Note: Errors of labeling in Fig. 1 are corrected on June 30, 2009

ANALYSES OF RECESSIONS: from 1955 to 2008


Chih Kwan Chen

January 20, 2009


General Characteristics of recessions occurred in the period from 1955 and 2008 are analyzed and early warning signs of those recessions examined. The connections of the booms and recessions in the globalization era with the ups and downs of trade deficits are summarized. The reason why the current recession is so nasty and the future prospect of US economy are discussed.

Section 1. Introduction

Most people should be aware by now that US economy is currently experiencing a nasty economic recession. When a recession becomes very severe, it is called a “depression”. Since the Great Depression of 1930s US economy has experienced quite a few cycles of boom and recession. How to define recessions? Is there any early warnings of incoming recessions? What are the characteristics of the recessions in general, and do the characteristics of recessions change in time? What forces are shaping the booms and recessions in recent years and in the past? Why the current recession is so nasty to the degree that have panicked US Government and has forced it into ad hoc bailouts and nationalizations as if trying to change US from a free market system to a socialist society? Those are the questions discussed in this article.

The next section is devoted to the definition of recessions and to the early warning signs of incoming recessions. In Section 3 distinctive characteristics of recessions in the pre-globalization era and those in the age of globalization are compared. How trade deficits are related to booms and recessions since the start of the globalization era are summarized in Section 4 in general forms. In Section 5 the tangled relations of trade deficits and booms and recessions in the globalization era are discussed in detail, and the last section is reserved for some concluding remarks.

Section 2. Clearly Recessionary Phases and Early Warning Signs of Recessions

Quarterly data of inflation adjusted gross domestic product, called “real GDP” are used to define “clearly recessionary phases” in this article. Annualized percentage changes of real GDP from quarter to quarter are plotted as the orange colored curve in the graph at the right, denoted as Fig. 1, from the first quarter of 1955 to the third quarter of 2008. The time scale of the orange curve is plotted at the bottom of the graph in red letters. The orange curve is so jumpy to the degree to make the extraction of useful information difficult. In order to smooth out the orange curve, percentage changes of one quarter’s real GDP from the real GDP of the same quarter of the prior year are plotted as the blue curve in the graph. The time scale of the blue curve is plotted at the top of the graph in blue letters. The year-to-year comparisons of the blue curve is a backward looking indicator, lagging the events in the real economy by about two quarters, so the time scale of the blue curve is shifted toward left compared with the time scale of the orange curve at the bottom of the graph. For example, the point labeled as “A” on the blue curve corresponds to the third quarter of 1956 according to the time scale in blue at the top of the graph. This means that point “A” is calculated by comparing real GDP of the third quarter of 1956 with real GDP of the third quarter of 1955. Point “A” on the blue curve is at the first quarter of 1956 according to the time scale in red at the bottom of the graph. This means that the event represented by point “A” is describing the event of the real economy around the first quarter of 1956. In Comment 64 four quarter moving averages of quarter-to-quarter percentage changes of real GDP are used to smooth out the orange curve. If the four quarter moving average curve is plotted on the graph (Fig. 1), it will be almost indistinguishable from the blue curve.

The nadirs of the blue curve that are very close to or below the 0 % line, that is the solid green line in the graph, are marked from “1” to “8”. The places marked from “1” to “8” are “clearly recessionary phases“. The next question is how to define a recession. We define a recessionary period as the period when the blue curve is below +1.0 %, measured from the time scale of red letters at the bottom of the graph. For example, the clearly recessionary phase labeled as “1” occurred in the real economy at the third quarter of 1957. The blue curve, at the second quarter of 1957, dropped below +1.0%, and at the second quarter of 1958 the blue curve jumped above +1.0 %. Therefore, the recession surrounding the clearly recessionary phase labeled as “1” is defined to have started at the second quarter of 1957 and have continued through the first quarter of 1958, a four quarter long recession. This definition of recession is different from two kinds of definitions of recessions widely quoted on the media. The first kind of definition of a recession is the official declaration by The National Bureau of Economic Research. This official declaration of a recession is based on a majority vote of a board consisting of 7 prominent economists; each economist uses his/her own criteria to decide whether the economy is in a recession. Outsiders of the board, even the insiders of the board, have no way to guess about the progress of this black box like procedure and must wait for a long time, close to one year, for the board to decide whether the real economy has been in a recession or had experienced a recession. We do not subscribe to this kind of subjective and black box like definition of recessions in this article. It should be noted that the official definition of economic cycle from The National Bureau of Economic Research only has two phases, either a recession or an expansion period. However, in our approach a similar definition of booming era, though is not given here, can be made, and between a boom and a recession there can be a transition period.

In the second kind of popular definition of recessions, a recession is deemed to have occurred when the real economy has experienced two consecutive quarters of negative growth. This popular definition has some problems. For example, from the study of the orange curve in the graph (Fig. 1), the clearly recessionary phase labeled as “2“ is not a recession since there were no two consecutive quarters that real GDP had scored negative growth during the period. More controversial is the recession around the clearly recessionary phase labeled as “8”. That was the painful economic down turn after the burst of Clinton era stock market bubble, and many jobs were lost. However, according to the popular definition of “two consecutive quarters of negative growth”, that was not a recession either since there were no two consecutive negative growth quarters as the orange curve shows. Our definition of recession classifies “8” as a 4 quarter long recession. The National Bureau of Economic Research also classifies “8” as a recession. In the popular definition, a recession ends when real GDP resumes positive growth. The durations of recessions become much shorter in the popular definition than both of our definition and the definition of The National Bureau of Economic Research. For example, “1” is a 4 quarter long recession in our definition, but is only a 2 quarter long one according to the popular definition. More interesting is to look at the current recession and see how three different kinds of definitions fare. According to the popular definition of two consecutive quarters of negative growth, the recession has not been confirmed yet. If the growth rate of real GDP of the fourth quarter of 2008 turns out to be negative, as widely expected, then the popular definition calls a recession that has started in the third quarter of 2008, but not earlier. The National Bureau of Economic Research has announced in early December of 2008 that the current recession has started in December of 2007. In our definition the rightmost point on the blue curve, based on real GDP data of the third quarter of 2008, indicates that the recession has started from the first quarter of 2008. The data of real GDP of the third quarter of 2008 was published at the end of October of 2008, so our definition beats the announcement of The National Bureau of Economic Research by more than a month in confirming the current recession.

The definition of recessions adopted in this article, though is more objective and timelier than the declaration of The National Bureau of Economic Research, and is more thorough and timelier than the conventional definition of two consecutive negative growth quarters, is still vastly out of synchronization with the real economy; for example, the current recession that has started in the first quarter of 2008 can only be confirmed at the end of October of 2008 as discussed in the previous paragraph. Apparently some better early warning signals are needed here. A close study of the blue curve in the graph does reveal the existence of such early warning signals. In the graph a broken horizontal green line is drawn to indicate the level of +2.0 %. It is when the blue curve drops below this +2.0 % line by a meaningful amount, it consists an early warning of a recession. Then what is the “meaningful” amount? It turns out 0.2% below the +2.0 % line is enough. In other words when the blue curve breaks below +1.8 %, it becomes an early warning signal. The early warning signals in the graph are marked as “A”, “C”, “D”, “E”, “F”, "G", “J”, “K” and “B”. Point “A” and “B” are especially interesting, so let us discuss them later. Quite a few early warning signals overlap with the entrance point into a recession so do not provide any additional information; points “C”, “D”, and “E” belong to this category. Points “F”, “G”, “J” and “K” are useful early warnings. For example, point “F” is calculated based on the real GDP data of the fourth quarter of 1979 that became available in the early part of the first quarter of 1980. At the first quarter of 1980 the real economy was in the very middle of a 3 quarter long recession labeled as “5” in the graph. When in a recession, observant people should be able to find some uneasy signs around him before the negative economic data actually floods in. The early warning signal like “F” will confirm his uneasiness to point out that a recession is indeed progressing. Readers can check out points “G”, “J”, “K” by themselves using the similar technique as used here. It should be warned that the very popular employment indicator, though is timely, is a lagging indicator of the real economy, and is usually inferior compared to the early warning signals discussed here.

Point “A” is a genuine early warning signal to the 1957-1958 recession. The point is calculated using real GDP data of the first quarter of 1956, comparing the data with the real GDP data of the first quarter of 1955. The 1956 Q1 data became available at the end of April of 1956 and was revised a few more times during the second quarter of 1956. Thus the warning signal was available in the second quarter of 1956. The 1957-1958 recesssion marked as "1" had started in the second quarter of 1957 and lasted for 4 quarters according to the definition of recessions used in this article. Point “A” became a superb early warning signal, one year ahead, of the coming recession. Point “B” is even more interesting since it is the real early warning signal of this ongoing recession. Point B is calculated using the real GDP data of the first quarter of 2007. 2007 Q1 real GDP data was first published by Bureau of Economic Analysis on its website on April 27, 2007. The calculation of point “B” based on that preliminary estimate of 2007 Q1 data yielded the result of +2.06 %. The 2007 Q1 real data was revised on May 31, 2007 and on June 28, 2007. The calculated values of point “B” according to those two revisions were +1.90 % and +1.91 % respectively. All those three calculated values were above the critical line of +1.8 % so they did not meet the criteria of an early warning signal. It was the annual revision published on July 27, 2007 that revised 2007 Q1 real GDP down substantially, and the calculated value of point “B” became +1.55 % as shown in the above graph. Only at that time point “B” became the early warning signal of this current recession. Incidentally this website has issued a “recession watch” on July 28, 2007, after the persistent worry about US economy due to the changed US trade deficit trend, the importance of which will be discussed later, confirmed by the massive downward revision of July 27, 2007.

We may summarize the early warning signals from the blue curve into following 3 cases:
Case 1 : The blue curve stayed above +1.8 % level for quite a while, but suddenly drops below +1.0 %. This indicates that a recession is already in progress for about two quarters.
Case 2 : The blue curve stayed above +1.8 % level for quite a while. Suddenly the blue curve drops below +1.8 % but above +1.0 %. If the reader feels somewhat uneasy about the economy, there is a very good chance that a recession is already in progress for about one quarter. If within the following 2 quarters the blue curve does not drop below +1.0 %, go to Case 3.
Case 3 : The blue curve stayed above +1.8% level for quite a while. Suddenly it drops below +1.8 % but above +1.0 %. The reader feels upbeat since major financial media are bullish and are advising investors to buy stocks. Consider the signal from the blue curve as the early warning signal of an incoming recession and runs for cover. That was exactly the case of point “B” and our issuance of the “recession watch” on July 28, 2007. That was the time about 10 days before the first financial firestorm of August 9, 2007. Most professional money managers and Wall Street were bullish and subsequently pushed major stock market indexes to their historic highs in the fall of 2007. Those, that had heeded to the “recession watch” of July 28, 2007 and had taken defensive measures accordingly, should have avoided major damages to their portfolios in this nasty bear market of stocks.

Section 3. Distinctive Characteristics of Recessions in the Pre-globalization Era and Those in the Globalization Age.

The blue curve in the above graph (Fig. 1) reveals two different phases with the high 1983-1984 peak as the dividing period. Before the 1983-1984 peak was the pre-globalization era. In the pre-globalization era, the blue curve gyrates quite violently whereas the average annualized growth rate of real GDP stayed around +4.0%. The intervals between two adjacent clearly recessionary phases were erratic at best. The longest interval was 10 years, registered between the recessionary phases “2” and “3”. The shortest interval was less than a year, registered between “5” and “6”. The recessionary phase “5” was caused by the Iranian Revolution and the resulting second energy crisis, and the recessionary phase “6” was caused by the draconian effort of The Federal Reserve Board to fight the hyper inflation. The peak of the blue curve between “5” and “6” reached +4.5%, a clearly booming condition. This basic understanding about the different natures of recessions “5” and “6” is consistent with the classification of “5” and “6” as two back-to-back recessions according to our definition, but not as one giant recession. The interval between “1” and “2” was only 3 years, the interval between “3” and “4” was a little more than 4 years, and the interval between “4” and “5” about 6 years. Most of the pre-globalization era recessions were caused by the stop-and-go monetary policy designed to control inflation. Readers interested in the era of stop-and-go policy are referred to Comment 31 for details.

The huge 1983-1984 peak of the blue curve, indicating a very strong economic boom, was the result of two overlapping developments. The first was the euphoria following the slain of hyper inflation dragon. The second was the start of the current (ad hoc) globalization scheme. In the globalization era the blue curve becomes less jumpy and the intervals between two adjacent clearly recessionary phases become very long. The interval between “6” and “7” was about 9 years and the interval between “7” and “8” was 10 years. The interval between “8” and the last data point on the blue curve, the third quarter of 2008, is more than 6 years; the current recession is still an ongoing process and we do not know when the bottom of the blue curve, supposedly will be labeled as “9”, will be reached. Why the recessions in the globalization era behave so differently from their pre-globalization brethren? This topic will be discussed in the next section.

Section 4 : The Role of the Runaway Trade Deficits and the Recessions in the Globalization Era

The current globalization scheme that we call “ad hoc” has been launched into orbit by combined pushes from Reagan administration, prominent economists, big businesses and Wall Street. Administrations after Reagan administration have all followed the footstep of Reagan and steadily expanded the scheme. The essence of the globalization scheme is to lower the barriers that are hindering the flows of capitals and goods across national boundaries. The drastic outcome of this globalization scheme is the runaway US trade deficits. Let us peer into the blue print of the globalization scheme that was sold to the US public initially. Under the plan the production of low end labor intensive consumer goods will be outsourced to developing countries in order to utilize low cost labor resources and free to pollute environments there to lower production costs, and then those products will be exported back to US. The high end technologies and their products will be retained in US due to American ingenuity and the flexibility of American financial and business system so that US can dominate the world as far as eyes can see. Unfortunately things have not worked out as the promoters of the globalization scheme had dreamed. The production of low end consumer goods does have been outsourced to developing places like Taiwan and Hong Kong and then exported back to US. However, it has been the reasonably priced high quality goods produced by highly efficient and disciplined Japanese labor force that have captured the US market. Thus the US trade deficit exploded under the watch of Reagan administration. That was the first phase of runaway US trade deficit, and the overwhelming portion of the trade deficit at that time was the trade deficit with Japan.

Pretty soon merchants in Taiwan moved beyond the manufacturing of inexpensive shoes, toys and garments, and wandered into the labor intensive but high tech areas like assembling radios, TV, computer mother boards, printing of integrated circuits and so on, backed by capitals and know how from Japan. By the end of 1980s products from the tiny Taiwan were everywhere in US retail markets. At the same time labor costs in Taiwan skyrocketed and the awareness of environmental pollution among Taiwan residents heightened substantially. Merchants in Taiwan, thus, wanted to migrate into China to continue their "produce and export to US" process. It was after the pass away of Taiwan’s last authoritative leader, Chiang Ching Kuo who inherited the authoritative regime from his late father Chiang Kai Shek, Taiwan has transformed into a democracy and the flood gate was open for Taiwan merchants to migrate into China. They emigrated to China en masse, bringing along their capitals, factories and know how, and helped enormously to launch China into the “factory of the world”. For example, one Taiwan based company, which employs hundreds of thousands of workers in China and produces lions share of popular goods like iPods(1), iPhones(1), Play-stations(2) and so on, ranks high in the list of top exporters of China. In 2000s China has overtaken Japan as the largest contributor to US trade deficit; in 2007 US trade deficit with China was over 250 billion dollars whereas US trade deficit with Japan was about 83 billion dollars.

Promoters of the current globalization scheme usually boast the scheme as the free market system. However, the most important markets of this scheme, that is, currency markets, are far from free. Governments are allowed to manipulate currency markets at will to suit their own designs. As the consequence, many governments, especially governments in the Pacific Rim like Japan, China, Taiwan and so on, routinely manipulate currency markets to keep their currency low compared to US Dollar so that they can continue their mass exports to US. The inflated Dollar bubble then allows US to run huge trade deficits for a very long time. One direct consequence of the prolonged runaway trade deficits is the suppression of inflation due to the influx of inexpensive foreign made goods. The taming of inflation makes the stop-and-go monetary policy unnecessary, and is contributing to the stability of the blue curve and stretched intervals between recessions. One may think those features mentioned so far are beneficial effects of runaway trade deficits. Why should we worry about trade deficits? The reason is that runaway trade deficits dictate the creation and destruction of economic bubbles as will be discussed in the remaining part of this section.

Any financial system needs to have seed money to function. In the pre-globalization era when trade deficits were not a big factor in the economy, personal savings played the major role of the seed money. The banking system lends out personal savings flowed in as deposits. The money lent out by banks change hands and circulate through the society. In the process of this circulation profits are made and are deposited back into banks. Banks then lend out those new deposits. The repeated deposit and loan cycle thus increases overall amount of loans that some call credits. The amount of loans that can be generated from the initial personal savings deposited in the banks within a year depends on how fast money circulates through the society. When consumers and businesses are upbeat, spending will pick up and the speed of money circulation picks up, too, resulting in expanded amount of loans and credits and an economic boom. When the mood is gloomy, the opposite condition develops. Government has many tools to control this lending-deposit process. Among those tools the reserve requirements, which require banks to put aside certain amount of money when they make loans, is an important tool to make sure that a bubble does not develop from the exploding amount of loans and credits created by the process. The reserve requirement is especially useful for countries where money markets are not well developed. For example, before the burst of the global bubble, China had been continuously raising the reserve requirement in order to check its runaway economic bubble, and now China is lowering its reserve requirement in order to stimulate its economy.

The runaway trade deficits upset the structure of financial system as discussed in the above paragraph since trade deficits play the role of seed money to the financial system, too. If US runs trade deficit, US dollars are handed over to foreign manufacturers. Those foreign manufacturers must convert those dollars generated from US trade deficit into their local currencies in order to continue their operation since US Dollar is not legal tender in foreign lands. Those trade-deficit-generated dollars eventually fall into the hands of large foreign financial entities and foreign governments, and must be reinvested in US to generate some returns. The returning trade-deficit-generated dollars are big block dollars, and will bypass the route of commercial bank deposits, but will be thrown into financial and stock markets directly. If trade-deficit-generated dollars are thrown into US Treasuries and the domestic capitals driven out of Treasury market buy junk bonds issued to take over some public companies, the money will fall into the hands of stock holders of the taken over companies. Those former stock holders then buy up new junk bonds and so on. That was the mechanism how Reagan’s junk bond bubble developed riding on the first phase of runaway US trade deficit. If the initial push from the trade-deficit-generated dollars goes into stock market and bid up stock prices, the money falls into the hands of stock holders that sold the stocks. Those former stock holders then buy another batch of existing stocks or newly issued stocks to boost stock prices higher, and so on. That was the mechanism how Clinton’s stock market bubble had developed riding on the second phase of runaway trade deficit. The mechanism of the development of Bush’s mortgage and housing bubble is as follows: When banks make mortgage loans, they need to put aside certain amount of money as reserve as discussed before. Banks then bundle those mortgages into mortgage backed securities and sell those securities. Once those mortgage backed securities are sold, the holders of those securities own those mortgages but not the banks. Thus banks can take back the reserves put up for the initial batch of mortgage lending, and use the money as the reserve for the next batch of lending. By this way banks can go around the regulatory system and create enormous amount of mortgage loans compared to their limited amount of capitals from which the reserve money must come from. It is also instructive to trace the flow of money when banks make mortgage loans through selling of mortgage backed securities. When the loans are made, the money start to circulate through the society and generates various kinds of profits. However, this time those profits do not need to be deposited back to bank accounts to earn miserable returns, thanks to the proliferation of non-bank financial institutions. For example individuals can trust their money to professional money managers that promise to get higher returns for them, whereas the professional money managers use gathered money to buy higher yielding mortgage backed securities from the banks. Individuals may put money into money market mutual funds to earn higher returns than provided by bank deposits. One way for money market mutual funds to earn higher returns is to buy short-term commercial papers issued by special investment funds that are set up to use money borrowed through the issuance of commercial papers to buy up even higher yielding mortgage backed securities. Thus a cycle for money to flow from banks to the soiety to non-bank financial entities to mortgage backed securities and back to banks, a cycle totally out side of the regulatory authorities, is formed to boost the formation of mortgage and housing bubble. Readers interested to learn more about the role of runaway trade deficits are referred to articles 10, 2A, 2, and 1, listed here in reverse chronological order. Readers interested to learn more about special investment funds designed to hold risky mortgage backed securities and their derivatives, and how the collapse of those special investment funds had triggered the first financial firestorm in August of 2007 are referred to Comments 48, 49, and 50 for details. Readers interested to learn more about the development model used by Taiwan, which we call “Taiwan model” and is followed by other Asian countries including China, are referred to Comment 39 for details.

The impact of the runaway trade deficits on personal savings also should not be overlooked. Since trade deficits play the role of seed money to the financial system, the personal savings become unnecessary for the financial system to operate. Thus consumers can spend more of their earnings to help the bubble created by the runaway trade deficit to grow further. At the beginning of Reagan administration annual US personal savings were at the size of about 8 % of GDP. At the high of the first phase of runaway trade deficit under the watch of Reagan administration, US personal savings had dropped to about 5 % of GDP. At the peak of the second phase of runaway trade deficit under the watch of Clinton administration, annual US personal savings had declined to 2 to 3 % of GDP. At the peak of the third phase of runaway trade deficit under the watch of Bush administration, annual US personal savings literary dropped to zero, even negative in some months.

Wall Street always profits from the bubble generated by the runaway trade deficit since Wall Street is an important engine that drives the circulation of money outside the regulatory system. However, other parties throughout the society benefit from such bubbles, too. Let us take Bush’s mortgage bubble as the example. Wall Street derives profits from underwriting mortgage backed securities and inventing related derivative instruments. Banks profit by issuing more and more mortgages and mortgage backed securities. As the housing prices skyrockets due to the mortgage bubble, many existing home owners use refinancing and home equity loans to convert their paper profits on their houses into real cash and have started to spend like no tomorrow. As the desire to expand the mortgage bubble intensifies among Wall Street and banks, the mortgage lending standards were lowered to attract more and more people to borrow mortgages, and eventually led to now infamous subprime mortgages. However, during the bubble middle income people and lower income people alike praised the bubble that allowed them to own homes the prices of which were way above their income would have allowed them to own. Politicians from right to left were all happy because their patrons from Wall Street to big businesses to middle income to low income folks were all happy. While the whole society was enjoying the party as if celebrating the ever approaching “globalization utopia” of “no work, just spend” as depicted in article 7, the danger of the burst of the bubble has been approaching silently. As US trade deficit exploded, more and more US dollars were pushed out, leading eventually to the devaluation of US Dollar vs. the currencies of its major trading partners. Soon the declining Dollar restrained the growth of US trade deficit. As US trade deficit stagnated and then started to decline, so is the amount of seed money sustaining the bubble. As the bubble deflates, the opposite of ever increasing credits and loans happens, the grand liquidity squeeze sets in and all the highly leveraged parties from home owners, who are not really entitled to own homes so expensive as to beyond their ability to carry the mortgages, to enormously leveraged Wall Street firms and banks all have run into troubles of refinancing their debts so many of them have failed. Readers interest to know more about the meltdown of Wall Street are referred to Comment 59 for more details. In the next section we will go back to the study of hard data in order to see how US trade deficits have entangled with the real economy.

Section 5 : Trade Deficit and the Real Economy, a Data Analysis

Quarterly ratios of inflation adjusted trade deficit over real GDP, expressed in percentages, are plotted as the red curve in the graph (Fig. 2) at the right. The time scale of the red curve is plotted at the bottom of the graph in red letters. When the red curve is in the positive territory, US is running a trade deficit, whereas if the curve is in the negative territory, US is running a trade surplus. The blue curve of the previous graph (Fig. 1), that is, the year-to-year comparison of real GDP, is reproduced in this graph. Again the time scale of the blue curve is plotted at the top of the graph in blue letters, and is shifted by 2 quarters to the left compared to the red time scale at the bottom of the graph. The blue curve represents the condition of the real economy if read by using the red time scale at the bottom of the graph, as explained in detail following the previous graph in Section 2.

Let us start from the pre-globalization period in the graph, that is from 1955 to about 1982. There is a steady run up of the red curve from near 0 % around 1963 - 1964 to +2.0 % by the end of 1972. Most of this run up was due to Vietnam War during which US imported large amounts of war related materials. Out side the war related anomaly, the red curve has the tendency to synchronize with the peaks and valleys of the blue curve, or slightly lagging behind the movement of the blue curve. Even during the period of the war we can still see the trace of such synchronization at the trough labeled as “3” and at the subsequent 1971-1972 peak of the blue curve. Such a dependence is easily explained by the natural consumer behavior, since consumers will buy more foreign made goods in booming years and cut back such purchases when the economic conditions are tough. In general the ratio of US personal savings to GDP was high in the pre-globalization era, and the financial markets outside the regulated commercial banks were still at their infancy so that the trade deficits were not be able to create bubbles by serving as the seed money outside the commercial banking system. Rather it was the real economy that was pulling around the trade deficits, and foreign made consumer goods formed just a supplemental part of US consuming habit.

Starting from the third quarter of 1982 US trade deficit shot up sharply, marking the beginning of the globalization era. The spending habit of US consumers have changed substantially. As low end consumer goods outsourced to developing worlds, high end consumer goods and autos dominated by high quality made-in-Japan products, and luxury goods market controlled by European companies, imports have become the indispensable part of US daily life. Thus trade deficit has started to replace personal savings as the seed money of US financial system and has started to pull the real economy around as discussed in the previous section. The sharp run up of the trade deficit in the span of 1982- 1983 pushed up the blue curve sharply higher, though a portion of the rise of the blue curve during that period was attributable to the euphoria after the slain of the hyper inflation dragon as mentioned before. The bubble created during Reagan era by the first phase of runaway trade deficit was a bubble of junk bonds. Using enormous credits created by the bubble, takeover specialists were able to issue vast amounts of junk bonds backed by the assets of a targeted public company, use the money obtained from the sale of junk bonds to buy up stocks from investors who owned the stocks of the company. By this interesting scheme the corporate raider only needed to risk a very small amount of his own fortune to take over a giant public company worth billions of dollars. Threatened by such corporate raiders many managers of public companies issued junk bonds based on the assets of their own companies, and used the cash from the sales of junk bonds to payoff their own stock holders in order to avoid been swallowed up by corporate raiders; such practices by the managers of public companies are called leveraged buyouts. Would-be corporate raiders silently accumulated big blocks of stocks of a target company, threatened to takeover the company and forced the management of the company to do a leveraged buyout that pushed the stock price of the company sky high, and thus the raiders made huge quick profits. Such wanton practices also profited ordinary stock holders and speculators alike, but at the expense of bond holders of the target company as the financial footing of the target company seriously undermined by taking in huge amounts of new debts through the issuance of junk bonds. Under the fire of the junk bond bubble, stock prices in general rose sharply. From the third quarter of 1982 to the third quarter of 1987, Dow Jones Industrial Average (abbreviated as DJIA) rose about 300 %. The massive amount of credits created by the bubble fueled by the runaway trade deficit enabled savings and loans and commercial banks to borrow heavily in short term, and they in turn used those borrowed money to buy more junk bonds or make risky mortgage loans to fuel a housing bubble.

The massive trade deficit decimated the smoke stack Midwest region, political pressure mounted and finally Reagan administration was forced to rein in imports from Japan. In the Plaza accord of early 1985 US and Japan agreed to devaluate US Dollar vs. Japanese Yen by almost 100 %, whereas Japan agreed to relax its monetary policy to spur its domestic consumption under US pressure, resulting in the now infamous Japanese bubble of late 1980s. With the usual time lag of about 2 years, the massive devaluation of Dollar had forced US trade deficit to turn the corner in late 1986. The waning US trade deficit means less seed money for the junk bond bubble and less corporate raiding and leveraged buyouts. The sea change finally hit the stock market and caused the sudden crash of stock prices in October of 1987. US economy did not succumbed to the crash of stock markets due to the revived exports to Japan from US manufacturers. The game of outsourcing was still young at that time. US manufacturers were down during the first phase of runaway trade deficit but not out. Helped by the devalued Dollar and the bubble in Japan, they were able to carry US economy through 1988. By 1989 Japan's bubble started to deflate, and the momentum of US manufacturers had started to wane, too. Also the companies saddled with junk bonds and weakened financially had started to fall one by one due to the liquidity squeeze caused by the deflating bubble as US trade deficits continued to fall, as the red curve in the graph (Fig. 2) shows. The failure of junk bonds thus pulled down savings and loans and banks that bought large sums of junk bonds. The liquidity squeeze also decimated those that made risky mortgage loans and caused wide spread failures as the housing bubble burst. Thus US economy plunged into the 1990-1991 recession, marked as “7” on the blue curve in the graph. US Government was forced to spend about 250 billion dollars to buy up failed assets of savings and loans. The backers of that bailout usually boasts that US Government has recouped all those 250 billion dollars eventually, but they fail to tell US general public that US Government was able to do so thanks to even higher trade deficits and even larger bubbles developed later on.

After the clean up of the mess left behind from the burst of Reagan bubble, the Federal Reserve Board lowered the short-term interest rate sharply in 1991 and kept the short-term interest rate at low level for a few more years. At that time US trade deficit had hit a nadir as the red curve in the graph shows so that trade deficit had stopped to be a major factor in the US economy. Under those conditions US economy had started to recover. However, this recovery started to lose momentum in 1994 as the blue curve indicates. During that period US trade deficit to GDP ration was well below +2.0 % so trade deficits did not play a major role in US economy. The 1994-1995 slow down of the growth rate of GDP was the result of natural economic cycle and had nothing to do with any bubble generated by trade deficits. On the other hand Japan had been suffering a low growth rate like 2 to 3 % a year after the burst of its infamous bubble of late 1980s. The low US trade deficit also meant that Japan could not count on exports to pull its economy up. As US economy recovered, US trade deficit had started to inch up from its nadir. However, the nightmarish memory of the runaway US trade deficit during Reagan era came back and the currency market bid Dollar sharply lower until it reached about 80 Yen/Dollar. The sharply lower Dollar in couple with the 1994-1995 US economic slowdown must have really scared the bureaucrats of Japan's Ministry of Finance, that was known for their mercantilistic attitudes, from the fear that Japan's exports may suffer. They forced Bank of Japan, under their tight control at that time, to take a huge gamble by lowering interest rates in Japan to near zero level. This radical move of Japan unleashed huge waves of yen-carry trades and pushed US Dollar sharply higher vs. Japanese Yen. In a short while the high flying Dollar made US trade deficit explode and thus the second phase of runaway trade deficits had opened. Yen-carry trades are for non-Japanese hedge funds to borrow Japanese Yen at near zero interest rate, dump those Yen for Dollar and invest those dollars in higher yielding Dollar denominated debt instruments or throw those dollars directly into US stock markets.

The period from 1995 to 2000 overlaps with the dawn of the internet age. People were euphoric about high tech stocks. The waves of yen-carry trade money followed by the money from the runaway trade deficit flooded into stock markets, and naturally inflated a giant stock market bubble. The painful memory of the burst of Reagan's junk bond bubble and the housing bubble was still vivid so that the money went into stocks instead of junk bonds and housings. Even DJIA, composed of 30 large capitalization stocks most of which are not high tech, rose about 300 % in 5 years. Looking back, some insiders probably had advance knowledge of the pending radical move of Bank of Japan, and had bid up US stocks 6 months before Japan's announcement of the near zero interest rate policy.

The near zero interest rate policy of Japan ironically has pushed Japan into the consumer led “L” shaped recession the end of which is still not in sight even today. Japanese consumers save a huge amount and rely on interest income from those savings to finance their retirement life; average Japanese workers are forced to retire at age 55. Near zero interest rate policy has forced Japanese consumers to cut back on spending and save more so they will have enough money for their retirement. This means an immediate domestic slow down, less income, more cut back of consumption, and so on. This vicious cycle thus pushed Japan into the never ending recession. The sharply depreciating Yen vs. Dollar shrank the yen denominated asset base of Japanese banks with an alarming rate, and the international money market started to demand higher interest rates, called “Japan premium” on the borrowings of Japanese banks. Highly leveraged banks like Japanese banks are very sensitive to added interest rate burden. Thus Japanese banks, which were saddled already with large sums of nonperforming loans made during the bubbling years of late 1980s, were hit from all directions. The last straw that broke the back of Japanese banking system was the Asian financial firestorm of 1996. Many small Asian countries have adopted “Taiwan model” of producing low cost consumer goods to be exported to US, the developing model used by Taiwan in 1970s and 1980s to climb up the economic ladder. However, following the advice of US economists based on some dubious reasons, those countries pegged their currencies staunchly to US Dollar. As Japan's near zero interest rate policy unleashed the tsunami of yen-carry trades and pushed up Dollar sharply vs. Yen, the currencies of those Asian countries went along with Dollar up. As the consequence those countries quickly lost all the competitive powers in their products. Those countries started to run trade deficits instead of trade surplus, and relied on the inflow of capitals form foolish hedge funds and enjoyed short lived booms. Those hedge funds were dazzled by the high yielding bonds issued by those Asian governments and believed that the peg of their currencies to US Dollar backed by US economists was the gold instead of the golden rule of investment that higher yields always mean higher risks. As one of such hedge funds discovered the silly condition it was in and started to run toward the exit, all other hedge funds followed and thus triggered the chain reaction of currency and financial crises of Asia. When this financial firestorm reached South Korea the entities of which had borrowed heavily from Japanese banks, Japanese banking system received the final blow and started to collapse. Japanese Government poured huge amount of money into the banking system to bail the failing banks out. However, Japanese Government's efforts only made Japan to avoid a spectacular collapse, but was not able to jump-start the credit creation cycle since Japanese banks have been fighting for their survival by steadily reducing their leverages. The Government money poured into the system has been parked idly in treasury debt instruments for their safety. The phenomenon that the wheel of credit creation does not turn and the economy just stand still in spite of massive influx of Government money is called “Japan Syndrome” in this website. Those interested to learn about the “Japan Syndrome” that is engulfing US at present are referred to Comment 60 for more details. It should be noted that in order to fight the crisis Japanese Government have poured astronomical amount of money into infrastructure constructions. Eventually the places to build roads and bridges were exhausted, and Japan started to pave even river beds, but all those government sponsored efforts have not be able to revive its economy.

During the play-out of the drama of near zero interest rates in Japan, Clinton administration enjoyed the prosperity and political popularity brought on by the second phase of runaway trade deficit based on the skyrocketing US Dollar, thanks to the tsunami of yen-carry trades. It used the catch phrase of “strong dollar policy” to cover the truth from general public and from themselves. However, when the shock wave started from Asian currency and financial crises finally reached Russia in 1998, Clinton administration was forced to consult with Japanese Government to jointly engineer a turn around of the exchange rate between US Dollar and Japanese Yen. At that time a large hedge fund had borrowed a large sum of money and then loaded up with Russian Government's bonds in hope of reaping huge profits from the high yielding Russian bonds while sleep on the safety of the peg of Russian Ruble to US Dollar as suggested by US economists. As Russian Ruble collapsed, the hedge fund was pushed to the edge of destruction, too. From the fear that the collapse of the hedge fund would bring down the whole global financial system, The Federal Reserve Board forced large Wall Street firms and banks to bail out the hedge fund. With that news supposed gradual turning around of Yen-Dollar exchange rate turned into a rout. Dollar fell from the pinnacle of 147 Yen/Dollar to 114 Yen/Dollar quickly. When the shock wave reached Latin America in 1999, Dollar tumbled further to near 100 Yen/Dollar. The falling Dollar then reined in US trade deficit, the Clinton stock market bubble burst and the economy entered into the recession marked as “8” in the graph. The details about the near zero interest rate policy of Japan and its impacts are analyzed in article 1 of Dec. 1, 1998. In that same article the burst of Clinton bubble was predicted precisely at the middle of 2000, based on the recognition of the dominant role of runaway trade deficits in the creation and the destruction of bubbles, and the time lag required for a major change of currency exchange rate to influence trade balances.

US trade deficit merely stagnated from 1999 to 2001. One may ask why just such a stagnation of trade deficit had tremendous effect of bursting the mighty stock market bubble. The answer lies in the extremely leveraged nature of stock markets. Suppose XYZ company has 5 billion shares of common stocks outstanding, and the stock is traded at $100 per share. Suppose 10,000 shares of excess buy order at market has pushed up the stock price by just 1 cents. This case means that there was an excess of 1 million dollars wanted to buy XYZ stocks, but the capitalization of XYZ company rose by 50 million dollars, a 50 times of leverage. When the influx of seed money stagnates, the capitalization of the company can tumble as easily as it rises, creating a huge panic that feeds on itself and causes the cascade down of stock prices.

As the ratio of trade deficit to GDP, the red curve in the graph, started to stagnate and US economy started to fall into a recession, currency market sighed a relief and started to lift Dollar from the start of 2000. By that time, China has been emerging as the power house in the picture of US trade deficit. Since Chinese Yuan had been pegged to US Dollar, US trade deficit with China was not influenced by the Yen-Dollar exchange rate so that US trade deficit with China moved up steadily. Thus as early as 2001 the third phase of runaway trade deficit had started, and US economy was lifted out of the recession accordingly. The massive imports, especially inexpensive goods from China, held down inflation rate and created an illusion that US may sank into deflation. From the fear of deflation The Federal Reserve Board lowered interest rate aggressively to 1 % by 2003. The low short-term interest rate stimulated housing market, and the seed money from the runaway trade deficit was induced to move into mortgage market and eventually created the giant mortgage bubble. In the mean while very low interest rate in US caused the unwinding of yen-carry trades and as the result Dollar tumbled again from about 135 Yen/Dollar level of early 2002 toward 107 Yen/Dollar level by the end of 2003. The rapid fall of Dollar vs. Yen forced Japanese Government to step in and bought up nearly 400 billion dollars during the stretch from the middle of 2003 to the spring of 2004. However, this massive dollar buying operation was only able to lift Dollar up to 114 Yen/Dollar. At that time criticism within Japan had emerged, in a very strange fashion (please see article 8 for the event) against the massive dollar buying operation. As Japanese Government abandoned the dollar buying operation, Dollar started to drift toward 100 Yen/Dollar line again as the end of 2004 approached. Without the help from Japan, the job to defend Dollar fell squarely on the shoulder of The Federal Reserve Board, and it had started to raise short-term interest rates since the end of 2004, and eventually raised it to above 5% by 2006. The dip of Dollar in the stretch of 2003-2004 curbed the rise of trade deficit and the red curve in the graph started to level off from the end of 2004 in spite of steadily growing trade deficit with China that was not affected very much by the movement of Yen vs. Dollar. The raising of short-term interest rate in US had failed to force long-term interest rates to rise for quite a while, creating so called “interest rate conundrum” as discussed in Comment 17 and Comment 21. Also the persistence of China to use its huge foreign currency reserve to buy massive amount of papers issued by Fannie Mae had helped to restraint the rise of long-term interest rates and prolonged the life of the mortgage bubble.

By 2005 the political pressure against the ever escalating trade deficit with China rose to the level that could not be ignored by Bush administration any more, so US pressured China to abandon the peg of Yuan to US Dollar. From the middle of 2005 China has started to allow Yuan to drift higher vs. US Dollar gradually. As the consequence the growth rate of US trade deficit with China has markedly slowed down starting from 2007, contributing to the sharp drop of the red curve in 2007 and beyond. The gentle turn around of the red curve in 2005 has ignited the grand liquidity squeeze. The gradual liquidity squeeze finally turned into a rout starting from 2007 as the red curve plunged, triggering financial firestorm after financial firestorms as discussed in the series of Comments titled “Tracing the liquidity squeeze”. With the melt down of Wall Street in September of 2008, The Federal Reserve Board and US Treasury Department have switched into the panic mode, and have started to push out unlimited amount of money into the financial market hoping to replace the disappearing liquidity due to the collapsing cycle of money circulation and credit creation outside the regulated commercial banking system. This is where US economy stands today.

Section 6. Concluding Discussions

Many hope that the massive bail out undertaken in the late days of Bush administration and the massive stimulus packages proposed by the new administration will play the magic like The New Deal played on The Great Depression. Any vibrant economy, like the rising US economy after The World War I, will bounce back when it hits a bottom. US economy during The Great Depression hit the bottom by 1933. Whether the bounce from 1934 to 1937 was due to The New Deal or to the natural bounce back mechanism is still debatable, since by 1938 US economy had fallen into a sharp slump again in spite of continued support from The New Deal. Only the start of the European War in 1939 and World War II in 1940 changed the economic landscape completely. Another example is the experience of Japan in 1990s and beyond as discussed in the previous section. At the middle of 1990s Japan's economy was bad but far away from the bottom of a nadir. The massive bailouts and stimulus packages of Japanese Government prevented the all out collapse of Japanese economy, but have failed to engineer a bounce back. It only replaced a collapse with a “L” shaped recession the end of which is still not in sight. There is a high chance that the current strategy of US, massive bailouts and stimulus, will create a “L” shaped recession just like the case of Japan. From such desperations we hear voices in recent days wanting to resurrect the catch phrase of “strong dollar policy”. We should know that the phrase of “strong dollar policy” is nothing but a disguise of wanting to make Dollar inflated artificially from the currency market manipulations in the hands of foreign governments, and create the fourth phase of runaway US trade deficit accompanied by another giant bubble of borrowing and spending in US to pull the whole global economy out of this pain. However, the graph of the previous section, Fig. 2, is pointing out the serious fault of this strategy. As the red curve rises steadily higher in each phase of runaway trade deficits, the resulting economic growth rate represented by the blue curve has become actually weaker. If we want to use another phase of runaway trade deficit to bail US and the global economy out, the red curve needs to rise much higher than the 2005 peak and a bubble substantially larger than the Bush bubble will be generated. When that even greater bubble bursts, we should be prepared to see the super power called USA will plunge into an abyss with no way of return.


1. iPods and iPhones are trade marks of Apple Computer.
2. Play-station is a trade mark of SONY.