Tuesday, December 7, 2010

Another thought on federal debt and deficit....

As long as the dollar is the world's currency of choice, we will have large deficits.

This is because other countries need dollars. Oil is traded in dollars, and countries want dollars for savings. So they export to us, without importing as much, so that they can hold on to dollars. This insures that we will run a trade deficit.

And since we are bleeding money abroad, the government must deficit spend to create more money domestically, or else the economy would dry up.

So a trade deficit almost always insures a budget deficit. But there is an exception:

During the late 90's we had a trade deficit, but a budget surplus. A budget surplus is a drain on the economy, because it means we are destroying more dollars through taxation than we are creating through spending. And the trade deficit is also a drain on domestic demand.

So what made up for all this anti-stimulus? Private credit.

The credit boom of the late 90's had the private sector moving heavily into debt and subsidizing the trade deficit and budget surplus of the US.

But that wasn't enough to last. The economy still went into recession at the turn of the century, partially because of the drain of the budget surplus.

So as long as the world wants dollars, trade and budget deficits are pretty much guaranteed.


  1. You might need to flowchart this one... I'm really curious on how you see the interdependency between trade, budget, ect, but I'm having difficulty following this one. I know I've been guilty of the same on these economic discussions... it's so much that I think we're both trying to address every little intracacy at once and perhaps sacrificing too much detail. I'm game for detail if you are.

  2. Randy, I hear ya.

    I don't know how good I am at charts, unfortunately.

    So, the world wants savings in dollars. In order to attain those dollars, they must export to us more than they import from us. So China sells us clothes (for instance), but then they do not buy clothes back from us, because they want to hold on to dollars.

    This is a net financial drain on our system, because we are sending more money away than we are importing. It's actually a benefit to us in REAL goods - we get actual things in exchange for financial assets, but there may be other costs (like the elimination of US manufacturing)... which is another subject.

    This is our trade deficit. We get products, but we lose money. It's a drain on our country's net financial assets.

    This drain should hamper spending, because we require dollars to spend and we are sending them away. Aggregate demand should fall (in the same way it would if taxes were too high - taxes are also a drain on financial assets).

    Therefore, the government deficit spends to make up the loss. And those dollars sent abroad (credited to different countries' accounts at the Fed) find their way into US Treasuries at the Fed - since it pays higher interest than keeping it in reserve accounts. So there is the debt we owe to other countries.

    This is why we are the world's consumers. Because the product they want is secure dollars.

    And, as a matter of accounting, if we did run a balanced budget or surplus, we would send the private sector back into more private debt, since the the extra taxes or reduced government spending required to balance the budget would lead to a decrease in net savings. And with other countries still wanting savings in dollars, this would exacerbate the problem leaving people with two choices:

    Go without. Which harms the economy because an increase in thrift right now would decrease demand and cause us to lose more jobs, then more demand is lost, then tax revenues go down even further and the budget balance requires less spending and then the cycle keeps moving downwards....

    Or go into private debt.

    I don't have a firm enough handle on this stuff to be more succinct. Sorry about that! Working on it though....

  3. Let me try a succinct stab at it (ha!)

    If the world wants dollars, they must come from somewhere, and the only organization that can create net financial assets in dollars is the U.S. government.

    So most people think that the world owning our debt is the result of excess spending. That's sort of true, but one reason we have excess spending (in relation to taxes collected) is that the world is demanding our debt as their instruments of savings. Demand creates supply.

    I should note that we must deficit spend anyway to an extent. As the economy grows, it needs more net financial assets. Banks can extend credit, but those have the corresponding liabilities, so there is no new net financial wealth created. A government should deficit spend in the amount required to keep its economy at optimum performance. Then if excessive demand spawns too much inflation for people's taste, the government can reign in spending or tax more to balance it out. This doesn't mean it WILL of course! :)

  4. This trade imbalance strikes me as yet another social policy issue. We're basically employing Chinese workers to the detriment of American employment. I wonder if perhaps our energy should be spent not on upholding the status quo by tweaking our economy, but on changing the manner in which we conduct our foregin dealings.

    There seems to be no shortage of demand. It's an exercise in blatant hypocrisy to countenance Chinese labor practices via our dollars while imposing numerous constraints on American businesses in order to preserve a standard of working conditions. If, as you said, demand for the dollar is high, we can use that to our advantage. We don't need to enact changes through the Fed. We need to enact changes to foreign policy. I see no reason why we must confine our moral notions of good to geographic regions.

  5. "We're basically employing Chinese workers to the detriment of American employment. I wonder if perhaps our energy should be spent not on upholding the status quo by tweaking our economy, but on changing the manner in which we conduct our foregin dealings. "

    I am open to the idea of reviewing trade policy with China. "Free trade", a mantra for a long time, is sometimes not what it's cracked up to be. I understand the desire for free exchange of ideas/products, etc. But with China's currency manipulation, I wonder if it really means the trade is free? Then there are human rights issues, safety concerns, etc.

    "There seems to be no shortage of demand."

    I don't agree here. Demand is purchasing power + the willingness to use it. China gives us products that require an artificially low amount of purchasing power. We would have to substantially increase the amount of demand in the US to pay higher prices for US made goods. However this may translate into higher paying jobs and eventually cycle upwards into greater demand across the domestic populace.

    However, this would require a good deal of fiscal stimulus in some fashion.

    "I see no reason why we must confine our moral notions of good to geographic regions. "

    I agree. I think there is a balance to be found. I am not sure the trade embargo on Cuba has done much recently except further the population's isolation. However, we don't want to legitimize a bad regime. Tough choices.

  6. We've reached a curious point... we actually seem to agree on at least the overarching idea that our dealings with foreign trade are not up to par. I spoke before about the stickiness of government programs. This is a great example. Once we got the ball rolling on foreign trade with little regulation it feels as though we must work within the confines of the established system, so it feels like we must continue to tweak our economic system. But, without the foreign trade element, I wonder how broken our system really is. I wonder how well Americans might perform on a more level playing field. Of the people, for the people... wait... which people again?

  7. "But, without the foreign trade element, I wonder how broken our system really is. I wonder how well Americans might perform on a more level playing field"

    Good questions. I have a feeling the dollar can't keep it's special status forever, and there is good and bad to that, I would imagine.

    I am not sure that government tweaking now is a way to preserve the status quo. The status quo is large amounts of debt in the private sector, so to de-leverage (pay back the debt) there must be deficit spending - unless we want to kill the economy. A large amount of debt in the public sector does not necessarily have to be paid back. And if it ever is (with real goods and services rather than bonds or notes), then the economy will boom.

    I think that one reason for our attraction to "free" trade with China is that it has raised real incomes of Americans (they can buy more), in spite of the fact that nominal incomes have remained flat or fallen in recent years. This despite the fact that income for the rich has risen spectacularly.

    So cheap trade is another way (like expanding the work force [women, illegal immigrants,more] and developing more debt instruments like credit cards) to keep wages low and profits higher, while still keeping consumption going. It also allows us to keep taxes low on the rich, so that they can continue to accumulate, without sacrificing all the buying power of the working and middle class.

    But it can't stay this way forever, as income inequality will be more difficult to sustain when demand from the lower classes dries up (like now), because credit has tightened. So the rich must be persuaded to dis-save in some way at some point, either by paying more taxes or by more deficit spending which might eventually raise inflation enough to discourage keeping money in savings instruments. Perhaps it will at least flow into the stock market instead of sitting around in cash. At least I hope!

  8. Your point about cheap goods is a good one; however, we both agreed before that American spending is basically out of control. Americans seem to spend until they can't anymore. If the average price of these non-grocery (for the most part) goods was to rise, I'm not certain the average American would be greatly impacted... most would have fractionally less stuff, but oh well. Some corporations would certainly be impacted, but I'm not so certain that would be a terrible thing. Again, these companies are basically circumventing American laws by hiring low cost foreign laborers indirectly.

    Any change on this scale would cause some headache to be sure, but I think the long term benefits could be astounding.