Debt-Financed Trade Caused the New Depression

The United States trade deficit hit $2 million A MINUTE in 2006. That was the rate ($800 billion that year) at which the US was going into debt to the rest of the world. When Adam Smith (1723-1790) and David Ricardo (1772-1823) wrote about the benefits of free trade, they could not have imagined a world in which a country could incur a trade deficit of $800 billion in one year and finance it with paper money. In their world, trade between nations balanced. It had to balance because gold was money and the gold standard contained an automatic adjustment mechanism that ensured that trade did balance. Understanding that adjustment mechanism is the key to understanding how, following the breakdown of the Bretton Woods international monetary system, the United States’ trade deficits destabilized the global economy and culminated in the New Depression.

The gold standard ensured that international trade balanced in the following way. One hundred and fifty years ago, for example, if England had a large trade deficit with France, then England’s gold would literally have been put on a ship and sent to France to pay for the shortfall. Since gold was money, England’s money supply would have contracted, its economy would have gone into severe recession, unemployment would have increased and there would have been deflation. The opposite would have occurred in France. As gold entered the economy, credit would have expanded, the economy would have boomed and there would have been inflation. Soon, the rich French would have begun to buy more cheap English goods; and the poor, unemployed English would have stopped buying so many expensive French goods. Before long, the trade between the two countries would have returned to balance.

The Bretton Woods system, put in place at the end of World War II, was designed to function so as to replicate the gold standard’s automatic adjustment mechanism. When Bretton Woods broke down in 1971, however, that adjustment mechanism ceased to operate. Soon afterwards, the United States began running large trade deficits – initially with Japan. As dollars entered the Japanese economy, they went into the Japanese banking system and caused credit to expand. As a result, the Japanese economy began to boom (in the same way that the French economy boomed in the example above). However, the United States did not deflate as England would have 150 years ago because the US was not paying for its deficit out of a limited amount of gold reserves. It was paying with paper dollars or US government bonds denominated in paper dollars; and there was no limit as to how many of those dollars the government could create. Consequently, the adjustment mechanism ceased to work and, as the Japanese trade surplus continued to expand, the Japanese economy continued to boom, and boom, and boom, until the gardens around the Imperial Palace in Tokyo were said to be more valuable than California.

And then in 1990, the Japanese bubble popped – as every bubble eventually does. At that point, asset prices plunged, banks failed and the government had to go deeply into debt funding large annual budget deficits in order to prevent the Japanese economy from collapsing into a depression. All economic bubbles pop for the same reason. Eventually asset prices became so inflated that the public can no longer finance them. The income of the public determines how much asset prices can inflate. Income is determined by wages. In bubble economies asset price inflation outstrips wage growth and, eventually, as a result, the bubble pops.

This bubbling process has occurred again and again in one country after another since Bretton Woods broke down. All the countries that have experienced large trade surpluses with the United States (or, more technically, large overall balance of payments surpluses) have been blown into bubbles. Japan bubbled and popped in the 1980s. The Asia Crisis countries (Thailand, Indonesia, Malaysia and Korea) bubbled and popped during the 1990s. By the 2000s, the US trade deficit had become so large that a worldwide bubble formed. It popped in 2008. Today, China is the most clear-cut case of a country where an economic bubble has formed as the result of an extraordinary trade surplus with the United States. China’s bubble has not yet popped, but it is certain that it will.

Between 1971 and today, the United States cumulative trade deficit has exceeded $7.9 trillion. That deficit was financed on credit. Never before has a country amassed a trade deficit on a scale such as this. Therefore, it must be understood that the trade regime that has evolved over the last 40 years is very different from what the classical economists described as free trade. The term “debt-financed trade” much more accurately describes the current system. Debt-financed trade produced very rapid economic growth for decades as countries around the world radically expanded their industrial capacity to satisfy the surge in debt-driven demand from the United States. However, now that the private sector in America can bear no additional debt, this unbalanced trade regime has left the world in a crisis characterized by excess capacity, insolvent banks and unsustainable fiscal deficits.

Debt-financed trade is not free trade. Free trade under a gold standard fostered prosperity in a balanced and sustainable way. Debt-financed trade has created extraordinary and unsustainable global imbalances on a previously unimaginable scale. When those imbalances began to come unwound in 2008, governments were compelled to borrow, print and spend trillions of dollars in the attempt to stave off a new great depression. It is still far from certain that they will succeed.

Regards,

Richard Duncan
for The Daily Reckoning

P.S. For more perspective from Richard Duncan you can visit his blog on economics in the age of paper money at www.richardduncaneconomics.com.