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US economy, trade deficit and monetary policy
Gerard Jackson
Admirers of President Bush are right to warn critics of the economy, particularly those Democrats who are praying for a Bush recession, that they are ignoring the economy’s enormous entrepreneurial resources and its remarkable resilience, despite the efforts of many politicians, not all of them Democrats, to chain this Prometheus.
Terrorist attacks, war in Iraq and Afghanistan, a world-wide campaign against Muslim terrorism, rocketing oil prices –– and to top it off, Hurricane Katrina just about wipes out New Orleans. And what happens to the economy? The colossus barely sneezes. This is a truly remarkable beast.
In November 2001 manufacturing hit bottom after it which it swiftly rebounded and has continued to expand. As a further sign of the recovery that the Dems and the leftwing mainstream media hate, non-farm employment grew by 4.2 million, nearly 4 million of these jobs are in the private sector. (Eat your heart out, Europa. In case you haven’t noticed, I’m in a rather classical mood today).
So to the dismay of the Dems the economy successfully enters it fifth year of continuous expansion, considered by some to be the longest recovery since WW II, without any signs of slowing down. Furthermore, analysts have noted that the yield curve has not inverted, meaning that long term rates exceed short term rates. A reversal of this situation is taken as a signal of a looming recession.
Unfortunately there are storm warnings ahead. Rates on 30-year mortgages have now risen to 6 per cent and are expected to rise further. The current account deficit is still blowing out, with some economists predicting a $US700 billion deficit this year, exceeding last year’s by about $US100 billion. But claims that oil and Chinese exports are driving the deficit are nonsense. This is the sort of economic illiteracy that is widespread in the media.
Let’s go back to 2000 and look at a little monetary history. As I predicted the economy went into recession with M1 actually contracting by 3 per cent, meaning that there was a mild deflation. However, since January 2001 M1 has expanded by nearly 17 per cent. This might not seem a lot but those commentators who think this is a modest figure are greatly underestimating the power of money.
It is no accident that the trade deficit started to rapidly grow again shortly after M1 began to quickly expand. Now many economic commentators claim that trade deficits are never a problem. They are perfectly correct, just as spots are never a problem when someone gets measles. My point is that if a trade deficit is being driven by a loose monetary policy then recession tends to be unavoidable.
Take oil as an example. Many journalists are asserting that the hurricane-related demand for oil will worsen the trade deficit and cause interest rates to rise, which in turn could depress economic activity. This is the old “necessities” fallacy that has been frequently used to explain growing deficits.
If there was any truth in this fallacy then countries would never suffer famines. Every time famine threatened all a country would have to do is run a trade deficit. So why doesn’t this happen? Because even necessities, including oil, have to be paid for out of purchasing power. If a country suffers a food shortage it will have to export more goods and services. If it does not have the necessary export capacity it must sell securities or other kinds of assets. If it has no assets then it must rely on charity.
This brings us back to the US deficit. When a country runs a deficit because it imports capital from willing lenders to expand its capital structures there is never a problem. However, when a country’s deficit is being largely driven by the printing press then things can get sticky.
Because of the sheer size of its economy, a monetary-induced deficit by the United States distorts the pattern of international trade as well as internal investment. Many of its enterprises will become excessively oriented toward the domestic market. The opposite holds true for foreign exporters. These countries will become excessively oriented toward serving American consumers.
One might even find that because of price distortions caused by loose monetary policy some US firms will have been deceived into abandoning investment in the US in favour of investing abroad. However, once the monetary brakes are applied and the trade deficit begins to falls, imports will drop off and those foreign firms that became dependent upon American consumers for their welfare could very well suffer severe losses.
This is what happens when the power of money is underestimated. Unfortunately very few members of the economic commentariat are acquainted with this line of thinking. And the way things look right now, I don’t think this situation will change any time soon.
At the end of the day, we ought to be able to see that the great economic destabiliser, the creator of the business cycle, the father of international financial crises and the demon behind rampant speculation and “irrational exuberance” is no other than lousy monetary policy caused by a lack of understanding of how money impacts on prices and investment decisions.
Gerard Jackson is Brookes’ economics editor
BrookesNews.Com
Monday 17 October 2005