Legal Commentary

Be more worried about the amount of federal debt than who holds the debt instruments

By Beldar

Bruce Bartlett has a pretty well-balanced but simple article in Forbes online in which he attempts to answer this question: "Is America's foreign-owned national debt a threat to the U.S. economy?" I agree with both parts of what I understand to be his overall conclusion: The skyrocketing amount of the national debt is an enormous threat to the American economy and, indeed, to America's prosperity and way of life. But there is much less reason, and indeed not very much reason overall, to be concerned that foreign powers, including China, are so heavily invested in American debt securities.

Bartlett does a nice job of clarifying recent changes to both the gross size of the federal debt and the percentage that's foreign-owned — one upshot of which is that a surprising amount, indeed slightly more than half, of the debt instruments (chiefly long-term federal bonds) cumulatively representing that indebtedness are still owned domestically. He explains how China's concentration of ownership represents a deliberate decision by China's central government policymakers to artificially depress the Chinese yuan against the American dollar, which in turn makes Chinese exports relatively less expensive and imports to China relatively more.

As far as generally quantifying the risks of Chinese or other foreign ownership, Bartlett also briefly explains that if the Chinese, or any other large debt holder, were suddenly to dump their U.S. debt security holdings ? to liquidate them in the proverbial "fire sale" through open-market transactions with the proverbial "willing buyer [at some price]" ? that might well cause a rise in the interest rates America would have to pay on future borrowings. That rising interest rate would of course make our borrowing more expensive, and I don't mean to trivialize the potential damage from that.

The Chinese are probably not unhappy at the prospect that with their relatively safe investment comes some latent and theoretical political power. Sure, it's a plus for them to the extent that there are any scenarios in which they could damage U.S. economic interests. But as Bartlett also notes, those scenarios could only play out if the Chinese were willing to simultaneously absorb huge and probably irreplaceable losses to the principal of their main governmental investment of wealth.

Just how big the impact would be, and how few or many interest rate points would be added, would depend on the spread in the distress sale, along with the availability and eagerness of other buyers. For rational economic actors, interest rates correlate with risk; and unless (or at least until) there is huge structural damage to the American economy, the risk of the U.S. government defaulting on paying its bonds is still lower than that of any other government with remotely the borrowing capacity we have. Indeed, the willingness of the Chinese government, and of other foreign investors who aren't bound by political strings to the Chinese, to continue buying American debt instruments even with almost no interest (and sometimes with an effective negative yield to maturity) during the last couple of years reflects a "flight to quality" in the international investment community. All of this suggests that their are serious intrinsic self-limits to the power of even a meddlesome and spendthrift rival to run up the interest rates on our government debt.

No, the main reason the Chinese ? and other foreign investors ? have bought into U.S. debt securities so heavily is that they're still the safest and most conservative investment out there. If that changes, we've got big problems all right ? but they're not problems limited to, or particularly caused by, the percentage of foreign ownership of our debt instruments.

I might quibble by arguing that Bartlett ignores one specific aspect of the nature of the risk, however. Specifically, in international finance, nation-state players may behave differently from the rational profit-maximizers in classical capitalist theory. We can't make the mistake of presuming that the Chinese will never act contrary to their objective economic self-interests; indeed, for an example of a government which does that routinely, one need look only to neighboring North Korea. There are lots of hypothetical scenarios under which the Chinese could plausibly be imagined to find adequate non-economic reasons to justify incurring those economic costs. And there are somewhat comparable examples in recent history. (Recall, for example, Middle Eastern oil producing companies' sacrifice of short-term profits during the oil embargoes of the 1970s.)

That the Chinese have some sort of power to influence the American economy isn't exclusively a function of their buying our debt instruments, however, but rather is an inevitable function of the sheer size of the other economic transactions going on between China and the rest of the world, most notably including us. If sufficiently motivated to abandon its own economic self-interests in the process, any country of major economic significance could, theoretically, find other ways to damage our economy that didn't involve debt instruments. We wouldn't be immune from rough treatment, in other words, even if we didn't borrow any money from any foreign countries.

In the process of explaining that China's use of its power would carry high costs, Bartlett or his editors stumbled very badly with this stinker of a sentence, however, and in the process omitted a fairly important point:

Further complicating the issue is the fact that the Chinese now own so many Treasury bonds that they are really in the position of being a company's largest shareholder.

Well, no, that's not at all right ? not even if we indulge in the useful fiction that in this borrowing transaction, the U.S. government is functioning like a private company. And it's a mistake that feeds into an irrational and unfounded fear, specifically the fear that by buying up our Treasury bonds or other debt instruments, the Chinese might acquire a direct say in what our government does. Such fears ignore the fundamental difference between debt and equity.

A company's largest shareholder is not much at all like its largest bondholder. He who buys a company's bonds gets to stand at the front of the line, ahead of equity holders (like shareholders), if there's a forced liquidation of the company and a distribution of its net assets. But in exchange, the bond holder generally has to forfeit all rights to participate in the management of the company's business unless and until there's a default by the company on its promise to repay according to the terms of the bond. And the caselaw says that companies owe all sorts of fiduciary and other unwritten, vague, but powerful duties to shareholders, whereas companies own nothing more to their debt holders than the precise minimums to which the companies are specifically committed by explicit written contractual promises to the bondholders.

Indeed, federal debt securities don't even include the kinds of negative covenants and restrictions that encumber many private debt offerings. They're not much more than a minimal "IOU," and that sublime simplicity is a fundamental attribute of that kind of investment opportunity.

No matter how many Treasury bonds China buys, it can't somehow "convert" those into a right to cast votes in the U.S. Senate or to give instructions to the Joint Chiefs of Staff. The holder of an American federal bond has a contractual right, enforceable against the U.S. government under its own laws and in its own courts, to repayment of principal and payment of interest on the exact terms specified in the bond. And that's all it has.

Viewed from another angle: The risks discussed above ? that China or other current holders might "dump" their holdings, and that China or other potential future investors may refuse to buy without higher interest payments ? are essentially built into the terms of the deal, but the trade-off for this kind of borrowing is that it comes without further strings attached. The bondholder may have to stand silent, grinding his teeth, while the borrower runs the business into the ground, but until there's a default, there's nothing the bondholder can do; unlike an aggregation of the shareholders sufficient to represent a majority, the bondholder has no right to replace the management, and hence the bondholder has only minimal and largely theoretical influence over that management. Until the bond's due date, so long as any required periodic interest is being paid, the bondholder's decision tree remains bleak and binary: Hold or sell.

You or I, or General Motors, can't get those kinds of favorable lending terms because we can't justify the same credit rating, in essence, that the U.S. government gets. Lenders want us to put up collateral; they want us to make all kinds of promises about what we will or won't do that might affect our ability to repay. The day may come when the U.S. government can no longer get such favorable terms, either. (Russia, which defaulted on its national debt just before the millennium, certainly can't.) But in assessing the risks ? and the limits to the risks ? of having foreign governments investing heavily in America's debt instruments, we ought take such comfort as we legitimately can in the fact that our national choices remain, for the present, mostly unconstrained despite the massive debt that Obama and his cronies have already gotten us into. There's already ample cause for concern, and indeed there is already more than ample cause for immediate change (e.g., a return to annual deficits measures increments of less than a quarter-trillion, just for a start). But don't panic, yet, about the Chinese in particular holding so many of our bonds. In any fair prioritization of our national problems, that one is neither one of the biggest nor the most urgent.

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UPDATE (Sat Mar 13 @ 9:45 a.m.): Veronique de Rugy at The Corner also discusses Bartlett's article, and has a useful chart. (H/t InstaPundit, who reprints the chart.)

Full post as published by BeldarBlog on March 13, 2010 (boomark / email).