The financial trap facing the U.S., China

By Jim Jubak

The United States, the world's biggest debtor, and China, the world's biggest creditor, each passed major statistical milestones this month.

In the second quarter, the Commerce Department announced this month, the United States paid more to its foreign creditors than it took in from its overseas investments -- the first time that's happened in 91 years. The gap was relatively small, $2.5 billion for the quarter, when measured against a $13 trillion economy, but it was still a milestone.

At the end of September, China's foreign-exchange reserves topped $1 trillion. Thanks to foreign investment in China and the country's huge trade surplus, China's foreign-exchange reserves are climbing by about $20 billion a month. In recent months, China's reserves have grown so quickly that the country has taken over first place from Japan, with reserves of $880 billion at the end of August.

2 countries on parallel tracks

The two countries couldn't seem to have less in common: The United States owes an increasing debt, and China is piling up foreign exchange at a record rate. But in reality, both countries face the same problems: How do you balance consumption and savings in a rapidly aging world? The U.S. has gone way too far toward consuming without saving, especially considering the huge financial costs that result from the aging of the baby-boom generation.

But China is out of balance, too. The country saves too much and often invests money foolishly. The country is aging even more rapidly than the United States, albeit from a younger starting point. And it has less infrastructure in place to support that aging population than the United States does. China's current cash flow may represent a one-shot opportunity to prepare for the aging of that society.

Each, in its own way, is spending too much on the present.

Is U.S. nearing financial avalanche?

In July, the United States may have reached a tipping point, one of those moments when all the snow that has been building up in the mountains suddenly becomes an avalanche. We've been spending more than we take in with both hands for a while now. But only recently has paying the interest on all that debt really started to cost us very much money.

The United States has piled up a string of monthly trade-deficit records recently. The July 2006 deficit of $68.04 billion, for example, erased the October 2005 deficit of $66.6 billion. For all of 2005, the United States spent $717 billion more on goods and services than it took in -- also a record. So far, 2006 is on a pace to handily surpass that deficit: The January-July 2006 deficit hit $453 billion, way ahead of the $398 billion deficit in the corresponding period of 2005.

At the same time, the U.S. government has been spending more than it took in. Since 2001, the federal government, certainly not the only layer of government practicing deficit financing, has borrowed $1.3 trillion to pay for tax breaks, new Medicare drug benefits and the war in Iraq.

Foreigners make U.S. deficits possible

Foreigners have picked up the tab for most of those twin deficits. Foreign investors have purchased U.S. government bonds that the federal government has used to finance its spend-now, pay-later policies. The dollars we sent overseas to pay for everything from oil to electronics to textiles to toys have been recycled by foreign investors into U.S. government bonds, corporate bonds and mortgage-backed securities (a form of debt backed by the mortgages on U.S. homes). My MSN Money colleague Bill Fleckenstein has railed against the way that we turned our homes into ATMs during the real-estate boom. Well, it was foreign investors buying bundles of mortgages on U.S. real estate who kept those ATMs stocked with cash.

By the end of 2005, overseas investors held $13.6 trillion in U.S. stocks, bonds, real estate, businesses and other assets. Subtract the $11.1 trillion in assets owned by U.S. residents and companies, and the U.S. had a net negative balance of $2.5 trillion. That's about $23,000 for each of the 110 million households in the nation, according to the U.S. Census Bureau.

U.S. net investment income now in red

But as any debtor knows, it's not the size of the debt that counts but the interest rate you have to pay. Until recently, the United States got a great deal on its debt because borrowing money was cheap. Remember that short-term interest rates -- and the U.S. government sells an awful lot of three-month Treasury bills -- were at 1% as recently as June 2004. The 10-year Treasury note yielded just 4.7%. At the same time, because U.S. investors preferred equities to bonds, they were earning closer to 8% on their equity stakes, giving the United States a positive net income on investments, even though it owed more than it owned.

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