Since the 1980s, the U.S. trade deficit has been a constant force in the American economy, rising more some years than others, while corporate bond yields have been generally falling.

The flow of funds table for “Rest of the World” ([1] F.107) shows that the excess of imports over exports has resulted in an increase in U.S. financial assets owned by foreigners.

These accounts also demonstrate the preference of foreign investors for fixed income securities and the dominant role that the trade deficit has played in the U.S. bond market.

Because rising trade deficits lead to increased demand for fixed income securities, and because issuers have not fully met this demand, the price of bonds has risen for twenty years, while bond yields have fallen, as the graph shows. To understand the capital market, we must examine the forces behind this remarkable trend.

The Starting Point: The Gold Standard Ends

In the early seventies, President Nixon unplugged U.S. dollars from gold and the gold standard was no more. Governments everywhere struggled to control their balance of payments in the post gold years.

In the U.S., the hangover from spending excesses of Johnson’s Great Society and the War in Vietnam, two Oil Crises, the domestic political turmoil of Watergate, the weak presidency of “Jimmy Carter”, and the coming of age of Baby Boomers, rounded out a dismal decade in which inflation and unemployment soared, producing a high “misery index” and a balance of trade that was, compared to later years, virtually in balance.

American bankers, still the world’s leading financiers, recycled “petrodollars” through undisciplined lending to third-world countries, many of which rationed foreign exchange and controlled imports. In the early 1980s, debtors to American banks, particularly in Latin America, began to default; import controls were abandoned and freer trade and economic chaos ensued.

The eagerness of foreign exporters to acquire dollars — a means of payment that was unquestionably better than the currencies of inflation-ravaged developing economies, and a worldwide easing of trade restrictions, plus U.S. trade policy that was friendly towards globalization and seemingly indifferent towards deindustrialization, encouraged the rising U.S. trade deficit that drove down bond yields.

By 1986, the strain of deregulation and easing in exchange controls, pressured American banks. With the Savings and Loan Crisis at home, problems with foreign debtors in Latin America, and speculative excesses in derivative markets, U.S. bankers were forced to retreat on a global scale.

In October 1987, the stock market crashed as risk concentrated in derivatives unhinged trading. For a few years following 1987, the trade deficit fell to levels reminiscent of the dismal “Jimmy” Carter era. However, fortunately the decline was temporary; by 1990 the trade deficit was again increasing. By 2003, six of the world’s top twenty banks were still owned by American interests.

The correlation between the trade deficit and bond interest rates is real, as the next graph and logic suggests. However, other factors also effect bond rates.

Finding A World Currency

The fatal flaw of the gold standard, which no one was able to resolve, was that the availability of gold-backed trading currency was limited by the physical supply of gold. World trade was a function of population growth, technological progress, and economic expansion — all of which were expanding faster than gold inventories.

For fifty years following WW II, world gold production per capita declined. The shortage of gold-backed money was braking the growth of commerce. What was needed was a trading currency that could expand and adapt to the needs of world trade.

Despite various suggestions of commodity-backed currencies that might replace gold, including one from Benjamin Graham, no leadership arose to implement such ideas. By circumstance and chance, rather than by design, the U.S. dollar was positioned to become the world trading currency once the gold standard was abandoned. There are commonsense explanations why this occurred:

1. Wealthy people in many countries had become accustomed to keep part of their savings in U.S. dollars. No other currency was as widely held and accepted.
2. When the U.S. went off the gold standard, American banks (and their English cousins) dominated international finance and had decades of experience in lending dollars to facilitate international commerce. It was easier to engage in dollar-denominated transactions than in other currencies.
3. The were no other countries in the world with economies sufficiently large and prosperous to support an international trading currency without interfering or conflicting with domestic affairs.
4. Other than the U.S., none of the largest countries had two hundred years of continuous government under a legal and economic system proven to be reliable and relatively protective of property and human rights.
5. No other country, of comparable size, allowed foreigners to freely purchase real estate and other assets, without discrimination and with full and credible protection of law. This meant that dollars, although not convertible into gold by the government, could be exchanged for American real estate or mortgages. Furthermore, the U.S. had a relatively open-door policy regarding immigration, especially immigrants with assets. This meant that foreigners with dollars could, in the event that their own country fell into economic or political turmoil, use dollar assets to move to the U.S. and safety.
6. No other country of comparable size and economic stability would permit a persistent trade imbalance that would result in the loss of better paying jobs and deindustrialization.

Is the Trade Deficit Inflationary?

The trade deficit has fueled long-term expansion in consumer and housing credit in the U.S., which ordinarily would lead to rampant inflation, but this has not happened. Or has it?

See “[2] Fiddling the CPI“

Inflation is defined as a generalized rise in prices. There is debate about the “causes” of inflation, but many people would say that inflation occurs when the supply of money outpaces the supply of goods and services.

In the United States, much of the trade deficit represents the result of Americans purchasing goods at prices lower than the same goods could be produced in the United States.

So, with regards to clothing and plastic toys, the trade deficit does not seem to be inflationary. However, with regards to oil, a large piece of American imports, prices are rising, so we can’t say that the trade deficit only represents cheap goods. Furthermore, the money that Americans save on the price of clothes and plastic toys now competes for a limited supply of medical services and college degrees, areas in which prices are clearly rising.

On other side of the trade deficit are dollars that foreigners leave on deposit in American banks or use to purchase U.S. debt instruments. The supply of these foreign savings, relative to the supply of debt securities, has helped to drive down bond interest rates for twenty years.

These foreign savings have also made credit readily available to American consumers. With easier credit for home mortgages, demand for larger and fancier homes is enhanced. Without question, real estate prices have been rising along with the rising trade deficit.

On the positive side, foreign holdings of U.S. Treasury bonds have allowed the government to run fiscal deficits, without printing money. In this way, the trade deficit helps keep inflation under control.

An interesting angle in the trade-deficit/inflation debate is the often-heard contention that bond prices rise to counter inflation. Is this true or not? For twenty years, bond prices have been falling, not because inflation has gone away, but because the more money has been chasing a limited supply of bonds.

You might even say that the trade deficit has caused an inflation in bond prices. On the other hand, the foreign exporters that are willing to accept dollars are often afraid of inflation — that of their own currency.

Before getting lost in the wilds of macro-economics, we might stick with a single thought: fear of inflation does not necessarily mean that bond prices will fall; bond prices fall when sellers of bonds are more motivated than buyers.

See “[3] The Motivation Axiom“.

Because bond prices have been rising for twenty years, we can conclude that bond buyers (many of whom are foreign investors) are more anxious to acquire bonds than issuers (agencies, ABS issuers, governments, and corporations) have been to sell bonds.

Why The Trade Deficit Grows

If the dollar is to continue to be the primary means of payment in world trade, the volume of dollars in the hands of foreigners must increase, to match the expansion of commerce. The only way that the amount of dollars held by foreigners can increase is for the U.S. to run a trade deficit.

According to OECD statistics, total world trade (goods and services) increased $72.9 billion between 2001 and 2002, and increased $95.8 billion between 2002 and 2003.

However, the trade deficit in 2001-2003 was about five times this reported growth in world trade.

Over the period 1980-2004, the U.S. trade deficit grew 15.3% annually. The WTO statistics show world trade growing at 7.08% (services) and 5.73% (goods) in the period 1980-2000.

In other words, as a source of currency for world trade, the U.S. trade deficit was five times larger and was growing twice as fast as needed. How might this discrepancy be explained?

How Big Is The World Market?

Like other statistics in which sources have motives to conceal things from the government, official world trade statistics are significantly understated. For example, the UNDCP estimates the world drug trade at $500 billion, which, if true, would mean that global trade figures for the period 2001 to 2003 were at least 20% understated. There are reasons to suspect substantial under-estimation of trade figures:

• Smuggled goods are obviously not reported, including drugs, clandestine military shipments, prohibited products, counterfeit goods, wild animals, tobacco, alcohol, firearms, diamonds, illegal logging, art, cultural artifacts, etc.
• Much of the trade between people living along borders is unreported, especially when distant from capital cities. (e.g., the Brazilian frontier.)
• In some cases, goods processed in “maquiladoras” and similar processing facilities are not properly reported.
• Goods carried by travelers are not reported.
• Services sold over the Internet or hand-carried (e.g., blueprints, plans, etc.) are not reported.
• Services sold through foreign subsidiaries are not reported as trade, but as foreign investment, even when the service providers are residents of and paid in the currency of the home country.
• Different methods are used to record data (e.g., f.o.b. vs. c.i.f.)
• Economic and political upheavals cause gaps in reporting.
• Shipments, including through the mails and delivery services, of gifts, merchandise, and household goods are often not reported.
• Under-billing is often used to transfer profits to affiliates abroad.
• Some countries do not gather statistics at all or do not report to international agencies.
• There is non-reporting of bunker fuels, port supplies, and transactions on airplanes and ships.
• Values are understated to evade customs duties.

Taking all these elements into consideration, it is possible that actual world trade could be double the official figures, which would mean that the size of the U.S. trade deficit would still be about double the amount necessary to support its role as an international currency.

Something else must be going on.

Part of this “something else” is the float phenomenon, described in the article “[4] U.S. Trade Deficit Increases 10% in October 2004“.

Another reason is dollarization described in the article, “[5] The Trade Deficit and Dollarization“. There are yet another reasons: the recurrence of international financial crises and the arrival of new players.

The Cost of “Getting Back Into The Game”

Like at the beginning of a Monopoly board game, players in the international trade arena started out in the 1970s with a supply of dollars with which to trade.

In Monopoly, players can keep playing as long as they have a supply of Monopoly money. When they run out of Monopoly money, players must quit. However, in the real world, countries are not able to quit the game.

In a post-gold standard environment, a country can engage in foreign trade for an indefinite period, unless it makes the mistake of using dollar debt as a source of capital to build factories, as occurred in Southeast Asia in the 1990s and in Latin America in the 1980s.

When a country that does not print dollars tries to use dollar debt as capital, the bill eventually comes due and economic meltdown follows. In order to “get back into the game”, the failed economy must go all out to increase exports and accumulate the dollars needed to remain a player in the global economy.

Over the last twenty years, there has been no shortage of countries with failed economies due to dollar debt: Brazil, Thailand, South Korea, Indonesia, Mexico, Russia, to name some. In most cases, these crises were followed by increased emphasis on exports, often to the United States, as part of an economic recovery plan.

Citizens of these countries, having just had a lesson on the perils of relying on their national currencies, gained respect for having savings in U.S. dollars. Their willingness to sell goods at very attractive prices into the wide open American market in exchange for dollars ensures faster expansion of the U.S. trade deficit.

The Needs of “New Players”

Pushing our Monopoly board game metaphor a bit further, let us imagine that new players come into a game that is already going on. They will need Monopoly money to play. Similarly, new countries will come into the global market in goods and services throughout the 21st century.

According to the World Bank, 117 countries are now in the low-income or lower-middle income classification. The participation of developing countries in the global market for manufacturing has increased from 7% in 1973 to 20% in 1995.

Many regions in Africa, the Middle East, and Latin America are still far behind Asia, Europe, and North America in production of industrial goods. There is enormous potential for growth of world trade as these countries and regions come into the “game”.

As each country begins to industrialize, new factories will produce for the world market, trying to maximize returns on capital. The source of capital for these factories will influence the currency preference of those controlling the export decisions.

The position of the United States, not only in international private banking, but in the World Bank and development banks, will support the advantage of the dollar as the preferred trading currency.

Seen in this light, the question becomes, “As more and more of the world industrializes, will the United States still be big enough to continue to act as supplier of the global trading currency?”

Natural Limits on the Trade Deficit

Rather than think of the trade deficit as a negative economic indicator, we might think of it as a source of economic advantages.

Lets suppose that the national goal was to increase the trade deficit and that there was complete indifference to deindustrialization and foreign ownership of domestic assets.

What might be the limiting factors on retaining the role of the dollar in international trade?

• The trade deficit cannot grow faster than American willingness and ability to purchase goods from abroad, which is related to the growth of the Gross National Product. Anything that slows the growth of the GNP, such as higher taxes, reduces the potential for an increasing trade deficit. As the trade deficit decreases and eventually disappears, the usefulness of the dollar as an international currency diminishes.
• If, over many years, GNP grows slower than the GNP of the Rest of the World, growth of the trade deficit will be limited and the dollar will eventually cease to meet the requirements of an international currency.
• Foreigners’ appetite for American debt may also be limited, at some point turning to real estate or commodities. If this happens, consumers would have less financing to buy goods from abroad, reducing the trade deficit. There would also be less financing to cover the fiscal deficit, which be inflationary, diminishing the worth of the dollar as an international trading currency.

It is almost certain that, at some point, the trade deficit will begin to fall, with consequences for the American capital market. However, this is not because the trade deficit is inherently unstable, but because the advantages of the trade deficit are not widely recognized.

With no specific policy to support the trade deficit (and the role of the dollar as the currency of international trade), sooner or later some well-meaning law will be enacted that has the unintended consequence of eliminating the trade deficit. (The intent to eliminate the trade deficit may also be conscious, such as in the 1988 Omnibus Trade and Competitiveness Act.)

Why Bond Prices Keep Rising

With a large trade deficit growing much faster than the U.S. GDP and the supply of credit instruments for a generation, bond prices were forced up; yields had to decline. It was just supply and demand.

The trade deficit increased not because interest rates attracted foreign investors, but because the dollar was the currency of global trade.

The graph, above, shows that over the period 1981-2003, bond yields rose on four occasions, and then resumed a downward trend caused by an ever-larger trade deficit.

It seems that, as long as the dollar continues to be the principal international currency, U.S. bond yields will continue to fall.

As in the last twenty years, there may be times when bond prices fall. But, while the dollar is the global currency, pressure from the trade deficit will continue to weigh on bond yields.

In addition to the trade deficit, there are other reasons why bond yields may continue to fall:

• There may be reallocation of assets from equities to fixed income securities, as the over-pricing of stocks becomes generally recognized.
• There may be a shift of pension savings from equities to bonds as Baby Boomers retire.

The ability to predict trends in the U.S. trade deficit is key to long-term forecasting of bond yields.

What Will It Take to Halt the Trade Deficit?

Since the 1970s, when the world went off the gold standard, political pressure to reduce the trade deficit has come mainly from the Democratic Party and labor unions.

Certainly, trade deficits were low during the Carter years, not the best of times. The reduction in the deficit from 1988 to 1991 followed Congressional passing of the Omnibus Trade and Competitiveness Act in 1988, with the notorious “Super 301″ provision.

This provision threatened retaliation against countries engaged in “unfair” trade practices. Since 1986, Representative Richard Gephardt (D-Mo) had been trying to impose import quotas against countries that ran large trade surpluses with the United States (principally, Japan, Taiwan, and West Germany).

The “Super 301″ provision of the 1988 Act brought violent condemnation from America’s trading partners, but also led, temporarily, to a reduction in the trade deficit.

Eventually, the deficit-anxiety hysteria went away, labor unions became more interested in government employees than factory workers, the U.S. sponsored NAFTA (1992) and joined the World Trade Organization (1995), and protectionist advocates ( like Richard Gephardt, Pat Buchanan, Lou Dobbs, and Ross Perot) became increasingly old-fashioned and quaint in a new era of globalization.

However, things could happen to reverse the upward trend in trade deficits and bond prices:

• A radical Democrat could be elected as President, together with a Democratic majority in Congress, with leaders determined to impose protectionist measures and abandon the World Trade Organization;
• Something could happen to close U.S. ports, such as weapons of mass destruction arriving undetected in shipping containers.
• There could be a collapse in the U.S. banking system, perhaps as the result of excessively large speculative trading positions in OTC derivatives or massive failure of computer systems.
• The Europeans might invent an international currency with advantages that would make the dollar less advantageous in global trade.

If any of these things happen, we might eventually expect bond prices to fall as demand of foreign investors fades away. Whether this is good or bad will depend on what position you have in bonds.