Much of the concerns about the budget deficit often relates to the fact that we owe a substantial portion of the debt to China. Linking the debt to China with the budget deficit reflects a mistaken understanding of the economy. In a post for the Roosevelt Institute's Econobytes, economist Dean Baker, co-director of the Center for Economic and Policy Research argues there is no direct tie between the size of the budget deficit and our debt to China.
The debt to China is in fact far more dependent on the trade deficit, which should be the main concern for those troubled by this debt.

  • The basic logic is straightforward, the trade deficit with China is the mechanism through which China obtains the dollars it needs to buy U.S. government bonds or any other dollar denominated asset.
  • China is in a position to buy large amounts of U.S. government bonds while most other countries are not, because most other countries are not running large trade surpluses. By definition, the fact that China has a trade surplus means that it is selling more goods and services abroad than it is buying.
  • This means that it is accumulating dollars which can then be used to buy government bonds or other U.S. assets.

 There is no special importance to the fact that China’s government is buying government bonds, as opposed to any other asset.

  • If China holds $2 trillion in U.S. government bonds then the interest on these bonds is paid out to China rather than people in the United States. In that sense it can be seen as a drain on the U.S. economy.
  • However if China were to sell its $2 trillion in bonds,  and instead buy $2 trillion of stock in U.S. companies then the dividends and capital gains from this stock would go to China instead of to people in the United States. This would also be a drain on the U.S. economy.
  • There is no obvious reason that we should be less concerned about China or any nation or foreign individuals owning shares in U.S. corporations than we are about them owning U.S. government bonds. In both cases there will be an outflow of payments in future years as a result of the foreign ownership of U.S. assets.
  • If the concern is that a foreign power could disrupt our financial markets by suddenly dumping government bonds, the same concern would arise with a sudden dumping of large amounts of stock of private companies. Both would have a substantial impact on the affected markets and the value of the dollar.

The extent to which a foreign government owns government bonds is entirely a matter of asset allocation and has no direct relationship to the deficit.

  • The United States government can be running a balanced budget or even a surplus and China could still opt to increase its holdings of government bonds by selling stock in private corporations and buying government bonds.
  • If the only concern is China’s holding of government bonds, then the U.S. government would be faced with a problem even though it wasn’t running a deficit.

The main determinant of the trade deficit itself is the real value of the dollar relative to the currencies of other countries.

  • When the dollar is over-valued it makes our goods less competitive internationally, leading people in the United States to buy more goods produced abroad and causing foreigners to buy fewer of our exports.
  • The remedy for this situation is a lower valued dollar. Ironically one of the supposed problems highlighted by many of those raising fears about the budget deficit is that it could lead to a fall in the value of the dollar.
  • If the problem is foreigners holding U.S. government bonds and other assets, then a fall in the dollar is exactly what we should want to see.

There is an argument that the budget deficit is contributing to an over-valued dollar and in a way leading to a trade deficit.

  • This argument hinges on the claim that budget deficits are raising interest rates, thereby encouraging foreign investors to buy up dollars to take advantage of high U.S. interest rates.
  • While there have been times where this argument may have been plausible, with long-term interest rates under 2.0 percent and short-term rates near zero, it is not plausible now.

 There is a more direct way in which the budget deficit does contribute to the deficit; it helps to boost the economy.

  • By increasing GDP, a budget deficit will lead the United States to buy more of everything, including more goods and services produced abroad.
  • In this sense, the budget deficit would be increasing the trade deficit and foreign indebtedness, but only because it lead to more economic growth.
  • Reversing course and lowering the budget deficit will reduce the demand for imports and thereby lower the trade deficit, but at the cost of higher unemployment and lower output.
  • Government budget deficits can be seen as raising the trade deficit and leading to more foreign indebtedness in the way that anything that boosted growth would lead to a larger trade deficit and more foreign indebtedness.
  • We can balance our trade and eliminate the deficit by having a severe slowdown in growth and much higher unemployment.
  • This is in effect what deficit hawks who want to see the trade deficit fall without lowering the value of the dollar are advocating.  

This blog post originally appeared in the Roosevelt Institute's Econobytes.