A loss of investor confidence | The Triangle

A loss of investor confidence

There has been a debate in the United States regarding China’s possible sale of the $1.4 trillion in Treasury bonds it has lent to the United States. This debate has become more relevant recently in the light of the United States’ repeated troubles in formulating its federal government budget and reducing its total government debt, which now exceeds 100 percent of its gross domestic product. There is a parallel debate on a similar issue in the United Kingdom, but the British debt is about 70 percent of its GDP, excluding the cost of bank bailouts. This debate has been carried out within the context of the loss of investors’ confidence and the consequent impact on domestic interest rates and the economy.

The answer to this debate — whether it is relevant to a country like the United States, the U.K. or Greece — depends formally on two basic factors: the size of the government debt and the type of the currency regime. The United States has a very large government debt relative to GDP, and so does Greece, but the U.K. does not. The U.S. and U.K. have a flexible exchange rate, but Greece follows a fixed exchange rate within the eurozone. This implies that those countries have different mechanisms in terms of how the loss of confidence by foreign investors affects their interest rates, exchange rates and the overall economy. Some believe that the end of the mechanism will lead to economic recession, while others trace the final outcome to the two factors: the proportion of government debt to GDP and the type of exchange rate regime, which they think could lead to expansion.

Let us first go over the theory before we find a balance between the competing theories that gives a more realistic view of the real world without any influence from ideology, whether it comes from freshwater economists or saltwater economists.

Let us start by assuming that there is a loss of confidence by foreign investors. The consequences of this shock will depend on the two factors I mentioned above.
The common belief: The loss of confidence will lead to capital outflows, which in turn induce an increase in interest rates. The final outcome is that the higher interest rates will choke off the aggregate demand and then lead to an economic recession.

Krugman’s view: Nobel Prize laureate Paul Krugman has a different view on the impact of the loss of confidence on the economy. He believes this loss will lead to capital outflows, which in turn decrease the capital account. Given the following identity:

Balance of payments = current account + capital account = 0

Following a decrease in the capital account, there must be a reciprocal increase in the current account to restore the equilibrium in the balance of payments. The trajectory that a given economy will follow will depend on the currency regime and the size of the government debt.

Fixed exchange rate within a currency area: In Greece, which follows a fixed exchange rate as part of the eurozone, domestic interest rates will soar, leading to lower demand and lower imports, therefore depressing the current account until it becomes equal to the capital account. The identity above is then the restored. However, Greece does not have the option of external devaluation through devaluing its currency to promote exports. It has the option of international devaluation through lower wages and prices to reduce imports and increase its export competitiveness in order to increase its current account. But this channel is blocked by downward wage and price rigidity and political opposition. The final result for a country like Greece is a devastating economic recession.

Unilateral fixed exchange rate: The countries that peg their currencies to an anchor like the U.S. dollar must have enough international reserves to defend these currencies in the face of large fluctuations in their foreign currency reserves. A loss of confidence by foreign investors will lead to massive outflows of short-term foreign capital. With this size of capital exodus, those countries will experience a devastating devaluation in their exchange and a paralysis in their production. The final outcome as we saw in the 1997 Asian crisis is a terrible economic recession.

Flexible exchange rate: Here the mechanism works differently from the above cases. A decrease in the capital account will lead to corresponding increases in the current account and the equilibrium until the balance of payments is restored mainly through external devaluation in the exchange rate, which should promote exports and reduce imports and maybe — just maybe — lead to economic expansion. Indeed, this adjustment is faster and less painful than the adjustment through drops in domestic wages and prices, but its efficiency is also subject to the share of government debt to GDP. It should be easier for the U.K. than for the United States because the former’s debt’s share in GDP is smaller than the latter’s.

But the real world does not go as the theory does or Krugman believes. If China, in cashing its U.S. debt, catches the Federal Reserve with its pants down, there will be an exodus by the Chinese and other foreign investors, like those in the Gulf who also have bought a sizable amount of U.S. Treasurys. If such a panic happens, it should first strike the short-term securities such as the U.S. Treasury bills. The central banks of the oil-rich Gulf countries and other OPEC exporters have most of their investments in U.S. Treasury bills. This short-term market is very vulnerable to such shocks, which should affect many operators in the United States ranging from stock brokers to businesses that need to finance their inventories. The plunge in the dollar could be disorderly, and the greenback may lose its role as the world’s foreign reserve currency. This possibility is not very far-fetched given the repeated failure of the United States to deal with its budget and debt ceiling. We will face this circumstance again in December and January as we faced it in October.

The Federal Reserve should not allow the chance to be surprised under any circumstances. It should be ready to do quantitative easing to buy up the Chinese debt if China cashes its U.S. debt. It should also have a plan to deal with the possibility of a plunge in the U.S. dollar. The Fed should consider such a plan as part of its forward guidance and new commination strategy. On the other hand, China should not surprise the Fed unless it wants to damage the U.S. economy, which is in no one’s interest.

Shawkat Hammoudeh is a professor of economics at Drexel University. He can be contacted at [email protected].