May 6, 2009

US Foreign Debt jumps to 35% of GDP

By Raymond Richman, Howard Richman, and Jesse Richman

On April 21, the International Monetary Fund (IMF) projected (see the World Economic Outlook, pp. 36-37) that the US foreign debt will increase from about 4.5% of world GDP in 2007 to about 9% in 2009. Given that the US foreign debt was 17.7% of US GDP at the end of 2007, this means that our foreign debt will be about 35% of US GDP by the end of this year as shown in the red line on the graph below.

US foreign debt tends to increase when the United States runs a trade deficit on goods and services using money either borrowed from abroad or invested by foreigners in U.S, assets. The black line shows the cumulative effects of US trade deficits since 1987. The black line has been rising every year, except 1991 when the Persian Gulf states gave us huge gifts in return for our liberation of Kuwait from Iraqi control.

The US Foreign Debt does not climb as smoothly as the cumulative trade deficits because the value of American holdings of foreign assets (mostly stocks) tends to fluctuate with stock prices, while the value of foreigners' holdings in the United States (mostly bonds) tends to be stable.

The United States is experiencing a huge debt problem at present. Not only are our households over-borrowed and our corporations over-leveraged, but our federal government is in the process of rapidly increasing its debt. On top of all that, by the end of this year we will owe foreigners about 35% of our GDP. As we continue to run trade deficits, payments to foreigners will be an increasing drag upon our incomes.

As wise economist and presidential advisor Herb Stein once said: "If something cannot go on forever it won't." Something will have to give. The next stage in our economic crisis could be some combination of dollar-collapse, high interest rates, and high inflation. Here is one possible future, as described in our 2008 book:

Once the dollar starts to plunge, there would be such a rush to sell dollars on foreign exchange markets that the dollar would collapse in value. The United States would experience inflation. Interest rates would skyrocket. Trade would become balanced but at a severely reduced level of imports.

The skyrocketing oil prices and need to cut back on oil imports would force the United States to begin rationing gasoline, probably using an equitable electronic system like Martin Feldstein's 2006 "Tradable Gasoline Rights" proposal.

If the Federal Reserve decides to inflate the money supply in order to pay off US debts with cheap dollars, we could experience runaway inflation. At the most extreme, the dollar might even be replaced with a new currency as has happened in Brazil multiple times. The Brazilian reis was replaced with the milreis, the milreis by the cruzeiro, the cruzeiro by the mil cruzeiro, the mil cruzeiro by the cruzado, the cruzado by the milcruzado, and finally the real. (pp. 188-189)

There is still a way to solve our debt problems without high inflation or a dollar crash: the Program for a Strong America that we lay out in our book. We desperately need tax reform to encourage savings and trade reform to balance trade.

The authors blog at tradeandtaxes.blogspot.com, and co-authored the 2008 book Trading Away Our Future: How to Fix Our Government-Driven Trade Deficits and Faulty Tax System Before it's Too Late, published by Ideal Taxes Association.