Sunday, June 20, 2010

Is National Debt Owed to Foreign Nations Simply a Claim on Domestic Output?

In a thought-provoking post criticizing Post Keynesianism, Cynicus Economicus argues that
The trick to understanding [sc. government debt] ... is not to think of government borrowing money, but of borrowing of resources. When a government borrows money from overseas, they are actually borrowing the output of that overseas country. For example, if borrowing from the Gulf states, it is the equivalent of borrowing oil .... All the time this consumption is taking place, there is an accumulation of an obligation to provide goods and services in the future to repay the loan of oil in the future. Those goods and services will necessarily require the consumption of resources (including oil) in the future to repay the loan of oil. If this is the case, then a percentage of the total resources of the US must be allocated to making this repayment.
In response to this, I made the point that foreign investors who either (1) fund a current account deficit through capital account surpluses, or (2) fund a government’s budget deficit by buying bonds are lending money, not output.

Money can be used to buy output or financial assets or real assets.

When you attract foreign exchange via a capital account surplus (“borrow” this money), the foreigners have bought a financial asset or real asset in your economy. They have an asset in exchange for their money and a return through interest payments, coupon rates or dividends and so on. They might sell this asset, exchange the domestic currency for foreign exchange (often US dollars) and then take their money to another country and buy a different asset. This type of activity happens all the time. And here is the fundamental point: no claim on the domestic output of the borrowing country necessarily happens. There simply isn’t an obligation to provide goods and services by the debtor country. There might be, but very frequently people are exchanging money for assets (real or financial) or vice versa.

A country pays for its excess imports (= current account deficits) through capital account surpluses. It gives foreigners financial assets and real assets in exchange for their money and a return on ownership of these assets. The foreign investors always want a return on their money, but there is no necessary claim on the output of the debtor country at all. Money can be taken out of the country by converting it into foreign exchange (often US dollars) and then the investor can buy another financial asset in a different country.

In fact, capital movements around the globe in the past 30 years have seen an explosion of speculative transactions, movements of “hot money,” and short term speculation on financial markets. People are investing money to make money and then to take it somewhere else and get further returns there through ownership of new assets.

We live in a world of current accounts (goods and services) and capital accounts (real and financial assets). A very great amount of money used to fund current account deficits or government deficits just gets moved around between financial and real assets between different countries – no claim on the actual output of the debtor country happens. Of course it could and often does, but this is very different from asserting that all or even most foreign debt must be paid back in the borrowing country’s output or saying that government debt is just borrowing overseas resources. Clearly, it is not.

In response to this criticism, Cynicus argues that I am “saying that lenders are lending with no expectation of interest in return. If this is the case, why lend?.

But I said no such thing, and have said quite clearly that foreigners obtain an asset in exchange for their money and a return (e.g., coupon payment on a government bond denominated in US dollars). Of course people get a return on their ownership of most assets. That return comes in the form of money. But then we are simply back to the truth that money can be a claim either on output or on financial/real assets.

Furthermore, Cynicus argues:
When a creditor lends a country money, they do so in the expectation that the money will be returned to a value that will allow them to purchase goods and services to a value equivalent at the time of the lending + interest. They do not want money, but the ability to purchase goods and services (or assets) in the country that is the destination of the lending.
They certainly want to get a return on their money and might want to use that money to consume goods and services to a value equivalent at the time of the lending plus interest. But in no sense is it the case that they will all demand such goods and services from the debtor country.

I can give a personal example. In the late 1990s, I was swept up in the tech bubble mania going on the US (yes, I was naive back then!). However, living outside the US, I exchanged my foreign dollars for US dollars and put that money into shares on the US stock market. Some time later I sold the stock at a higher price than what I paid for it and converted my US dollars back to my own domestic currency and make a tidy profit both in the rise in the value of the stock and the fact that the US dollar had risen in value. The US dollars I brought into my country could be used to claim the output of China, the UK, New Zealand or many other countries by the person or company that next used them. And as for me, I had no interest in consuming US output with the money earned. I used both the original investment and profit to consume my own country’s output. There must be millions of people like me who do the same thing. We are not interested in actually purchasing goods and services in the US. We just want a return in the form of money and then take that money overseas as US dollars and convert it back to our domestic currencies.

Strangely, Cynicus also states that
Alternatively, rather than use the money returned in repayment [sc. from the debtor country] to directly purchase output, they might decide to purchase the output indirectly by purchasing an asset. In doing so, they take greater risk for the potential reward of securing even more of the country's output.
But purchasing an asset in the debtor country is not simply “indirect” purchasing of that country’s output. The asset can be exchanged for money on a market but that money can be used to buy output or financial assets or real assets. There is no obligation on the debtor country to provide its output in exchange for the asset. That decision rests entirely with the creditor, many of whom shun output for financial assets or real assets, either in the debtor country or in someone else’s country.

For example, creditors who have bought US government bonds can just take their return (money from coupon payments) and the money from selling the bond, and then take their total US dollars (principal plus return) overseas and convert them into a local currency and buy further financial assets there.

And here is the fundamental reality: the US dollars they brought to the new country can be used to claim output from any country on earth and there is no necessary claim on US output at all. The alleged claim on the original debtor country’s output is severed. The US dollar is the world’s reserve currency. Most commodities in international markets are priced in US dollars. Those US dollars could circulate in international trade without ever being used to buy US output.

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