The Investment Scientist

The Trade Deficit: How Would It Affect You?

Posted on: April 3, 2018

 

trade-deficit.jpgIn 1971, Nixon ended the gold standard and since then the US has been consistently running a trade deficit. The US has not gotten poorer but instead has benefited tremendously from trade deficits.

Prior to that time, foreign holders of dollars could  redeem the money in gold and ship it out of the country, resulting in the loss of national wealth. That’s why prior to 1971, the US generally had a trade surplus.

After the ending of the gold standard, the US dollar became a fiat money that can theoretically be printed at will. When the trade deficit with China was $350 billion last year, what it actually meant was that China sent us $350 billion worth of goods, and we gave them our printed paper(fiat money dollar) in exchange. The USA is the only country that can do that because the dollar is the world currency! I suspect China is secretly envious of our position.

The paper money they earned didn’t get shipped back to China because it has no use there. It got recycled back into our economy through the capital market.
 That’s why China is the biggest foreign holder of our treasuries. For years, treasury yields were below inflation rate. In effect, Chinese money has been subsidizing our federal government with a negative real interest rate, also indirectly making mortgage rate very low thus housing more affordable for the average American.

If the trade deficit is a one way street, the US has been winning hand over fist.

The danger going forward is that dollar may not remain the world currency forever.

Shortly after ending the gold standard, Nixon negotiated with Saudi Arabia, then the biggest oil producer in the world, to make dollar the only tender for Saudi oil, thus the term “petrodollar.” With that and the fact that the US was so dominant in economy, trades and military, the dollar quickly became the world currency even though it was a fiat money not backed by gold.
Today, although our military remains dominant, our economy is less so, and we are no longer the #1 trading nation. That title now goes to China. On top of that, China just started yuan-denominated crude oil futures trading in Shanghai. This could be seen as a shot across the bow at petrodollar.

President Trump’s visceral hatred of trade deficits, much like his fondness of coal and steel, might come from the bygone age, but it is also not too soon to prepare for the rainy day when the dollar is no longer the only dominant world currency. However, actions he has taken to reduce trade deficits already has a side effect: Interest rates are creeping up! The economic logic is straight forward: the lower the trade deficit, the lesser the capital in the market and the higher the borrowing cost. This cost will be borne by the federal government and home buyers alike.

(Feel free to share if you find it insightful.)

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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