VIEWPOINTS : Will the United States Be Pulled Under in the Sea of International Debt? : <i> Without Policy Change, the Worst Will Happen </i>

So America has become a debtor nation. For the first time since World War I, America owes foreigners more than they owe it, according to the Department of Commerce.

Does it matter? True, it means that some day Americans will have to produce more than they consume, as many commentators have pointed out this week. But this did not seem to worry the President much at his press conference last week. America is a “a buy now, pay later” country, and it has worked pretty well. And the numbers look quite small; after all, the federal government owes Americans nearly $2 trillion and the sky has not fallen in.

But it does matter, and not just for the next generation. The rate at which America is going into debt to foreigners is a time bomb ticking away that could well go off in a year or two and plunge the United States and the world economy into a new and dangerous recession. First, America is going into debt faster than any country has before.

By 1990, our external debt could reach $1.3 trillion if the dollar stays at its present level. Will foreigners be willing to lend this vast sum to the United States? No, because the big difference between borrowing from Americans and borrowing from foreigners is that somebody has to carry an exchange-rate risk.

So far, because of the pre-eminent position of the dollar in world financial markets, America--unlike other debtor nations--has been able to borrow in its own currency. And, so far, foreigners are quite happy about this.

Not only have they been earning high interest rates on the money they have lent to America, they have also seen the value of their investments measured in their own currencies--which is what interests them--go up with the dollar (by 70% for a German, and more than 100% for a Frenchman or an Englishman since 1980).

Situation Actually Worse

But what if the dollar goes down? There is a vicious cycle here. If the dollar does not go down, U.S. foreign debt will go on rising indefinitely. To stop the United States from going further into debt, the dollar would have to go down by 35%--and much more--against currencies like the deutschemark and the yen. But if the dollar does go down this much, foreigners will lose a lot on the money they have lent to America.

The situation is actually worse than this. Because the dollar is so widely used, many other countries have borrowed in dollars. So foreigners already hold an uncovered portfolio of dollar-denominated claims of around $800 billion on which they will also lose money when the dollar goes down, even though these come largely from the debts of other countries, not the United States.

Britain learned this lesson the hard way, and Chancellor of the Exchequer Nigel Lawson tried to warn America of the dangers of borrowing by a reserve-currency country when he addressed the International Monetary Fund annual meeting last year: “The availability to borrow abroad in one’s own currency gives opportunity and time which would not otherwise be available, to some extent at the expense of the rest of the world. But we also have experience of the consequences that occur when this special privilege is abused.”

Put bluntly, foreigners will lose a great deal of money--upwards of $400 billion, according to my estimates. Being human, they are not going to like it. At some point, they will try to cut their losses and get their money out of dollars.

This will not happen overnight--markets take time to change their minds--but at some point, say 12 to 18 months after the dollar begins to go down, foreigners’ willingness to put their savings into the United States ( ex ante , as economists put it) will fall to zero and become negative.

What happens then? Right now, because of the huge federal budget deficit, America is investing $120 billion more than it is saving. When the inflow of foreign savings dries up, the nation will have to “cut its coat after its cloth.”

There are only two ways to do this. The right way would be to cut the budget deficit drastically. Since this seems unlikely for political reasons, the only other way is for private investment to be cut back sharply. This means a recession.

Moreover, with a falling dollar and a U.S. recession, other countries will find that the strong demand stimulus they have been getting from America dies away and goes into reverse. And so the recession will spread to the rest of the world.

This would be dangerous because the world economy is still in a fragile state after the 1981-82 recession. There would be a new debt crisis in the developing countries and--with domestic debtors also in trouble--intense strains in the world’s financial system.

With unemployment on the rise everywhere, protectionist pressures could become irresistible, threatening a breakdown in the world trading system.

The worst does not have to happen. But it will happen unless there is a major change in the fiscal, monetary and exchange rate policies of both America and its major allies. Does it matter that America has become a debtor nation? You bet it does.