Comment 18: Is America sinking into an abyss or climbing toward a paradise? (April 6, 2005)

Some analysts believe that the United States of America (abbreviated as America) is treading a dangerous path by running "twin deficits"--the government budget deficit and the trade deficit. We have maintained that the trade deficit is the bane of America but the government budget deficit has only a secondary importance to the health of American economy. The natural result of relentless expansion of the trade deficit is the steady growth of the gap between domestic demand of credits from the government and the private sector combined and the credits available from domestic savings; the exploding gap is filled by the exploding trade deficit that is nothing but the borrowings from foreigners. We believe that America is already on the road of no return toward an eventual economic crash due to its wanton addiction to the expansion of the trade deficit. The crash of the American economy will bring down the economies of many other countries, large and small, and will mark the end of globalization, as we know it. However, there are opposing views. The commentary by David Malpase titled "Running on Empty?", published in the Wall Street Journal (March 29, 2005, page A16) is a typical example of such views. The author claims that the domestic savings rate is meaningless. His magic number to gauge the health of American economy is the net asset value of America. Most of that consists the home owners' equity in residential houses and the value of stocks held in the hands of American citizens. According to the tabulation of the Federal Reserve Board, this magic number has reached a new peak of about 65 trillion dollars and is growing rapidly. Since the magic number of America is growing much faster than the magic numbers of Europe and the Asian Pacific Rim countries as a whole, the author declares that the American economy will overwhelm all the other economic entities in the world soon, and thus America is ascending to an economic paradise. The purpose of this comment is to analyze Malpase's view and show that the so-called "magic number" is artificially adjustable so that it does not have any relevance to the health of a real economy. The thing to watch is still the trade deficit that will lead the American economy into a black hole.

We start our analysis by considering the following mathematical game:

Let us consider a subdivision that consists of 100 similar houses. We assume that each household has four members and an annual income of $100,000. The market value of each house is $300,000. For the sake of simplicity, we also assume that not a single household has any mortgage on its house outstanding. The total homeowner's equities for the whole subdivision is thus $300,000 x 100 = 30 million dollars.

Now suppose 10 households want to sell their houses and move away. An economic wizard among the remaining 90 households fears that the sell of 10 houses in a not so robust housing market may depress the market value of each house in the subdivision and thus reduce the total homeowners' equity of the subdivision; if the fear of the wizard should become the reality, the magic number tabulated by the Federal Reserve Board will naturally be reduced accordingly. The wizard proposes the following scheme to the other 89 households that will remain in the subdivision.

  1. The remaining 90 households will form a private equity investment fund and the fund will establish a cash pool.
  2. Each of the 90 households will take out a mortgage equals to one-third the market value of each house.
  3. Each of the 90 households will transfer 70% of the mortgage money into the pool of the fund and retain 30% of the proceeds from the mortgage loan to help over future mortgage interest payments.
  4. The fund will use all the money in the pool to buy up the 10 houses of the subdivision on the market, but the fund must treat every one of the 10 houses equally.
  5. In the future if the remaining households need to repeat this process, the fund should also take out a mortgage for each house it owns according to conditions 2 and 3.
The proposal is accepted and is put into action. First, every household among the remaining 90 takes out a mortgage of $300,000 / 3 = $100,000. Each of them transfer 70% of the money that it receives from the mortgage, that is, 0.7 x $100,000 = $70,000 into the pool and retain 0.3 x $100,000 = $30,000 to help cover the mortgage interest payments. The pool now has 90 x $70,000 = $6,300,000. The fund uses the money in the pool to buy up those 10 houses on the market with a price of $630,000/house. Thus the market value of each house in the subdivision suddenly jumps to $630,000 and the total valuation of the houses in the subdivision jumps to 63 million dollars from the original 30 million dollars. After subtracting the total amount of mortgage taken out by the households of the subdivision, that is, 90 x $100,000=$9,000,000, the new total amount of homeowners’ equity for the subdivision jumps to 54 million dollars from the original 30 million dollars. Thus the magic number tabulated by the Federal Reserve Board suddenly increases by 24 million dollars thanks to the proposal of the economic wizard.

To make the game easy to calculate, we assume that the houses in this subdivision always come in a unit of 10 when they need to be sold. After a while let us assume that another 10 households want to sell their houses in order to take the advantage of the inflated price. The remaining 80 households then take out a second mortgage equal to $630,000 / 3 = $210,000 for each household, contribute 70% of that $210,000, that is, $147,000 to the pool and retain $63,000 to help to cover the mortgage interests. The fund does exactly the same for the 10 houses it owns as mandated in Condition No. 5. The pool now has $13,230,000, so it buys up each of the 10 houses for sale for a price of $1,323,000. The market value of each house is now $1,323,000 and the total homeowners’ equity of the subdivision is 104.4 million dollars. Thus the magic number of Federal Reserve Board jumps by another 50.4 million dollars.

Readers should have noticed that this game can only continue up to step 10 when all the houses in the subdivision will be owned by the private equity fund. We have tabulated vital financial statistics at the end of each step, from 1 to 10, in the following: