(1) The growing US foreign debt is manageable because it is denominated in dollars
(2) China will sustain a loss on its reserves when the dollar inevitably depreciates
The chart below suggests that such thinking may be unwise. It shows the logged dollar return on
Although, as would be expected, the dollar appreciated against sterling over this period, from nearly five dollars to the pound in 1914 to about two now, the consequently higher interest rates required to retain debt capital in the UK fully compensates for this depreciation, despite the existence of exchange controls in the UK until 1979. It seems that uncovered interest parity (UIP) approximately holds in the long run. In fact, if anything, sterling debt has provided a slightly higher return, presumably reflecting the risk premium of holding a declining currency managed by a weak central bank.
Although sterling debt lost ground from 1914, the interest rate penalty was sufficiently large that sterling had caught up as early as 1925. And a similar pattern was seen after successive sterling devaluations, including those of 1931 (the suspension of gold convertibility), 1949 and 1967.
To conclude, easy money and dollar neglect can delay, but not reduce, America’s debt burden. While China may report a