This problem of accelerating foreign indebtedness began in 1981 with economic policies that presumed the rest of the world didn't exist. We had 22% interest rates while the Germans and Japanese had 5% and 6% rates. That disparity attracted a massive inflow of money from their economies to ours. This drove up the value of the dollar and made American products noncompetitive on world markets.
As a result, a huge trade deficit developed, which forced us to borrow money from abroad to cover the difference between what we produced for export and what we consumed.
By 1986, foreigners lent us one out of every four dollars we borrowed. Of the $800 billion we borrowed, $200 billion came from foreigners. In other words, if foreigners had not lent us the money, one out of every four cars could not have been purchased, one out of every four homes could not have been financed, and one out of every four credit cards would have to be taken away This debt is essentially the cost of living beyond our means.
If the money we were borrowing from abroad all went into factories and robots, we wouldn't have to worry because the debt would be self-liquidating It's the fact that we are using it entirely for consumption that makes it a serious problem.
If such a cooperative relationship could be put in place, then the short term problems would not be that serious. But straightforward discussions are not likely.
German and Japanese stimulation to purchase more American goods would help bring the US imbalance back into equilibrium. However, neither country has employed demand stimulation policies during the postwar period. They've always relied on the US to be the locomotive of the world economy.
The Germans are reluctant because they deeply fear the kind of inter-war inflation that fanned fascism. The Japanese simply aren't willing to turn their export-led economy into a domestic-led economy. Therefore, in a continuing environment of world economic stagnation, the only cure for the US balance of payments is the falling dollar. And the only cure for the mounting debt is inflation.
Inflation & Recession
Inflation is also a path of least resistance because it would make the hundreds of billions we owe the rest of the world worthless. Additionally, it would reduce the debt burden of the Latin countries. For policymakers who realize that the debt will keep growing until we restore competitiveness to the US economy, inflation is a far more attractive option than facing a steep drop in the American standard of living.
Add to this the decision to cute our balance-of-payments problem by letting the value of the dollar fail. German and Japanese products will become too expensive and their exports will fall. If Germany and Japan don't rebuild their economies for domestic-led growth, they will slow dramatically because they can't rely on exports. If they fall into recession, then we are dragged along because there is no one to purchase our exports.
The central short term issue, then, is whether we may slip into a recession without the capability to do anything about it. Who can play the role of economic locomotive for the world when the US is so overburdened with debt there is no room for Keynes?
When the Lending Stops
In reality, the lending will stop long before we get to that ultimate limit because foreign lenders fear they will be repaid in devalued dollars, In the first quarter of 1987, there was evidence that the private capital inflows from abroad began to stop. Most of the capital now comes from governments who have stepped in for fear of instigating a credit crunch that would set off bankruptcies and recession,
When the foreign lending stops, all of our debts - our foreign debt, the federal budget deficit, the Latin debt, corporate and consumer debt - will be harder to roll over because the amount of credit will be constrained. As I pointed out earlier, one out of every four dollars we borrow now comes from foreigners. If that suddenly stops, a tremendous tussle will erupt in our society over who gets the other three dollars of credit.
If the federal government is still a big net borrower when the lending stops, it will simply pay whatever interest rate is necessary on Treasury bills to get what it needs. Presuming taxes aren't raised to get government out of the credit markets, government will absorb one of the remaining three dollars, leaving two dollars rather than the previous four to cover the credit needs of the entire private sector. In other words, half of the machine tools, houses and cars now financed with borrowed money just won't be able to be purchased. In this credit crunch, somebody is going to end up owing money they can't repay.
Tremendous pressure will be placed on Latin debtors to default because interest rates on their loans are keyed to US rates which will rise rapidly. Brazil, for example, might wake up tomorrow and find that interest rates have doubled. They can't pay today's rates, no less twice that rate. Default would be the only option. The other most vulnerable group would be the cluster of 3,000 small savings and loans which are already technically bankrupt.
Two other things will happen when the lending stops and the balance of payments is restored to equilibrium. First, other countries must lose their trade surplus. Our trade deficit of $170 billion means they have a trade surplus of $170 billion, which equals about 4 million jobs. So, when they lose their surplus because we stop buying $170 billion worth of their goods, they will lose 4 million jobs.
Second, the United States' standard of living will fall by 8% or 9%. Here's why: In 1986, we consumed $170 billion worth of goods we didn't pay for with production. That amounted to 4% of GNP When we cure our balance-of-payments by lowering the value of the dollar, what we receive when we sell products to the rest of the world gets smaller. Conversely, the amounts we will have to pay when we buy foreign products will get bigger because the dollar is less valuable. That's called an "adverse shift" in the terms of trade. So, to improve our balance-of-payments by 4% with a dollar halved in value, we will have to export 8% more in order to maintain our current level of consumption. It won't be the Great Depression when the standard of living dropped 28%; but it will be a lot worse than the 2% drop suffered during the worst postwar recession.
The unpleasant reality is that we will have to live within our diminished
means when the lending stops.