Every Sunday, Fortune publishes a favorite story from our archive. Turn to 1985 – the year the U.S. became debtor to the rest of the world for the first time since World War I. At the time, economists debated whether this was something to fear. Before Alan Greenspan, who later became U.S. Federal Reserve Chairman in 1987, believed the nation could safely take on more debt as long as it was denominated in U.S. dollars. Clearly, today’s ongoing debate in Washington over raising the nation’s $14.3 trillion ceiling has presented an unforeseen twist.
U.S. will soon owe other nations more than those big-league borrowers Brazil and Mexico. Should we worry?
At some unrecorded moment earlier this year-perhaps it was in February when the dollar reached a peak against foreign currencies, or maybe it was on April Fools’ Day — the U.S. became a debtor to the rest of the world for the first time since World War I. This development has touched off a “debate among economists: some brush aside the debt as a nonworry; others view it as a menace to the nation’s well-being.
In some ways there’s little cause for concern. The U.S., after all, has a great and growing economy, well able to repay loans. But the sheer pace at which the country is going more deeply into hock (see chart) gives reason for unease. Within a few years the burden could clamp serious constraints, on Washington policymakers, cut into U.S. living standards, and trigger a sudden, disruptive flight from the dollar.
By the end of this year, net U.S. indebtedness — the difference between all known foreign holdings of equity and debt in the U.S. and similar American investments abroad — will reach $100 billion, matching the amounts owed by those notorious borrowers Brazil and Mexico. By the end of 1986 the debt is expected to swell to between $200 billion and $300 billion. After that, an extrapolation of current trends would put the debt at $1 trillion by 1990, and much higher later.
Hardly anybody expects the trend to go that far. Long before indebtedness reaches mind-boggling numbers, most economists agree, the conditions that have created it will change or governments will be forced to take remedial action. The question is whether the adjustment will proceed in a relatively calm and evolutionary fashion or, as some fear, will resemble what happens when unrelieved stresses in the earth’s crust produce an earthquake.
The U.S. trade imbalance, exacerbated in recent years by the strong dollar, has played a major part in turning America into a borrower. The U.S. hasn’t had a positive balance of merchandise trade since 1975. But the recurrent account — which includes services, interest income, dividend payments, and other items as well as merchandise — remained roughly balanced for a while longer, largely because earnings on American investments abroad were big enough to offset the trade deficit.
Beginning in 1979, though, the Federal Reserve Board jacked up interest rates to bring inflation under control. Higher yields made the U.S. a more desirable place to invest, and the dollar began to ascend. With the dollar strong, imports skyrocketed when the U.S. economy recovered in 1983 and 1984 and other industrial countries continued to limp. At the same time, more and more U.S. exporters found themselves priced out of foreign markets. With income from U.S. investments abroad no longer offsetting the trade gap, the current-accounts deficit leaped to $100 billion last year and is running at about the same rate in 1985.
Partly to balance the books, the U.S. has been issuing what amount to IOUs: foreigners have been lending and investing in this country. They’ve had other reasons to put their money here. The Reagan Administration has made the U.S. even more appealing to overseas investors by cutting taxes on business (which will generally remain below pre-Reagan levels even if Congress passes the Administration’s new business tax increase). In this climate the policies of foreign countries have acted as a further prod. Japan, for example, has high income taxes and low interest rates compared with the U.S. So the Japanese, who are heavy savers, have become big investors in American securities, chiefly bonds. At the same time, U.S. corporations have throttled back on foreign investments and American banks have become warier lenders. In particular, they have backed off making new loans to risk-prone Third World countries. New foreign lending by U.S. banks dropped by $18 billion, or 71%, last year.
In many ways the torrent of foreign capital has been a boon. It has helped fuel the expansion, and without it, interest rates might have been far higher. Nor is added indebtedness a bad thing per se so long as it finances further economic growth — just as it helped pay for the country’s railroads and steel mills generations ago. Some foreign economists hail the U.S.’s willingness to borrow and accept a deteriorating balance of payments for a different reason. Gerhard Fels, director of the Institute of the German Economy, a recurrent search organization, describes himself as “rather relaxed” about U.S. indebtedness. “It has prevented the world economy from collapsing in the last two or three years,” he says. The rest of the world, Fels and others add, badly needed a creditworthy country willing to import more than it exported.
Some economists believe the U.S. could safely take on gobs more debt. Alan Greenspan, a former chairman of the President’s Council of Economic Advisers, is outspoken on this point. People who equate what the U.S. is doing with what Brazil and Mexico did, Greenspan says, make a fundamental mistake. “You have a problem only when you owe debt in a foreign currency,” he argues. “Most of the U.S debt is in dollars.” Since the U.S. has what Charles de Gaulle once called “the exorbitant privilege” of borrowing in its own currency, it doesn’t risk having the size of its debt suddenly multiplied if the dollar drops. If you are paying off a dollar debt, asks Greenspan, what difference does it make whether the ‘creditor is in the U.S. or in Singapore?
Greenspan also maintains that the Latin Americans frittered away their debt on consumption, while the U.S. is using much of its borrowings to finance businesses that create jobs. No one knows exactly what proportion of foreign investment goes into U.S. plant and equipment. Department of Commerce statistics show that one-third of last year’s inflow was invested in U.S. business, but that means little because money is fungible. The funds could have freed up American capital for consumption.
What is known is that total capital investment in U.S. industry, from all sources, rose sharply last year and is expected to keep climbing, though more slowly, this year. Greenspan says he “surmises” that the proportion of foreign investment going into new plant and equipment is large. As long as this is so and the debt is in dollars, he argues, the size of U.S. indebtedness is irrelevant.
Few economists would go that far, and some believe the growing indebtedness is cause for alarm. “The deficit in our current accounts says we are living beyond our means,” warns David Rolley, director of international financial analysis for Chase Econometrics, a forecasting company. C. Fred Bergsten, director of the Institute for International Economics, a Washington think tank, and his colleague Stephen Marris have been writing and talking about their apprehensions. Bergsten finds “ominous” similarities between what the U.S. is doing today and what the Latin American borrowers did a few years ago. Some of the borrowed money, he acknowledges, is financing industry. But a disturbingly large part, by his estimates, is bankrolling a spending spree by the federal government and consumers.
Even at its present level, the critics say, foreign indebtedness is narrowing Washington’s economic options. “Our debtor nation status is driving our policy,” asserts David D. Hale, chief economist for Kemper Financial Services Inc. At some point, Hale says, the government might wish to lower interest rates sharply to spur a sluggish economy. But the federal budget deficit, one-fifth financed by the foreign inflow, might dictate high rates to keep the capital coming.
As foreign debt grows, other economists say, it could drag down the American standard of living. Each additional $100 billion in debt at, say, 10% interest, means an additional $10 billion a year that must be paid to foreigners. If the lenders reinvest the interest in the U.S., the living standard would not suffer, at least not in the short run. But to the extent that they bring the interest income home, purchasing power would leak from the U.S. economy. Output and employment would decline a bit.
The net indebtedness would have to balloon to several times its present size before the interest outflow would be large enough to seriously hurt a $3-trillion economy. But the potential losses a few years down the road look big enough to worry Nariman Behravesh, a vice president of Wharton Econometric Forecasting Associates. “It’s not an immediate problem,” says Behravesh, “but more like a cancer that is slowly growing.”
Before too many years, the pessimists warn, the U.S. debt could precipitate a world financial crisis. If the debt keeps building without restraint, foreigners might suddenly lose confidence in U.S. creditworthiness, yanking out their money and sending the dollar into a free fall. This could create global calamity. The U.S. could well plunge into a major recession as the Federal Reserve Board desperately raised interest rates — and business’s and consumers’ borrowing costs — to support the dollar. This is the kind of threat Fed Chairman Paul Volcker probably had in mind when he told Congress recently, “The stability of our capital and money markets is now dependent as never before on the willingness of foreigners to continue to place growing amounts of money in our markets.” ,
Whatever the U.S. does, the debt will mount for a while because it will take at least two or three years to shrink the trade deficit significantly. But the right steps taken now would lessen the risks of big trouble later. If, for instance, the dollar gradually fell by 30% over three years, the U.S. could make a good start at balancing its international payments. The first and major step in that direction is to cut the budget deficit, considered by most economists a large factor in keeping interest rates high and the dollar strong. “A $50-billion cut this year would help,” says Bergsten. The budget package that recently passed the Senate would lop an estimated $37 billion off federal spending in fiscal 1986.
If U.S. interest rates moved lower in relation to those of other countries, that would slow the movement of capital into the U.S. What the U.S. doesn’t need is to attack the trade deficit with more protectionism. New trade barriers would be fruitless: foreign governments would surely retaliate.
Many economists believe the U.S. will need the help of other countries to control its debt, especially Britain, West Germany, and Japan. The sluggishness of their economies has cut demand for U.S. goods. If these governments apply some stimulus, as Britain and West Germany are talking of doing through tax cuts, demand for U.S. exports would pick up. With the right actions abroad and in Washington-and some luck-the U.S. journey into debt needn’t end with a crash landing.