Trade Deficit

Trade Deficit

January 2001

Does the Trade Deficit Matter?

The Balance of Payments (BOP) has been in a deficit for so long that it’s often referred to as the “Current Account Deficit” by academics and economists. For this article I’ll keep the terminology simple by using the more common title and abbreviating it.

The BOP takes into account several aspects of trade and money transfers. Of course, it tallies the values of the goods exported and imported. It also takes into account the income derived from investments and services. To explain further, I’ll quote the December issue of National Economic Trends, published by the St. Louis Federal Reserve Bank.

The table shows the main components of the current account balance. The second and third rows show the difference between U.S. exports and imports of goods and services, respectively. The balance on income has two parts: the difference between returns on U.S. investments in other countries and returns earned by foreigners on investments in the United States, and the difference between compensation paid to U.S. workers abroad and foreign workers in the United States. Net unilateral transfers consist primarily of U.S. grants to foreign countries and private remittances.

U.S. Current Account – Major Components $ Billions
	1997	1998	1999
Balance on Current Account	-140.5	-217.1	-331.5
Balance on Goods	-196.7	-246.9	-345.6
Balance on Services	90.7	80.0	80.1
Balance on Income	6.2	-6.2	-18.5
Net Unilateral Transfers	-40.8	-44.0	-48.0

Source: U.S. Department of Commerce, Bureau of Economic Analysis

In terms of services, the United States does a very good job of earning its keep. But it gives a lot of money away, which probably accounts for why unilateral transfers stay in negative territory. In the income arena, the United States used to be a powerhouse. But foreign investments in U.S. securities are so huge today that foreigners are reaping more income from their investments than Americans are earning on their investments in foreign lands. Therefore, income is now in the minus column.

Asian Crisis Fuels Deficit

Between 1990 and 1997 the U.S. BOP deficit grew at an average annual rate of 9%, increasing from $77.0 billion to $140.5 billion. Then in two years the annual deficit increased 54% to $331.5 billion in 1999. The primary reason for this huge increase in the BOP deficit is that the BOP cycles with economic activity. For instance, after the Asian currency crisis struck in late 1997, exports to Asia dropped off sharply while consumers in the booming U.S. economy snapped up cheap Asian goods. This contributed to the very sharp increase in the trade balance deficit. In addition, the sharp increase in the price of oil in 1999 and 2000 exacerbated the trade imbalance even further. As we all know, the United States is dependent on foreign oil for more than 50% of its oil needs. Without importing foreign oil at whatever cost, U.S. economic activity will immediately grind to a halt.

I’ve printed three quarterly BOP charts. The first is the BOP in nominal dollars. The second is the BOP in constant dollars. The third is the accumulated BOP. In the third chart, each quarter’s performance is added to the accumulated total of all prior quarters going back to the first quarter of 1960.

From 1960 through the first quarter of 1976, the accumulated U.S. BOP was a positive $37.45 billion. Starting in the second quarter of 1976, the U.S. trade balance slipped into negative territory. It has been there ever since. As the years passed, the accumulated figure dating back to 1960 swung from positive to an astounding negative total of $2.2 trillion. That’s quite significant considering our annual Gross Domestic Product is only $10 trillion.

I am concerned with the accumulating BOP deficit. I believe in time it will come back to haunt not only all Americans, but all citizens of the world.

Back on August 15, 1971, President Nixon slammed shut the gold window and totally divorced the U.S. dollar from international gold backing. He completed what President Roosevelt had initiated in 1934 when gold ownership was outlawed in the United States. That move put Americans on the same footing as the Russians, the only other industrialized country in the world that I’m aware of that made gold ownership illegal for its citizens.

Gold Used To Back Currencies

Before the dictatorial acts of those two presidents, the United States had a gold-backed currency as did just about every other country in the world. That meant that all currencies were redeemable for a fixed quantity of gold. Therefore, all currencies were defined and given value, and they had fixed relationships that were the same from decade to decade. In those days, when the U.S. credit system grew too fast and Americans became too aggressive in acquiring foreign goods, the dollar started piling up in the hands of foreigners. Eventually, if the foreigners could not find U.S. goods to purchase with their dollars, they would exchange their dollars for gold. This would shrink the U.S. banking industry’s reserve base and force credit to contract. As credit contracted, domestic demand for foreign goods would wane, and as domestic prices fell, foreigners would once again exchange their gold for dollars in order to buy cheaper U.S. goods.

Gold, the world’s money, was, is, and will always be in limited supply. Moreover, it cannot be created by banks and politicians. As a result, in the old days gold was a hard and fast accounting mechanism that kept everyone honest to a fault. It was the “honest to a fault” aspect of gold that was its downfall. People, especially unscrupulous and/or ignorant politicians, did not want their credit systems disciplined by outsiders. They opted out of the gold exchange monetary system. Today’s credit-backed credit system is the result.

So what happens today when dollars accumulate abroad? Well, as long as foreigners believe dollars are good things to hang onto, then they will actually prefer to accumulate and hoard dollars and/or dollar-denominated securities. For the past 10 years, belief in the dollar has known no upside boundaries. Even the central banks of many foreign countries have been so impressed with holding dollar-denominated securities that they have been aggressive buyers of dollars and sellers of gold! The rationale has been that gold doesn’t earn interest (dollars do) and that the dollar is and will continue to be stronger than gold.

Bankers Hold Irredeemable Currencies

In light of the fact that dollars are irredeemable for anything other than goods in the marketplace, it is rather unbelievable that astute international bankers could be sold on the idea of exchanging their gold (real money) for credit instruments of a country that is hemorrhaging in the BOP department. When a country is running a perpetual trade deficit, that means its consumers are exchanging the pieces of paper they create out of midair for real manufactured things. Foreigners can use those pieces of paper to buy goods from Americans. But if Americans don’t manufacture the goods foreigners need at a competitive price, they won’t buy. When this happens, dollar-hoarding bankers will have put in their reserves a currency foreigners don’t want because America either doesn’t produce the goods foreigners need or its prices are not competitive.

Over time this nonsense will hit some kind of wall. There are limits to dollar accumulation even in a world awash in bogus monetary thinking. And there is no shortage of events that can trigger a loss of confidence in the dollar:

>> The U.S. stock market can continue to fall, initiating disinvestment by foreigner interests.

>> The dollar could fall versus the Euro and other foreign currencies, causing currency traders to jump on the trend.

>> The U.S. economy could slide into a depression, which would cause the BOP deficit to shrink, but it would raise concerns for the U.S. credit structure and the long-term viability of the dollar, the primary credit instrument of the United States. This event would be similar to the sudden credit seizure that struck Asia in late 1997 and the world’s reaction to that event.

>> Price inflation could become a more serious problem in the United States if the commodity price cycle enters a protracted period of generally rising real prices following its 25-year downtrend in constant dollars.

Any one of these events could trigger serious concerns for the dollar. As John Exter told me 30 years ago, “Suspicion is confidence asleep.” Over the ensuing years I’ve seen those words ring true time and time again. That’s why I can’t for a minute believe that the world has entered an era of perpetual prosperity with ever-increasing confidence that will know no tests.

Stuck with Debt That Will Be Tough to Pay Off

Since 1960, the accumulated BOP deficit has created an outstanding dollar float that now exceeds $2.2 trillion. That total is debt, pure and simple. No matter what happens, it is debt that will either be paid off with more exports and fewer imports or by a drastic dollar devaluation. It is a debt that, until it is paid off, will be with us through good times and bad. If times get tough and today’s $10 trillion economy contracts, the accumulated trade deficit will not shrink with economic activity. Instead it will appear to grow larger.

Offsetting the accumulated BOP debt are domestically produced goods for sale. Unfortunately, the U.S. has promoted free trade too aggressively. The consequence of that failed policy is that too many basic manufacturing jobs have been exported to foreign lands. Instead of being great producers of goods, Americans are now dependent on foreign manufacturers for many of the basics of life. So what’s left to meet the demands of dollar holders if we don’t supply goods? The only thing left is our nation’s gold and foreign currency reserves.

I checked the Treasury Department’s Web site to get a handle on our nation’s foreign currency reserves. The latest weekly report available was for December 5, 2000. On that date the total U.S. foreign reserve position was $65.678 billion, a decrease of nearly $10 billion from June 1999. The figure was broken down into four general categories.

There was $11.046 billion in gold valued at $42.2222 per ounce, a number chosen from out of the blue when Nixon repriced gold at the end of 1971. (At $265, the U.S. gold hoard is actually worth about $69.328 billion.) The U.S. Special Drawing Rights (SDR) holdings were $10.387 billion. The Reserve Position in the International Monetary Fund was $13.504 billion. Foreign Currencies holdings, which in the past have been equally divided between the Treasury’s Exchange Stabilization Fund and the Federal Reserve’s System Open Market Account, totaled $30.741 billion. All of the holdings were valued at “current market exchange rates or, where appropriate, at such other rates as may be agreed upon by the parties to the transactions.”

If the reserve position is revalued for the market price of gold it becomes $123.960 billion. Assuming that the artificially created SDRs will actually have value in a crisis, compared to the $2.2 trillion accumulated BOP deficit, the U.S. foreign reserve hoard is chicken feed. If 6% of the world’s dollar holders opted out of the dollar, they alone could more than wipe out the entire U.S. foreign reserve holding.

Only two places exist for dollar holders looking for an exit. One is into the foreign exchange market, where they can exchange currencies for other currencies. The other place is the commodity markets, where they can exchange currencies (debt instruments) for real assets that will always have value over time.

Head for Commodities if Dollar Collapses

If folks lose confidence in dollars and move into the currency markets to dump dollars for other currencies, the dollar would fall substantially versus other world currencies. If that happens, the dollar has such a huge weighting in the reserve bases of most of the world’s central banks that its collapse would cause folks to lose faith in the foreign currencies they acquired when they moved out of dollars. This domino effect means that when the crap hits the fan, so to speak, the only escape is to swap currencies for commodities, commodity-producing land, and other tangibles that are real tangible assets and not someone else’s liabilities.

The U.S. BOP deficit has created a dollar overhang that is not the only strain bearing down on the world’s delicate money and credit structure. Some of the others include:

1) The excessive stock market valuations and the financial reliance so many consumers have placed on stock prices maintaining their lofty levels.

2) The unsustainable buildup of debt in the private sector, which fueled the economic boom in the United States over the past 10 years, that can’t be serviced if the economy slips into a depression.

3) The U.S. government’s entitlement-laden spending patterns that will soon come into conflict with a major reduction in tax revenues as the economy slows. The resulting fiscal deficits could dramatically and negatively impact confidence in the dollar.

4) After falling for nearly a quarter century, constant dollar commodity prices are due for a significant real increase versus all other things, fueling price inflation. As price inflation builds and dollar confidence wanes, the estimated 10,000-ton short position in the world’s gold market has set the stage for explosive upside action in the gold price. That alone will force incredible strains on the highly leveraged credit and equity markets, exacerbating a collapse in confidence in all intangibles.

I think we’ll be hearing more about the trade deficit in the months ahead. As that topic starts to dominate the headlines, I’m sure more folks will start to figure out that the BOP deficit does matter.

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