Debt-Financed Trade Caused The New Depression

The United States trade deficit hit $2 million A MINUTE in 2006. That was the rate ($800 billion that year) at which the US was going into debt to the rest of the world. When Adam Smith (1723 – 1790) and David Ricardo (1772 – 1823) wrote about the benefits of free trade, they could not have imagined a world in which a country could incur a trade deficit of $800 billion in one year and finance it with paper money. In their world, trade between nations balanced. It had to balance because gold was money and the gold standard contained an automatic adjustment mechanism that ensured that trade did balance. Understanding that adjustment mechanism is the key to understanding how, following the breakdown of the Bretton Woods international monetary system, the United States’ trade deficits destabilized the global economy and culminated in the New Depression.

The gold standard ensured that international trade balanced in the following way. One hundred and fifty years ago, for example, if England had a large trade deficit with France, then England’s gold would literally have been put on a ship and sent to France to pay for the shortfall. Since gold was money, England’s money supply would have contracted, its economy would have gone into severe recession, unemployment would have increased and there would have been deflation. The opposite would have occurred in France. As gold entered the economy, credit would have expanded, the economy would have boomed and there would have been inflation. Soon, the rich French would have begun to buy more cheap English goods; and the poor, unemployed English would have stopped buying so many expensive French good. Before long, the trade balance between the two countries would have returned to balance.

The Bretton Woods system, put in place at the end of World War II, was designed to function so as to replicate the gold standard’s automatic adjustment mechanism. When Bretton Woods broke down in 1971, however, that adjustment mechanism ceased to operate. Soon afterwards, the United States began running large trade deficits – initially with Japan. As dollars entered the Japanese economy, they went into the Japanese banking system and caused credit to expand. As a result, the Japanese economy began to boom (in the same way that the French economy boomed in the example above). However, the United States did not deflate as England would have 150 years ago because the US was not paying for its deficit out of a limited amount of gold reserves. It was paying with paper dollars or US government bonds denominated in paper dollars; and there was no limit as to how many of those dollars the government could create. Consequently, the adjustment mechanism ceased to work and, as the Japanese trade surplus continued to expand, the Japanese economy continued to boom, and boom, and boom, until the gardens around the Imperial Palace in Tokyo were said to be more valuable than California.

And then in 1990, the Japanese bubble popped – as every bubble eventually does. At that point, asset prices plunged, banks failed and the government had to go deeply into debt funding large annual budget deficits in order to prevent the Japanese economy from collapsing into a depression. All economic bubbles pop for the same reason. Eventually asset prices became so inflated that the public can no longer finance them. The income of the public determines how much asset prices can inflate. Income is determined by wages. In bubble economies asset price inflation outstrips wage growth and, eventually, as a result, the bubble pops.

This bubbling process has occurred again and again in one country after another since Bretton Woods broke down. All the countries that have experienced large trade surpluses with the United States (or, more technically, large overall balance of payments surpluses) have been blown into bubbles. Japan bubbled and popped in the 1980s. The Asia Crisis countries (Thailand, Indonesia, Malaysia and Korea) bubbled and popped during the 1990s. By the 2000s, the US trade deficit had become so large that a worldwide bubble formed. It popped in 2008. Today, China is the most clear-cut case of a country where an economic bubble has formed as the result of an extraordinary trade surplus with the United States. China’s bubble has not yet popped, but it is certain that it will.

Between 1971 and today, the United States cumulative trade deficit has exceeded $7.9 trillion. That deficit was financed on credit. Never before has a country amassed a trade deficit on a scale such as this. Therefore, it must be understood that the trade regime that has evolved over the last 40 years is very different from what the classical economists described as free trade. The term “debt-financed trade” much more accurately describes the current system. Debt-financed trade produced very rapid economic growth for decades as countries around the world radically expanded their industrial capacity to satisfy the surge in debt-driven demand from the United States. However, now that the private sector in America can bear no additional debt, this unbalanced trade regime has left the world in a crisis characterized by excess capacity, insolvent banks and unsustainable fiscal deficits.

Debt-financed trade is not free trade. Free trade under a gold standard fostered prosperity in a balanced and sustainable way. Debt-financed trade has created extraordinary and unsustainable global imbalances on a previously unimaginable scale. When those imbalances began to come unwound in 2008, governments were compelled to borrow, print and spend trillions of dollars in the attempt to stave off a new great depression. It is still far from certain that they will succeed.

8 comments

  1. Had a chat with a friend from China who was convinced that foreign analysts do not understand China and there is no bubble. The only concern he mentioned is the widening income gap between the rich and the poor which could lead to social unrest. Even last year there were 70,000(!) unreported protests in China. Property markets in the region got a boost from Chinese investors lately, which could also be a sign that some of them have worked out escape plans, in addition to storing their wealth abroad.

    I tend to think that China is a bubble, but whether that bubble will burst first or the US (public) debt bubble, that remains to be seen. And the investment implications can be different. If China pops first, that will have a negative impact on commodities (and Australia, Brazil, Argentina etc. will get hurt immensely). At the same time the dollar may rally and gold could decline temporarily. If the US pops first, then the dollar collapses and all other currencies will lose value relative to gold and other commodities.

    Currently it looks like that China will pop first, because the US will keep printing money and the Chinese have two options,:
    1. keep the currency peg, but then their inflation problem will get worse and worse
    2. strengthen their currency vs the dollar, but then a lot of companies (export oriented) will go out of business because their profit margin is so thin that a significant CNY appreciation would erode those margins

    Would be curious to hear other people’s investment thesis.

    1. I totally agree with you on the point that while US will keep printing money to delay the final disaster to the last minute and China will pop first.

      Regarding correction in Chinese economy, I think, foreign capital could play a role. At the moment, huge amount of foreign capital is flowing into china, on top of trade surplus. However, for some reason, either amount of capital inflow could dwindle or worse net capital capital outflow could take place. In this case, on the back of ongoing inflationary pressure, collapse in money supply, resulting from smaller foreign capital inflow combined tighter monetary policy by government, would seriously affect Chinese economy.

      It could be worth observing a change in
      1. foreign capital inflow to china
      2. breakdown of such capital inflow

  2. What I have not seen addressed much is the political situation in the U.S regarding QE and long term running deficits. Middle class is feeling food & fuel increases due to Fed policy and most Americans are against further QE. If the Fed is curtailed, that could seriously curtail inflation in China and around the world. Egypt & Tunisia are the canaries in the food inflation coal mine. More potential unrest to follow which could put outside political pressure on U.S. & Fed policy as well. China may have it’s decision made for them.

    1. Dear Douglas,

      As you mention US inflation, I am hugely curious about it. We all know Fed maintains its complacent stance towards it, repeatedly saying inflationary pressure is low. I am living in Korea, and, inflation in Asian countries except for Japan is pretty bad, which is evidenced in another Chinese rate increase the other day.
      I am also very curious about political situation in US regarding politicians’ view towards inflation, government deficit including municipal financial crisis, and, unemployment. They must know better than to try to solve all these at the same time.

  3. Those who thought China had a bubble, and it would burst before the U.S. do NOT know much about China!

    The West has been claiming China would collapse for more than 2 decades now, yap, eventually, they will be right, but ONLY OFF big time in time line. China will NOT collapse in at least another 10 years! Just watch it!

  4. While it seems counter-intuitive, China’s net exports are probably a relatively small part of its GDP. Although they have fallen off substantially, the effect on GDP appears to have been relatively inconsequential, suggesting that this is indeed the case.

    A big reason for this is the fact that a large portion of China’s export trade consists of processed goods, i.e., goods which are assembled from imported components rather than manufactured from the ground up. Less value and therefore less GDP is added by processing exported goods than if they had been manufactured using components made domestically.

    This needs to be acknowledged because it suggests that the Chinese economy is much less export-dependent than is popularly believed to be the case. Thus, whether China is in a bubble caused by the enormous trade surplus with the US I think requires more examination.

    China may well be in a bubble but its cause might not be a trade surplus with the US. On the other hand, it may be undergoing substantial growth simply because it is developing infrastructure and otherwise growing organically. At this point, I think we need more evidence before concluding that China is in a bubble. It is undoubtedly undergoing inflation but inflation does not necessarily mean a bubble exists.

  5. To summarise, the article deals with the effect of the debt-financed trade on the global imbalances – as put by the author “Debt-financed trade has created extraordinary and unsustainable global imbalances on a previously unimaginable scale”. The view here is one-sided and blame falls on the deficit running countries, presumably, the US, Spain, France, i.e. the worst abusers. This is only one half of the story. The imbalance was created by Japan 2-3 decades ago, and is being created by China at the moment. Fixing the exchange rate or not allowing the rate to be freely determined by the market forces artificially worsens the competitiveness of the US, for example. In effect, it is the US who subsidises the economic growth in China (Japan in the past) at the expense of their (states’) own workforce. The bubble in Japan burst, among other things, because the exchange rate was let to float in 1985. I truly believe that it is a fair response to the abusive practices of the “Eastern Tigers” (why brackets? Let them try to develop on their own without the Western markets for their goods. Who could’ve bought those T-shirts, jeans, trainers, Walkmans, etc. inside the producing countries 20 years ago and provided salary to those poor agri workers in Asia? It took Japan, South Korea about 2 decades to get out of poverty and become develped economies. It is said that around 600 million Chinese got out of poverty thanks to the cheap Chinese export. Where is the miracle?) Neither, I believe, it is fair to pay for hard labour with bits of paper printed on some fency paper, nor it is fair to determine the hourly wages without the reference to the objective prices for labour on the global market. The Occidentals have unemployment – the Orientals have worthless paper. It’s a balance.

  6. I do not think Americans will keep on buying these foreign imported goods much longer at least not to the extent the have been.people here a running out of money and stores/restaurants are closing by the day. Sometimes I find I am the only customer! I sold my business in 2003 before the gas went up. Everything else already did insurance, dues, medical, mechanical. I saw the writing on the wall. I got out. Many who did not get out are now being forced out at major loss. It is so sad. Now Wallmart will be charged $6,000 for each of its employees its send down to sign up for free Medicaid at public expense. The “free ride” for corporations is officially over.

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