Part IV: Trade Deficits and Asset Inflation
by Mark Lawrence
Mark's Market Blog
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Portfolios & Risk
What is money?
Interest and Growth
Money Utility and Risk
Trade Deficits and Inflation
Distribution of Income
Distribution of Wealth
Zero Coupon Bonds
Reading Bond Pages
Risk & Volatility
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In Money Part I, we saw that money is mostly electronic, and it's created out of thin air by banks. In Money Part II we saw that charging interest on loans requires that the entire economy grow: there must be more and more people borrowing more and more money to consume more and more stuff, or the entire system collapses. In Money Part III we saw that the value people place on money depends on the amount they already have, and that this valuation drives important parts of our country's investments and lotteries. Today we ask about the trade deficit and the recent Internet, stock market, and housing bubbles. Are they related?
The US has been running a trade deficit since I was a teenager (that's depressingly long ago). Our last trade surplus on a year, when exports exceeded imports, was in 1975. We've been running a trade deficit for so long that it's now considered normal. Is it? What does a trade deficit really mean?
US trade by quarter, 1960 to 2008
A trade deficit means that we buy more goods from foreign countries - cars, oil, shoes, clothing - than they buy goods and services from us - airplanes, software, engineering and management consulting. Conventional economics after WWII taught that trade deficits could not be maintained for long: foreigners would send us cars, get payment in dollars, and see nothing that they wanted to buy with those dollars. They would raise their prices as they would be unimpressed with collecting little green pieces of paper. The value of the dollar would then sink compared to Euros, Yens, Yuans, and our goods and services would be more competitively priced. Exports would increase, imports would decrease, and trade would come into balance. We see in the chart above that this theory was a brilliant failure - the US trade deficit has continued for over 30 years. In the chart below we see the value of the US dollar against a basket of foreign currencies. The dollar went up in value at the same time as the trade deficit was increasing from 1982 to 1985. The dollar dropped from 1986 to 1992, and so did the trade deficit. This is the exact opposite of what economics predicted. If physics performed the same way, the Hiroshima bomb would have wiped out Chicago.
US dollar against foreign currencies 1973 to 2008
We're not the only people in the world living on borrowed money and sales of assets, in fact we're not even close to the worst. In the table below, we see that the US debt is about a year's income for an average worker. In Switzerland this same number is ten years income. Of course the reason for this is that Switzerland imports bank deposits, and exports chocolate, army knives, and bank account numbers. Ireland, which is not at all famous for their banks, is a close second, and several other European nations are doing their very best to catch up with this race to borrow money, drive Japanese cars, and wear Chinese cloths and shoes.
Per Capita (US$)
(% of GDP)
So, how can we account for this? The answer comes from considering where you would have invested your money in the last 30 years. Asians have rapidly increasing incomes, but no social programs like Medicare or Social Security. They consider it paramount to save for their retirement and the care of their parents. Where to put these savings? Europe was in the middle of a long and failing semi-socialist experiment leading to very low growth rates and almost no job creation. Japan has been in a non-stop recession since 1990. Africa and South America got nothin' we want. The #2 export of the Arab nations is used cars, one can hardly say they have an economy outside of oil. Asia was experiencing impressive growth, but there have been ongoing fears of government instability and changes in property ownership laws. If you had money to save and invest, the US seemed like the best place to many. So, we imported cars and shoes and exported shares of stock, treasury bonds, and houses in Florida and California. Looking closely at the trade deficit and dollar value charts above, we can easily conclude that the US trade deficit is actually a measure of the foreign demand for US investments.
This placed the US in a unique and seemingly paradoxical situation: Walmart imported a couple trillion dollars worth of cheap Chinese products, which kept US consumer inflation low. Meanwhile, the people selling us the cars and shoes were buying up Internet stocks and speculating on houses like there was no tomorrow, leading to massive asset inflation. Unfortunately the Fed doesn't have much of a history or interest in tracking asset inflation. Even in retrospect, it's hard to see what the Fed could have done: had they raised interest rates, which normally slows the economy, US investments would have seemed an even better deal to foreigners and the influx of money would only have increased. Had the Fed dropped interest rates, the US economy would have over-heated and inflation would increase even more. Today it's popular to blame Alan Greenspan, the previous Fed chairman, for much of our current mess, but it's unclear that the steering wheel he was holding was actually connected to anything - much like the steering wheel in a toy car, it only gave the illusion of control. (Shown at right, Greenspan at an early stage in his education and training.) In fact Greenspan has said that in 2004 and 2005 he was surprised to find that when he raised interest rates, mortgage rates didn't budge: the Fed had lost all control over mortgage rates. We now know this is because of securitization, people were bundling up mortgages into bonds and selling them like 50 cent ice cream cones. Today we see what we needed was better regulations on who could get a mortgage and on how bond risk was measured and disclosed.
How much money are we talking about here? Today, the US owes about 25% of all foreign debt in the world, about $13T. This is nearly a full year of our GDP. Where is this money? Some of it is held by foreign banks in their vaults as exchange reserves, but these bank reserves account for only about 13% of all foreign debt. The rest of this debt, 87%, is invested somewhere. Interestingly, the details of this investment are not known: economists are unable to get the debt / reserves / investment numbers to add up, some of the $51T has gone missing. Once again, we're deeply grateful that it's not the economists who build and maintain the nuclear bombs.
Gorbachev once told a joke to Reagan: "They say Mitterand has 100 mistresses, one of them has AIDS, but he does not know which one. They say Reagan has 100 secret service guards, one of them is an assassin, but he does not know which one. And they say Gorbachev has 100 economists, one of them is smart, but he does not know which one."
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Revised Thursday, 11-Jun-2009 19:54:53 PDT