When Will History’s Biggest Consumption Bubble Burst?

- November 14th, 2017
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Ask 10 physicists where an asteroid will be in one year, and you’ll get one answer, and it is likely to be correct. Ask 10 economists where the economy will be a year from now and you’ll get 10 answers—all wrong. The disheartening truth is that economists are notoriously bad at prediction. We saw this recently with the 2008 financial crisis: very few economists saw it coming, and fewer still knew when it would hit.

There are many reasons for this: the time-horizon is often too long to provide economists with adequate feedback, meaning they cannot learn from their mistakes. Paradoxically, economists have too much and too little data, ensuring they either lose the signal in the noise or have nothing to work with; and many economists are paid to profess certain positions.

My point: economic prediction is pointless.

But that doesn’t mean we’re helpless. Economists may not be able to predict the next crisis, but they can make forecasts. The difference is important. A physicist can predict, with certainty, where a billiard ball will travel if struck. Economists traditionally liken themselves to physicists: the economy is a giant pool table governed by laws like supply and demand, and if we have enough information we can predict its behavior. This is a terrible analogy, and it explains why economists are often wrong. The economy is more like earth’s atmosphere or the human mind because it is a complex system, governed by second-order causality: its emergent properties tangle cause-and-effect chains to such a degree that prediction is impossible.

At best, economists can identify areas of systemic weakness, places where the economy is most vulnerable to shocks and contagion. Knowing where trouble is likely to occur is valuable because it gives us time to plan—we cannot stop the next hurricane, but we can build levees in vulnerable areas.

America’s Trade Deficit is Hurricane Alley
Contrary to the leftists at the Washington Post, the trade deficit poses vast risks to America’s economy. Why? It exacerbates the problem of debt-fragility, and it is the ideal conduit for an otherwise isolated economic contagion to infect America.

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. Right now America is running a massive trade deficit and has done so every year since 1973. In 2016, America’s goods trade deficit was $750 billion, and we also ran a services surplus of $250 billion. Therefore, America’s overall balance of trade was negative $500 billion in 2016. The deficit is large and has been growing for decades.

How do we pay for the deficit? After all, there is no such thing as a free lunch. America has four ways—and only four—to acquire foreign goods:

1. We could get them for free through theft or gifts.  Unless we’re prepared to become Viking raiders or default on all of our foreign debts, this isn’t a viable option.

2. We could trade our 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 foreign goods using stuff we made in the past—for example, by selling off assets such as stocks and land. This results in a trade deficit.

4. Or we could buy foreign goods using stuff we promise to make in the future—selling debt such as U.S. Treasury Bills or corporate bonds. This also results in a trade deficit.

America runs a trade deficit, which necessarily means we are paying for it using options three and four, selling assets and debt. The data bears this out.

Foreign investors, flush with cash from their trade surplus with the United States, own 20 percent of all American equities. That’s up from just 12 percent in 2007. Likewise, foreigners have bought up billions of dollars worth of physical property in America—everything from penthouse suites in New York to ranches in Oklahoma. In 2015 alone, foreigners purchased more than $100 billion in U.S. real estate. This is partly why houses are 73 percent more expensive (in real terms) today than they were in the 1970s—we traded “cheap goods” for expensive housing.

Foreign entities (governments and private investors) also bought U.S. debt with their trade surpluses, which is part of the reason government spending is so out-of-control—the trade deficit ensures foreigners are a replenishing source of capital. Currently, foreign investors (governments and individuals) own some 44 percent of America’s national public debt, valued at over $6.3 trillion. Not only must this principle sum eventually be repaid, but we also owe interest on it which will cost taxpayers hundreds of billions over the coming decades. Further, foreigners also bought-up much of America’s private market, and now own 29 percent of all U.S. corporate bonds.

Crystal Goblets and Hydra
Although there are many economic and political reasons for reducing the trade deficit, I would like to focus on a reason that receives very little attention: fragility.

Something is fragile if it is harmed more than helped by volatility. The classic example is a crystal goblet: change can only hurt it. Contrast this with the mythological Hydra, which grows two heads for every one it loses. Crystal goblets hate volatility; Hydras love it.

The trade deficit creates fragility in many ways. For starters, foreign trade necessarily increases national fragility by increasing economic interdependence: the more the United States depends upon foreign products, the more the country may be harmed by logistical or price disruptions (volatility). Likewise, large trade deficits mean we depend more on our trading partners than they rely upon us: this strips us of leverage should things go south. Trade is essential, but it’s possible to have too much of a good thing.

The trade deficit also makes America fragile by feeding our debt addiction. My favorite stock-trader-turned-philosopher Nassim Taleb notes that high debt loads create fragility by limiting options—high debt limits our room to maneuver in times of financial crises. Further, there is a psychological component at play in that people are far more likely to panic when they are highly indebted. Panic is what causes everything from bank-runs to stock market crashes. It’s why little hiccups tend to snowball.

Most importantly, trade deficits aren’t sustainable. Eventually, we will run out of property to sell and our debt will be too expensive to service. What then? Either we’ll need to reduce our consumption by buying fewer imports or increase our output to trade for foreign goods. Right now we’re living in a consumption bubble, and to pay for it, we’re selling our inheritance and mortgaging our future.

Eventually, the bubble will burst. When it does, we will be worse off than if we had never run the deficit in the first place. History and theory attest to this truth. For example, Great Britain ran a large and persistent trade deficit at the end of the Victorian Era, which contributed to the country’s economic decline. Likewise, the economist Joseph Stiglitz has shown that chronic trade deficits inevitably lead to consumption declines when the bubble bursts. In fact, his models suggest that it’s a “mathematical certainty.” The piper always gets paid.

It’s impossible to predict precisely when and where the next big hurricane will hit—it could make landfall anywhere between Corpus Christi and New York City—but we do know how to make our cities and buildings more robust concerning floods and windstorms. The same is true when it comes to economics. We don’t know what will cause the next economic crisis, but we do know that significant trade deficits and high debt loads will inevitably make it worse.

We should get our house in order before the next storm lands.

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