Comment 66: Remarks about foreign capital inflow and US trade deficits. The pulse of globalization (3) (March 20, 2009)

With the escalation of bailouts and stimulus packages, US budget deficit is not only exploding but will continue at the highly elevated level for some years to come. Such exploding federal government budget deficits will lead naturally to the massive expansion of the issuance of new US Treasuries. Since foreign forces, like Chinese Government and Japanese government, are large holders of US Treasuries, some have started to worry that without the stepped up foreign purchase of US Treasuries, US economy will be in serious trouble. Extending this logic, some have warned that big holders and potential future buyers like Chinese Government will be able to hold US in hostage. Actually such worries are off the mark. US Treasuries can only be bought with US dollars. In order to make the sale of new US Treasuries smooth, the prerequisite is to have plenty of dollars in the market. The issuance of US dollars is controlled by US Government, not by foreign governments. It is a misunderstanding to think that US needs to beg foreigners to hold a large amount of US Treasuries. The purpose of this comment is to explain the basics of the flow of capitals, and goods and services across the national boundaries to make clear where the problem of issuance of large amount of new Treasuries may or may not rest.

Every sovereign state has a book describing its transactions with foreigners. This book contains three accounts, they are, the current account, the capital account, and the financial account according to the classification of Bureau of Economic Analysis that compiles statistics of those accounts. The balances of those three accounts should add up to zero by definition. For the case of US the overwhelming factor in the balance of the current account is the balance of trades of goods and services, so we may simply equate the trade deficit as the deficit of the current account. The balance of the capital account is very small compared to the financial account, so can be ignored in our discussion here. The balance of financial account is measuring net flow of capitals in and out of US. Thus the present situation is for the large trade deficit to cancel out the large net inflow of capital into US, that is, the surplus in the financial account. This net inflow of capital is exactly the influx of foreign money that is the potential candidate to purchase US Treasuries.

From the discussion of the previous paragraph, it is clear that the call of increased purchase of US Treasuries by foreign entities is nothing but to call for expanded US trade deficit. Besides the point whether or not to use expanded trade deficit to finance everything including the stepped up purchase of US Treasuries by foreigners is an act of economic suicide, let us first examine the situation of US trade deficits. The graph at the right is borrowed from article 9A showing the monthly US trade deficits. The red curve shows the deficits of goods trade, and the blue curve shows the deficits of goods trades less foods and industrial materials; the deficits from the trade of industrial materials come mostly from the deficits of crude oil imports. The red curve shows that the overall deficits of goods trade is plunging rapidly in recent months. The blue curve, that is, the core of deficits in goods trade has been falling earlier than the overall trade deficits of goods; the overall deficits are strongly influenced by the crude oil price. To gauge the future trend of the trade deficits, the trade deficit weighted dollar index as defined in article 9 and updated in article 9A is a better prognosticator than the trade weighted dollar index compiled by The Federal Reserve Board. As shown in the first graph in article 9A the trade deficit weighted dollar index is rising much slower than the trade deficit weighted dollar index. Combining the recent trends of the trade deficits with the behavior of trade deficit weighted dollar index, we expect that US trade deficit will continue to slump and than stagnate for quite a while. As the consequence, the ability of foreign entities to purchase US Treasuries will continue to wane for some time.

Does the reduced purchase of US Treasuries by foreigners cause problems for US efforts to stimulate the economy? The answer is a resounding “No”. Reduced US trade deficit is compensated by the increased domestic saving so the total amount of money available for the purchase of US Treasuries does not change. Furthermore, a large sum of money is parked in US Treasuries at present, looking Treasuries as the safe haven and as the result pushing the yield of US Treasuries down to unprecedented low levels. The issuance of new Treasuries is simply absorbing those money looking for save haven and siphon them back into the process of lending to the needy and thus to jump start the economy. At the time of the writing of this comment, on March 18, 2009, The Federal Reserve Board has announced that it will buy 300 billion dollars of US Treasuries outright within next 6 months, that is, the monetization of US Government debts, a highly inflational tactic. Furthermore The Federal Reserve Board will purchase 750 billion dollars of mortgages and debts of Fannie Mae and Freddie Mac, two giant mortgage buying agencies recently nationalized by US Government. With this kind of massive money creation in the hands of US Government, the sale of new US Treasuries will certainly go smoothly without any stepped up purchase by foreign entities.

Some are worried about the sudden sale of a large amount of US Treasuries in the hand of Chinese Government. Let us contemplate the following scenario as the example to probe the consequence of such an action by Chinese Government. Suppose that Chinese Government has sold 200 billion dollar worth of US Treasuries and used the sales proceeds to purchase crude oil from Iran and Venezuela to build up its strategic oil reserve. Both Iran and Venezuela are not friends of US and thus will dump those dollars for Euro. It will be European banks that sell Euro to those two countries and get 200 billion dollars in return. European banks must reinvest this 200 billion dollars in dollar denominated assets to generate some returns. If European banks plow this 200 billion dollars back to US Treasuries, there will be no effect on US Treasuries at all. Only the holder of 200 billion dollar worth of US treasuries changes from Chinese Government to European banks. On the other hand Iran and Venezuela will spend the windfall and will boost the global economy to certain degree. Thus the sale of US Treasuries by Chinese Government is a good news for the global economy and is not anything should be worried about. What if European banks do not plow back the 200 billion dollars into US Treasuries, but buy something else, like US stocks? In that case the yield of US Treasuries will move up alongside with US stock prices. This phenomena is a sign that US economy is recovering, and should be a more than welcome development. It should be noted that Chinese Government cannot use this 200 billion dollars to stimulate its domestic economy, since doing so requires to convert this 200 billion dollars into Chinese Yuan. Then Chinese Yuan will appreciate rapidly vs. US Dollar, and will undo painstaking efforts of Chinese Government to limit the sharp rise of Yuan vs. Dollar in order to help China's export industry.

Readers may ask then what is the problem for The Federal Reserve Board to inject huge amount of liquidity into the financial system to smooth out the sale of new Treasuries and to use the proceeds of the sale to stimulate the economy and to bail out the financial system and all other needy industries. If the draconian efforts of The Federal Reserve Board and US Treasury Department fail to reinvigorate US economy but are able only to prevent its wholesale collapse, US economy will enter into a “L” shaped recession that is also called the “Japan Syndrome”, and repeated doses of massive liquidity injections will be required without the light at the end of the tunnel. If the massive injection of liquidity works and US economy starts to recover, the injected liquidity needs to be withdrawn promptly to prevent the emergence of a hyper inflation. However, the vested special interests like the housing industry and Wall Street, with the backing of US Congress will certain to make the effort of withdrawing liquidity very difficult at the early stage of the recovery, and as the consequence a hyper inflation will be allowed to raise its ugly head. Once that happens it requires an enormous effort to put the genie of hyperinflation back into the bottle. It is during the struggle with the hyperinflation, US economy will plunge into another deep recession. There is, of course, an easy way out. The course is to let US trade deficit to run wild again and to usher in the 4-th phase of runaway trade deficits to suppress inflation so that the massive liquidity injected into the system at earlier stage does not need to be withdrawn. To take this road, foreign governments need to be encouraged to manipulate the currency markets to inflate US Dollar to artificially high levels. A bubble much larger than the Bush bubble will rein in the fourth phase of the runaway trade deficit as has been discussed in article 10 and has been summarized in article 12. Eventually US Dollar will collapse as the currency market manipulations are overwhelmed by the giant pressure of the runaway trade deficits, and subsequently US trade deficit will be curbed. As US trade deficit wanes, another severe liquidity squeeze will set in and the the gigantic bubble generated by the fourth phase of the runaway US trade deficit will burst. The global economy will enter into a true depression that will most likely spell the end of another super power called The United States of America.