The Missing Link
The badly flawed consensus thinking about the implications of sustained large U.S. capital inflow starts with the error that U.S. assets are uniquely attractive to foreign investors. The reality is that U.S. investors are earning far higher returns on their assets in Europe and Asia than foreign investors do on their U.S. assets. European firms and investors who invested heavily in the United States during the "new paradigm" years in the late 1990s are still smarting from horrendous losses. The DaimlerChrysler disaster is by no means an isolated case.
As to U.S. bond yields, they are just marginally above euro yields, but considerably below the yields obtainable in emerging countries. What is more, after inflation, they are the lowest in the world. A falling dollar is, of course, a virtually prohibitive deterrent to foreign bond purchases. In fact, it might induce selling.
This leaves the central banks of Asian surplus countries as the potential buyers of last resort for the dollar, unwanted by private investors. They did heavy dollar buying in 2003 and in early 2004, but never forget, the dollar purchases by the central banks have a heavy price in turning healthy economies into sickly bubble economies.
The sustainability of the U.S. capital inflows is, actually, the totally wrong question to ask from the American point-of-view. Far more important is another question, concerning the effects of the trade deficit on the U.S. economy, in particular on employment and income creation. We find that the dogmatic belief in the mutual benefit of foreign trade has stifled any reasonable discussion in this respect.
The benefits for the surplus countries are obvious. Exports in excess of imports create higher employment, higher profits and higher incomes. But what are the benefits to the United States? Frankly speaking, we do not see any true benefit of a trade deficit. What the American "mutual-benefit" apostles fail to see is that a balance in benefits essentially presupposes a balance in the underlying trade.
Yet there is a widespread view that the flood of cheap imports, by keeping a lid on U.S. inflation and wage pressures, fosters lower interest rates, which tend to spur economic growth.
For us, both effects are not beneficial at all, because the imports implicitly distort both inflation rates and interest rates to the downside. In essence, the lower inflation rates allow a looser monetary policy than domestic conditions justify. For Greenspan and many others wanting the loosest possible monetary policy, this was certainly a highly esteemed effect of the trade deficit. For us, it is insane.
Nobody seems to realize the enormous damages that the egregious trade deficit has inflicted on the U.S. economy. Indisputably, it diverts U.S. demand from domestic producers to foreign producers, and this implies an equivalent diversion of employment and associated income creation from the United States to these countries. That is the manifest direct damage of the trade deficit to the U.S. economy, the obvious main victim being the manufacturing sector, with horrendous job and income losses.
Blinded by the dogma of compelling mutual benefits; policymakers, economists, investors and the American public flatly refuse to see this disastrous causal connection. The alternative explanation is that America's extremely poor job performance has its main cause in the highly desirable high rate of productivity growth.
It is a convenient, but foolish explanation, reminding us of the early days of industrialization, when people destroyed machinery for fear of unemployment. For us, productivity growth that destroys millions of jobs is definitely suspect as a mirage. Historically, strong productivity growth has always coincided with strong capital investment involving, in turn, strong employment growth in the capital goods industries.
That is presently, of course, precisely the missing link in the U.S. economic recovery. (As an aside, in a healthy economy with adequate savings, cutting labor costs generally takes place through investment, not through firing.)
The job losses from the soaring trade deficit have always been there. But they did not show up in the aggregate for many years because the booming economy - driven by extremely loose monetary policy - created sufficient alternative jobs. But this alternative job creation has drastically abated since 2000, and the soaring trade deficit's damage to manufacturing is now surfacing in full force.
Having said this, we hasten to add that the U.S. trade deficit must be seen as one imbalance among several others, whether zero or even negative national savings, a soaring budget deficit, record-low net capital investment or sky-high consumer debt. They all derive from the same underlying key cause: Unprecedented credit excesses that have boosted consumption for years at the expense of capital formation.
What governs the U.S. trade deficit is not the law of "comparative advantages," but the careless depletion of domestic saving and investment resources though policies that have recklessly bolstered consumption. Essentially, employment creation through capital investment is out. Putting it bluntly, the U.S. trade deficit, like all other imbalances, reflects a grossly skewed resource allocation toward consumption.
To American economists, this idea that over time, excessive consumer spending leads to recession and worse, by crowding out capital investment may seem preposterous. Widely unknown, it happens to be the central idea that F.A. von Hayek developed in his famous lectures at the London School of Economics in 1931.
In essence, he explained in great detail that an increase in consumer demand at the expense of saving will inevitably lead to a scarcity of capital, which forces a "shortening in the process of production," and so causes depression. Putting it in simpler parlance: Excessive consumption inevitably crowds out business investment. As a share of GDP, consumption in the United States is presently excessive as never before. And it keeps worsening.
Assessing the U.S. economy's prospects, it also has to be realized that the bubble-driven consumer-spending boom represents artificial, unsustainable demand. Apocalypse will follow when the housing bubble bursts - which is sure to happen in the near future.
As the Boston Herald recently reported: "[Stephen] Roach met select groups of fund managers downtown last week, including a group at Fidelity. His prediction: America has no better than a 10% chance of avoiding economic 'Armageddon'... Roach's argument is that America's record trade deficit means the dollar will keep falling. To keep foreigners buying T-bills and prevent a resulting rise in inflation, Federal Reserve Chairman Alan Greenspan will be forced to raise interest rates further and faster than he wants. The result: U.S. consumers, in debt up to their eyeballs, will get pounded."
We could not agree more. Our particular nightmare is that the huge carry trade bubble in bonds will inevitably burst in this process. A fire sale of bonds in unimaginable proportions would begin, with bond prices crashing and yields soaring. With the prices of housing, stocks and bonds crashing, the entire U.S. financial system would be at risk.
It is typically argued that the U.S. economy is importing too much in comparison to exports. Superficially, that is true. Yet on closer look, it is a mistaken perception. Compared to other industrialized countries, U.S. imports are very low as a ratio of GDP. The true key problem is abysmally low goods exports, accounting lately for barely 7% of nominal GDP. This compares, by the way, with a German goods export ratio of 35% of GDP.
The next implicit question is the cause or causes of this extremely low U.S. export ratio. The answer is strikingly obvious. It is precisely the same cause that chokes productive capital investment - the progressive shift in the allocation of available domestic resources away from capital formation through saving and investment in plants and equipment, and toward immediate consumption.
That is the supply-side problem. Yet there is a demand-side problem, too. Greenspan and others like to boast that America is creating growing demand for the rest of the world. The ugly truth, rather, is that U.S. monetary policy has been excessively loose in relation to potential domestic output, because Greenspan has wanted maximum economic growth for years. But lacking domestic output capacity to meet the soaring domestic demand, an increasing share of the demand creation from monetary excess exited to foreign producers, resulting in the huge U.S. trade deficit.
It is a flagrant policy failure that has created a monstrous, unsustainable imbalance, both domestically in the United States and globally. However, for years, American policymakers and economists have glorified this deficit as America's great contribution to world economic growth. But the day of reckoning is rapidly approaching.