THE QUESTION BEING WHETHER THE WORLD COULD SUSTAIN A LACK OF OUR DEBT:

US debt and China: a tale of two deficits: Deficit hawks are manipulating mistaken fears about the dollar and the US trade gap to push a highly partisan cuts programme (Dean Baker, 4/22/11, guardian.co.uk)

The reason that we are borrowing from abroad every year is that the United States has a trade deficit of the order of $550bn a year, or just under 4% of GDP. This trade deficit is financed by foreign borrowings. The logic is simple. If the United States buys more than it sells, then it must borrow the difference.

Note that this has nothing to do with the budget deficit. If the United States buys $500bn more from other countries than it sells to other countries, then it must borrow $500bn a year from them, regardless of whether the United States is running a budget surplus or a budget deficit. Foreign borrowing is determined by the trade deficit, end of story.

There are two ways that reducing the budget deficit can affect this picture. First, cutting spending and/or raising taxes can slow the economy, as will likely be the result from the cuts recently pushed through by Congress. If the economy is smaller, then we will buy less of everything, including fewer imports. In other words, if cutting the deficit makes the downturn deeper, then we will have a lower trade deficit. This means that the deficit hawks can reduce our borrowing from bad guys – if their intention is to throw the economy into a severe and prolonged downturn.

The other route through which reducing the fiscal deficit can lead to a lower trade deficit is if it results in a lower-valued dollar. The argument here is that if we get the deficit down, then interest rates would fall. Lower interest rates would make foreigners less interested in buying dollar-denominated assets, like US government bonds.

If foreigners investors are less interested in buy dollar-denominated assets, then they have less need for getting dollars. The reduced demand for dollars would cause the value of the dollar to fall. A lower-valued dollar will then make US goods more competitive in international markets, leading us to buy fewer imports and to increase out exports.

However, this channel for reducing the value of the dollar is not working right now, since many governments – most importantly, China's – are deliberately propping up the value of the dollar against their currencies. They are doing this to sustain their export markets in the United States.

It is very difficult to see why China would be less interested in sustaining its export market in the United States if we reduced our budget deficit. Does anyone believe that President Hu is going to decide that China no longer needs its export market in the United States because we have reduced our budget deficit?

Of course, this is absurd. China's decision to prop up the dollar is not going to be affected by the size of the US budget deficit. Which means that the US trade deficit and our borrowings from China are not going to be affected by the budget deficit. If we are interested in reducing our borrowings from China, then we should be focused on reducing the value of the dollar, not the budget deficit.

So, why do all the deficit hawks talk about borrowing money from China? They do it for the same reason that George HW Bush talked about Willie Horton when he was running against Michael Dukakis. It works.

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