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Increasing Trade Deficits and the US Economy


The significance of the US trade deficits in the recent economic crisis has been largely overshadowed by the allegations of greed pinned on financial executives drawing astronomical salaries, and their unaccountability. Yet, even a cursory analysis of events will make it clear that it all began with the unsustainable trade deficits. If the situation continues, history may repeat itself.


The significance of the US trade deficits in the recent economic crisis has been largely overshadowed by the allegations of greed pinned on financial executives drawing astronomical salaries, and their unaccountability. Yet, even a cursory analysis of events will make it clear that it all began with the unsustainable trade deficits. If the situation continues, history may repeat itself.


The Trade Deficits of United States in Twenty-first Century

Increasing trade deficit of the US economy had been baffling economic experts the world over before 2008. The way it was rising unabatedly was a phenomenon that seemed impossible to explain. This trade deficit of United States neither caused inflation nor an economic downturn till late 2007, creating questions about its sustainability, as well as raising questions over our understanding of modern economic phenomena. Finally, when the economic downturn did arrive, it is still not perceived as an outcome of unsustainable US trade deficit, as the primary blame for it has been cornered by the over-enthusiastic sub-prime housing credit market and financial agencies that made it possible.

Two Major Blind Spots

The first decade of the twentieth century will always be remembered for the awareness it created about two major blind spots in our vision and understanding of economic processes. The first is the sustainability of constantly rising trade imbalances, reflected by surplus of China and OPEC and deficit of United States. The second is the puzzle of asset pricing during phases of bubble formation and its aftermath, as evidenced throughout the global economy in the booming asset bubbles till late 2007 and their subsequent bursting with a resultant global crisis.

Link between trade Deficits and Subprime Crisis

Many people still do not see the link between US trade deficit and the subprime crisis. Some see it, but are not willing to agree, while others see it, understand it and are ready to agree provided there is sufficient evidence. Empirical evidence is scarce primary because of the overemphasis of current economists in mathematical modeling of human behavior, and the inability of such models to properly cover the 'human' decision making that is behind speculative investing and sub-prime housing investments.

During the period from 2003 onwards till end of 2007, US Economy witnessed a rising US trade deficit that was closing towards the US $ one trillion mark. During the same time, China had achieved the impossible by keeping its currency fixed, behaving like an open economy and taking its forex reserves to a mind boggling figure of over two trillion. The OPEC countries were reaping the benefits of crude prices which had inflated over 300% in a short duration. The puzzle was that in spite of this mammoth deficit, the US dollar was not weakening, nor was any other adverse impact observed in US or global economy.

The Answer to this Economic Puzzle

The answer to this puzzle lies in the balancing of the US current account deficit by its capital account surplus that was a result of investments in treasury bills flowing from China, other parts of Asia and Oil exporting countries. Their surpluses found a safe haven in US dollar, and the resulting demand of dollar prevented its slide. The excess inflow of capital was entering in to US economy not for the purpose of consumption, but as investment and that too not in the real sector, only the monetary and financial sector. It served to balance the currency demand and supply, but it created havoc on the demand of assets. As treasury prices rose, their yields fell, as did the interest rates in the initial years, before Fed intervened and began to raise the rates.

In the meantime, while the economists the world over were pondering as to when that thin line between sustainability and unsustainability will be breached, the excess of financial capital supply created by capital inflow of close to a trillion dollars per annum was having an impact on the asset prices. US stock markets and other economic indicators have become the strongest signals for the whole speculation industry of this planet, so the asset prices of other countries followed their tail. The resulting asset price boom also has a feel good factor. People around the globe, as also in United States, begin to spend more because of the dramatic increase in price of their assets, their equity portfolio and real estate. Some were spending in anticipation, others by taking mortgage loans against their property. The result was more demand, more supply and more incomes. Everything looked just perfect.

Just as all good things have to come to an end, asset prices can also not rise forever. When the yield of treasury bonds started to fall below a level that would attract investors, investments shifted to more risky options. As prices of stocks, precious metals, commodities including oil and even real estate rose to yet higher levels, and as the economy was running on all fours, financial institutions especially non banking ones, lead by the liberalization of the last decade, began taking more risks. Thus came along the sub-prime chapter of credits, which were distributed but never returned, once the asset bubble burst. As the news of bankruptcies and disasters started flowing, the dream was over. Assets became bad investment, and suddenly there was a crisis that engulfed the world.

Things May be Improving ... Or Are They?

After around two years, things finally seem to be improving. In these two years, the trade deficit of US economy has also moderated as the anxiety of recession made people adopt a more conservative and less consumerist approach. One fears that as the economy returns to normal, this conservatism will again be replaced by another wave of spending, which may push US deficit back to its earlier levels.

If that happens, it will create another challenge for the economists the challenge of forecasting how long the situation will remain sustainable!
 

POSTED BY V Kumar On 2012-02-25
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