Introduction

Here is what Paul said:

We spend too much money and borrow too much money. And, actually, we’re going to bring back Obama era deficits. I was elected to combat Obama era deficits. I remember running for office and saying, we’re going to have trillion-dollar annual deficits. That’s what we’re going to have this year. So, now it’s Republicans in charge busting all the spending caps. The Democrats are complicit. Both parties, the establishment want to spend more money.

And I think part of the reason the markets are so jittery is they worry about the long-term imbalance of government debt. We have a $20 trillion debt. And we’re going to now adding a trillion dollars to it this year because of this spending deal. This is a rotten deal and not good for the — any of those of us who believe that you can get too much debt for a country to bear.

Rand Paul said the Republicans are now in bed with Democrats in caring more about increasing military expenditures than worrying about the deficit. He is correct. He is also right is saying the rapidly growing US debt is worrisome. In what follows, data is provided on why and how Paul is right and what the implications are.

Projected Deficits

Table 1 provides data on Federal Government deficits. As was fitting, the deficit grew during the recession started in 2008 as a means to increase aggregate US demand. The deficits projected for the next few years with the country already at full employment are unprecedented.

Table 1. – US Federal Government Deficits

Source:  Committee for a Responsible Federal Budget

The Right and Wrong Times for Deficit Finance

When a country is in recession, as the US was in 2009, it is entirely appropriate for governments to increase aggregate demand via deficit finance, either by reducing taxes or increasing expenditures. But the US is now at full employment. When you increase demand at full employment, several things can happen.

  • Wages and prices go up – inflation;
  • Firms might use their the tax savings and to purchase more labor-saving technology and thereby reducing employment;
  • Increased demand will spill over into increased imports, thereby worsening the US trade deficit.

It appears that all of this has started to happening: wages and prices have increased prompting speculation that the Federal Reserve will soon have to increase interest rates. And US imports are growing more rapidly than exports causing the US trade deficit to grow.

The Trade Deficit – A Closer Look

Long ago, the US actually ran a trade surplus. That is, it exported more goods and services than it imported. But since 1970, the US has run a deficit. For most countries, running a deficit for an extended period of time would cause its currency would weaken.

So why not for the US? In actual fact, the dollar has weakened relative to the currencies of certain countries. For example, between 1983 and 2000, the dollar lost 45% of its value against the Japanese Yen. Without that depreciation, the US trade gap would have been much larger. And Toyota would not be producing more than a million cars a year in the US.

Table 2. – US Trade Deficits

Source: US Bureau of Economic Analysis

But there is more at play here. International capital flows help maintain the value of the US currency. For a number of years, the world has loved US securities and in particular, US Treasuries. While not included in US trade data, US capital inflows are a significant US export. As indicated in an earlier piece, foreigners bought $1.7 trillion of US debt between 2012 and 2016. Foreigners needed dollars to make these purchases, and this demand for dollars supported the value of dollars relative to other currencies.

Today, the US government has issued $20 trillion in debt securities, with more than $6 trillion held by foreigners.

Foreign Holdings of US Treasury Securities, Nov. 2017

Source: US Treasury

As noted by Bloomberg, this could be a very slippery slope. The foreign demand for US securities could turn on a dime. Foreigners are watching the lack of fiscal management in the US. China and Japan have both stopped adding to their US government debt. The current lack of US fiscal discipline will trouble foreigners further. And keep in mind, without those foreign purchases of US securities, there is nothing to balance the US trade deficit. The result would be a lower demand for dollars would fall, thereby putting a chill on the foreign demand for US equities.

Of course, there are countervailing forces at play. Foreign holders of US securities do not want to see the value of their holdings fall further. So they will be very prudent in their liquidations. One immediate effect of these concerns will be that the US will have to pay more for new debt issues. And even with very low rates, the US government is already paying out $230 billion annually.

Investment Implications

All of the above suggests now would be is a good time for US investors to consider off-shore investments. In all likelihood, the dollar will weaken against the Chinese Yuan in the coming decade. Recently, I have suggested it is worth looking carefully at China. Both ETFs and mutual funds should be considered. Specifically, Guggenheim China Technology ETF (CQQQ), Matthews China Investor (MCHFX), and Guggenheim China Real Estate ETF (TAO) warrant a close look. All of the above suggests now would be is a good time for US investors to consider off-shore investments.