Every month, so the numbers show, the U.S. is getting deeper into debt. Each trade deficit needs external financing. Thus with each monthly figure that shows a deficit in foreign trade, the U.S. foreign investment position is deteriorating.1
Trade deficits imply that foreigners lend the money to the United States with which the imports can be bought. The U.S. sends blips on a computer screen abroad and receives goods in exchange for consumption at home.
A blissful economic symbiosis exists between the United States, China, and Japan. The U.S. consumer wants his binge to never end. China needs the U.S. dollars earned from its trade with the United States in order to buy goods from other countries and pursue its economic development strategy. For Japan, the United States serves as the harbor for the savings surplus that it has accumulated.
Seen from an U.S.-perspective it may appear as if China (as it was said of Japan in the 1980s) was competing in an unfair way. It is said that China keeps its currency intentionally undervalued. But while the United States has a huge trade deficit with China, most other countries have a surplus in their trade with China.2
The U.S. deficit with China is not so much the expression of superior Chinese competitiveness, but the result of a lack of competitiveness of the United States. China is reluctant to revalue its currency because the Chinese authorities are right to fear that a revaluation of their currency would lead to an increase of China’s trade deficit with the rest of the world, particularly with its Asian trading partners.
The U.S. trade deficit is an American problem. It is the result of insufficient savings at home and a widening budget deficit. In structural terms, the U.S. trade deficit shows that the productive capacity of the U.S. economy is too small relative to spending. Foreign financing allows the government to expand its expenditures without putting too large a burden on the taxpayer. This way funds are set free for private consumption.
The U.S. economy is propped up by China and Japan, while at the same time these two countries depend on the United States. Japan is helped by its persistent trade surplus with the United States to soften the consequences of its economic stagnation, and China relies on its surplus in foreign trade with the U.S. in order to proceed with its development strategy. By this arrangement, Japan can maintain its level of wealth, while China is in a position to develop and accumulate wealth at a rapid pace. In this constellation, the United States is the beneficiary in terms of real goods and enjoys its present period of prosperity.
The government of Japan will do the most it can in order to maintain this status quo. Besides the economic and financial link, Japan depends for its military defense on the United States. Japan needs the United States as its partner with a big stick. China’s interest in maintaining the current state of affair is likewise manifest. The longer the magic symbiosis will hold, the further China will advance in its economic development project.
Even the Europeans look at this constellation with some satisfaction. They must not ward off so much of the brunt of exports coming from China or Japan, and they can profit from the economic expansion in China and the rest of Asia by exporting to this area and by providing direct foreign investment.
The joker in this game is neither China nor Japan, nor Europe, but the United States itself, or, being more specific, the problem is the U.S. balance of payments. 3 A trade deficit may result from an imbalance with the trade of goods, but it may also result from the service account. In the service account the payment of interest is of particular importance. It is a decisive economic difference whether capital imports serve to finance the import of goods or if foreign loans are used to pay interest on the foreign debt position. In both cases a financing of the trade deficit occurs, but the economic nature of the transactions has changed fundamentally.
In the United States, as of now, the trade deficits have widened because the import of goods has been increasing. But what will happen when the trade balance is largely in the red because of U.S. interest payments on accumulated debt? When more and more of the trade deficit will come from interest payments and less from the import of foreign goods, the lifeblood of the trans-Pacific symbioses will dry up.
In the past couple of years, foreign loans to the United States coming from Asia have created more or less the equivalent in foreign trade. The turning point in this deal will come when the interest payments of the U.S. as the debtor country will lead to a crowding out of its import of goods. Then the arrangement no longer makes sense for the creditors.
The United States traditionally has had a surplus in its investment service account. In the past years, however, this surplus began to shrink and based on current trends it will turn negative. Given the rapidly rising foreign debt position of the U.S., its investment service account is about to deteriorate drastically in the coming years.
The trade balance plays a crucial role in what is happening. As much as it can be said that the underlying reason for the U.S. trade deficit is insufficient national savings, the connection between foreign trade and savings can also be formulated the other way around. Then it is foreign loans that allow for the existence of a trade deficit and make it possible for the U.S. to have a low savings rate.
Likewise, with regard to China and Japan, it can be said that its trade surplus with the U.S. is not so much the result of the Chinese development strategy, but that the existence of the trade imbalance and its external financing allows China to pursue this strategy. In the same line of reasoning, Japan’s trade surplus can be explained as the expression of its savings surplus, but it also can be argued that the American trade deficit and Japan’s savings exports to the United States are two sides of the same coin.
With an increasing share of foreign funding being absorbed by pure debt financing in the future, less is left for the U.S. to continue with the import of foreign goods. Equivalently, exports to the United States will have to shrink. This will impact directly on China’s external trade and its development strategy.
In order to assess future developments, the central question emerges whether Japan will be capable of continuing to provide funding for the United States in a dimension that would compensate for the shortfall of financial flows from other sources.
Japan is still by far the largest creditor to the United States. Japan’s economic and financial symbiosis with the United States began right after World War II and experienced its highlight in the 1980s. Over the decades Japan has become the most important financier of the U.S. trade and budget deficits. This linkage is tight enough that Japan’s financiers could only move out of U.S. bonds by severely hurting themselves.
However, even more so than Europe, Japan is faced with a rapidly ageing population, and the pension burden is rising. With less income generated at home, Japan must resort to its overseas financial investment, i.e., its savings that have been harbored in the United States.
Neither for Japan nor for China will it make sense to finance the American trade deficit when it is more and more the result of interest payments and less because of the import of goods. Pure debt financing would take away the economic rationale from the current arrangement.
Financial markets work by anticipation. Even if the crowding-out effect in the trade balance as the result of a rising share of interest payment is not yet severe, private financiers will become more reluctant to lend. The Asian central banks as creditors to the United States may wait somewhat longer than private investors, but when trade exchange begins to weaken, they, too, will reduce and finally stop lending.
With the pool of available external savings shrinking, the United States will be confronted with the task of generating sufficient savings at home. This requires a reduction of private consumption and will put a hard pressure on governmental expenditures. The implications of the new constellation with an end of the blissful symbiosis will go far beyond economics and will impact massively on domestic and international politics.
The problem of what lies ahead consists not only in the challenge that comes from the dimension of the required adaptations, but also from its speed. The process of debt accumulation tends to happen gradually and thus there is time for the real economy to adapt to the financial conditions. The contraction phase, however, typically is compressed in time and thus puts a sudden massive burden on the real economy.
- 1For current data see U.S. Department of Commerce. Bureau of Economics Analysis (www.bea.gov)
- 2For data and analysis on China’s bilateral trade balances with selected economies see “China’s Growth and Integration into the World Economy. Prospects and Challenges”, edited by Eswar Prasad. International Monetary Fund . Occasional Paper No. 232. Washington, D.C. 2004, table 2.6. p. 10 et passim
- 3The balance of payment, as an accounting statement, registers monetary inflows and outflows. In the balance of payments the money flowing in comes from export receipts and from capital imports (like receiving foreign loans and foreign direct investment). The money flowing out is composed of payments for the import of goods, services (including interest payments to foreigners) and capital exports. Including also unilateral private and public transfers, the balance of payment consists of two major sub-balances: the current account (trade, services, transfers) and the financial account (capital acquisition and loans). For more details see A. P. Mueller: “Do Current Account Deficits Matter?” in: Mises Institute Working Papers. February 27, 2004. (mises.org/workingpapers)
