Back in April Saudi Arabia threatened to sell up to $750 billion in U.S. assets if Congress passed a bill that would allow the Saudi government to be held responsible in American courts for the 9/11 attacks.
After the story broke, it seems the “up to $750 billion in assets” line quickly morphed in some corners of the media and blogosphere into $750 billion in U.S. Treasurys. A few weeks ago Saudi Arabia disclosed it holds $117 billion in U.S. Treasurys.
So what would happen if Saudi Arabia actually did follow through on its threat and sold its Treasurys? Pretty much nothing. To understand why let’s take a look at how such a transaction might be carried out and what role Treasurys play in the financial system.
The role of Treasurys
Many people erroneously believe that the U.S. government issues Treasury bonds (I’m going to use the term Treasury bonds from here on out to describe all types of Treasury securities including bills and notes) to pay for deficit spending. That’s not exactly how things work. What actually happens is the money is spent first (credited to bank accounts), and the Treasury bonds are issued after the money has been spent in order to soak up excess reserves in the banking system and manage interest rates.
This is why a Treasury bond auction has never failed. The government spending creates the demand in the banking system for Treasurys, and the bonds are issued in order to satisfy the demand. In fact, it wouldn’t even be necessary for the government to issue Treasury bonds if it chose (though the financial system might grind to a halt since Treasurys are used as collateral for all sorts of transactions).
How a Saudi Arabia Treasury sale would work
Let’s take a look at how a hypothetical sale of a block of say $100 million Treasury bonds would work. In our example we will assume that Saudi Arabia wants out of any type of U.S. assets including dollars.
The graphic below shows a hypothetical set of transactions. We used hedge funds and banks in our first example, but really you could use any entity you wanted. As you’ll see it’s all just circular.
In this example Saudi Arabia sells $100 million in Treasurys to an American bank in return for $100 million. Saudi Arabia then turns around with its $100 million and buys U.K. government bonds (gilts) from a British bank. Meanwhile the American bank has $100 million in Treasurys and decides it would rather have the cash it originally had. At the same time the British bank has $100 million in cash and would rather be earning interest by owning Treasurys. Let’s say a trader at a hedge fund has caught wind of and pays $100 million for the American bank's Treasury bonds so he can flip them to the British bank.
Does all this seem confusing? Like it’s some type of never-ending circle? Well that’s because that is exactly what it is. Assets would just shift around to different institutions without much of anything changing.
The only thing that might change is the time component. Does someone want 30-year bonds or an overnight bill? For example, say Saudi Arabia sells Treasurys to plug their budget hole. They sell Treasury bonds in order to import corn from a large U.S. corporate farm. The farmer takes the money from selling the corn and decides to buy a new tractor from John Deere (DE, Financial). John Deere knows demand is low for equipment right now so it just sits on the cash rather than investing in new production equipment or hiring more workers. The bank that is holding the cash will then need to reinvest those excess reserves overnight.
The point is that because of the way the monetary system is constructed and that Treasurys are actually issued to soak up excess demand for reserves in the banking system rather than to support deficit spending, there is nothing Saudi Arabia can do with its Treasury bond stockpile that would be detrimental to the U.S. In fact, if Saudi Arabia actually followed through and sold its Treasurys to purchase goods and services from the U.S., it would be an immense benefit to our economy since it is running below full employment, which brings us to our next point.
Why Saudi Arabia has large Treasury holdings
The biggest problem for Saudi Arabia is that it is one of our largest trade partners. Saudi Arabia sells us a large amount of oil for U.S. dollars; it then in turn parks those dollars in Treasury bonds. In fact, if you take a look at the largest foreign holders of Treasurys they are all our largest trading partners and nations with whom we have trade deficits. (In the graphic below Saudi Arabia would be under “oil exporters.”)
(Graphic: New York Times, Data: U.S. Treasury)
These countries own treasuries as a direct result of their trade policies. Saudi Arabia ships us oil in exchange for dollars. It then doesn’t spend the same amount of dollars on buying U.S. goods and services; instead it hoards them (the same as Japan, China and any other nation with whom we have a trade deficit). In an environment of full employment and maximized industrial capacity this would benefit us greatly as our country would receive real goods in return for what amounts to a piece of paper. In our current economic situation it is detrimental. I’m sure anyone who is out of work or underemployed would much rather have Saudi Arabia and others spending that money in the U.S. and increasing our economic activity. It’s real economic activity, not the trading of financial assets, that matters the most.
Remember the 'Treasury shocks' of the 1970s?
Do you remember the “Treasury shocks” of the 1970s? No, of course, you don’t because there never was such a thing. We had the oil shocks of 1973-1974 when Saudi Arabia and other OPEC enacted an oil embargo against the U.S. It’s the flow of real goods and resources and the effect they have on the economy that matters. It doesn’t matter what Saudi Arabia does with its oil dollars; they will just end up in the global economy somewhere.
What could drive the market is decisions Saudi Arabia makes regarding its demand and supply for real resources. Decisions like how much oil to export and to whom to sell it or whether to buy military equipment from the U.S. versus Russia or China are ones that could have an impact domestically. When Saudi Arabia threatens to stop buying our tanks and planes and stop importing our trucks and soybeans, then it’s time to pay attention.
Summary
Once you have a proper understanding of how the Treasury market works and the role Treasurys play in the financial system you realize that Saudi Arabia’s threat is meaningless. In fact, we should probably root for it to carry out its threat. Go ahead and sell those Treasurys and spend that money on U.S. goods and services! Import more U.S. vehicles and agricultural products and put more Americans back to work. Saudi Arabia’s threat is hollow once you understand how everything works.
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