Over the last few months, the United States has embarked on an unusual policy experiment. At a time in the economic cycle—judged by the unemployment rate—when the fiscal deficit typically falls, Congress has passed tax cuts and spending increases that will raise it by about two percentage points of GDP. In 2019, the U.S. budget deficit is projected to reach five percent of GDP. Analysts expect that without major policy changes, it will stay at or above that level for the next decade.

The United States now has the loosest fiscal stance of any of the G-7 countries. Yet there is little doubt that it will be able to raise the funds it needs to finance its deficits.

Most of the large economies in Europe and East Asia set aside far more than they invest at home, generating over a trillion dollars a year in spare savings that they need to lend out. With interest rates rising in the United States while they remain below zero in Japan and most of Europe and low in South Korea and Taiwan, the prospect of lending to the United States remains attractive. Even Italian bonds, which have fallen in price thanks to the country’s political turbulence, offer a worse return over ten years than U.S. Treasuries.

But the effects of the U.S. deficit go beyond the United States. Thanks to the dollar’s outsize global role, the first casualities of a somewhat irresponsible U.S. fiscal policy are likely to be emerging economies that have used the dollar to denominate their debts, not the United States itself. A stronger dollar and rising U.S. interest rates are increasing the burden of paying all dollar-denominated debts around the world.

THE EMERGING-MARKET SQUEEZE

After the 1997 Asian financial crisis, many countries recognized that using the dollar—or another foreign currency—for lending and borrowing was a major source of financial vulnerability. The burden of repaying foreign currency debt rises when a currency falls, thus making a weaker currency a financial risk. Over the last 20 years, several countries have successfully reduced their vulnerability. The governments of many emerging-market countries now borrow primarily in their own currency, and many banks in those countries do the same. Yet progress hasn’t been uniform: the countries that have gone furthest in this direction tend to be those that are a source of surplus savings, not those that need to borrow from the rest of the world, as those countries often have limited domestic savings and domestic banking systems that are crimped in their ability to lend.

That has opened up some emerging economies to trouble. Emerging economies that export oil are doing fine for now, despite rising U.S. interest rates and a stronger dollar, even if they have strong links to the dollar. Thanks to the rise in the price of oil, each barrel of oil they export generates far more hard currency than a year ago. The risk comes among those emerging economies that import oil, have lots of domestic dollar deposits, and have borrowed heavily from the rest of the world in dollars. That is because the rising value of the dollar makes it more expensive for firms in these countries to pay back loans they have taken out in dollars. Rising U.S. interest rates also make risky assets, including government debt in emerging-market countries, less attractive, so many governments face higher borrowing costs.

Several emerging economies have come under pressure, but Argentina and Turkey have had the worst of it. These two countries share some important characteristics that make them particularly vulnerable to higher U.S. interest rates and a rising dollar. They don’t save much. They aren’t big exporters. They have long histories of relatively high inflation. And they borrow a lot from the rest of the world in dollars, in part because their domestic banks lack the capacity to finance rapid growth without access to external financing.

In Argentina, the government is the one borrowing abroad. A few years back, Argentine President Mauricio Macri was the darling of the international bond market after he settled with Argentina’s holdout creditors. That allowed the country to start issuing bonds in the global market again. But borrowing tens of billions a year quickly added up, and a strong Argentine peso started to weigh on exports. In 2017, Argentina’s current account deficit nearly doubled, reaching around five percent of GDP. Increasingly, the dollars that the Argentine government borrowed from the world were going to pay for imports, not to rebuild its foreign currency reserves. On top of these problems, Argentina suffered a bad harvest in 2017–18, which may reduce GDP by as much as one percent. The country quickly found itself in real trouble, with a rising need to borrow from abroad but a falling ability to find willing lenders in the market.

Argentina saw the writing on the wall and, in May, turned to the International Monetary Fund for a $50 billion loan. The IMF asked it to tighten its fiscal policy in an effort to gradually bring down its need to borrow from the rest of the world. In return, the IMF allowed it to draw on IMF funds to cover some of its financing needs. In what is a potentially risky decision, the IMF has built its program around a bet that the value of the Argentine peso has already fallen by as much as is needed and that subsequent falls won’t drive up the burden of Argentina’s large foreign currency debt any further.

Mauricio Macri and Christine Lagarde at the G7 summit in Quebec, Canada, June 2018. REUTERS

In Turkey, the big borrowers have been banks and firms, not the government. In that respect, Turkey’s situation has some similarities with the countries that underwent the Asian crisis of 20 years ago. Turkey got in trouble because greater borrowing by domestic firms last year pushed up the country’s trade deficit, and the resulting increase in its need for foreign funding left it vulnerable to a rising dollar and higher oil prices.

For now, Turkey is trying to tough it out on its own. Heavily indebted Turkish firms are talking to their banks about renegotiating their loans, and the central bank has been forced to raise interest rates to shore up the falling lira, despite the wishes of Turkish President Recep Tayyip Erdogan, who has long feared that higher rates would hurt growth. The interest rate hike has halted the lira’s fall, but it also will force Turkey’s banks to cut back on their domestic lending.

Strangely, the overall problem of Turkey’s economy is that it has borrowed too much in dollars, but the banks’ specific problem is that they are perpetually short of Turkish lira to lend out. The banks have lots of domestic dollar deposits as well as the ability, at least in good times, to borrow dollars abroad, but they can lend to Turkish households only in lira. As a result, they have come to rely on their ability to borrow dollars and swap those dollars for lira in the international financial market and, in a pinch, to borrow lira from the central bank. Higher domestic interest rates will slow consumer spending and bring Turkey’s trade deficit down and will make foreign investors more willing to keep on swapping lira for the spare dollars in Turkey’s banking system. But Turkey’s financial stability will still depend on the willingness of its external creditors to keep rolling over the country’s large mass of short-term dollar debt.

Sooner or later, both Argentina and Turkey would have faced pressure to cut back their external borrowing no matter what. Stronger emerging economies have also faced some difficulties. Brazil and India, for example, have seen their currencies weaken recently. But both have big reserve buffers and thus more options. Both also have smaller external deficits than they did heading into the so-called taper tantrum of 2013, when the cost of borrowing rose for many developing countries after the Federal Reserve signaled that it would wind down its asset-purchasing program known as “quantitative easing.”

Right now, emerging economies that want to attract foreign investment and run trade deficits are finding it hard to compete with the United States for the world’s spare savings. That will drive up the U.S. trade deficit despite the Trump administration’s wishes. As a matter of accounting, the United States cannot borrow from the rest of the world to cover its rising fiscal deficit while keeping business investment up without running a higher trade deficit as well.

The intensity of the financial pressure on Argentina and Turkey and the less intense difficulties faced by other emerging economies are a reminder that the financial choices the United States makes affect the entire global economy. Modestly irresponsible U.S. fiscal policy can force emerging economies to behave more responsibly or risk a severe crisis.