Global Policy Forum

By Floyd Norris

The Bush administration is not very popular overseas, at least if you believe the opinion polls. But if money could talk, it would tell a different story. For most of this year's second quarter, the United States was waging a war in Iraq, with help from the British and not very many others. There were demonstrations around the world against the war.

But guess who was financing it? The world was. Figures released this week showed that private foreign citizens bought an unprecedented $129 billion in United States government and agency securities. Official accounts, mostly central banks, added $43 billion more. All told, foreigners bought almost 80 percent of the net increase in Treasury and agency debt during the quarter. They now own 38 percent of outstanding Treasuries, more than double the figure of a decade ago. Those numbers came from the Federal Reserve this week, in its quarterly flow of funds report. That report tends to be ignored because it is late, voluminous and complicated. But the foreign aspect of it is extraordinarily important these days because the United States must attract so much capital from the rest of the world. We need that capital because of the huge current account deficit this country is running. That deficit — largely reflecting the trade deficit — went above 5 percent of gross domestic product in the first quarter for the first time in history. The second-quarter number, when it is released Monday, is likely to be about the same.

Such deficits can be financed only by investment flows. If they are not large enough, then currency values must adjust. A few years ago, it was fashionable in some circles to argue that the growing current account deficit was a sign of American strength because it reflected just how attractive American investments were to foreigners.

That argument does not work now. In the late 1990's, most of the foreign money was going into investments that were a bet on the vibrancy of the American economy: corporate stocks and direct investment, meaning foreigners were buying companies or building plants. A lot of those investments went bad when the bubble burst, reflecting the fact that foreigners often tend to come a bit late to parties. Someone has to buy at the top.

The really big overseas accumulations of American stocks started in 1999 and continued into 2001. The overseas investors did not turn into net sellers until the first quarter of this year, after stocks hit bottom and started to recover. In the second quarter, they bought $21 billion worth of shares, a big gain but less than a third of the amount they bought in early 2000, when the market was peaking.

The second-quarter surge in private purchases of Treasuries may reflect a bit of bubble buying as well, as plunging bond yields and rising prices attracted speculators. John Vail, senior strategist of Mizuho Securities USA, notes that Japanese investors appear to have sold Treasuries in July, as rates were rising and prices were falling. But speculators aside, much of the foreign investment reflects the need for a place to park the dollars foreigners receive when they sell all those toys, textiles and Toyotas. It's a nice situation while it lasts. We get cheap imports, which hold down inflation and enable consumers to buy more. The flood of foreign money helps to keep interest rates low while supporting the dollar. The war can be financed relatively cheaply at those low rates. But borrowers may eventually need to pay attention to the views of the lenders. It would not be fun if foreigners began to invest the way they talk.

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