Thursday, November 23, 2017

Are Foreigners Financing America?

Like the proverbial sky falling on the head fear, the financial community is perennially worried that foreigners will stop financing America's current account deficit--specifically, that they will stop buying Treasury debt and start selling it.

People think of 'our dependence on foreigner investors' as if America were perched on a high tree trunk and foreign investors were armed with saws, ready to cutoff the limb. The analogy is not bad, except that it has the actors switched. The question is not, "What will happen to us if foreigners stop buying our debt?" but, "What will happen to other countries if they can no longer sell us their goods?"

Two fallacies underlie the worry that we will be abandoned by foreign investors. The first is that foreigners somehow bring money to our markets that otherwise would not be there, and the second is that they can make money disappear from our economy. Last time I checked, Treasury debt was denominated in dollars, and the United States was obligated to make interest and principal payments in dollars. I also note that the Federal Reserve, not international investors, determines the US money supply. Only if foreigners actions made the Fed compelled to support the dollar through higher interest rates would domestic credit conditions tighten.

Foreign investors can affect currency markets, but they can only frighten or briefly disrupt the Treasury market. Suppose a foreign investor becomes fed up with financing America's debts, so he sells all his US government bonds and converts the proceeds to euro, yen, or gold. Unless he does business with Houdini, the dollars do not disappear or magically turn into gold, yen, or euro. Now someone else owns the dollars and what will they do with them? Dollars pulled out of the US asset markets by foreigners wishing to repatriate do not vanish but instead keep flowing back to the same markets.

Widespread selling of dollar denominated assets could put great pressure on the dollar's exchange rate. Although the supply of dollars is not changed, the bond market could sell off because it believes that the weak dollar will cause inflation, forcing the Fed to tighten. But these are effects on perception. To be sure, such misplaced perceptions could cause momentary turmoil in the bond market, but economic reality would soon bring it back to balance.

A drop in the US dollar would have some effect on US inflation. However, the impact is likely to be muted. First, services, which are domestically produced, constitute the bulk of the CPI. Second, even the link between import prices and domestic goods prices is hardly tight. As the chart below shows, when the dollar appreciates, domestic consumer prices rise relative to import prices and vice versa. In effect, there appears to be some relative "price stickiness." Another way to look at it is that, when the dollar appreciates, US consumers do not enjoy the full benefits and vice versa. Curiously, the relationship seems to have completely broken in recent years--note that the surge in the dollar in 2014-2016 had no discernible impact on the relative prices.



Which brings us to the bigger question. Who is dependent on whom? Foreign countries are not buying Treasury securities out of munificence. Nor is their buying of Treasury securities 'financing' anything. Rather they acquire dollars when they agree to accept dollars are payment for goods they sell in the US. How they allocate the thus acquired dollars to various dollar-denominated assets is a portfolio choice not a financing decision. Of course, they could decide not to accept dollars as payment for goods. But then where are they going to sell their goods to keep their factories running? As long as the rest of the world has not figured out a way to generate domestic demand sufficient to keep its domestic supply gainfully employed, the world will remain dependent on the US as the buyer of last resort.

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