The US Current Account Deficit
December 22, 2008 · Posted in Global Economics
The credit expansion by the Federal Reserve bank has set in motion the workings of the business cycle in the United States. As explained, in phase 5 of the business cycle, would-be savers are crowded out of the market and purchase either inflated stocks or consume part of their earnings which they would have usually saved. This additional demand for consumer goods, coupled with a decline in the actual production of these basic consumer goods, sends consumer prices higher.
Now, if we introduce a second country, say China, to this model, the consumers in the US will turn to goods produced abroad whose prices have not risen yet. Since they have to exchange their fiat money for foreign fiat money, the value of the US Dollar will drop against the Chinese Yuan, thus, after a short adjustment period, curbing US demand again and limiting Chinese exposure to inflated demand from the US and keeping US consumers from outbidding Chinese ones with inflated money. In addition, a cheapening of US goods to Chinese consumers will impel Chinese consumers to buy goods from the US, balancing the current account.
If, however, the Chinese central bank, prints additional Yuans in order to buy the excess Dollars and thus keeps the price of the Dollar in Yuan up, this will enable US consumers to outbid Chinese ones on the market for Chinese consumer goods. This way the Chinese central bank essentially inflates together with the US and lets the Chinese consumer shoulder the burden of US induced inflation, favoring Chinese export businesses who receive the new Yuans first and get to spend it first. A prolongation of the current account deficit in the US ensues which will not disappear until phase 9 of the business cycle, the correction, is completed.
(What adds to imports from China are added imports from other countries that also occur as a result of credit expansion. If the currencies of those countries are free floating, the exchange price of the Dollar will fall when expressed in those currencies. This is what could be observed when looking at the Dollar exchange rate in terms of Euros, Canadian Dollars, and lots of other currencies over the past years.)
The official RMB(Yuan)/USD exchange rate was pushed from 1.50 yuan in 1980 to 8.62 yuan by 1994 (lowest ever on the record). The Chinese government then maintained a peg of 8.27 yuan per USD from 1997 to 2005. As can be seen in the chart above, the current account deficit has developed accordingly.(From 2005 on, China began to peg its currency to a basket of currencies rather than the US Dollar alone. But a certain level of pegging against the Dollar remains due to this basket.)
In doing so, the Chinese central bank impelled its countrymen to produce more and consume less than they would have done without the monetary intervention. The Dollars obtained in exchange for newly printed Yuans were invested in US Treasury securities and thus in effect loaned out to the US government. This is how the Chinese central bank amassed its infamous portfolio of US Treasury securities, providing for an ongoing suppression of the interest rate on US Treasury securities, and creating the illusion of a never ending supply of financing from abroad. Of course the money was being spent by the US government on more consumption at home and thus ultimately resulted in domestic consumer price inflation as well.
If US politicians were sincere about addressing the issue of the US current account deficit, they would need to remedy the source of the problem. This would require an unconditional abandonment of the policy of credit expansion and a return to a sound monetary policy under a gold standard.