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The rest of the world holds $16.8 trillion in US financial assets, according to Federal Reserve release Z.1, as of Q1 2009.
Foreign exporters’ love affair with dollars
Most of US financial assets held by foreigners result from the United States having imported more from the rest of the world since 1971 than it has exported and from the fact that sellers of foreign goods have been happy to receive US dollars in payment.
Foreign trade based on dollars.
US financial assets held by the rest of the world consist mostly of debt instruments denominated in US dollars.
About $5.6 trillion is made up of direct investments and miscellaneous assets like real estate. Another $1.6 trillion is in US traded equities. The balance, about $9.6 trillion, is dollar-denominated debt owed to non-resident holders.
Although this “foreign debt” poses no real threat to US citizens, since it is denominated in US dollars, many people, including economists who should know better, think otherwise.
So, how long would it take to “work off” this debt?
Long-term devaluation of the dollar
As long as the rest of the world accepts dollars in payment for exports, while the US continues to import more than it exports, the US trade deficit will continue to grow.
The decline in the value of the US dollar is nothing new.
It has been going on for over half of century, since President Roosevelt rescinded convertibility into gold.
The decline accelerated with President Nixon’s complete abandonment of the gold standard. Current variations in the value of dollar are hardly a blip in the long term trend. Of course, other fiat currencies have also been declining in value.
What if foreign exporters reject dollars?
Let’s pretend that foreign exporters suddenly decide that they will no longer accept dollars in payment for their goods and rush to get rid of their holdings of US financial assets.
Here is what would probably happen:
- The value of the dollar against other currencies would plunge.
- US export goods would become incredibly cheap in terms of foreign currency. This would tempt foreign holders of US dollar debt to trade it for cash and buy export goods.
- By dumping dollar bonds to buy export goods, interest rates on US bonds would soar as prices fell. This would tempt some foreign holders not to sell.
The US dollar has declined since FDR abandoned the gold standard.
- American importers, unable to pay in dollars as in the past, would need to borrow foreign currencies to import essentials like oil. Imports of “non-essentials”, like plastic dolls from China, would drop. Oil prices would rise. Americans would use their cars less.
- Foreigners holding dollar assets would find that the only way to get rid of the now-unwanted dollars would be to use them to buy non-financial assets from Americans (such as real estate and export goods). Dollars are legal tender in the US.
There is plenty of US real estate and other non-financial assets to absorb the accumulated trade deficit.
- US exports in Q1 2009 were running at an annual rate of $1.5 trillion.At this rate, it would take a little over six years to “work off” the dollar-denominated financial debt due foreigners by selling them US goods and services. Of course, if the rest of the world was really anxious to get rid of their dollar debt, they could buy US export goods at a faster rate, while rushing to buy US real estate and making direct investments in US businesses (which by now would be humming along quite nicely to supply the booming export market.)
- Faced with soaring prices of oil and the inability to pay in dollars, the US would suddenly forget the “green dream” of wind farms and bio-energy and rush to drill in the Gulf of Mexico, while building nuclear plants in every state.
- As foreigners got rid of US financial assets, a major source of credit card financing would dry up. Americans, by necessity, would become thrifty.
- As a major source of easy credit disappears, corporations would be forced to turn to old-fashioned methods of equity financing. Stock buybacks would be a thing of the past.Stock prices would fall — effected by rising interest rates.
- Foreign exporters, faced with falling demand from the United States that now lacks the currency with which to pay for their products, would have to lay off workers, while employment picks up in the United States in the export sectors.Foreign governments might even seek to boost the dollar.
In other words, if the rest of the world were suddenly to turn against the dollar, the trade deficit might be eliminated in a few years, causing a boom in industrial production and real estate in the US, radical changes in economic behavior, and less employment in former exporters to the US.
What could cause this to happen?
The easiest way to destroy the credibility of the US dollar would be to jack up government spending to the point of bringing on hyper-inflation. In other words: just follow the current policies of the Obama administration.
However, there are countervailing forces that make the above scenario unlikely:
- The US is still a representative democracy: Despite the bizarre seating of the not-so-funny comedian Al Franken as a US Senator and the presence of representatives of “safe districts” like Nancy Pelosi and Barney Frank, the public can still be counted to turn away from its leaders, once the “misery index” gets above 15%.
US Senator Al Franken (D-Minnesota)
Since unemployment is expected to surpass 10% soon, while even modest recovery should send inflation above 5%, the current government is likely to be voted out of office once the public finally understands that Obama promises have been false.
Just as in the days of Jimmy Carter, a return to conservative government will restore confidence in the dollar, as steps are taken to curb inflation and reverse Obama policies.
- A cheap dollar will boost American exports: As foreign factories cut back production to meet declining US demand, there will be pressure to accept payment in dollars, as before.After all, many countries have dollar balances, while balances in other currencies are far smaller.Because the value of the dollar has fallen, the value of goods that can be purchased with a dollar will have increased.As foreign unemployment rises, the urge to return to the dollar will also increase.A stronger dollar means not only more sales for foreign factories, but less competition from US exporters.
This “thought experiment” shows that fears of America’s children and grandchildren having to work for years to pay off debt to foreigners are unfounded.
The trade deficit would quickly disappear in an extreme inflationary environment. The system has self-correcting mechanisms.
Illustrations: Wikimedia Commons
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There’s an assumption that Asian countries will be as inept as Americans and deteriorate their industrial base for (un)fair trade. What happens when Asians just say, ‘We aren’t going to play this international game anymore (now that we have all the money).’ Imagine the outrage by economists when they do such a thing. “How could they possibly not play by the WTO rules. We’re now going to sue them in WTO court!,” they’ll say. Any lawyer knows that possession is 9/10 of the law.
One thing Asian countries haven’t counted on was the war option the US holds over them. You don’t think that will happen, well think again. Just look at America’s history of war for the past 50 years will tell you how we might act in the next 50 years.
People have got to stop with these exotic economic theories and realize at the end of every transaction there is a human. Just because the book says something should work out in such a way, doesn’t mean it will. Economic theory is as accurate as predicting human behavior in groups. Being right 50% of the time is a pipe dream away, and at best a subset of a group can be predictable on any given day.
A falling dollar will have no effect upon reducing the trade deficit because currency valuations have almost nothing to do with driving our trade imbalance.
Our enormous trade deficit is rightly of growing concern to Americans. Since leading the global drive toward trade liberalization by signing the Global Agreement on Tariffs and Trade in 1947, America has been transformed from the wealthiest nation on earth – its preeminent industrial power – into a skid row bum, literally begging the rest of the world for cash to keep us afloat. It’s a disgusting spectacle. Our cumulative trade deficit since 1976, financed by a sell-off of American assets, exceeds $9.2 trillion. What will happen when those assets are depleted? Today’s recession is the answer.
Why? The American work force is the most productive on earth. Our product quality, though it may have fallen short at one time, is now on a par with the Japanese. Our workers have labored tirelessly to improve our competitiveness. Yet our deficit continues to grow. Our median wages and net worth have declined for decades. Our debt has soared.
Clearly, there is something amiss with “free trade.” The concept of free trade is rooted in Ricardo’s principle of comparative advantage. In 1817 Ricardo hypothesized that every nation benefits when it trades what it makes best for products made best by other nations. On the surface, it seems to make sense. But is it possible that this theory is flawed in some way? Is there something that Ricardo didn’t consider?
At this point, I should introduce myself. I am author of a book titled “Five Short Blasts: A New Economic Theory Exposes The Fatal Flaw in Globalization and Its Consequences for America.” My theory is that, as population density rises beyond some optimum level, per capita consumption begins to decline. This occurs because, as people are forced to crowd together and conserve space, it becomes ever more impractical to own many products. Falling per capita consumption, in the face of rising productivity (per capita output, which always rises), inevitably yields rising unemployment and poverty.
This theory has huge ramifications for U.S. policy toward population management (especially immigration policy) and trade. The implications for population policy may be obvious, but why trade? It’s because these effects of an excessive population density – rising unemployment and poverty – are actually imported when we attempt to engage in free trade in manufactured goods with a nation that is much more densely populated. Our economies combine. The work of manufacturing is spread evenly across the combined labor force. But, while the more densely populated nation gets free access to a healthy market, all we get in return is access to a market emaciated by over-crowding and low per capita consumption. The result is an automatic, irreversible trade deficit and loss of jobs, tantamount to economic suicide.
One need look no further than the U.S.’s trade data for proof of this effect. Using 2006 data, an in-depth analysis reveals that, of our top twenty per capita trade deficits in manufactured goods (the trade deficit divided by the population of the country in question), eighteen are with nations much more densely populated than our own. Even more revealing, if the nations of the world are divided equally around the median population density, the U.S. had a trade surplus in manufactured goods of $17 billion with the half of nations below the median population density. With the half above the median, we had a $480 billion deficit!
Our trade deficit with China is getting all of the attention these days. But, when expressed in per capita terms, our deficit with China in manufactured goods is rather unremarkable – nineteenth on the list. Our per capita deficit with other nations such as Japan, Germany, Mexico, Korea and others (all much more densely populated than the U.S.) is worse. My point is not that our deficit with China isn’t a problem, but rather that it’s exactly what we should have expected when we suddenly applied a trade policy that was a proven failure around the world to a country with one fifth of the world’s population.
Ricardo’s principle of comparative advantage is overly simplistic and flawed because it does not take into consideration this population density effect and what happens when two nations grossly disparate in population density attempt to trade freely in manufactured goods. While free trade in natural resources and free trade in manufactured goods between nations of roughly equal population density is indeed beneficial, just as Ricardo predicts, it’s a sure-fire loser when attempting to trade freely in manufactured goods with a nation with an excessive population density.
If you‘re interested in learning more about this important new economic theory, then I invite you to visit either of my web sites at OpenWindowPublishingCo.com or PeteMurphy.wordpress.com where you can read the preface, join in the blog discussion and, of course, buy the book if you like. (It’s also available at Amazon.com.)
Please forgive me for the somewhat spammish nature of the previous paragraph, but I don’t know how else to inject this new theory into the debate about trade without drawing attention to the book that explains the theory.
Pete Murphy
Author, “Five Short Blasts”
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