Do U.S. deficits threaten global financial stability?

Hilton Root Yale Center for the Study of Globalization Los Angeles

Many of the world's most influential economists -- Paul Krugman, Jeffrey Sachs, and Larry Summers and the IMF among them -- and business leaders, including Peter Peterson and Warren Buffet, believe that U.S. fiscal policies and the country's US$500 billion trade deficit threaten global financial stability.

Politicians, spreading fears that the U.S. economy will be left to the mercy of foreign investors, have urged protectionist policies that will likely prompt new rounds of anti-Americanism and stall future steps towards global integration. But will these short-sighted fiscal policies, as critics suggest, truly lead the world economy to disaster?

Despite the misgivings of experts, global demand for the U.S. dollar remains strong. Indeed, big budget deficits created by the U.S. government hike up interest rates, thus attracting foreign capital to the United States. More importantly, there is a continuing trust in the dollar, driven by forces outside the U.S. government's direct control.

A nation's fiscal capacity relies upon more than just its savings rate. It also depends upon the general reputation of its political institutions and the stability of its social organizations. Before issuing loans, foreign lenders evaluate the likelihood of repayment by assessing whether debtors' political institutions are healthy and supported by social consensus.

Many critics believe that the underfunded U.S. social security and medical care system threaten future U.S. financial stability; this debate politically divides the U.S. population down the middle. But a resolution of these current divisions can be accomplished within the context of those institutions. None of the parties are likely to take up arms or demand a new constitution to see that their interests are protected.

Long-term global comparisons among world regions reveal there is, in fact, no substitute for the relative health and stability of U.S. economy.

In Europe, an overburdened public sector slows growth and diminishes the appeal of European assets. For Europe to contend for a larger share of international capital flows, the policies that are currently the basis of political stability must dramatically change.

Asian economies, suffer from ill-defined relationships between the state and the private economy. In China, weak institutions have facilitated growing deficits and fiscal uncertainty. Though the government needs help to fund its expansive policy of public investment and support for state-owned industries, the wealth of the growing private sector remains untaxed. Similarly, East Asia's tiger economies, Japan included, suffer from cultural ambivalence about the government role in industry regulation.

Latin American governments suffer from an inability to reach a consensus about spending priorities. Governments cannot collect adequate revenue because the poor refuse to pay taxes for undelivered services, and the rich have no incentive to pay for services they do not use.

The damaging impact of political instability is always a possibility in China or Latin America when questions concerning public programs funds are raised.

In the United States, raising taxes, although politically unpalatable, will not provoke an institutional crisis. Despite the strong differences expressed by this year's presidential candidates, whichever position is eventually enacted into law will be reliably funded by Congress. Even if a new political party comes to power, it will continue to honor the liabilities incurred by its predecessor.

So, what of the United States' growing debt? Historically, there have been several examples of the world's greatest power being the world's greatest debtor. The rise of Holland in the 17th century and England in the 18th century can be attributed directly to their ability to borrow at comparatively low interest rates.

Being able to borrow at lower rates of interest can be a source of strength, but it can also be a liability. Should the rates suddenly shift due to unexpected terms of trade, the strong parties' burden might be magnified beyond the means of repayment. Politically strong nations face the peril of overextending their fiscal reach by being too attractive to the savings of their neighbors.

People will send their money to a country that appears to be politically strong, thus allowing that nation to live beyond its means. Should a short-term disruption occur in the ability to repay or borrow, a major financial crisis can ensue. The consequences of a sudden disruption of capital flows can be devastating, even to a sophisticated financial system. This is precisely the danger that the next U.S. President must address.

Ironically, critics view extensive overseas borrowing by the United States as a threat to globalization. One could easily make the opposite argument: Exposure to the U.S. economy gives international investors a stake in the successful management and prosperity of the United States.

U.S. policy makers should encourage private savings and discourage government spending, but new domestic fiscal policies will not be enough to shift the flow of international capital to those parts of the world that are most in need.

The credibility of U.S. domestic political institutions gives the country a strength that makes dollar-denominated investments attractive to foreign investors. For the foreseeable future, instead of unrealistic rhetoric about drastically cutting the trade and fiscal deficits, politicians might be wiser to implement a well-planned investment policy.

America's long history of budget deficits, excessive federal spending, and trade deficits has not deterred capital flight from developing nations. The capital flight from developing nations to the U.S. stems largely from domestic governance failures that cannot be corrected by the U.S. administration. Capital does not end up in the country that needs it most, but in the country that treats it best.

The writer was a senior advisor to the Treasury Department and is now Freeman Visiting Professor of Economics at the Claremont Colleges and Senior Fellow at the Milken Institute.