I.O.U.S.A. is an educational documentary to tell the US public the economic ills of their society. It lists four deficits as the major sources of the illness. They are, the government budget deficit, the savings deficit, the trade deficit and the leadership deficit. The government budget deficit and the leadership deficit are well publicized and easy to understand. The savings deficit is often mentioned by economists, economic policy makers, and financial analysts as the problem but not explained properly to the general public why it is so. The trade deficit is rarely covered in major financial media and its effect on the economy almost never discussed. The trade deficit is treated like a taboo. Actually those four deficits are inter-connected. In our view the trade deficit is the mother of all ills and other three deficits are merely the natural derivatives of the trade deficit. The purpose of this comment is to explain the logic behind our conviction, and in the process the effects and the causes of each deficit is analyzed.
Let us start from the trade deficit and lay out the facts about it first. The trade deficit, of course, arises when imports exceed exports. When we talk about imports and exports here, we always mean imports and exports of both goods and services. Many mistakenly think that trade deficit drains dollars from the US economic system. The truth is that dollars never leave the US economic system through trade deficits. Let us clarify this point further. Suppose US consumers buy made-in-China goods and dollars are handed over to Chinese manufacturers as the consequence. The Chinese manufacturers incur costs payable by Chinese Yuan but not by US Dollar so they must sell the dollars for Yuan. On the other hand Chinese importers buy dollars to pay for their purchases of foreign goods and services. Since China is running a whopping trade surplus, the amount of dollars for sale far outruns the demand. In a natural setting the huge imbalance between the supply and demand of Dollar vs. Yuan will boost the price of Yuan sharply higher against Dollar and will quickly reduce China's exports and thus its trade surplus. In order to prevent such an outcome, Chinese Government buys up all those unwanted dollars to keep Yuan undervalued and Chinese export engine humming. Chinese Government will certainly not convert those purchased dollars into dollar bills and store them in warehouses waiting to rot. Chinese Government brings those dollars to Wall Street firms to buy high yielding dollar denominated debt instruments like I.O.U. issued by Fannie Mae and Freddie Mac, and thus keep US mortgage rate low and the US mortgage bubble bubbling. As has been pointed out in article 10, Wall Street firms and banks turn over the influx of trade-deficit-generated dollars as fast as they can to make maximum amount of profits, and in the process of the turnover frenzy various bubbles are inevitably formed. We will review the history of those bubbles related to runaway trade deficits quickly and leave the details to article 10.
The current globalization scheme has started in earnest since the early part of 1980's, pushed strongly by the Reagan administration. Before the globalization the US trade deficit was small, averaging out to less than 1% of the nominal GDP. During the Reagan era the first phase of runaway trade deficit set in and the trade deficit peaked at 3.15% of GDP in the second quarter of 1987. That phase of runaway trade deficit ignited the junk-bond bubble under the demand of the mad rush of corporate takeovers and leveraged buyouts. The oversupply of dollars from the runaway trade deficit eventually caused US Dollar to collapse. With some time delay the US trade deficit waned, less dollar flew into the hands of Wall Street firms, and the stock market crashed in 1987. The steady shrinkage of trade deficit burst the Reagan junk-bond bubble and eventually ushered in the 1991 recession.
The second phase of runaway trade deficit started in early 1997. The instigator of that phase of runaway trade deficit was Japan's near-zero-interest-rate policy. Near-zero interest rates in Japan has been installed in the middle of 1995 and ushered in the frenzy wave of Yen carry trades to boost the value of Dollar sky high. Yen carry trades are for large speculators to borrow Yen at near-zero interest rate, dump those borrowed Yen for Dollar, and then use the dollars to buy high yielding dollar denominated instruments or engage in various speculations. With some time delay the high flying Dollar ignited the second phase of runaway trade deficit. The influx of tremendous amount of dollars generated by this phase of runaway trade deficit into Wall Street produced the stock market bubble of the Clinton era. The sky high Dollar created a chain of currency crises, first in Asia, then spreading to Russian and Latin America. As the currency crises spread, Dollar fell hard against Japanese Yen, and that in turn capped the runaway trade deficit at a peak of 4.06% of GDP in the third quarter of 2000. As the influx of trade-deficit-generated dollars into Wall Street stagnated and then declined along with the trade deficit, the Clinton stock market bubble burst and the US economy plunged into another recession. Readers interested in the events of that era are referred to article 1 for details.
The trough of the trade deficit after the burst of the Clinton bubble was reached in the fourth quarter of 2001 at the level of 3.44% of GDP. From that point the trade deficit rose anew. It is difficult to say precisely at what point the third phase of runaway trade deficit has set in, but by early 2004 the third phase of runaway trade deficit was vividly visible. The third phase of runaway trade deficit peaked at the level of 6.13% of GDP in the fourth quarter of 2005, and has been falling slowly with some zigzags since that time. At the second quarter of 2008 the trade deficit is at the level of 5.17% of GDP. The third phase of runaway trade deficit has ignited the giant debt bubble that is deflating as the trade deficit waned. The mortgage bubble to which the infamous subprime mortgages belong, is an important component of the giant debt bubble and is deflating painfully along side with the giant debt bubble. The third phase of runaway trade deficit is ignited by the emergence of China as the heavy weight in the global trade scene as China has replaced Japan as the number one source of US trade deficit. After 1989 Tienanmen Square Incident China made two consecutive devaluations of Yuan, bringing Yuan down drastically from 3 Yuan/Dollar level to 8 Yuan/Dollar level within a few years. This drastic devaluation of Yuan has made already low labor cost in China even lower by a massive degree. The extreme low labor cost in China in conjunction with the lack of economic sanction from US against China for the Tienanmen Square Incident encouraged Taiwan businessmen to migrate en masse into China to produce consumer goods to be exported to US. At that time businessmen were bothered by escalating labor costs and stringent pollution controls in Taiwan. Made-in-Taiwan goods in the US consumer market were quickly replaced by made-in-China products since the manufacturers of those goods have simply hopped into China from Taiwan. Thus “Taiwan Merchants” have transformed China into the factory of the world. For example, most PC's sold in US, and popular iPhones and iPods are all manufactured by Taiwan Merchants in China today. US trade deficit with China were $83 billion in 2001, but had exploded to $200 billion in 2005 and $256 billion in 2007. The rapid rise of crude oil consumption in China, the result of the rapid economic growth under pined by the runaway trade surplus, in combination with the persistently high gasoline consumption in US supported by the debt bubble induced by the runaway trade deficit has eventually strained the global crude oil market and has caused the recent surge of the crude oil price.
Stunned by the exploding trade deficit with China, backlash against the globalization itself has erupted. The focus of the backlash is on the peg of Chinese Yuan to US Dollar that had kept Yuan at a perpetually under valued status. Under strong pressure from the US Congress, Bush administration abandoned its allies on Wall Street and its long held “strong Dollar against Yuan” policy, and pressured China to give up the peg. In the middle of 2005 China has started to allow Yuan to drift slowly up vs. US Dollar. As has been pointed out earlier Wall Street profits enormously from runaway trade deficit by brewing economic bubbles, so the Wall Street free trade advocates routinely label the attempt to rein in the exploding trade deficit with China as “protectionists”, but this time they have failed to stamp out the backlash. As the runaway trade deficit is curbed by the slowly rising Yuan in combination with the long standing slide of Dollar vs. Euro, the inflow of trade-deficit-generated dollars slowed, and the giant debt bubble has started to deflate. The financial firestorm of August of 2007 surrounding the subprime mortgages was the herald of the beginning of the end of the giant debt bubble. The pain of the liquidity squeeze resulted from the burst of the debt bubble is continuing today with no end in sight, and is endangering many Wall Street firms and banks as those so called “free traders” have foreseen.
With the above review of the situations about the trade deficit, readers probably understand why we list the runaway trade deficit as the mother of all economic ills. Now let us turn our attention to other three deficits and explain why they are merely the natural derivatives of the trade deficit. We start from “savings deficit” first. In an economic entity like the US economy before the globalization when the magnitude of trade imbalance is small compared to the size of GDP, personal savings are the only meaningful source of seed money for the financial system. Suppose $100 is deposited into a bank account by a consumer. The bank lends out this $100 to a borrower. The borrower deposits this borrowed $100 into his own bank account. The bank holding borrower's account then lend out this new $100 deposit to someone else, and so on. Thus the original $100 multiplies into a large amount of loans that pushes the economy ahead. If consumers increase spending by reducing the savings, what will happen? The GDP will receive a temporary boost due to the increased consumer spending, but the reduction of savings means less seed money and less loan available. Thus interest rates will rise and the economic growth will fall back. On the other hand if consumers reduce spending and increase savings, though the economic activity will fall temporarily, the increased seed money will make more loan available and interest rates lower, so the economy will be reinvigorated. In other words in the pre-globalization US economy, personal savings will find the ideal level by itself. However, the runaway trade deficit of the globalization era invalidates the above arguments. As discussed before the influx of trade-deficit-generated dollars are the money to be borrowed. This means that trade-deficit-generated dollars serve as the seed money for the financial system just as personal savings. When trade deficit runs wild, consumers can reduce savings and spend more and more of their earnings without causing interest rates to rise. As the trade deficits rise in the globalization era, US personal savings has indeed fallen steadily toward zero but without endangering the economic expansion. This shows that the savings deficit is the natural result of the runaway trade deficit.
In the pre-globalization US economy, there are two ways to finance government budget deficits. The first is to ask the central bank, that is, FED (The Federal Reserve Board) to issue money to finance the deficit, called “monetizing the budget deficit”. This approach will lead to hyper inflation if the deficit is substantial. The second method is for the government to issue I.O.U. like Treasury Bills, Note and Bonds, and sell them in the open financial market. However, this approach will push up interest rates and slow down the economic activity. Thus in the pre-globalization era, imprudent large government budget deficits will bring on economic punishments quickly and the administration will be thrown out of office soon. However, the runaway trade deficit of the globalization era makes the above argument up side down again. The government now can tap into a portion of the trade-deficit-generated dollars to cover its budget deficit without the fear of pushing interest rates higher, as long as the trade deficit is large enough to satisfy both the thirsts of private borrowers and the government at the same time. The Reagan administration and the current Bush administration used the first phase and the third phase of runaway trade deficits to cover their huge budget deficits respectively without causing long term interest rates to rise. The Clinton administration did not run budget deficit during the second phase of runaway trade deficit. Ironically, if the Clinton administration had run budget deficits, the size of the Clinton stock market bubble will be reduced somewhat. The ability of government budget deficits to reduce the size of the bubble when the trade deficit is running wild is due to the inefficiency of the government bureaucracy. Any money injected into the government will be slow to come out. Thus if the government budget deficit eats away a portion of trade-deficit-generated dollars, the overall speed of turnover of money will be slowed somewhat and the size of the bubble will be reduced accordingly. This argument shows again that it is the runaway trade deficit that allows the government to run budget deficits without the fear of immediate economic punishment.
Readers may wonder how come the leadership deficit is also related to the trade deficit. The reason is as follows: To use runaway trade deficit to fund the borrow-and-spend habit is like to take illicit drugs to achieve highs. There is no painless way to kick the very addictive habit. Even if there is a politician who understands all about the ills caused by the runaway trade deficit, and has the courage to speak out against it by prescribing painful remedies, the politician will certainly be attacked by Wall Street free traders and spurned by the general public that hates to suffer any economic pain, and will be thrown out of office at the end. Therefore it is the runaway trade deficit and its anesthetic effects that causes the leadership deficit.
If no effective and painful means are taken to address the problem of runaway trade deficits, the natural economic rhythm will dictate the course of future events. The cycle of runaway-trade-deficit = economic-bubble and retreat-of-trade-deficit = economic-pains will repeat again and again, with the peak of the trade deficit getting higher and the size of the resulting bubble larger in each cycle. Eventually a large enough bubble will appear and its burst will topple the economic super power and reduce it to a second or even a third rate regional economic entity. Whether or not the giant debt bubble caused by the third phase of runaway trade deficit is large enough to do the job, of course, is still open to debate.