may be some other ways to read the data on international reserves.

First, I believe the US dollar as a percent of international reserves kept by other countries has actually fallen from about 72% in 2000 to somewhere around 62% in 2011. It will tick back up a bit after this year, but certainly not back to what it was a decade ago. So there does seem to be a slow decline if we look at the composition of foreign exchange reserves. Of course, since there has been a dramatic increase in the amount of reserves being kept in the last decade, the US can borrow very easily.

Second, the dramatic growth in the amount of reserves being accumulated, particularly in Asian emerging markets since the Asian financial crisis, most likely represents a form of insurance against reliance on the IMF in crisis situations. As such, this somewhat weakens the ability of the IMF to advance a stark ideological agenda (through conditional lending in the context of a crisis) which has largely been shaped and spread by American trained economists (in what James Boughton rightly described as the Silent Revolution) and the US government since the 1982 debt crisis. If global hegemony consists of more than just the ability to project military power, then American hegemony is not rolling along all that smoothly. It is also worth noting that a very large chunk of the reserve holdings is probably attributable to two Asian countries, Japan and China. My hunch (and I haven’t checked the numbers) is that around three quarters of world reserves can be attributed to about seven or eight Asian countries (particularly if we include sovereign wealth funds in the mix). So I think it is inaccurate to imply that foreigners in general have an unquenchable desire to hold dollars.

Finally, to your point about China slowing down and thereby giving the US a breather or a chance to “recover in a way”… China is currently set to surpass US GDP in 2018 if it grows at 7.75% in real terms and the US grows at around 2.5%. Let’s say the Chinese growth rate slows to 5% because it fails to make serious reforms, the US won’t get more than three years of a breather b/c Chinese would still surpass the US in 2021 (for underlying assumptions see:… ). It is in the realm of possibility that China could derail in the next decade, but China does not really need to make major reforms to surpass the US. And since the neo-liberal American state has squandered its borrowing on wars and consumption, it hardly has made the kind of infrastructural and human capital investments that could spark a resurgence in the next decade. Meanwhile, if China does reform at least its monetary policies and shore up its banking sector by injecting its banks with capital, Christine Lagarde has stated that the Yuan could become an international reserve currency in the future – a prospect not wholly threatening to the Chinese government.”

Robert Kelly (me): “Stein’s Law – if something cannot go on forever, it will stop – was conceived with exactly this current account imbalance problem in mind, but printing the reserve currency seems to let it go on and on, long past what everyone ever thought. My inclination is to agree with you, and originally I thought a lot about retrenchment because of this concern. But US borrowing costs are going down (1.44%), not up; foreign ownership of US assets is going up, not down:… and informal dollarization is widespread:…. Not even the GWoT-Great Recession-QE three-step – cue the Ron Paul freak-out over the gold standard – lead the bond-market to turn against the US. Wow. I just can’t figure that out…

I used to believe folks like Niall Ferguson or Barry Eichengreen on this:…. But these inaccurate predictions have been made since Nixon closed the gold window unilaterally – 40 years ago!

This tells me that there is a lot of confidence in the dollar, or to be more specific, there is little confidence in other fiat currencies, which is all the dollar really needs. The euro-zone crisis particularly is a huge boost for the US. And I am pretty skeptical of the internationalization of the RMB. Exchange rate manipulation has been a pretty central element in the ‘Asian miracle’ formula since 50s. Japan has never really permitted proper internationalization of the yen even though people talked about that a lot in the 80s and 90s. And given how much poorer and poorly governed China is by comparison, I have large doubts that China will internationalize the RMB properly or soon. Maybe, but just consider the amount of corporate governance improvement (all the sunlight in dark corners of the banking system) required for China’s banks to really open up. That could get really ugly and even threaten CCP rule because of the sheer scale of corruption I am almost positive it would unveil.

Finally, there is a problem in just comparing raw GDP sizes. As Wohlforth and Brooks argued in World Out of Balance, simply adding more and more poor people will eventually give any state the world’s largest GDP. Instead, absolute GDP must be cross-referenced against GDP per capita. What exactly is the right ratio of GDP vs GDP-per-capita in making the calculation of whether a state is great power or not, is actually a really good question. I.e., China won’t displace the US superpower when its GDP is larger absolutely, but it is also so demographically big, that it probably doesn’t need to equal US GDP per capita to displace the US either. What would a reasonable GDP per capita threshold be – 50%?”

VY: “First, like you, I don’t think the current account situation will force retrenchment of alliance partners. What we are seeing instead is a continued hollowing out of the state over time but this may be unrelated to the dollar’s status as the premier international reserve currency (a status propped up not so much by faith in the US economy as rational attempts by emerging markets to shield their sovereignty from American economic imperialism) except to the extent that the dollar’s status facilitates easy credit to continue the trend. An economically neo-liberal state stakes its claim to sovereignty mainly on the provision of (domestic and cross-border) security and opportunities for unrestrained consumer consumption. The evidence of US decline will not be found in military sector or in the prison industry; decline is evident in the neglect of infrastructure, education, healthcare, etc. while inequality grows and democratic governance fades. The state will still be able to project power for decades to come but it will gradually erode the basis for internally regenerating that power and it will have to rely more and more upon poaching talent, financing, and resources from other countries.

Second, the establishment of the Yuan as a reserve currency would take at least a decade, probably two — as it did for the US near the start of the 20th century. But I would not be too concerned about transparency in the banking sector. The US financial sector is clearly non-transparent, over leveraged, excessively inter-dependent, and brittle as the last crisis showed. Some reform is necessary to be sure in both countries, but the banking sector is not the main barrier to the Yuan becoming a reserve currency.Third, I think GDP at market rate is the appropriate comparison for our purposes. Measuring GDP per capita (particularly at PPP) is more useful as a rough indicator of economic development (if it is coupled with data on income distribution and broader indicators of human development). Aggregate GDP comparisons are more useful for our purposes because this tells us something about what the state can tax and use to build or purchase military resources.

The new great powers will be different from those of the last century, they will be characterized by the persistence of mass poverty alongside the accumulation of massive revenue — as great powers were before the industrial revolution. What is important to note is that China is on track to surpass the US and once it does it will continue to generate ever greater GDP even if it only increases productivity by a little bit each year. It will take about four decades before China catches up in per capita terms, but the Chinese state will gain significant resources well before then. Of course, (and as you noted) China has long since realized the pitfalls of translating economic power into military power too quickly — so I don’t think it will aim to displace the US so much as to assume its rightful place a major power.”

RK (me): “Our comments are becoming more dense than the post itself. I guess we are fairly close. I would add a few final points.

1. I am not sure how neoliberalism or the economic sovereignty of LDCs plays into this.

2. When it comes to hollowing out, I don’t actually see that so much. Borrowing allows the US to put off choosing between guns and butter, and that ‘putting off’ has lasted far, far longer than anyone ever thought possible. That is what is remarkable and what motivated the post. The last decade expanded, not hollowed out, the welfare state with Medicare Part D and ObamaCare. The real welfare question at home, IMO, is not raw levels of funding declining under the weight of defense spending, but distributional issues; i.e., transfers are increasingly upward, from poorer healthier workers, to wealthier, unhealthier retirees.

3. Obviously spending of any kind is fungible, so defense spending obviously leaves less for everything else. In that general sense, one could argue for hollowing out. But I think a better question is, if we can no longer borrow to have both guns and butter, what will be choose? One read of the GOP’s effort to delegitimize ObamaCare, SS, and Medicare is to pre-set the ground for this debate. If the GOP convinces Americans that the welfare state is for lazy slacker wimps, that makes it easier to ring-fence defense and so keep hegemony rolling along.

4. But I don’t honestly think Americans will choose guns over butter. No matter what the GOP says, SS, Medicare, and Medicaid are part of the US social contract now. They’ve been around a long time, and people have come to expect them; they feel they are ‘rights,’ not ‘programs.’ Norquist may think ‘starving the beast’ will work, but so far it hasn’t, because the government borrows, not cuts, when taxes short-fall. The GOP is fundamentally out of step with American expectations of government assistance, but it has (very destructively) convinced the median voter that he shouldn’t have to pay for such assistance (hence we borrow). So when Perry and others call SS/M/M ‘ponzi schemes,’ people worry, just like W’s second-term effort to privatize SS failed miserably. In fact, I think if Americans were really forced to choose between more aircraft carriers and checks for grandma, they would choose the latter. This is one reason I find the DC foreign policy consensus for hegemony so toxic and support retrenchment. I don’t think most Americans want ‘empire;’ they want welfare and safety nets (in part because exceptionalist, ‘foreign-aid-is-for-third-world-socialists’ Americans generally couldn’t care less about foreigners. It’s DC elites who get teary-eyed comparing the US to Pericles Funeral Oration and say we must be the ‘weary titan’ who sacrifices at home for a ‘national greatness’ cause abroad.

5. On RMB internationalization, I am far more skeptical than you. Agreed, the US banking sector is a mess even with the best trading app availability still there, but comparable to China, really? The difference is still vast to my mind – can foreigners even list on Chinese stock markets? I wonder how many people would really be prepared to hold serious savings and value in a currency from a still technically communist state whose banking and corporate governance ‘rules’ are shot through with famialism, corruption, and informal political manipulation. These problems still plague the won and the yen, and Japan and SK are decades ahead of China in terms of openness and development. Is China really ready for serious, long-term foreign ownership of major assets and to allow the market to set the RMB’s value without tinkering? I doubt it; no one else in Asia does that and never has. I still think currency manipulation and other gimmicky nationalist barriers are central to the Asian growth model. Here is a nice example of just how bad this can be, even in supposedly-open Korea.

6. And that brings me to my last point on Asian self-insurance. I agree that some of Asian stockpiling is to prevent IMF ‘imperialism,’ but Japanese, Korean, and Chinese stockpiles go far, far beyond what is needed for reasonable exchange rate defense. In fact, all three purposely and regularly intervene to make their currencies even softer, making me wonder what ‘defense’ is needed. IMO, these reserves really reflect, 1) Asian mercantilism, the very deep social belief in these states that they absolutely must run a trade surplus, and 2) the enormous political power of mega-exporters in these states. Asian consumers are punished with insane foreign reserve levels and exorbitant prices because the kereitsu, chaebol, and Chinese super-exporters are deeply tied at the highest levels to political elites in tight collusive circles of corruption. The bizarre side-effect of this East Asian crony corporatism is massive US dollars holdings which the US can then borrow at insanely low rates – hence the point of the OP.”

Cross-posted at Asian Security Blog.