The Danger of U.S. Foreign Debt

Very often, writing blog posts is a bit like investing. I can choose a safe, conservative course by writing about a topic that I know well, but the result probably won't provide very much in the way of new information. In other words, little risk, but little gain. Alternatively, I can take the chance of delving into a topic about which I know very little. The potential gain is in addressing a topic upon which I haven't previously touched. The risk is that I will get things wrong. Today I have decided to take a risk. For months I have been accumulating articles about the U.S. Treasury bond market and the possible exposure that market creates to foreign pressure. Opinions about the risk created by foreign Treasury bond holdings span the spectrum from no risk at all to a potentially deadly Achilles' heel. My conclusion is that there is a serious risk, but not exactly in the form that is normally suggested. Topics such as U.S. budget deficits, the U.S. national debt, Treasury bills, bonds, and other instruments, and international finance are complex and quite aways outside my wheelhouse. So, while I am doing my best to be accurate, and have relied on quite a bit of research, I would not be at all surprised for a true expert to come along and scoff at everything I have to say. With that caveat in mind, let's take a look at the risks presented by foreign U.S. Treasury holdings.

First, some very basic background. The U.S. tends to have budget deficits, which simply means that the government spends more than it receives in revenue. The deficits add to the national debt, which is the total amount that the government has borrowed to make up for the deficits. The debt is financed by Treasury securities, for instance, Treasury bonds. Much of this debt is held by foreign entities, anything from governments to corporations to individuals. Simply put, the U.S. government is partially funded by financing provided by foreign entities. If these entities choose to sell their existing portfolios of Treasury securities or decide not to purchase more, the cost of financing our national debt will increase. This will also affect other lending rates such as commercial borrowing and home mortgages.

In his recent speech to the World Economic Forum in Davos, Switzerland, Canadian Prime Minister Mark Carney complained that "great powers have begun using economic integration as weapons". His argument was that after World War II, there was a movement toward economic, political, and security integration. While this new order favored strong countries, particularly the United States, the system was sufficiently useful to justify accepting its flaws. However, that integration created vulnerabilities that are now being exploited to the detriment of countries like Canada. Carney declared that the system has been "ruptured" and argued for building a new international system.

The other side of the coin that Carney was describing is that the U.S. also has vulnerabilities due to the financial integration that has developed over the past half-century. A significant vulnerability is its foreign debt. At the time that Carney was speaking, cult leader, convicted felon, and failed President Donald Trump was in the midst of threatening to take over Greenland. In the face of a potential U.S. invasion, several European countries sent a handful of troops to Greenland. Trump threatened those countries with additional tariffs. European countries were considering what options were available to confront the United States. French Prime Minister Emmanuel Macron was particularly vocal in arguing that Europe should exploit U.S. debt vulnerabilities.

According to a recent article published by the Centre for Economic Policy Research (CEPR), Europe is the largest external holder of U.S. federal debt with roughly $12.6 trillion in exposure. Were Europeans to begin a sell-off of those securities, U.S. Treasury bond prices would collapse, yields would skyrocket, causing significant disruption to the U.S. economy. A Danish pension fund announced the sale of $100 million worth of bonds, showing that the risk was real.

However, there are other realities that reduce the effectiveness of European bond holdings as a weapon. The first problem is that the European holdings are not held by a single entity. To the contrary, they are institutionally fragmented across countries and types of entities. It would be impossible to get all the holders to act in concert. Moreover, even if somehow a giant sell-off could be arranged, it would be self-defeating. The Europeans would see the value of their own portfolios deflated. The economic disruption would be such that it would spill over to European economies as well. A massive sell-off of U.S. treasuries is simply not a credible threat.

However, a large-scale sell-off is not the only threat exposed by the U.S. debt. Smaller sell-offs are a possibility and would have serious but less dramatic impacts. But the largest threats arise from Trump's own policies that create a situation in which responsible financial decision-making is almost indistinguishable from retaliatory political gestures.

The economic strength of the United States has not been solely based on its own economic performance. Rather, much of U.S. power was derived from its position as a linchpin of the world order. As Trump is taking steps to disentangle the United States from international alliances and systems, the importance of the U.S. to the international order is necessarily decreasing. Essentially, the U.S. is weakening itself and, in doing so, is creating risks that didn't previously exist. Moreover, a U.S. government that increasingly behaves in a corrupt or erratic manner is obviously less trustworthy. As the CEPR article referenced above says:

Foreign demand for US sovereign debt traditionally rests on three components: perceived safety, systemic convenience, and intertemporal returns. Evidence suggests that all three have weakened.

The report goes on to say:

Concerns over safety are not about an imminent technical default, but about the normalisation of policy options once considered implausible, including selective default, political interference with debt servicing, and asymmetric treatment of foreign creditors, as suggested by Stephen Miran (2024), a current member of the Federal Reserve Board of Governors.

As for convenience, "Trade restrictions, tariffs, and broader geoeconomic fragmentation weaken the transactional demand for dollar liquidity." To put it another way, Trump's policies are making the dollar less useful.

Regarding the third component, intertemporal returns, the report says:

Historically, foreign investors have been willing to accept lower current returns on US debt in exchange for long-term stability, liquidity, and currency strength. That trade-off becomes less favourable when persistent fiscal expansion is combined with trade barriers and signals of limited concern for creditor interests.

The bottom line is that even absent a decision to weaponize holdings of U.S. assets, European demand for U.S. treasuries is likely to decline. This decline is almost entirely a result of Trump administration policies. In effect, the Trump administration is shooting itself with a weapon of its own making. Unless the European demand for treasuries can be replaced, bond yields will have to increase in order to attract buyers. This will raise the cost of servicing the U.S. debt. Keep in mind that this is in a context in which rapidly increasing debt will require even more treasury sales. As the U.S. debt becomes increasingly unmanageable, the risks that treasuries will present will grow, resulting in even more reluctance among buyers. This could easily turn into a vicious circle.

For decades, U.S. leaders worked to create a global system based on rules with the U.S. at its center. The resulting system heavily favored the U.S., but the privileged position was accepted by other nations in exchange for the benefits the system provided. With Trump as president, the U.S. has not only worked to dismantle that system, but has exploited it to punish historic partners. At the same time, the exploding U.S. national debt has created a U.S. reliance on foreign financiers. This has, in turn, created a significant vulnerability, one that may be damaging to the U.S. even without foreign debt being weaponized.