Another essay with an organization of thoughts regarding a commonly misunderstood economic phenomenon regarding the trade deficit and $ hegemony, please criticize at will!:
Smothered by all of the hysteria over spending and government debt, we almost never hear an honest discussion about the driver of economic imbalances in the United States: the trade deficit.
The deep trade deficit fueled by a nearly-unspoken policy of providing the world with a reserve currency, perpetuates imbalances in the public and private sector that are largely misunderstood. Consequentially, this nagging perpetual current account imbalance has been central to the perceived problems regarding the “national debt” and private deleveraging.
History of the Trade Deficit
Figure 1: Current Account Balance
However, after Richard Nixon removed the US economy from the gold standard, the dynamics of how policymakers believed the future of the economy would be composed shifted drastically. The new system driven by fiat currency mechanics and globalization policies focusing on “free trade agreements” with developing economies led to opportunities where the US could import cheap goods and finance it with outflows of dollars, By the 1980's under Ronald Reagan, the realization of this phenomenon led the trade deficit to explode as the United States poisitioned itself as the dominant world economic super power and demand for the dollar as a world reserve currency surged.
The trend continued after a brief trade balance was reached under George HW Bush, and reached critical levels under George W. Bush. The dollar has now become the standard currency of trade and investment in demand all around the world, with foreign entities transacting using dollar-denominated assets, meaning the American economy has needed to run a current account deficit to fuel this ever-growing demand.
But what are the effects of such a deep deficit?
Macroeconomic Flow Accounting Identities
The trade deficit has consequences on private and government finance that are unappreciated and often times completely ignored by the media.
To understand the mechanics behind this, it's important to note one rock-solid accounting identity in macroeconomics, that is:
Private Sector Balance (Income-Spending) = Trade Balance (Exports-Imports) - Fiscal Balance (Taxes-GovSpending)
Let's rearrange this for illustrative purposes relative to the Trade Balance:
Trade Balance (Exports-Impports) = Private Sector Balance (Income-Spending) + Fiscal Balance (Taxes-GovSpending)
And we know that this massive trade deficit (based on a number of factors as discussed earlier) is harming the overall economic balance. If the trade balance is in a steep deficit, that means that either the fiscal balance or the private sector balance also has to be in a deficit (or, one of them must be in a larger deficit than the Trade Deficit and then get offset by the other sector).
The Great Recession of 2008-present was an offshoot of the housing bubble made possible by overly-loose credit market conditions, which led to a completely unsustainable path of private debt accumulation:
Figure 2: Private Sector Debt Outstanding
So, going back to our accounting identity:
Trade Balance (Exports-Imports) DEFICIT = Private Sector Balance (Income-Spending) SURPLUS + Fiscal Balance (Taxes-GovSpending) ???
This leaves only the fiscal balance. If we're running a trade deficit as large as in present conditions, and the private sector is busy paying down debt accumulated during the housing boom, then the fiscal balance MUST be in a deficit. That is to say, the government must be running a deficit in order to fulfill the accounting identity.
Address The Trade Deficit, and The Rest Will Fall In Place
The answer to this obvious imbalance is not to attempt to first balance the government's books, but to instead focus on reducing the trade deficit. With that, a more balanced government budget and a less-indebted private sector become much easier goals to reach. There are many who wish to perpetually fuel the dollar as the reserve currency, but this is not a viable long-term strategy by which to base assumptions. China and other powers will rise with opposing systems and we have to craft the foreign exchange policy of the dollar with this in mind. I take issue with the proposition that we should just be running deep deficits into perpetuity, as this will undoubtedly come to an end when the regional titans of Asia and Laitn America rise up and grow their own independent systems that we have to compete with the international capitalists for investment into.
The private sector will not have the capacity to take on the debt necessary to offset a more balanced fiscal position, not any time soon at least. Given this constraint in the identity discussed above, the only way to offset a trade deficit is with a government deficit.
In this sense, the trade deficit is the dog wagging the tail of government and private finance. To attack the government imbalance or the private sector imbalance, one must first focus on trade deficit reduction, which is mathematically required to help offset government leveraging or private debt accumulation.
It all boils down to one strange issue with American economic policy: we ignore the power of the foreign exchange value of the dollar and choose to take a “hands-off” approach, which is contrary to what the vast majority of economies in the world choose to do. By fueling current demand for the dollar as a world reserve currency, in the future if this status is challenged then the United States will be faced with an ever-declining dollar anyway, as people sell their dollar holdings to diversify into other currency assets.
There are numerous solutions, (depending on how one feels about the dollar being a world reserve currency) which I won't go into detail with in this essay (this is for a later time), but I will mention the options briefly:
1) Devaluing the overvalued dollar. We should ask ourselves, why is our trade deficit so steep? It's not Chinese currency manipulation, because they've strengthened the Remnimbi significantly over the years, and it can't be blamed on any other misbehaving market actors, so what's going on?
If we are importing a lot more than we are exporting, clearly our dollar is over-valued and hurting American manufacturing and exports. The simplest way to offset this imbalance would be to engage in a “competitive dollar” policy that would help improve the trade position of American exporters and make imports less attractive to domestic consumers. However, “currency wars” bring up rather nasty thought experiments where countries continuously slash their foreign exchange value, undercutting one another with no end in sight.
2) Classic protectionism. We can engage in protectionist policies through tariffs or subsidies. The problem here is that we have an international organization that governs these sorts of things, called the World Trade Organization. Any explicit support of export markets is monitored closely by competing nations, and cases are regularly brought to the WTO as a way of mediating problems and promoting free trade as a successful mutually-beneficial principle.
3) Capital controls. This is a bit of a mixture of the first two options, and probably the most extreme. By forcing a limitation of fund flows that essentially produce an artificial trade balance, it would then address the root problem, only to cause numerous other ones.
There's no law anywhere stating that a perfect balance in Trade, Private, and Public accounts is required for optimal economic growth. In fact, the United States has had rather impressive growth despite a relatively unbalanced set of economic fund-flows.
Given the modern reality of the United States producing the world's reserve currency, a current account deficit and over-valued currency is an implicit Treasury policy. As Triffin warned decades ago, a nation that positions itself as the supplier of the world's reserve currency will necessary need to run a current account deficit in order to finance the demand for its currency.
It's worth noting that so many of the dollars flowing out from the trade deficit are invested in Treasuries. In my other essay “The Case For Stimulus” I detail how the debt is easily sustained when the demand for Treasuries is high enough to maintain a stable rate of return.
Since it's an unofficial Treasury policy to promote the US dollar as a reserve currency, it's possible that the trade deficit will never close to levels that people may be more comfortable with, but that's not necessarily a suboptimal set of circumstances.
People should not blindly be calling for a balanced government budget without considering the mechanics of the dollar as a reserve currency necessitating net outflows of dollars to meet international demand, as well as the accounting identity that shows if we do not run a government deficit to meet the trade deficit, then the private sector must go into a deficit (net borrowing), which the economy currently is not in any position to begin.
There is thus a decision that should be made by those who are promoting the idea of a balanced budget: if you support the dollar as the reserve currency, while desiring the goal of a balanced budget, this is an implicit call for the private sector to be running a deficit, rather than the government. However, if you believe there are negative long-term consequences to the dollar as a reserve currency, particularly regarding future potential volatility in FX value when competing currencies gain prominence, then winding down that effect would make the management of the tradeoff between government and private sector balance much more politically feasible to address.
Under a smaller current account deficit with an unwinding reserve currency status, the more optimal policy would be for the government to run a perpetual structural deficit (exceeding the trade deficit), which leads to a stable and sustainable building of private wealth, a long-run equilbrium for a healthy economy. The current American hegemony will not be something we can extract rents for forever, and responsible policy would be to position ourselves for change.