Who’s Funding Uncle Sam?

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In, The Lowest Common Denominator, I quantified the extent to which growth of consumer, corporate and government debt has greatly outstripped economic growth and our collective income. This dynamic has made the servicing of the debt and the ultimate pay back increasingly more reliant on more debt issuance.

Fortunately, taking on more debt for spending/consumption and to service older debt has not been a problem. Over the past 20 years, there have been willing lenders (savers) to fund this scheme, even as their reward, measured in yield, steadily declined.

Unfortunately, two of the largest holders of U.S. Treasury debt (China and the Federal Reserve) are no longer buying as aggressively as they once did. More concerning, this is occurring as the amount of Treasury debt required to fund government spending is growing rapidly. The consequences of this drastic change in the supply and demand picture for U.S. Treasury debt are largely being ignored.

Foreign bond holders

In our article, Triffin Warned Us, we provided a bit of history on the Bretton Woods Agreement. This pact from 1944 essentially deemed the U.S. dollar the world’s reserve currency. As a result of the agreement, foreign nations rely heavily on U.S. dollars for all types of international trade. For instance, if Uruguay sells widgets to Australia, Australia will most likely pay Uruguay in U.S. dollars. Because of the reliance on dollars for trade, Uruguay, Australia and almost every other nation holds reserves of dollars.

Foreign entities with dollar reserves maximize the interest they earn on reserve accounts with the objective of taking as little risk as feasible. Think of reserve accounts as savings accounts. As such, foreign reserves are most often invested in “safe” U.S. Treasury securities. As world trade has grown over the years, the need for dollar savings has grown in step and has resulted in more lending to the U.S. Treasury by foreign governments.