The Long View
We at Casey Research like to take the long-term view. As part of our ongoing research to understand current investment options and stay abreast of long-term economic trends, we look at how the economy fared under the previous stressful times of the Great Depression. Are there any important similarities?
There are a number of important sub-models of this investigation, but only one of them is featured here. Identifying a number of the significant economic drivers of then and now, we will expand on others in an upcoming International Speculator issue.
It is critical to get the real data for this kind of analysis because even after seven decades, there are very differing interpretations of the causes of the depression. Many who worry about the parallels and see economic difficulty ahead are looking for similarities, like the expansion of debt and the unusual rise in stocks. This piece examines one of the most important imbalances of our time, an item that is decidedly different from the 1920s: the Trade Deficit.
How Serious is the Trade Deficit?
Last weeks report from our Treasury on foreign investment in the U.S. brings me to focus on the trade balance, related foreign investment, our loss of manufacturing, and the long-term implications.
I have been monitoring the big imbalances of our economic system to determine if we are heading toward a big economic convulsion that would change our investments and our lives. I have been evaluating long-term historical measures of prosperity and economic movement, comparing the last big depression to now to see if we face similar situations. Some of the similarities look dangerous, like the large overall indebtedness of then and now. Some of the differences do not show so serious a situation today, such as the relatively stronger financial institutions that would surely get government bail-out if liquidity became a problem. But there is one difference that is much worse now: the trade deficit.
First, here is the trade balance as usually reported, showing a big drop starting in the 1970s, as we began to buy more than we sold abroad:
Accumulating the annual numbers above shows the position of how much the U.S. owes or is owed by the world:
The question is what that means for our financial system. Decades ago, the U.S. was smaller and dollars were worth more, so we need a baseline to make the periods comparable. The method I use is to calculate the ratio of trade deficit (or surplus) to GDP. The positive position we enjoyed in the lead-up to the 1929 crash has eroded now to a negative position.
The trade position of the U.S. was very strong before and during the great depression. The dollar was devalued against gold one time by Roosevelt, but was generally strong. In fact, we experienced deflation, meaning the purchasing power of the dollar increased, as prices of homes and other items crashed. The foreign situation of accumulated international debt is exactly the opposite of what it was in the 1920s. This important difference shows why the dollar then turned out to be strong, even in the face of disastrous economic contraction that brought 25% unemployment. Now, the accumulated trade deficit hangs over the dollar so that this time looking forward, the opposite conclusion is more likely: the dollar will succumb to decreasing purchasing power. Many commentators suggest that if we are headed toward recession or, even worse, to depression, that will be deflationary just like it was in the 1930s. I believe we are headed toward serious financial times, but I do not see the deflation of that time returning. Foreigners lending us $2.5B per day can't continue forever. When it fails, we will not see deflation but big inflation. Foreigners all wanting to get out of dollar positions will drive the dollar down and prices up as they bid for assets other than dollars.
We can look at today's numbers from the Treasury on foreign investment to see the size of foreign support by their reinvestment of their trade surplus in our Treasuries, agencies, stocks and bonds. I monitor the reinvestment as an indicator of pressure on the dollar. The data from today, averaged over the last 3 months, does not show a problem. Foreigners are still investing in U.S. financial assets, despite pronouncements from the Chinese and other central banks that they want to divest some of their U.S. holdings. In aggregate they are continuing to invest. The reinvestment by foreigners is equal to the trade deficit, so imbalances have escalated together as shown in the chart below:
The underlying data from today show this source of reinvestment may be more precarious than the surface shows. China is the country we watch most closely because they hold the biggest hoard of foreign currencies of $1 trillion. China still added to their U.S. dollar denominated holdings, even if at a slower rate this month. The other two biggest purchasers are London and Grand Cayman Islands. They are different because they are money centers, and are passing through investments from other countries from such sources as hedge funds and countries that prefer anonymity, like oil countries. The surprise is the amazing size of the investment from London:
Investing money centers are potentially able to change their position on a whim, as seen in London's negative move in July. London's investment of $47B is huge compared to the worldwide net foreign purchase of $88B. This trade deficit and investment juggling act has succeeded, and on the surface has held together. When you look at the components, the underpinnings do not look so stable.
The other side of the trade deficit is that foreign cheap labor has replaced manufacturing in the U.S., hollowing out our lower and middle class incomes. The chart below shows U.S. manufacturing jobs as % of total jobs. The expanding trade deficit matches the decreasing U.S. manufacturing jobs. This is exactly as expected, but it is not good for the long-term economic strength of the U.S.
The destruction of productive capacity will decrease our long-term wealth creation. With U.S. production decline, there is less need for investment in that productive capacity. Investment, which is the basis for future growth, has moved to Asia. U.S. corporations seeking to increase profits by cutting costs actively supported these moves. That means less wealth for the U.S. because we are not producing as much. The economy will weaken because we are not paying our workers to make the things we import, so they will have less to spend. Foreigners have put off the problem in the short term by lending us the money to buy their exports and maintain our lifestyle. But this can only continue until foreigners fear that they may lose by holding too many dollar investments that start to decrease in purchasing value.
So in conclusion, the trade deficit is very serious, especially in the long term. It is part of the hollowing out of American production and wealth creation. As a consequence of borrowing to buy those foreign goods, we have sold off some of our future profits as we have to pay interest on Treasuries and dividends on stock holdings, with the result that the dollar will weaken. Foreigners have continued with the deadly embrace of extending more credit to us, so we appear wealthier than we are. But should they try to extricate themselves from their dollar holdings, the consequence will be a devaluing dollar. Even if we head toward a massive economic slowdown 1929-style, a serious deflation is unlikely because of the negative position of our trade deficit. A weakening dollar will be supportive to gold and precious metals in the long term.
In future editions of the International Speculator, we will comment on other important economic movers such as the stock market, debt, housing and gold--comparing how they interacted then and now with the unfolding economic scenario.
Bud Conrad holds a Bachelor of Engineering degree from Yale University and an MBA from Harvard. Among others, he has held positions with IBM, CDC and Amdahl. Currently he serves as a local board member of the National Association of Business Economics and teaches graduate courses in investing at Golden Gate University.
His data and analysis regularly appears in the pages of Doug Casey's International Speculator, which is dedicated to uncovering gold and silver stocks with 100% or better profit potential... For more information, click here.