Mr. Moderate

The United States has been running a trade deficit for as long as I can remember. It seems like almost every year sets a new “record high” trade deficit. The USA has gotten away with this for at least half-a-century, but we should not expect that we can get away with this “forever.” Someday, there must be a day of reckoning.

In the early decades of the trade deficit, the USA got away with it because there was a huge demand for dollars to be held overseas as a “reserve currency.” Foreign banks would hold US dollars for the same reason that the US treasury holds gold reserves: to provide at lease some psychological backing for their own nation’s currency. And in some sense, these reserves constitute a “rainy day fund” that can be used in an economic emergency to lubricate a nation’s economy until things got back to normal.

Our present economic system was designed largely by people who had lived through the Great Depression, and so the ideas were always relative to the problems that caused that economic catastrophe. This is roughly equivalent to designing the current army to fight the last war you were involved in. You are only rarely lucky enough to have two similar calamities in a row.

In the usual case (according to theory), if a nation has a trade deficit, the value of its currency will go down due to the usual functioning of The Law of Supply & Demand. So long as exchange rates are free to move, one currency against another, no nation should be able to run trade deficits for any significant period of time because the fluctuations in exchange rates will automatically correct those imbalances.

A lower value for the US dollar will effectively raise the prices of imports and, according to The Law of Supply & Demand, a lower demand for imported goods will be the result. That will lower the value of imports and tend to correct any trade deficit. Similarly, a lower value for the US dollar will effectively lower the cost of US exports in the world market. Again according to The Law of Supply & Demand, that should increase the demand for US exports and, once again, tend to correct any trade deficit.

That is, at least, the theory. But that theory depends upon a free market for currency exchange rates, and such a thing has never existed in the past several decades. Instead, currency exchange rates are largely set by government fiat and enforced through state bank participation in the currency marketplace. The Bretton Woods Agreements created a system of national banks and exchange rate controls which refuse to allow the market to function for any “major” currency. As the United States was the most powerful nation in the world at the end of World War II, the US Dollar became the benchmark currency for the world’s economy, and the Bretton Woods Agreements would not allow the US Dollar to fluctuate to compensate for any US trade deficits.

For decades following World War II, there was quite simply no alternative to using the US Dollar as the world’s reserve currency. However, in the past decade, the Euro (the European currency) has gotten to the point where it is not only a viable alternative, but it is clearly more stable than the US Dollar. Accordingly, many central banks have been gradually converting their reserve currency holdings from US Dollars to Euros, or at least adding new reserves in the form of Euros instead of US Dollars.

The salvation for the United States over the past decade has been the willingness of the Chinese government to finance both the US trade deficit and the US budget deficit by agreeing to take US Treasury debt in return for its trade deficit with the US, caused by the vast quantity of goods and services that China supplies to the United States while taking relatively little in return.

It was recently (early 2007) declared that the Chinese had crossed the point where they now hold a trillion dollars worth of US treasury debt. That is more than $1,000,000,000,000.00 worth of various classes of T-bills, Treasury bonds, and so forth. That represents an equivalent amount of both US budget and trade deficits that the Chinese have agreed to hold as part of an effort to maintain the totally artificial (and very unfair) exchange rate between the Chinese Yuan and the US Dollar. It is uncertain in the extreme what the Chinese hope to do with all that US money. But their agreement to hold it has prolonged the current economic cycle beyond its normal breaking point and put off the day of reckoning until something else happens to cause the system to “break.”

The long-term maintenance of this unfair and grossly-imbalanced system has caused industry in the United States to wither and die, greatly exacerbating the problem. As manufacturing plants are closed in the United States and moved overseas, that decreases the value of US exports and increases the value of US imports, if everything else remains in rough balance. When I was a child, the USA was known as the world’s greatest producer of automobiles, steel, and other valuable export goods. Increasingly, the USA is more of a third-world “colony” nation as our primary exports consist of food and raw materials for use in manufacturing plants overseas. Probably the last major industry where the USA is the world leader is the aircraft industry, but that remains true only so long as Boeing can successfully compete with the Europeans.

We have reached the point where the citizens of the United States need to be forced to take some bitter medicine by way of the devaluation of the US Dollar. A minimum devaluation of two-to-one is required, and frankly, ten-to-one could be easily justified based upon comparing US labor costs with the labor costs of our largest trading partners. If the US is going to compete in the global market, then US labor costs must reflect global realities. The alternative is to attempt to insulate the US economy from the global economy the way that other nations do. But I do not believe that maintaining an artificially-insulated market could ever possibly work over the long run (see you will just motivate the creation of black markets).