The US and Australia: Are Their Foreign Debts a Problem?
The apparent inexorable rise of foreign debt in the US and Australia has caused consternation for some commentators while others remain blasé, arguing that the expanding foreign debt is a sign of the US economy's strength. The only sign I see here is one of bad economics. The situation is not much different down here. Tim Colebatch stressed that the net foreign debt had risen from $144 billion in 1991 to $522 billion $522 in 2006. (The Age, We're growing wealthier and ever more indebted, 19 December 2006). So, according to Colebatch, "If we're doing so well, why are we doing it on borrowed money?" Kenneth Davidson expressed the view that "underinvestment in human capital and physical infrastructure [has created an] unsustainable current account deficit and foreign debt..." (The Age, Costello saves up incorrect definition to suit the market, 9 October 2006). On 3 August 2006 Davidson averred that:
The Government cannot acknowledge the extent to which economic growth over the past decade has been financed by foreign debt, or why the debt has been used to finance a real estate and share price bubble rather than new export and import replacement industries that could repay it (The Age, Howard's plan to transform the economy).
Concerns about foreign debt have been around for years. In the 1980s Tim Congdon was warming that Britain's foreign debt could become unmanageable within a few years. (The Debt Threat, Basil Blackwell, 1988). The same thing was being said about the US economy. Once again there were less concerned voices to the contrary. (Robert Heilbroner and Peter Bernstein The Debt and the Deficit, W. W. Norton & Company, 1989, ch. 11. Compare their analysis of deficits with A. James Meigs' monetary analysis, Money Matters: Economics, Markets and Politics, Harper & Row, 1972). Then we have Thomas E. Nugent using the consumption- drives-the-economy fallacy2 to defend the US trade deficit. According to his view:
While a good many politicians and some pessimistic economists bemoan the onset of a consumer slowdown in spending, few if any of the intelligentsia recognize the power of the foreign consumer to keep the domestic economy growing at a sizeable clip (National Review Online, Clinton's Capital-Control Crapola, 5 March 2007).
As I have pointed out before, what really matters is not the deficit itself but how it is funded. At this juncture the usual response of the so-called informed is to point the finger at borrowing. This is where the public gets confused -- along with our economic commentators. To the ordinary man in the street borrowing means to voluntarily transfer purchasing from one person to another for a period of time. Quite naturally he applies this commonsense thinking to institutions -- until he discovers the magic -- perhaps that should be intellectual fraud -- of fractional banking. (See F. A. Hayek's Monetary Nationalism and International Stability, Augustus M. Kelley Publisher, 1971, Lecture II: The Function and mechanism of International Flows of Money).
Starkly put the central bank allows the banking system to expand credit by creating phony deposits. If credit expansion is particularly aggressive this will result in current account deficits. Paul Samuelson uses the example of an American who wants to buy an English car and uses his bank to exchange his dollars for pounds that will be transferred to the English dealer's account. (Economics, 10th edition, McGraw-Hill Book Company, 1976, pp. 646-47).
However, as Mr Nugent kindly pointed out, the American purchaser need not have any savings to draw on to make the transaction. All that is needed is for the bank to obligingly make a loan by creating a deposit which will be in the name of the English dealer. The imported car shows up in the current account as a debit: the dealer's deposit is put down as a credit. The result is that the trade account goes into deficit because imports exceed exports while the capital account runs a surplus.
If you the readers reckon there is something decidedly not right here -- then you are absolutely spot on. What has happened is that the bank has conjured up a deposit from out of nothing. There is no genuine transfer of purchasing power and therefore no exchange of goods, either bilaterally or multilaterally. And it is this process that our sophisticated economic commentators completely overlook.
This is why they cannot make the link between credit expansion and our growing foreign debt. As the banking system -- with the support of the central bank -- more and more credit is generated nominal incomes rise and debt continues to pile up as more and more deposits are created to accommodate the rising demand for imports. In short, we are looking at a reckless credit expansion as the real culprit. This process is always triggered by an artificial lowering of interest rates. (Charles P. Kindleberger and Robert Aliber' Maniacs, Panics, and Crashes: A History of Financial Crises, John Wiley & Sons Inc., 2005, draw heavily on the Hyman Minsky credit model)
Although Colebatch and Davidson continue to whine about Australia's foreign debt burden it never seems to occur to these geniuses to examine the Reserve Bank's monetary aggregates. During the period referred to by Colebatch Australian bank deposits rose by 387 per cent. The same period in the US saw deposits, including thrift institutions, rise by 154 per cent2.
No wonder Charles P. Kindleberger noted
That there have been more foreign exchange crises than in any previous period of comparable length, beginning with the breakdown of the Bretton Woods system of adjustable parities for national currencies in the late 1960s and early 1970s. [It looks like we could be heading that way again] (Ibid. p. 242).
Unfortunately our economic commentariat refuses to even consider the role monetary policy plays in distorting the pattern of production, destabilising exchange rates and creating balance of payments crises. It's as if they would rather the economy sank than admit they were wrong.