Foreign Investment Aids Cleanup, Despite Adding to U.S. Deficit

The latest Treasury report on foreign lending showed that investors abroad poured $101.4 billion into the United States in July alone -- a voracious clip -- to snap up stocks, bonds and everything else available. So while the federal government keeps spending and while tax cuts remain politically sacrosanct, continued foreign investment should help pick up the estimated $200 billion cleanup tab for Katrina and further postpone a final reckoning on the budget deficit.

"We know [Katrina] is an extraordinarily consequential event for the people and the region, but it's one the economy can weather," said Douglas Holtz-Eakin, director of the nonpartisan Congressional Budget Office. "The evidence is, we can finance this with borrowing. I don't see any evidence we couldn't do that."

Any debt must be paid back, with interest, so running up the deficit to reconstruct the Gulf region carries a cost, at least to future generations. Foreign holdings of U.S. government debt exceeded $2.03 trillion in July, meaning that every man, woman and child in the United States owes foreign investors $6,846.

Holtz-Eakin said Congress and President Bush face a choice on how to finance the recovery: raise taxes, cut spending or let foreigners pay. The decision will reveal much about the government's ability to set priorities in the face of far larger challenges, such as the baby boom's nearing retirement, Holtz-Eakin said.

Ever since record budget surpluses turned to yawning deficits, some economists have issued warnings of pending doom that have yet to come true. They predicted that foreign lenders would sour on U.S. government debt as the Treasury Department sold billions of bonds and notes each day. To keep those buyers happy, interest rates would have to rise substantially. Housing, cars and other items bought on credit would turn expensive, and the U.S. economy would slide into recession.

Despite such warnings, Congress and Bush cut taxes every year since 2001, and spending soared, largely to finance the war in Iraq but also to fund the largest expansion of Medicare since President Lyndon Johnson created the program in 1965, the most expensive transportation and public works bill in history, and now, the biggest domestic reconstruction effort ever.

Compared with the size of the economy, federal tax revenue has plunged, to 16.3 percent of the gross domestic product last year from 20.9 percent in 2000, before recovering to 17.5 percent of the GDP this year. Meanwhile, spending has climbed steadily, to an estimated 20.2 percent of the economy this year from 18.4 percent in 2000, and that CBO estimate came out before Katrina struck.

But economic disaster has not hit.

"These long-run worries, there's an element of truth to them, but I think frankly the fears are exaggerated," said James Glassman, senior U.S. economist at J.P. Morgan Chase.

On the contrary, tax receipts, buoyed by a thriving corporate sector, set a single-day record last Thursday. The Treasury pulled in $71 billion that day, shattering the $61 billion record set June 15. And corporate tax receipts on Thursday -- $63 billion -- surpassed the total for any previous month on record. At 4.9 percent, the unemployment rate is the lowest since August 2001.

And interest rates have shrugged off Katrina. The small increase in rates in recent days stems mainly from inflation fears that predated the hurricane, said Steven Englander, chief currency strategist for North America at Barclays Capital in New York.

That seeming contradiction can be solved by looking abroad. Foreign holdings of U.S. government debt reached slightly more than $1 trillion in 2000 and have more than doubled since. Japan, long the nation's largest creditor, now holds $683 billion in U.S. government debt. China, which recently surpassed Britain as the United States' second largest lender, has seen its stake in the U.S. government more than triple, to $242 billion this summer from $71.4 billion in 2000.

And there does not seem to be much lessening of appetite. Foreign purchases of U.S. stocks and bonds have nearly doubled in the past four months. Asian nations appear intent on buying U.S. assets to prop up the value of the dollar and keep U.S. interest rates low, thus helping U.S. consumers buy their goods. And that Asian buying spree is financed by U.S. consumers who continue their spending on Asian goods. On top of the bill for that new flat-screen television, add the interest owed to Chinese and Japanese lenders.

The United States also remains blessed by its competition: Foreign investors, looking for a stable place to park their money, still see U.S. assets as far more attractive then European or Asian investment options.

Katrina will do nothing to shake that arrangement, said Michael P. Dooley, a senior adviser at Deutsche Bank in New York and an expert on currency markets.

And Katrina just is not as big as it sounds, most budget analysts agree. Currently, about $4.1 trillion in U.S. government debt is traded worldwide. So far, Congress has enacted $64.6 billion on Katrina-related legislation, and the Senate has approved additional legislation worth nearly $11 billion. Without doubt, $75.6 billion is a large amount, larger than the budgets of the Justice, Homeland Security and Energy departments combined. But borrowing $76 billion tomorrow would add a little more than 1 percent to the amount of federal debt already on the market.

Nevertheless, economists who have warned for years of the dangers of the deficit are not about to give up yet, "not on your life," said Stephen S. Roach, chief economist at Morgan Stanley and a leading deficit hawk. "Here we are taking on $150 [billion], $200 [billion], $300 billion in debt for Katrina at a time when we're doing Iraq, we're doing Afghanistan, and the national savings rate is at a record low for any leading nation in the history of the world," he said. "It will come back to haunt us."