MICHAEL KEATING. What country seeks to go to war with its banker? (Repost from 30/1/2018)

This article supports Hugh White’s conclusion that the US is unlikely to succeed in fighting China for primacy in Asia. The US has been living beyond its means for a long time, and has depended on foreign finance, and especially Chinese finance, to sustain its living standards. Challenging China would require sacrifices from the American public that they are ill-prepared to make. Accordingly, it is very risky for Australia to continue to base its foreign and defence policies on the presumption that the US can be counted on to maintain its position in Asia without substantial change. What country seeks to go to war with its banker?

In a recent article (Pearls & Irritations, 23 January), Geoff Miller contrasted the conclusions from the Government’s recent Foreign Policy White Paper and those from Hugh White’s Quarterly Essay, Without America. As Miller points out, the two views are in direct contradiction. The Government’s whole future international strategy is based on the presumption that the United States will continue to carry out its traditional roles in the Indo-Pacific, and with its traditional effectiveness. On the other hand, White argues that ‘America has no real reason to fight China for primacy in Asia, shows little real interest in doing so and has no chance of succeeding if it tries’.

In this article I want to elaborate on White’s last point that the US is unlikely to succeed if it refuses to adapt to China’s rising power and accept some changes in the present rules-based system, which the US originally developed for its own benefit and to establish its own hegemony.

Indeed, as the Government’s White Paper itself recognises, ‘In the Indo-Pacific, the economic growth that has come with globalisation is in turn changing power balances’.  But I wonder whether the true extent of that shift in power, and how much further that power shift will go in the next decade, is fully appreciated by policy makers in the US and Australia.

The seminal fact, describing this shift in power, are the forecasts of future GDP provided by the Australian Treasury in the White Paper itself. These forecasts show that in 2016 the Chinese GDP was already some 15 per cent bigger than the American GDP, but by 2030 this gap is projected to have grown to as much as 77 per cent.  By any standards this represents a huge future difference in economic power between China and the US, and even if the US aims to retain its military superiority that begs the question of how much it could afford to.

Most recently, Trump has declared that the US will increase defence spending so that it can better stand up to Russia and China, while at the same time very costly tax cuts have also been legislated.  Trump’s contention is that this will all be paid for through economic growth.

Former President Reagan said the same thing, when he introduced major tax cuts along with his “star-wars” arms race in the early 1980s. Under Reagan the US fiscal deficit increased by as much as 3 percentage points to 4 per cent of GDP, and it was more than a decade later, under President Clinton, before the US fiscal position was restored to what it had been when Reagan took office. Subsequently, President George W. Bush made similar claims about his tax cuts in the early 2000s, and the US Budget still has not recovered. In each case US economic growth remained much the same, but the combination of extra defence spending and less revenue plunged the US Budget into an intractable deficit.

In short, all the evidence is that tax cuts do not pay for themselves. But someone has to pay, and if defence spending is also increased at the same time then that someone has to pay more again. As the former conservative Australian Prime Minister, Malcolm Fraser, used to put it: ‘there is no such thing as a free lunch’.

But what is most interesting about the US, is how much of the US overspending, and thus living beyond its means, has been sustained in this century by the support of foreigners. The key facts are that:

  • the general government fiscal balance has shown a deficit of as much as 6.0 per cent of GDP in 2003 (after the George Bush tax cuts), and it was still as high as 5.0 per cent in 2016;
  • in the same years, the current account deficit was 4.5 per cent of GDP in 2003 (and as much as 5.8 per cent of GDP in 2006), and 2.4 per cent in 2016. This current account deficit must be financed by foreign borrowing, and so it gives us an indication of the reliance on net capital inflows.

In sum, therefore, at least half of these unaffordable tax cuts were financed by foreign borrowing, and even more if we add extra defence spending.  Furthermore, the biggest source of this foreign finance to sustain the US Budget has been China.

This of course raises questions about the future. Why would China be prepared to finance the US to enter an arms race with it. Or to reverse the question: what country seeks to go to war with its banker?

Some time over the next few years, the US will inevitably have to face the reality of its situation. The US is not only not the biggest economy in the world, it doesn’t even pay its way. In these circumstances the US can only offer challenges to China if its citizens are prepared to make sacrifices in their living standards, to finance that challenge. However, I suggest that nothing has been done in the US so far to prepare the US public for this choice.

Instead, further policy drift is the most likely outcome for some time yet, even if we had a US President rather more far-sighted than President Trump. This drift may then result in the worst of both worlds: the US will not come to terms with its loss of power and its economy will remain over-dependent on the good will of others. But we for our part, would be silly to put our trust in the US staying a course which it is not prepared to pay for.

Michael Keating is a former Head of the Department of Prime Minister and Cabinet.

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2 Responses to MICHAEL KEATING. What country seeks to go to war with its banker? (Repost from 30/1/2018)

  1. Ken Oliver says:

    “What country seeks to go to war with its banker?”
    Actually, many a ruler has gone to war with their banker – it’s one way to avoid repaying them. I wonder if that will occur to Mr Trump? After all, he has a track record of finding a way to dud his bankers.

  2. Nicholas says:

    How is China “America’s banker? The United States has not done any “foreign borrowing”. It has no debts that are denominated in foreign currencies.

    The United States Government has adopted the voluntary accounting practice of matching deficit-spending with debt issuance in USD-denominated bonds. It does not need to do this. The practice of matching deficit-spending with the issuance of bonds is a form of corporate welfare because it provides a guaranteed interest-bearing asset for institutional investors and wealthy people. The USG should stop issuing bonds. And it should simply retire all outstanding Treasury bonds by converting them into reserves (which is a USD asset that does not bear interest).

    When foreigners, including foreign central banks, buy USG bonds, those assets remain within the reserve accounts of the United States central bank. They are not a debt in any meaningful sense of that word. The USG is not financially constrained when it makes payments in USD. It simply uses keystrokes on computers at its central bank to write up the reserve accounts of the institutions that it wants to pay.

    If the USG had large amounts of debt in foreign currencies, that would constitute a financial constraint on the USG because the USG would need to either earn or borrow sufficient amounts of that currency, or sell assets to obtain that currency, in order to have the funds to service the debt. But the USG does not borrow foreign currencies. Instead, what the USG does is unnecessarily issue debt instruments in the currency that it keystrokes into existence. There is an immense difference between those two scenarios.

    The USG issues an unpegged, floating currency, and it enforces tax liabilities in that currency. Consequently, the constraint that it faces is the availability of real goods and services that are for sale in its own currency. The USG does not face a financial or budget or revenue constraint.

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