Dean Baker
The Guardian Unlimited, April 22, 2011

See article on original website

In the movie "Philadelphia," the lawyer played by Denzel Washington is shown repeatedly telling his clients to explain their case to him like he was a 9-year-old. This is a good rule to follow in explaining issues to economists and policy analysts, since they seem to get confused easily in discussing economics.

One of the lines frequently repeated by the deficit hysterics is that if we don’t get the deficit under control then there could be a run from the dollar. This is a great line for getting little boys and girls and reporters at elite news outlets very scared. After all, the prospect of the dollar becoming worthless is pretty scary.

One of the other lines pushed by this same crew is that we are borrowing hundreds of billions of dollars from foreigners, with the Chinese also being cited for special mention. The prospect of the Chinese holding trillions of dollars of U.S. government debt is also scary to little boys and girls and reporters at elite news outlets.

The problem with these two scary stories is that they actually are in direct contradiction to each other. The only plausible way that we can stop borrowing hundreds of billions of dollars a year from those nasty Chinese is by having the dollar fall in value against the currencies of our trading partners. This decline probably would not take the form of a scary run that ends in the dollar being worthless, but more likely a substantial and sustained decline that makes U.S. goods much more competitive in international markets.

The reason that we are borrowing from abroad every year is that the United States has a trade deficit on the order of $550 billion a year or just under 4 percent of GDP. This trade deficit is financed by foreign borrowings. The logic is simple. If the United States buys more than it sells, then it must borrow the difference.

Note that this has nothing to do with the budget deficit. If the United States buys $500 billion more from other countries than it sells to other countries, then it must borrow $500 billion a year from them regardless of whether the United States is running a budget surplus or a budget deficit. Foreign borrowing is determined by the trade deficit, end of story.

There are two ways that reducing the budget deficit can affect this picture. First, cutting spending and/or raising taxes can slow the economy, as will likely be the result from the cuts recently pushed through by Congress. If the economy is smaller, then we will buy less of everything, including fewer imports.

In other words, if cutting the deficit makes the downturn deeper then we will have a lower trade deficit. This means that the deficit hawks can reduce our borrowing from bad guys if their intention is to throw the economy into a severe and prolonged downturn.

The other route through which reducing the deficit can lead to a lower trade deficit is if it results in a lower-valued dollar. The argument here is that if we get the deficit down, then interest rates would fall. Lower interest rates would make foreigners less interested in buying dollar denominated assets, like U.S. government bonds.

If foreign investors are less interested in buying dollar-denominated assets, then they have less need for getting dollars. The reduced demand for dollars would cause the value of the dollar to fall. A lower-valued dollar will then make U.S. goods more competitive in international markets, leading us to buy fewer imports and to increase out exports.

However this channel for reducing the value of the dollar is not working right now since many governments, most importantly China’s, are deliberately propping up the value of the dollar against their currencies. They are doing this to sustain their export markets in the United States.

It is very difficult to see why China would be less interested in sustaining its export market in the United States if we reduced our budget deficit. Does anyone believe that President Hu is going to decide that China no longer needs its export market in the United States because we have reduced our budget deficit?

Of course this is absurd. China’s decision to prop up the dollar is not going to be affected by the size of the U.S. budget deficit. Which means that the U.S. trade deficit and our borrowings from China are not going to be affected by the budget deficit. If we are interested in reducing our borrowings from China then we should be focused on reducing the value of the dollar, not the budget deficit.

So why do all the deficit hawks talk about borrowing money from China? They do it for the same reason that George H.W. Bush talked about Willie Horton when he was running against Michael Dukakis. It works.

The deficit hawks want the country to agree to take steps that are incredibly unpopular. They want the public to support the gutting of essential support programs for the middle class like Social Security and Medicare. Naturally this is a hard sell. Therefore if it takes a little China bashing to make the policy go down easier, the deficit hawks are perfectly prepared to go that route. That’s the way politics works in the United States.