In the early 1980s, and throughout most of its history, the United States was a creditor. The value of U.S. investments abroad exceeded the value of foreigners investments in the United States. The positive figure in 1982 of $328 billion represented accumulated U.S. savings.

When a country runs a current account deficit, it is borrowing. In the case of the United States, it began borrowing from a position of strength. The early years of borrowing just reduced the savings that had built up over decades. In the late 1990s and beyond, the growth in accumulated debt became extreme. The U.S. debt to the world at the end of 2004 stood at $3.5 trillion.

As with the current account deficit, the debt that the United States owes to the world is the largest amount in history. As with other figures, there are nuances where the figures are adjusted for the size of the economy and the current value of the assets (the data in Figure 6.2 use the historical cost of the investment, not the current market value). When these nuances are taken into account, the trend is identical. The United States has had a dramatic change from global creditor (and saver) to debtor (and consumer).

Loan Sharks and Latin American Defaults

The accumulated U.S. debt to the rest of the world stands at $3.5 trillion. While this is a lot of money to you and me, the real puzzle is why such a small amount of debt is any trouble at all. After all, $3.5 trillion is only about 3 months worth of U.S. economic output.

Compared to how much individuals frequently borrow, the U.S. international debt seems small. For example, my brother in-law Henry racked up about $150,000 in debts during graduate school. At the time, the loans represented many years of income. However, his education allowed him to become a physician so the borrowing was justified. When people borrow for houses, we borrow many years worth of income.

Therefore, the puzzle is why such a puny amount as $3.5 trillion is considered a problem for the United States. The answer, as my Harvard

Business School colleague Professor George Baker points out, is that the amount of credit available is a function both of the income of the borrower as well as the ability of the creditor to force repayment.

Charlie, the bedbug took my thumb, says Paulie (played by Julia Roberts brother Eric) in The Pope of Greenwich Village. The bedbug is the local Mafioso chief and by a series of poorly executed steps, Paulie owes more than he can pay. The bedbug actually goes easy on Paulie because of family connections. Nevertheless, debts that arent repaid in this world invite severe punishments.

Why would anyone borrow money from a loan shark? As one might expect, people who borrow from loan sharks usually have no alternative. Some desperate circumstance leads them to need money, and with all other doors shut, the loan shark fills the void. The puzzle then is not why people borrow from loan sharks, but why loan sharks are willing to loan money when all others arent.

The ability of the bedbug to take Paulies thumb explains why loan sharks will loan money to people who cannot borrow from anyone else. Because loan sharks are willing to collect in extreme ways, most people try really, really hard to repay them.

The financial situation of the borrower as well as the tools available to collect debts are the keys to understanding credit limits. With this perspective, it is easy to see why the biggest loans in most peoples lives are associated with their houses. Banks lend a lot of money, relative to salary, for housing because it is relatively easy for banks to get their money back by repossessing the property. When creditors cannot take thumbs or houses to ensure repayment, they are not willing to lend very much.

International lenders always have to consider the possibility of default. In December 2001, Argentina defaulted on its loans and stopped repaying agencies such as the International Monetary Fund. At the time, Argentina owed more than $100 billion. Could Argentina repay these debts? Absolutely-they represented about one years worth of production.10 So just as a homeowner can pay down a similarly sized debt over the years, Argentina could have repaid the money it owes.

But countries will default on loans when it is in their interest to stop making payments, not when debts become too large. Argentinas President Nestor Kirchner said that he would rather bear the consequences of default rather than cut spending; he stated that repayment would be paying with the sweat and toil of the people. 11

John Maynard Keynes said, If you owe your bank a hundred pounds, you have a problem. But if you owe your bank a million pounds, it has. The United States owes the world $3.5 trillion and Keynes suggests that this is a bigger problem for the creditors than for the United States.

Because the creditors appreciate their trouble, they are reluctant to loan even more. This is one reason why the U.S. debt is problematic even though it is a relatively small sum for such a large economy. A second reason is that no bank or country has the ability to come to the United States and force repayment, so lending money to the United States relies upon its good graces for repayment. By this second measure alone, the United States is the worst sort of borrower. No one can force the United States to repay debts.

While the United States looks like a bad debtor for these two reasons, it has another feature that makes it a low risk for default. When it gobbles down the worlds oil, cars, and other products, the United States issues IOUs denominated in U.S. dollars. Now, guess who controls the ability to create as many U.S. dollars as are needed to ensure repayment? The answer is the United States. Because the United States can create an infinite supply of dollars, it is impossible for it to default.

Many other countries, including Argentina, promise to repay in a currency they dont control (usually U.S. dollars). When Argentina needs to come up with U.S. dollars to repay a loan, Argentina has to trade something valuable in order to get those dollars. In contrast, the United States has the ability to make U.S. dollars for nothing (both by actually printing banknotes and by electronic entries in the Federal Reserve system).

In some respects, therefore, the United States is the best possible debtor. No lender need fear a default. U.S. creditors can be absolutely certain to get back every penny of the $3.5 trillion in loans. Because