I hate to have to correct Nobel prize winners (okay, that's not true), but Robert Solow does get one item somewhat wrong in an otherwise useful column on the government's debt. Solow notes that close to half of the publicly held debt is owned by foreigners. He then tells readers:
"This part of the debt is a direct burden on ourselves and future generations. Foreigners are entitled to receive interest and principal and can use those dollars to acquire goods and services produced here. If our government had used borrowed money to improve infrastructure or to improve the skills of workers, the resulting extra production would have made repayment easier. Instead, over the last decade, it used the money for wars and tax cuts."
This is somewhat misleading. Suppose that the United States had been running balanced budgets for the last three decades, so there was little or no public debt for foreigners to buy, but we had run the same trade deficits over this period. In this case, foreigners would own the same amount of U.S. assets, except they would be private assets like stocks, bonds, and real estate. The income from these assets would be:
"a direct burden on ourselves and future generations. Foreigners are entitled to receive interest and principal and can use those dollars to acquire goods and services produced here."
In other words, the fact that we have given foreigners a substantial claim to our future income is the result of our trade deficits, not our budget deficits.
There is an argument that the budget deficit has contributed to the trade deficit, but it is not as simple as many people in policy debates seem to believe. If a budget deficit provides a boost to the economy, as the stimulus did in 2009-2010, then it will increase the trade deficit. The logic here is simple. If the economy is bigger, then we buy more of everything, including more imports.
In this argument, if we cut our budget deficit, we can reduce our borrowing from abroad by shrinking the economy. This is true, but it seems like a rather dubious argument. Do we really want to have millions more people out of work just so that we can deny foreigners a share of our future income? It is also worth noting that an increase in private sector investment or consumption would have the same impact in increasing the trade deficit.
When the economy is below full employment, anything that raises GDP will lead us to purchase more imports. This includes budget deficits.
The other way in which the budget deficit can lead to a higher trade deficit is by causing the dollar to rise. The logic here is usually that larger budget deficits mean higher interest rates, which in turn will raise the value of the dollar. However the exact mechanism does not matter, the point is that the proximate cause of the larger trade deficit is a higher valued dollar, not the budget deficit. If the deficit does not cause the dollar to rise, then it would not have an impact on the trade deficit.
The other implication of this line of reasoning is that if we are concerned about our growing indebtedness to foreigners then we should be concerned about the over-valuation of the dollar. Whatever steps we take to reduce the value of the dollar will increase the competitiveness of U.S. goods, reducing imports and increasing exports. This means that those who are troubled by the extent to which foreigners will have a claim on future income should be concerned about the value of the dollar, not the budget deficit.
If we lower the budget deficit without lowering the value of the dollar, then it will not improve our trade deficit (except to the extent that the lower deficit reduces GDP). On the other hand, if we can lower the value of the dollar without reducing the budget deficit then we will have addressed the concern about foreigners buying up U.S. assets and thereby getting claims to future income.
Note: Typo corrected -- thanks John.