Monday, November 24, 2008

How the Current Account Deficit Explains What's at the Core of the Current Financial Crisis

I like to make things simple. And the reason I like to make things simple is not because I'm trying to dumb them down or provide a simplistic explanation of things, but ultimately when boiled down, things really are that simple. And this current financial crisis is no different.

Talk about mortgage brokers, SWAPs, bailouts all you want, what is ultimately driving this crisis is the fact that Americans are not producing enough to warrant the prices of our assets. Housing, stocks, you name it, all derive their value from the profits or income that can be produced from them. And if there is no profits or income, then there is no value in those assets.

For example, housing. Housing rose to unrealistic heights based on temporary and flighty demand as sub prime slime who could not afford those houses long term, flooded the market only to go bankrupt 3 years later. The problem is rents, the thing that ultimately gives property its value, did not go up. This is why a bubble formed and you are now experiencing dropping property prices. The markets finally realized that housing cannot "always go up" unless there is a corresponding increase in the rents, which never happened, ergo why Case Shiller is showing plummeting housing prices.

Stocks are another perfect example. The stock market, for decades, has been flooded by basically Baby Boomer and Gen X retirement money based on the principle that we should religiously and always invest in the stock market for our retirement. The problem is we are no longer investing in the stock market for the profits the firms generate, but rather because we were told by the government to use them as a retirement vehicle. Now, as corporations report horrendous corporate earnings, not to mention practically all of the financial services industry is filing for bankruptcy or a taxpayer bailout, the market is realizing that the ultimate driver of value of stocks (PROFITS) are non-existent, and ergo, why should those stocks have any value.

The problem, however, is that while the stock market and housing market are certainly very important to the economy, it does not address the overall economy. ie-the American people. How much "wealth" or "production" do we produce as an economy. And not only how much do we produce, but how much do we spend. ie- are we net producers or are we net parasites?

Take a guess which one we are.

The metric by which this is measured is the current account balance. It shows, simply, how much more or less do we produce versus consume. It basically looks at the national accounts, measures how much we made, and then how much we spent. And for the past 20 years, we have been spending more than we made.


Going from just a 0% of GDP balance in 1991, we have persistently and continually spent more than we made in this country, more recently spending 5% more each year than we made.

Now, I know that it is blasphemy to criticize or critique the Neo-American past-time of spending more than we make. That it is a crime punishable by death to suggest people be responsible and live within their means. But that still doesn't change the fact that Americans have essentially been becoming progressively "economically lazier" as time has gone on. We work less, spend more, and don't give a damn about how to pay for it, let alone ever have the intention to pay for it.

It is this that is causing asset prices all over the place to collapse. Stocks, housing, the dollar, as nobody, Americans or foreigners, are willing to invest their money in assets that are ultimately reliant upon Americans to churn profits out of them. We're too busy watching American Idol. We're too busy campaigning for Barack Obama. We're too busy majoring in sociology to hopefully become a "community organizer." None of which produce one ounce of GDP, income, or profits.

Meanwhile, I suggest you take a look and see what the Chinese, Arabs and Russians are majoring in, in college. And then take a look at their current account balances.

16 comments:

  1. Couldn't agree more.

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  2. Anonymous2:18 PM

    Your theory is simple and elegant, but reality is a bit more complicated.

    According to your theory, it should be pretty easy for the USA to improve the current account by letting the US dollar depreciate, if the amount of export goods and services produced were the only problem. However, the dollar has been undervalued for most of the last 20 years without any significant effect on the current account balance (the 1980s Plaza Accord flop is the best example).

    Now, one could advance an argument about the type and quality of exports, which you rightly did.

    I suggest you take a look and see what the Chinese, Arabs and Russians are majoring in, in college. And then take a look at their current account balances.

    However, the countries you named export either oil or cheap industrial products that cannot be produced in high-wage countries anymore. Meanwhile, the USA exports research-intensive modern stuff like computer technology, medical technology, and genetically modified food.

    Europe currently has a better current account balance than the USA because it still has some of the old heavy machinery industry that the US abandoned several decades ago. As the Emerging Markets boost demand for industrial machinery again, Europeans benefit from their backwardness.

    The point is that exports and imports are not only driven by demand and exchange rates, but also by structural developments in an economy.

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  3. Anonymous4:37 PM

    Convincing people that we need to generate more economic activity is easy. It is convincing people that specific activities and people do not have a positive economic impact that is the problem. Thus there is support for excessive military spending and there will support for the next administrations' plans to "invest" in education, infrastructure and inefficient
    (but politically powerful) producers by sacrificing the productive parts of the economy.

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  4. isn't the current account offset by the capital account?? and so basically meaningless

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  5. isn't the current account offset by the capital account, and so basically meaningless

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  6. Captain, I have a better way to explain the present crisis. As we all know, the amount of debt, private and public is a measure of the amount of money in circulation. The only way the Fed has of controlling the money supply (flexible currency) is by lending which they do by controlling the interest rates. In early 90’s, the Federal Reserve Bank Of Kansas City’s Economic Review set the tone with the discussion of the relationship between personal taxes, borrowing, government spending, and the standard of living. They wrote the definitive stand on the Board’s fiscal philosophy. They recommended that taxes remain high and interest rates low because except for a limited amount of infrastructure, the government sector does nothing to grow the economy. “All economic growth comes from the private sector.” It was a bad mistake. The people who pay taxes are PRODUCTIVE. We tax income, capital gains, and profits, all measures of productivity, not wealth. I would much rather trust the people making the money to spend it wisely, than a bunch of crooked bankers, corporate hacks, and outright criminals borrowing it. This was after Reagan blew a $600 billion bubble in the savings and loan debacle, Clinton then blew a $1.6 trillion dollar tech stock bubble, Bush’s bubble is probably (to early to even guess but its really big) greater than $10 trillion. What people will invest in with the cost of money at 6% is a lot different to what they will invest in at 2% considering the price of houses is increasing at 15%. Of course the current account deficit is falling, cheap money lets us buy overseas and for the past 15 years the Fed has been committed to cheap money and high taxes. The real question to ask is, “Given that debt is a natural consequence of the Federal Reserve System, who should hold that debt?” For the government to hold it all (borrow it all and cut taxes to control interest rates to 6%) makes it a liability on all holders of currency, foreign and domestic. For the private sector to hold it leads to the bubbles, defaults, and financial disasters we are experiencing.

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  7. Anonymous6:20 PM

    Gonna have to call you on this one, Captain. The current account balance only looks at the balance of trade, but not the capital account. From a blog post I made years ago:

    "The trade deficit is one of the more popular points among economic armageddon prophets. They say that because we are importing more goods than we are exporting we are uncompetitive, and thus, doomed.

    That is not actually the case. When we are importing more than we are exporting, something has to make up the balance. Those dollars that we are giving in exchange for foreign goods come back somehow, but it's not in the form of trade purchases. Rather, it takes the form of foreign investment in the United States, which is not figured into the balance of trade statistics.

    The United States offers a high rate of return on business investment. This is partly due to our somewhat less restrictive regulations, and partly due to the huge market for goods that is the United States. If we import more goods than we export, and foreign investors take the difference and establish new companies in the United States, it's a winning arrangement for everybody.

    here is a downside, however. Not all money invested in the United States goes towards a productive purpose. The US government has been financing their enormous deficit by issuing bonds which are purchased by foreign investors, especially in Asia. Those "investments" do not represent an increase in the productive capacity of the United States, but rather they represent a claim upon future goods to be extracted through taxation. The interest on those bonds is like the interest on any other loan; the bigger the balance and the longer you maintain it, the more you have to pay in total and the greater percentage of it is just interest. If the deficit were large enough, government could reduce all other expenditures to zero, raise taxes, and still face a growing debt. We're not to that point, but the Bush administration has increased spending more than any president in 25 years. At the rate government debt has been increasing, and with the inflation-crazy Ben Bernanke as the chairman of the Federal Reserve, we would see an inflation snowball scenario within a couple of decades if nothing changes. It could be sooner if the petrodollar evaporates or if the dollar ceases to be the world's reserve currency of choice. A reduction in government spending is needed."

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  8. I acknowledge yours and Dtrum's point (which are true and valid), but I'm still sticking with the CA deficit as it more or less is a direct sign of the not only attitudes of Americans, but their capabilities.

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  9. Anonymous4:54 AM

    It should be noted that this is the capital account as a percent of GDP. I'll agree with the captain that this is an imperfect measurement of consumption vs. output.

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  10. Anonymous8:14 AM

    Ryan Fuller said:

    "Those dollars that we are giving in exchange for foreign goods come back somehow, but it's not in the form of trade purchases. Rather, it takes the form of foreign investment in the United States, which is not figured into the balance of trade statistics."

    That's not entirely true. Thanks to the status of the US dollar as the world's defacto reserve currency, leaders in countries that have trade surpluses with the US and have accumulated reserves of US dollars can - and do - choose to spend some of those US dollars acquiring assets in countries that provide them with natural resources & commodities such as oil, base metals, or precious metals.

    Because of other countries' willingness (so far) to accept our trade surpluses, along with the US dollar being the world's defacto reserve currency, our monetary inflation has for many years been able to manifest its bad effect of rising consumer prices in other countries.

    This is one reason why for many years we could "have our cake and eat it too" - go deep into dept and inflate like crazy, but people in other countries paid the penalty in the form of the higher prices. But sadly, that is coming to an end.


    dtrum said:

    "the USA exports research-intensive modern stuff like computer technology, medical technology, and genetically modified food."

    US imports consist of raw materials (like oil) and all types of manufactured products, from simple to the complex. But US exports consist increasingly of raw foodstuffs and "products" heavy with intellectual property, the latter of which tend to sell only in sample quantities in countries like China. The only category of manufactured item where the US does clearly lead is advanced military weapons.

    We cannot remain a world power nor close our current account deficit with sales of entertainment items like hollywood blockbusters, ring tones.

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  11. Anonymous10:41 AM

    Concerning the capital account, Anonymous made an important point:

    Because of other countries' willingness (so far) to accept our trade surpluses [...] This is one reason why for many years we could "have our cake and eat it too" - go deep into dept and inflate like crazy [...]

    This contains what the Captain said, namely that the USA develops into a bunch of parasites, living off others' savings. This can go well as long as other countries' financial markets remain too underdeveloped for investment, and, of course, as long as the US market is the most sophisticated (I hope you read this, Mr Obama!).

    The Captain is right when he says that the CA somehow reflects American attitudes and capabilites, but I'd say that this is mostly by coincidence. Remember one of the economists' commandments: "correlation is not causation"!

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  12. Anonymous12:36 PM

    FWIW - a correction:

    In my previous post, the phrase,
    "Because of other countries' willingness (so far) to accept our trade surpluses..."

    As is probably evident from the context, that should actually be "deficits" rather than "surpluses."

    The condition I was describing is
    our deficit, their surplus.

    But it got mangled in the course of an edit.

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  13. Anonymous3:44 PM

    As is probably evident from the context, that should actually be "deficits" rather than "surpluses."

    HA! I didn't even notice. I guess my brain's already trained to automatically identify the word "surplus" as a typo in the context of a discussion about American economics.

    ;-)

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  14. Anonymous9:38 PM

    "look what the Chinese, Ruskies & Arabs are studying"

    I hope like hell they are studying the same nation killing BS that passes for economics in US colleges these days. And I hope they do it better, faster, cheaper.

    We are a nation of Keynesian poonannies and my only hope is we hang in there long enough to survive the next New Deal.

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  15. Anonymous11:19 PM

    Is there any more historical data available? I'm certainly curious to see what the spread would look like back into the 70's. I seem to recall the boomers ran a lot of credit in the 80's and now perhaps their kids are doing the same. Oh, that's just a guess because the spoiled brat generation (of the 60's) continues to annoy me to no end, but it would be interesting to see this go farther back in time.

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  16. Anonymous9:44 AM

    Try this one:

    http://www.oldamericancentury.org/charts/graphs/trade_deficit_6003.gif

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