Trade Deficits, Debt-Fragility & Seismology: Forecasting The Next Economic Collapse

by Spencer P Morrison, NEE

Why America’s Trade Deficit Will be at the Heart of the Next Economic Collapse

Ask ten physicists a question about physics and you will get one (correct) answer.  Ask ten economists a question about the economy and you will get ten answers—all wrong.
It’s no secret that economists are notoriously bad at predicting how the economy will behave.  In fact, distinguished academics have made entire careers, and written books pointing this fact out.
There are many reasons for this: the time-frame is often too long to provide adequate feedback to forecasters, the economy is a complex system that’s governed by second-order causality, and many economists just aren’t that bright (and many more are simply corrupt).  Like I said, lots of reasons.
My point: prediction is pointless.
At best, economists can forecast the likelihood of major events, like the next big stock market crash, or the ever-impending economic collapse.
In this article I’m not going to try to predict anything—I’m sure I’d be no better than a coin-toss.  Instead, I’m going to identify areas of systemic weakness, areas of the economy that are exceptionally vulnerable to shocks.  In doing so, I will be acting more like a seismologist: I can’t tell you when the next big earthquake will happen, but I can tell you where to expect trouble.
This method (identifying weakness) is both much easier, and much more useful.

Fault Lines: the US Trade Deficit

US trade deficit chart
The US trade deficit is a smoldering fault-line, and it poses dangers that are tectonic in scale.  Not only does the trade deficit generate debt-fragility in the US, but it is the ideal conduit for (otherwise isolated) economic contagions to spread globally.
But first, what is the trade deficit?   Simply put: America runs a trade deficit when it buys more stuff from foreign countries than it sells.  It is when our imports are greater than our exports.
America’s running a massive trade deficit, and has every year since 1973.  In 2016 America’s goods trade deficit was $750 billion (we ran a services surplus of $250 billion).  Overall, according to the US Census Bureau, America’s balance of trade was a negative $500 billion in 2016.
 
Basically, the deficit is large.  More importantly, it’s been growing for decades (as you can see in the graph).
There are many reasons (environmental, political, and economic) to shrink the trade deficit, but for now, I’ll just focus on how the deficit increases the risk of economic collapse.
 
 

America’s Living in a Consumption Bubble—Eventually it’ll Burst

 
Debt and integration are the two biggest fragilizing elements in any economy.  The trade deficit creates the former and necessitates the latter.
What many people don’t seem to understand (or don’t want to understand) is that there’s no such thing as a free lunch: the piper must always be paid.  We pay for the trade deficit.   How?
There are four, and only four ways for the US to acquire foreign goods:
1. We could get them for free via theft or gifts.  Unless we’re prepared to become Viking raiders, or default on all of our foreign debts, this probably isn’t a viable option.
2. We could trade our own goods for them: this would result in a neutral balance of trade.  We’re doing this, obviously, but we’re not selling enough to balance the books.
3. We could trade for them using stuff we made in the past—ie. selling off assets, like property, stocks, and land.  This causes a trade deficit.
4. Or we could buy foreign goods using stuff we promise to make in the future, in other words, debt, like US Treasury Bills.   This also results in a negative balance of trade.
Since we have a deficit, we know we’re dealing with options three and four.  Think of it this way: if America were a family, we’d be selling aunt Betty’s antique furniture (assets) and using uncle John’s platinum credit card (debt) to pay for the groceries.  It’s a bad idea for Betty and John, and it’s a bad idea for America.
As America’s trade deficit rises, so too does foreign ownership of American property.  For example, foreign investors now own 20% of all US equities—up from just 12% in 2007.
Likewise, foreigners have been buying up billions-worth of US property (land and housing).  In 2015 alone, foreigners purchased over $100 billion in US land assets.  This is one of the reasons that homes are 73% more expensive (in real terms) today than they were in the 1970s.
That takes care of the assets.  Now for the debt.
Currently, foreign entities hold roughly 44% of America’s national debt—that’s $6.3 trillion.  When we buy foreign goods, we sell them our debt, which enables additional government spending.  It’s a cycle.  And it’s a bad one.  Why?  Because not only do we owe them the principle (the amount of our debt that they bought), but we also owe them interest—we’re paying foreigners for the privilege of buying their products.
The below graph shows you what I mean:

US debt graph
America’s national debt has been increasing dramatically in recent years. In part, this growth’s been fueled by our trade deficit—we buy foreign goods in exchange for debt.

Of course, it’s not just the government that’s acquiring huge sums of debt—it’s the American public too.  Foreign countries and private investors now own 29% of all US corporate bonds.  And this number’s increasing.
graph showing US personal debt to GDP ratio 1947-2015
The same is true of US household debt: although the 2008 Recession cooled it down slightly, we’re gearing up for more borrowing.  We didn’t learn our lesson.
So why is this all bad?
To start with, high debt loads create fragility by limiting optionality: we have less room to maneuver when we’re manacled by mountains of debt.  And of course, people are more prone to panic when carrying high debt-loads.  This causes little hiccups to snowball.
Moving beyond debt: trade deficit aren’t sustainable.  Everything has a price, and eventually we’ll run out of stuff to sell.
 
At that point, we’ll either have to lower our consumption (which decreases our standard of living) or increase our  output to trade for foreign goods (why delay what’s inevitable?).
Right now we’re living in a consumption bubble, paid for by selling our inheritance and mortgaging our future.
When the bubble bursts, we’ll be worse off than if we had never traded.  This is well-attested to both in history and in economic literature (dating back to at least 1970 in a paper written by Joseph Stiglitz).
Bubbles always burst—the piper always gets paid.
Finally, the trade deficit is, by its very nature, a product of increased economic globalization.  Trade is often described as the lifeblood of the economy.  This is apt.  However, what’s left out of the analogy is that the bloodstream carries cancerous cells just as effectively as it does healthy cells.  Integration aids contagion.
This is why problems in tiny Greece brought the EU to its knees.

How to Survive the Next Economic Collapse

Knowing where the risks lie is important: it is like having a map of where all the worst fault lines are.  We can’t predict the next economic collapse (or earthquake) with certainty, but we know where it’ll be.
America needs to ween itself off the trade deficit, and its addiction to debt.  This will not prevent the next economic disaster, but it will limit its scope and impact.  It will be manageable.
It’s time we fixed America’s economy.