Comment 28: Globalization Trap and Signs of Crack in the Foundation of the Scheme (March 14, 2006)

The globalization scheme is like a giant trap. USA is trapped and has no choice but to see its trade deficit expand explosively. China and other Asian-Pacific countries are trapped and have no choice but to continue to buy up more and more US dollars and to hold them semi-permanently until the crash of the whole scheme. As the trade deficit explodes, jobs within USA inevitably flow to developing countries in the Asian-Pacific rim, especially to China. This job-outflow process has diminished US job market's ability to bounce back from economic recession induced slumps (see Section 4 of Article 2A for details). This fact has energized many US citizens and politicians to demand trade deficit curbing measures, especially from China since China has become the largest source of US trade deficit, replacing Japan. Those people think that once US trade deficit is controlled, everything in USA will be fine. On the other side many financial analysts are floating the scary story that, if pushed too hard, China may decide to unload its vast dollar holdings while Chinese people look on and applaud to see US economy goes down the drain. Those analysts advocate not doing anything to bring on this kind of anger from the far land across the Pacific Ocean. This comment will show that both types of thinking are based on ignorance about the true nature of the globalization scheme. However, the status quo of the current globalization scheme cannot continue forever, otherwise the strange situation as depicted sarcastically in Article 7 will become the reality. After the passing of 20+ years since the earnest run of this globalization scheme has started in the early part of 1980's, it becomes instructive for us to discuss in a serious fashion how and when this monstrous globalization scheme will come to its end and what kind of impact that its end will have on the global economy.

It is the persistent theme of this website to claim that US economic prosperities since the onset of the globalization scheme in the early 1980's have been the result of the run away US trade deficit. The first of such a claim is registered in Article 1 of 1998 (originally published on a webpage different from this website), and is summarized in a later article, Article 2. In recent years, US policy makers have belatedly been admitting that the onslaught of foreign capital inflow is sustaining US economic prosperity. Let us first show that the "foreign capital inflow" is nothing but the "trade deficit" itself. The international transaction account of any country consists of two components, the current account and the capital account. By definition, the sum of the balance of the current account and the balance of the capital account should be exactly zero, just as in corporation accounting the debit balance, taken as a negative number, should always cancel out exactly the credit balance. For example, if USA is running a current account deficit of 700 billion dollars a year, USA must have a capital account surplus of 700 billion dollars a year, and vice versa. When the capital account has a surplus, it is said that foreign capital has flown in. When the capital account has a deficit, we say that domestic capital has flown out of the country. The phrase of "foreign capital inflow" is exactly the same as the phrase of "current account deficit". Then what is "current account deficit"? The balance of the current account in turn consists of two components. One is the easily understandable balance of goods and services trades. The second component is the net repatriation by corporations and individuals not related to trades and investments. If money is sent to a foreign land from USA except in the course of a trade or for investment purpose, the money is considered to have flown out of USA and is booked as a negative number to this second component, whereas if money is sent from a foreign country into USA outside of any trade or investment related transaction, the money is said to have flown into USA and is booked to this second component as a positive number. In USA, the current account data of the 3rd quarter of 2005 show that the net repatriation part has a surplus of 512 million dollars, and the trade balance part has a deficit of 182,795 million dollars. We can see that the cause of the massive current account deficit of USA is due to its run away trade deficit. Thus the phrase uttered by US government officials that US economic prosperity is sustained by the foreign capital inflow is the same as the phrase that US economic prosperity is sustained by the run away trade deficit, used by us for the past 8 years. In the graph at the right hand side, quarterly trade deficit of goods and services are plotted as blue dots, and the quarterly values of capital inflow that must equal to the current account deficit are plotted as red dots; the graph covers from year 1972 to the 3rd quarter of 2005. We can see from the graph the close relation between the trade deficit and the capital inflow.

It is useful for us to make a detour and investigate the reasons of ups and downs of the trade deficit as shown in the graph. From the graph we can see that the first phase of the explosion of trade deficit had started around 1983 and peaked around 1987. The rise was due to the overvalued US Dollar that was brought on by very high real long-term interest rates in the early era of Reagan administration; Reagan administration insisted on funding its run away budget deficit by selling long term treasury bonds into the open market, instead of funding the deficit through The Federal Reserve Board System as its predecessor administration did and brought on the hyperinflation. That tactic of Reagan administration caused very high real long-term interest rates since the hyperinflation dragon was just slain by The Federal Reserve Board under the leadership of Paul Volcker. Thus the very high real interest rate brought on the overvalued Dollar and the explosion of US trade deficit. The exploding capital inflow that is the mirror image of the exploding trade deficit formed the base of Reagan era economic miracle. The peaking of the trade deficit around 1987 was due to the vast devaluation of dollar against yen that started in 1985. The rise of US trade deficit stagnated in early 1987 and started to shrink from the latter half of 1987 until 1991. A drastic movement in currency exchange rates usually takes 2 to 3 years to be reflected in the trade balance as discussed in Article 2. The rise of trade deficit from 1992 to 1995 was due to two different factors. The first was the rebound of US Dollar vs. Japanese Yen in the stretch of 1989 to 1992 that was translated, with the usual 2 to 3 year delay, into the renewed rise of US trade deficit from 1992 to 1995. The second factor was the vast devaluation of Chinese Yuan against US Dollar in 1989 and early 1994 that had induced Taiwan Merchants to migrate en mass into China to produce goods to be exported to USA. By late 1994 US trade deficit with China had already exploded up to 50% of US trade deficit with Japan (see Article 6 and Comment 26 for the emergence of China). Seeing the rapid rebound of US trade deficit, currency markets took Dollar down sharply against Yen starting from 1993 until 1995. The effect of this rapidly falling Dollar vs. Yen took effect 2 years later and stagnated the rise of US trade deficit in 1995. US trade deficit was saved from a meaningful fall in the period of 1995 to 1997 due to the emergence of China as the powerhouse to generate US trade deficit and the fact that Chinese Yuan was pegged to Dollar after the early 1994 devaluation. Seeing the reluctance of US trade deficit to fall significantly, currency markets took Dollar down even more sharply against Yen, and Dollar touched the all time low of 80 Yen/Dollar in early 1995. If the currency market had been allowed to carry through its self-policing mechanism, Dollar would have had plunged toward 50 Yen/Dollar, and the later exploding global trade imbalance would have been reduced substantially. However, seeing the free fall of Dollar in early 1995, US administration and Japanese government conspired a massive market manipulation scheme. It was first to let Japanese government to intervene in the currency market to stop the fall of Dollar, but to no avail. Then Japanese government launched its super low interest rate policy in the middle of 1995. This near zero interest rate in Japan sealed the fate of Japan into the decade long stagnation and deflation on one hand, it had unleashed the furor of yen carry trades to push Dollar rapidly higher against Yen on the other hand. As Dollar was pushed up sharply by yen carry trades, Japanese institutions followed by dumping yens for dollars to gain on interest rate differences. Thus Dollar caught fire and rose to over 150 Yen/Dollar by the middle of 1998. The sharp rise of Dollar vs. Yen in the period of 1995 to 1998 caused the explosion of US trade deficit, equivalent to the deluge of capital inflow, starting at 1997, again with the usual 2-year delay. The explosion of US trade deficit from 1997 formed the base of Clinton era economic bubble. On the other hand this sharply higher Dollar had caused a chain reaction in the form of Asian economic crises and the crises beyond Asia as discussed in Article 1. This chain reaction finally caused the highflying Dollar to collapse on its own weight in the middle of 1998 and again in the middle of 1999. The collapse of Dollar in 1998 then translated to the drop of US trade deficit in 2000 and the burst of the Clinton bubble, reminding us the now routine 2-year delay effect. Again the persistent rise of China as the major source of US trade deficit and the peg of Chinese Yuan vs. US Dollar softened the falloff of US trade deficit during 2000-2002 period, otherwise US economic slowdown of that period would have been much worse. Dollar started to rebound against Yen from 2000, paving the way of rebound of US trade deficit from 2002. The slight dip of US trade deficit in 2003 was due to the subdued mood of the society caused by The Iraq War and the SARS scare. The effect of the fall of Dollar vs. Yen in the spring of 2002 was muted in 2004 since by then China has become a far larger source of US trade deficit than Japan, and imports from China continued to grow at a healthy pace in 2004, offsetting any negative effect on US trade deficit from the fall of Dollar vs. Yen in 2002. The effect of another fall of Dollar vs. Yen at the end of 2003 to the early part of 2004 should be felt around this time. However, any drop of trade deficit with Japan is overwhelmed by the continuing rapid increase of trade deficit with China and the escalating costs of oil imports due to very high oil prices. Through the discussion of this paragraph we can see the overwhelming importance of currency exchange rates on US trade deficit; before 2002 it has been the rate of Dollar vs. Yen dominating the scene, but since 2003 the value of Chinese Yuan vs. Dollar is eclipsing the exchange rate of Yen vs. Dollar as China looming increasingly larger in the international trade scene.

With the equivalence of the phrases, "foreign capital inflow" and "trade deficit", established, the next question is how the trade deficit, or the foreign capital inflow, is sustaining US economic prosperity explicitly as claimed by us and by US government officials. We can look at this issue from two different directions, the direct influence and the indirect influence. How trade deficit directly boost GDP (Gross Domestic Production) is summarized in Section 3 of Article 2A so the argument will not be repeated here. To discuss the indirect influence of trade deficit, it is more advantageous to think about the phrase, "foreign capital inflow". As US companies import from foreign countries, US dollars are handed over to foreign suppliers as the payments for the imported goods and services. Since US dollars cannot be used as the mean to purchase goods and services in foreign lands, foreign suppliers must sell the received dollars in currency markets for their own currencies so that they can continue their operations. If US companies export goods and services, the foreign buyers must buy dollars from currency markets to pay US exporters. Since US is running a huge trade deficit, there is a large net amount of dollars flowing into currency markets as new supplies. We call those dollars generated by the trade deficit as trade-deficit-dollars. Those trade-deficit-dollars eventually end up in the hands of foreign governments and foreign financial institutions. The trade-deficit-dollars must be returned to US markets so that they can generate interests or can buy some US related assets. When trade-deficit-dollars return to US markets, they become foreign capital inflows for US. Why US interest rates must be raised in order to lure back trade-deficit-dollars, and how foreign countries holding a large amount of trade-deficit-dollars can influence US monetary policy are already discussed in Comment 27. Majority of capital inflows end up buying dollar denominated debt instruments, because US public sentiment has turned against foreign purchases of US assets deemed worth to be bought. The domestic capital invested in the debt instruments are pushed out of the debt market due to the massive buying by the flowed-in foreign capitals, and the displaced domestic capitals are redeployed to US stock markets. That is why the major stock market rallies, the pre 1987 rally and the rally prior to the 2000-2001 crash coincided with the major expansions of the trade deficit. As the expansion of trade deficit started to stagnate in late 1987 and at the latter half of 2000, US stock markets crashed accordingly. The strong stock market rallies due to the massive influx of foreign capital that was the result of run away trade deficit, in turn lifted the wealth of US investors and sparked consumption booms. In recent time there is a trend that a substantial portion of foreign capital inflow is directed to buy US mortgage-backed securities issued by semi-governmental agencies like Fannie Mae and Freddie Mac. As the result the mortgage rate in US is capped in spite of rapidly rising short-term interest rates. The slow rising mortgage interest rate, in turn, sustains US housing market and prevents the burst of the housing bubble; the burst of the housing bubble would have damped US personal consumption and would have reduced US imports from Asian-Pacific rim countries. However, the shrinkage of US trade deficit and the resulting reduction of foreign capital inflow will cause a substantial rise of US mortgage rate and will induce the burst of the housing bubble and a sure-fire economic recession.

The discussion in the previous paragraphs explains the reason why US administrations have been extremely cautious about any move that will upset the explosion of US trade deficit and thus bring along an economic recession. The run away US trade deficit is the result of vastly overvalued US Dollar. US administration in the latter half of 1990's was explicitly encouraging the overvaluation of Dollar under the catch phrase of strong dollar policy. The current US administration has witnessed the massive dollar buying by Japanese government that bought 400+ billion dollars in the stretch from the summer of 2003 to the spring of 2004, and the continuing dollar buying by Chinese government that bought about 200 billion dollars in 2005 alone. The list of offenders of dollar buying also includes Taiwan, South Korea and so on. Though US administration is mandated by US Congress to issue periodic reports about currency manipulating countries, it has hesitated to name any of them as "currency manipulator", apparently from the fear that such a label will undermine the strength of dollar, invite the shrinkage of US trade deficit and usher in another economic recession. The inability and the unwillingness of US government to move against the overvalued dollar and the resulting run away trade deficit shows vividly that USA is already deeply trapped in the status quo of the globalization scheme and can only idly watch its trade deficit to explode upward further in the foreseeable future.

As there is a huge US trade deficit and the exploding capital inflow, there must be the matching trade surpluses and capital outflows from various countries around the globe. We first consider the case of China, rapidly becoming one of the most important links of the globalization scheme. Though we have previously referred readers to Article 6 and Comment 26 for the discussion of the emergence of China as an economic powerhouse, we must lay out some basics about China's economy to facilitate discussion here. China is developing along an economic development model that we call "Taiwan model". Taiwan model is based on two essential ingredients, very low labor cost and loose environmental controls to lure foreign manufacturers to set up factories to produce goods to be exported to USA, the only run away trade deficit country on the surface of the globe. Foreign manufacturers bring in capitals and technological know-how, thus save a tremendous time for the host country to develop its own technology in manufacturing. Taiwan model, when applied to Taiwan, was proven to be able to generate an explosive economic growth. Contrary to the mistaken fantasy held by western experts, Taiwan model requires not a democracy, but an authoritative political regime to sustain. The reason of this political reality should be obvious. Under a democracy, labor has the right of free unionization and will demand rapid wage increase as the economy expands, and citizens have the right of free speech and free association that will translate quickly into the overwhelm demand for a cleaner environment to protect their own health. Actually in Taiwan, the Taiwan model was applied during its authoritative political era, and when the era of democracy arrived, Taiwan model quickly faded away as Taiwan manufacturers moved in wholesale to China to take advantage of very low labor cost and very loose environmental controls there. The current authoritative communist regime of China fits very well with the requirement of Taiwan model, and Chinese economy expanded rapidly in recent years as subscribed by the model. In spite of the rapid economic growth and brisk job creation, more than 10 million new labor forces a year cannot find jobs in China. Adding on hundreds of millions of poor and underemployed rural populations waiting to find jobs in industries, the employment situation in China is so severe that is beyond the imagination of many western experts. It is not an exaggeration to say that the life of the current political regime is dependent on the uninterrupted path along the Taiwan model that is the only way to generate enough jobs to avoid the down fall of communists in China. That means that China must continue to expand its exports at the current explosive pace and USA must continue to increase its trade deficit to accommodate the Chinese exports. In 2005 China had a trade surplus of 100 billion dollars. The net repatriation will be ignored to simplify the discussion; it should be a rather small number compared to the trade surplus of China. Thus China's current account surplus and equivalently the capital account deficit are about 100 billion dollars. The sum of direct foreign investments and the hot money flowed into China in anticipation of the upward revaluation of Yuan amounts to 100 billion dollars, and that amount comprises the capital inflow o China in 2005. This implies that there were about 200 billion dollars of capital outflow from China in 2005 to make China's capital account deficit to be 100 billion dollars. Where do 200 billion dollars of capital outflow from China come from? The current account surplus of 100 billion dollars and the capital inflow of 100 billion dollars mean that 200 billion dollars had flown into China in 2005 and were converted into yuans. It was Chinese government that single handedly bought those 200 billion dollars and reinvested them into US markets as reflected in its expansion of foreign currency reserve, creating the required capital outflow of 200 billion dollars to make capital account deficit 100 billion dollars. If Chinese government did not buy those 200 billion dollars, Dollar would have collapsed against Yuan, Chinese export industry idled and Taiwan model of China ruined, probably along with the Chinese communist regime. For a conceivable future duration, China will have no choice but to continue to buy up whatever amount of dollars offered on the currency market to prevent a sharp revaluation of Yuan vs. Dollar that will certain to ruin China's Taiwan model. It is a complete error to claim that China has the ability to unload its vast dollar holding in order to punish USA. If China engages in such a folly, the first causality will be Chinese economy and Chinese communist regime itself.

Taiwan and South Korea, two other suppliers of vast amount of capital outflows to quench the US thirst for a massive capital inflow, are in no better position than China to walk away from the current dollar buying frenzy. Both countries grew from exports, and most of their merchants only know about exports. As China is rising as the factory of the world, those two countries are increasingly serving as the supply bases for the Chinese export industry. To play that role, the undervalued Taiwan Dollar and Korean Won vs. US Dollar are essential. That is why Taiwan and South Korea governments have no choice but to continue to buy US dollars from currency markets and reinvest them into US markets. In 2005 a South Korea official in charge of its foreign currency reserve uttered some careless phrases that can be taken as the desire to divest South Korea's vast dollar holding in its foreign currency reserve from US Dollar to other currencies. Currency markets have immediately pushed up the value of Korean Won against US Dollar at the time when its competitors' currencies are showing some weakness against Dollar. That has forced South Korea government to come into the currency market to buy up more US dollars to suppress the upward revaluation of Won. As the result South Korea government ended up holding more dollars than before the careless comment from the official. This incident shows how the globalization trap works; more the one trapped struggles, more tangled it becomes, just like a giant spider web.

Recently Dubai Ports World, a company controlled by the government of Dubai that is an entity of The United Arab Emirates, has tried to buy a UK company that owns many terminals in the eastern ports of USA. This transaction has enraged US public opinion, spearheaded by some US news media and radio talk shows. The anger of US public opinion forced US Congress to move against both the deal and US administration that has approved the deal. On the surface the public anger is due to the national security concerns, but many suspect that the anger is generated partly from the backlash against the globalization scheme itself and partly due to the prejudice against the Muslim world in general. Some analysts suggest that the oil producing middle east countries may slow down of reinvesting petrodollars, a substantial part of trade-deficit-dollars in 2005, to hurt US Dollar. However, those analysts have failed to carry their own suggestion to the conclusion. If US Dollar is hurt substantially by whatever means of oil producing countries, the shrinkage of US trade deficit will occur, a US recession follows, the export industries in Asia will be hit, the global demand of oil will plunge, crude oil prices will collapse, probably heading toward 20 dollars per barrel, and gulf region autocratic governments will fall like dominos. Once we understand the inner workings of the globalization trap, we do not believe that oil-producing countries will take any such suicidal steps. In other words oil-producing countries are equally trapped by the globalization scheme and have no choice but to recycle petro-dollars back into US markets, either directly or through European intermediaries.

Reading up to this point, many may think that the web of the globalization scheme is so strong that no country is capable to escape from the trap. Thus the status quo of the globalization scheme will run forever and eventually the ridiculous situation as sarcastically depicted in Article 7 will be within the reach. Actually things are not so rosy for the globalization scheme. There are many events that may disrupt or even destroy the globalization scheme as we know today. However, we will not discuss many natural and manmade disasters that have the potential to interrupt the globalization scheme, but will concentrate our attention on the crack developing within the scheme under its own weight. Our attention will be focused on the massive dollar buying of Japanese government from the fall of 2003 to the spring of 2004, and the subsequent absence of Japanese government from the currency market. Within the stretch from the latter half of 2003 to the first part of 2004, Japanese government bought over 400 billion dollars from the currency market in order to prevent Yen to rise above the 100 Yen/Dollar level. During that period of dollar buying, Japan had an annualized current account surplus of about 150 billion dollars, or the same amount of capital account deficit. This implies that about 250 billion dollars of foreign capital had flown into Japan during the period so that Japanese government needed to buy 400+ billion dollars and recycled them back to US markets to make up 150 billion dollar deficit in Japan's capital account. A substantial part of that 250 billion dollar influx into Japan during the period came from US domestic capital market. We could imagine what would have happened if Japanese government had not absorbed that extra 250 billion dollar capital inflow into Japan. Dollar would certainly fall through the line of 100 Yen/Dollar and have retested the all time low of 80 Yen/Dollar, and would probably crash through even that all time low level and run toward something like 50 Yen/Dollar. With the usual 2 year delay, Japanese current account surplus would vanish, US current account deficit would shrink at least by the similar amount, and a deep recession would have engulfed US economy by now. The capital market in US is enormously huge, probably more than 10 trillion dollars. If Japanese government is forced to come into the currency market again, it may be the signal for a substantial part of that US domestic capital, following the strategy of the famous private investor, to flee US dollar and run into Japanese yen, and the capital that flows into Japan will multiply to many times of the 250 billion dollars encountered during the period of concern. Then even the ultra stubborn Japanese MOF will be washed away in front of the deluge, US Dollar will crash to the ground and the current globalization scheme will come to its end. Thus we should take the dollar buying of Japan during the period of 2003 to 2004 as the first warning shot to mark the beginning of the end of the globalization scheme.

After the dollar buying frenzy of Japanese government, the burden to sustain US Dollar at the overvalued level in order to sustain the globalization scheme is thrown back to The Federal Reserve Board of USA. That is why Fed (short hand for The Federal Reserve Board) has been raising short-term interest rate persistently since the middle of 2004. We should note that the difference between the short-term interest rate of USA and that of Japan today is not so different from the level of the latter half of 1990's, and is re-igniting yen carry trades as in the latter half of 1990's as has been pointed out in Update of Nov. 12, 2005 of Currency and Gold section. However, this time around yen carry trades have only boosted Dollar to 120 Yen/Dollar level from around 100 Yen/Dollar level, whereas in the case of late 1990's yen carry trades pushed Dollar up from 80 Yen/Dollar to 150 Yen/Dollar. This situation implies that Fed needs to continuously raise short-term interest rates for foreseeable future to defend Dollar so that the current globalization scheme can continue its course. However, as short-term interest rate rise continues, the long-term interest rate will also rise, though grudgingly. This ever-rising interest rate scenario, of course, cannot continue forever. When the rise of interest rates stops, Dollar will start to weaken again, requiring further rise of interest rates or intervention by foreign governments of an unprecedented scale. The repetition of this process will eventually lead to the final destruction of the globalization scheme under its own weight.

Another warning sign of the beginning of the demise of the current globalization scheme is the movement of the price of gold. For a long time gold's movement is more or less synchronized with the movement of Euro, or inversely correlated to the value of Dollar vs. Euro. However, Euro has started to weaken against Dollar from the early part of 2005 due to the steadily rising US interest rates, whereas gold price started to rise steadily from the summer of 2005, and eventually caught fire in November of 2005. Gold is known as the monetary metal that hedges against inflation and does not yield any interest. The rapid rise of the price of gold at the face of a strong Dollar and steadily rising interest rates that are assuring a calm inflation environment in the foreseeable future deserves our attention. The unusual behavior of gold price is due to the market apprehension about the sustainability of the current monstrous globalization scheme, cracking under its own weight of run away trade imbalance. Ironically, as the necessity of higher interest rates increases in order to support the dollar from collapse, more apprehensive the market will become and higher the price of gold will go. Thus the price of gold can be used as a market assessment of the final fate of Dollar and the globalization scheme. At the eve of the final collapse of Dollar and the demise of the current globalization scheme, the price of gold will be sure to skyrocket to an unprecedented level.