Historically, our national debt has been financed almost entirely domestically. In the 1960s, foreign ownership of the debt was less than five percent. This crept up to about 20 percent in the late 1970s, as oil exporters invested much of their cash flow in Treasury securities. But the percentage of foreign ownership fell in the 1980s despite the growth of budget deficits. By 1984, foreign ownership was down to 13 percent.

During the Clinton Administration, the amount of the national debt owned by foreigners roughly doubled, from 18 percent in 1992 to 35 percent by 1999. This figure drifted downward as budget surpluses emerged, but has shot upward since 2002. As of the end of 2004, foreign ownership of the debt reached almost $2 trillion, 44 percent of the total held by the public.

When concerns are raised about this situation, the Treasury points to the fact that most of the foreign-owned debt is not among fickle private lenders, who may dump their holdings at the first sign of trouble. Rather, most of the increase in foreign ownership has been by foreign central banks, which are presumed to be long-term holders. At the end of 2004, foreign central banks owned $1.2 trillion of the $1.9 trillion of Treasury bonds, bills and notes owned by foreigners, 60 percent of the total.

Of course, foreign central banks are not buying Treasury securities as a favor to us. They do so partly because Treasuries are the safest place to put their money, since the risk of default is nonexistent. But the main reason is that buying and selling Treasuries is the way they control the value of their currencies vis-à-vis the dollar.

Because the dollar is the dominant world currency, the one in which the bulk of world trade takes place, including all transactions in the oil market, the U.S. has the luxury of ignoring the international value of the dollar. It goes up or down on the free market, largely free of intervention by the Treasury Department.

But other countries cannot do this. The value of their currency is a vital element of their economic policy, having an enormous impact on trade and capital flows and the standard of living. Those that get it wrong, such as Argentina, suffer very badly and may go through years of economic stagnation as a consequence.

When a nation wants to keep its currency stable against the dollar, it must sell dollars from its portfolio against its own currency when market pressure is causing their currency to fall. This reduces the supply of their currency relative to dollars and causes their currency to rise. When their currency is rising against the dollar, they do the reverse, selling their own currency and buying dollars.

In recent years, there has been strong upward pressure on China’s and Japan’s currencies. This has forced their central banks to buy a lot of dollars, which they hold in dollar-denominated assets. Treasury securities are the most convenient of such assets. Hence, their large holdings of Treasuries is mainly a consequence of their exchange rate policy.

The Chinese and Japanese exchange rate policy is basically to facilitate trade. If their currencies rose against the dollar then their goods would become more expensive to us in terms of dollars and our goods would become cheaper to them in terms of their currency. Without active intervention in the foreign exchange market, therefore, the market would automatically help redress the U.S. trade deficit. But as long as the yen and yuan are prevented from rising, this mechanism does not operate.

Many in the U.S. view this as a form of protectionism that in effect subsidizes Chinese and Japanese exports to us while penalizing our exports to them. This may be true, but the necessary consequence of doing so is that China and Japan must finance their own exports by lending us the money to buy their goods.

Although China has said it will continue buying dollars and investing in Treasury securities, other countries have decided that they have enough dollars and will start curtailing their purchases. Russia and Korea have announced plans to reduce their dollar holdings and Japan is saying that it will diversify its foreign exchange portfolio in the future. The end of the free lunch may now be in sight.