HOW THE DOLLAR AND TRADE DEFICIT CRISIS
                                WOULD HAVE EMERGED UNDER GOLD STANDARD
 

                                                                                        by

                                                                              Chih  Kwan  Chen
                                                                                 (Jan. 24 , 2004)
 
 

                                                                                     Abstract

                                      It is shown that under a gold standard scheme the same Dollar and trade deficit
                                      crisis as we are in today could have developed. This exercise dispels the
                                      misunderstanding that the current Dollar and trade deficit crisis is due to the lack of
                                      gold standard. Due to the simplicity of gold standard this exercise also shows the true
                                      nature of the crisis which otherwise may be obscured by the complexity of modern
                                      monetary system. The transfer of the purchasing power and the living standard from
                                      the trade surplus country, which starts the crisis by its mercantilistic instinct, to the trade
                                      deficit country is computed explicitly and the final course of the crisis is discussed.
 

1. Introduction

       The current Dollar and trade-imbalance crisis of the world is due to the liberalization of merchandise trade on one hand,
whereas nations are allowed to freely manipulate the value of their currencies to distort the flow of  merchandise. The rising gold price is a simple reflection of this crisis. However, there are some who misunderstand this crisis as caused by the lack of gold standard and misinterpret the rising gold price as the market inkling to return to gold standard. In this article we will first show that under a gold standard scheme, exactly the same Dollar and trade-imbalance crisis can emerge, thus dispel this misunderstanding. In Section 3 we will make the gold standard scheme under consideration more quantitative so that we can calculate explicitly to show that as the crisis developes, it is the purchasing power and living standard of the trade surplus nation that will be transfered to the trade deficit nation. This implies that the nation which has started the "competitive devaluation" is actually the economic loser and the trade deficit nation is the benefactor. The underlining mechanism of the crisis in this simple gold standard scheme is not very much different from the real world of modern monetary system, and this exercise helps us to understand why the mercantilistic Japan, whose only economic policy seems to be the competitive devaluation of Yen against Dollar, has assigned herself into the spiral of prolonged recession and deflation, whereas the huge trade deficit country, USA, is doing economically so well. The last section of this article is devoted to the study of whether this crisis may end or can sustain itself indefinitely.
 

2. The Developement of a Trade Imbalance Crisis under a Gold Standard Scheme

       Let us assume that the whole world consists of two nations which have same size of land and population, have same amount of gold, and both of them do not have any military force. We also assume that populations and amount of gold are fixed. The two nations are both under gold standard so their currencies are 100% convertable to gold. Furthermore, to simplify the matter, two nations are assumed to have exactly similar industrial and agriculture bases, same kind of natural resources, and both nations do not use any checking, saving and any kind of banking accounts; in other words every transcations are done by cash and their money supplies consist of cash only. Therefore, two nations are exact twins except one is called "USA" with a currency called "Dollar", and the other is called "Japan" with a currency called "Yen". Now suppose the rates of exchange to gold for both "Dollar" and "Yen" are such that one "Dollar" equals one gram of gold, and one "Yen" also equals one gram of gold; at this exchange rate let us assume that the cost of production of everything in "USA" and in "Japan" are the same. This condition is called a "steady state" here. In this "steady state" trade between "USA" and "Japan" is not feasible. Suppose someone transport a Japanese product to "USA". The breakeven sales price of the product in "USA" must equal to its production cost in Japan plus the transportation cost, and it will always be higher than the price of the same product made in "USA" since the production costs of the product in "Japan" and in "USA" are the same under the exchange rate of one "Yen" equals one "Dollar". Thus in this steady state, each nation just keeps going by itself without the need of any trade with the other party.

       Now suppose a "mercantilist" party comes into power in "Japan".  The platform of mercantilists is to equate the richness of a nation to the amount of gold it holds, and the "mercantilist" party wants to increase the wealth of "Japan", that is, to increase continuously the amount of gold it holds. However, in this ficticious world, the amount of gold is fixed, so the only way to increase the gold holding of "Japan" is to get it from "USA". In the steady state there is no military force for both nations, so "Japan" can not invade "USA" to rob its gold. The mercantilist government in "Japan" comes up with a plan which it think is very smart. The plan first calls "Japan" to unilaterally devaluate "Yen" such that instead of one "Yen" equals one gram of gold, they can set one "Yen" equals to, for example, only 0.9 gram of gold; this devaluation of "Yen" will make the cost of production of goods in "Japan" lower than that of "USA",  at least initially. Whether this lower cost of production of "Japan" can be maintained or not depends on whether inflation will set in after the devaluation. The topic of inflation after devaluation will be discussed in detail in the next section. Here we assume that there will be no inflation after devaluation so lower production cost of  "Japanese" goods will be maintained, and exports from "Japan" to "USA" become feasible. As "Japan" exports to "USA", "Japan" will receive gold and will increase its gold holding. However, such a plan will not succeed since the market will adjust and quickly cancels out all the "Japanese" cost advantage from the devaluation of "Yen". The market mechanism works as follows: As "USA" imports from "Japan", it must pay the imports from "Japan" with gold. The gold holding of "USA" will drop and its "Dollar" holding increases as "USA" citizens convert "Dollar" to gold to buy "Japanese" imports. This will reduce the amount of "Dollar" in circulation in "USA". With fewer money chasing same or larger amount of goods, deflation in "USA" will occure, the production cost of "USA" made goods will decrease to the degree to match the production cost of "Japanese" made goods and exports from "Japan" will stop. To circumvent this build-in safeguard mechanism of gold standard, the plan of mercantilist "Japanese" Government calls for an agreement with "USA" to continuously borrow gold from "Japan" to make its gold holding steady, and continuously return the "Dollars" that are tendered by "USA" consumers in the process of paying for the imports from "Japan", to "USA" citizens in the form of government loans or as entitle programs. In return for loaning the gold to "USA" Government, "Japanese" Government will get debt instruments issued by the government of "USA" which promises that the holder of the instrument can use it, at an unspecified future time,  to buy real assets of "USA". If debt instruments are so exercised, "USA" Government must pay the seller of the real assests with "Dollar". If "USA" Government does not have the required amount of "Dollar", it then can use its taxing power to get it from its citizens. We must note that this taxing mechanism will not reduce the amount of "Dollar" in circulation since the taxed away "Dollars" will  be handed over immediately to the sellers of the real assets and be reinjected into the "USA" society.  The clever "USA" Government considers the offer and accepts the scheme. Thus the era of trade imbalance dawns.

       Some may think that there is a simpler scheme than the one outlined above to achieve the goal of the mercantilist "Japanese" Government, that is, simply for "USA" to prohibit the export of any gold or "Dollar" so that the amount of gold within "USA" will not change. Let us study this proposal and we will show that the simpler scheme is actually similar to the one outlined above, but with some disadvantages. Under the simpler scheme, a Japanese exporter will receive either gold or "Dollar" for his exported goods, but he has no means to repartriate the proceeds of his sales back to "Japan". Thus he will not be able to use his profits nor be able to reuse his capital went into producing the goods back in "Japan". Certainly no sane merchant will export anything from "Japan" to "USA" under such a condition, and the scheme of mercantilist "Japanese" Government will be destined to fail. Only way out of this dilemma is for "Japanese" Government to buy up the gold or "Dollar" from the exporter. Now suppose "Japanese" Government buys up the gold. However, "Japanese" Government also can not export gold back to "Japan", and it must store them in a warehouse physically located in "USA". As the holding of gold of "Japanese" Government, stored in "USA", increases, the holding of gold of "USA" Government decreases, but "USA" Government will hold more and more "Dollars" which are tendered by "USA" citizens to redeem gold in order to pay "Japanese" exporters. Through this process the amount of "Dollar" circulating in the society of "USA" will be reduced steadily and deflation will set in in "USA"; the prices of "USA" made goods will drop quickly until the export of "Japanese" goods become impossible. To hold "Dollar" instead of gold for "Japanese" Government will introduce exactly the same kind of deflationary effect in "USA" as discussed here and will self-defeat the design of mercantilist "Japanese" Government. The way to resolve this dilemma is for "Japanese" Government to use aquired gold or "Dollar" to buy up real assets hold by the private sector of "USA" and reinject the "Dollar" back to the "USA" society. Thus the amount of "Dollar" in circulation and the amount of gold held by "USA" Government will be constant, and will allow the export from "Japan" to continue. Therefore, the outcome of this so called simpler scheme is the same as the one with the instrument of debt ; the latter has a definite advantage over the simpler scheme, that is,  to save Japanese Government the embarassement of the need to purchase the real assets of "USA" continuously.

       The discussion here also illustrates that the debt instruments held by Japanese Government are not worthless papers; they are equivalent to the real assets of "USA". Though it is not possible for "Japan" to increase the holding of gold located physically in "Japan", the government can claim the real asset equivalent accumulated in "USA" as equals to gold, and thus in the book of accounting of mercantilists,  "Japanese" wealth will steadily increase. Does this mean that Japanese citizens will live richer life and the living standard in "USA" will drop? The detailed study in the next section will show that the result is exactly opposite to this naiive thinking; the fact is that the consumption power and living standard will be transfered from "Japan" to "USA" as the result of this foolish scheme of "Japanese" mercantilist government.
 

3. Transfer of Purchasing Power from "Japan" to "USA"

       In order to study further the fictitious gold standard scheme and the plan agreed upon between the mercantilist "Japanese" Government and "USA" Government to induce a continuous trade imbalance, we need to assign explicit numerical values to the economies of "Japan" and "USA". We start by assuming that each of "Japan" and "USA" has 1 trillion grams of gold such that there will be 1 trillion "Yens" and 1 trillion "Dollars" circulating in "Japan" and "USA" respectively. We will take "Japan" as the example to study its economy in the "steady state", that is, before the devaluation of "Yen", though exactly the same argument will apply to "USA" if we replace the words "Japan" by "USA" and "Yen" by "Dollar" in the next paragraph.

       We must understand that even under gold standard, we need to talk about Gross Domestic Product (abbreviated as GDP), purchasing power, inflation and deflation. We simplify the picture by assuming that GDP only consists of the components of "final sales" (also is called "personal consumption"), imports and exports, and government spending; all other items like fixed investments and inventory are ignored. Let us assume that "Japan" produces 500 billion "Yens" of goods from its factories every year. When those 500 billion "Yen" worth of goods go through the retail channel, values will be added and finally sold to consumers for 5 trillion "Yens"; in other words every "Yen" worth of good from a factory will increase its value 10 times when is finally sold to a consumer.  This means that "final sales" of "Japan" is 5 trillion "Yens". We must note here that the numbers like 1 trillion "Yens" in circulation, 500 billion "Yens" of outputs from "Japanese" factories and 5 trillion "Yens" of final sales are arbitrarily assigned; readers can substitute them with any other numbers of their choice, but be aware that subsequent calculations will all change if those numbers are altered though the implications of the whole article will stay the same. Since in the "steady state" there is no imports and exports as discussed in the previous section and we assume that there is no government spending in the steady state, nominal GDP of "Japan" in the "steady state" is also 5 trillion "Yens" a year. We can also look at the picture from "purchasing power" side, and it will reveal the relations among GDP, money supply, and inflation and deflation. Purchasing power is defined as the result of multiplying total amount of money in circulation(money supply) by the "velocity" of money. The "velocity" of money is measured as follows: We tag a "Yen"  and observe how it circulates in the society. The time span between the time when this tagged "Yen" is used to pay for a final stage consumer good and the next time when the same "Yen" is used to pay for another consumer good is called "the time of circulation" of the "Yen". If we tag each "Yen" in circulation, we will get an average time of circulation, measured by days. The velocity of  money in "Japan" is obtained by dividing 365 days by the average time of circulation; it is measuring how many times in average a "Yen" turns over in a year to be used to purchase final consumerable goods. In the steady state we assume that the price level is stable, that is, inflation rate is zero. This implies that final sales equals the purchasing power. Since final sales is 5 trillion "Yens" here, so is the purchasing power. With money supply equals to 1 trillion "Yens", the velocity of "Yen" must be 5, meaning that an average "Yen" turns over 5 times in a year to be used to purchase final stage consumer goods. Now suppose by some reason "Japanese" consumers suddenly become very pessimistic about the future and start to rein in their spending. This will cause the turn over rate of "Yen", that is, the velocity of "Yen" to plunge below 5. This in turn will creat an excess of final consumer goods for a lessening purchasing power, and the average price of consumer goods must come down so that final sales can meet the purchasing power; this phenomenon is called "deflation". On the other hand, if "Japanese" consumers become very enthusiastic in spending and boost the velocity above 5, resulting in the increase in purchasing power, then the prices of final stage consumer goods must rise and cause "inflation" in the society. Inflation and deflation can also occure when the amount of output from factories are altered or there is some disruption within the retail channel to decrease the availability of final stage consumer goods, whereas the purchasing power is steady. Thus even under gold standard, both inflation and deflation are possible, though we are assuming that in the steady state under consideration, inflation rate is zero. This means that the real GDP of "Japan" equals its nominal GDP, that is 5 trillion "Yens" a year in the steady state.

       Now let us proceed to the plan designed by the mecantilist "Japanese" Government. Since "Japan" exports and "USA" imports in this phase, the economic conditions of two nations will be vastly different. Here, we consider the case of "Japan" first. We assume that as the result of devaluation of "Yen", from 1 "Yen" = 1 gram of gold to 1 "Yen" = 0.9 gram of gold, 20% of the products  from "Japanese" factories, that is, 100 billion "Yen" worth of goods a year are exported to "USA". Whether this flow of exports can continue or not depends on the inflation or no inflation in "Japan" after the devaluation. Since only 400 billion "Yen" worth of goods from "Japanese" factories will enter the retail channel of "Japan" in this new phase after the devaluation, the goods available for the final sales to consumers will only worth 4.0 trillion "Yens". If  the purchasing power of "Japanese" consumers stay the same as in the steady state, that is, 5 trillion "Yens", then more money chasing less goods, inflation will start to nullify the cost advantage of "Japanese" product over "USA" product, and trade between "Japan" and "USA" will stop quickly. If "Japanese" consumers, realizing the downsizing of their economy and worrying about the groomy prospect of their job security, start to save, for example, 200 billion "Yens" a year by stacking the money under their matresses, then "Yen" in circulation will be cut down to 800 billion "Yens". With turn over rate still at 5 times a year, the purchasing power of "Japanese" consumers will be 4.0 trillion "Yens" a year, which just balances with the amount of goods for sale at the final stage. Thus in this case no inflation will occure, and "Japanese" economy enters a new, but shrinked, steady phase. This no inflation case can also be achieved by "Japanese" consumers cutting back their spending in stead of saving 200 billion "Yens"; in that case the turn over rate of "Yen" will be reduced, say to 4 times a year instead of 5, then the purchasing power will be 4 x 1 trillion "Yens" (money supply) = 4 trillion "Yens", and will balance with the supply of final stage consumer goods. If the panick among "Japanese" consumers is stronger than the no-inflation case, and they save more than 200 billion "Yens" or the turn over rate of "Yen" goes below 4 times a year, the purchasing power will be less than available goods and a typical deflation will start. In the case of deflation, the cost of "Japanese" product will sink below the design of "Japanese" Government's devaluation plan, and more than 20% of "Japanese" factory outputs will be exported. This expanded exports means that even less goods will go through the retail channel in "Japan", more panick and more saving or more cut back of spending, more deflation, more exports and less nominal GDP, and so on into the death spiral of deflation and continously shrinking nominal GDP. Here, for simplicity we stick to the case of no inflation and no deflation. In this new steady phase, "Japan" loses final sales, or purchasing power of 1.0 trillion "Yens" a year compared to the original steady phase before the devaluation, but in the book of accounting, it is increasing its gold holding equivalent by 100 billion "Yens" a year, that is, 100 billion "Yens" worth of debt instruments that is equivalent to real assets of "USA" which "Japanese" consumers can not use. Finally we need to consider the flow of gold and "Yen" under this senario. When "Japanese" exporters bring back gold from "USA", they need to tender them to "Japanese" Government for "Yen" which they can spend. "Japanese" Government then loan those gold received from exporters back to Governemtn of "USA". Since all the "Yens" are in circulation, "Japanese" Government needs to tax its citizens for the "Yen" to pay for the tendered gold from exporters. However, since exporters are also in the private sector of "Japan", the amount of "Yens" in circulation will not change and this taxing mechanism does not comprise as government spending, so we can ignore this flow prcedure in our consideration of "Japanese" economy.

       For the side of "USA", there are a rosy senario and a pessimistic senario. The rosy senario goes as follows: As imports from "Japan", 90 billion "Dollars" (Note:100 billion "Yens" = 90 billion "Dollars" here) of them,  flows in, either no competing "USA" products will be replaced ("USA" consumers may simply absorb all the products made in "Japan" and in "USA"), or even the competing "USA" products are replaced, displaced workers and capital will go quickly into other existing or newly invented sectors to make up the lost production. In that rosy senario, the goods going into the retail channel of "USA" will be 590 billion "Dollars" a year and the final sales will be 10 times of that, i.e. 5.90 trillion "Dollars" a year. As discussed in the previous section, "USA" Government must continuously spend to release the tendered "Dollar" back to the society to keep the amount of "Dollar" in circulation constant, and the amount of government spending should be equal to the amount of gold it borrows from :Japanese" Government. Therefore, "USA" GDP will be 5.90 - 0.09(imports) + 0.09(government spending) = 5.90 trillion "Dollars" a year. That is 0.9 trillion "Dollars" of increase in "USA" GDP thanks to the generocity of mercantilist "Japanese" Government. If looked from the money supply side, "USA" consumers simply quickened the turn over rate of money from 5 times a year to 5.9 times a year. No matter how to look at it, an economic boom has befallen on "USA". The pessimistic senario is as follows: The 90 billion "Dollars" of "Japanese" imports replaces 90 billion "Dollars" worth of "USA" products, and displaced "USA" workers and capital for those lost 90 billion "Dollars" become idle, that is, can not be redeployed into any new production. In this case "USA" GDP will be
5.00 - 0.09(import) + 0.09(government spending) = 5.0trillion "Dollars" a year, which is the same as the GDP of the original "steady state" before the devaluation of "Yen". The reality probably lies somewhere between  the rosy and the pessimistic senarios. If we take the middle of the two senarios, "USA" will still enjoy a boost of 0.45 trillion "Dollars" a year in its GDP compared to the "steady state" before the devaluation of "Yen". From this discussion, it should be clear why we have called "USA" Government "clever".

       It should be noted that for the whole world the overall purchasing power is eroded by 1 trillion "Yens - 0.45 trillion "Dollars" = 0.45 trillion "Dollars" a year as the result of this scheme.
 

4. How the Crisis Will end or Can it run Forever?

       Before we answer the question posed in the subtitle of this section, let us study what is the outcome if the scheme to induce trade imbalance is terminated. The termination of the plan will occure either "Japan" upwardly revaluates its "Yen" back to 1 "Yen" = 1 gram of gold, or "USA" devaluates "Dollar" to 1 "Dollor" = 0.9 gram of gold. Apparently the trade between "Japan" and "USA" will stop and both nations will go back to their original "steady state"; that means "USA" will lose 0.45 trillion "Dollars" a year in its GDP, and "Japan" regains 1.0 trillion "Yens" in its GDP.

       Under the simpler plan discussed in Section 2, which requires "Japanese" Government to continuously buy up real assets of "USA" in stead of receiving debt instruments, the plan can go to the point when "Japanese" Government holds every bit of real asset of "USA". Then the plan must terminate and the situation goes back to the original "steady state". However, in the scheme of issuance of debt instruments by "USA" Government, even when the total amount of debt instruments in the hands of "Japanese" Government becomes equal to the total value of real assets of "USA", "Japanese" Government can use creative accounting to book the newly issued debt instruments, which in reality do not have any intrinsic value any more, as still equivalent to gold and make the wealth of "Japan" appear to continue to grow. If "Japanese" citizens let their mercantilist government get away with this kind of deception, then this foolish scheme of the mercantilist "Japanese" Government can go on indefinetely to the joy of "USA" consumers.