Trade Deficit to Spark War

In order to understand deficits, you’ve got to read hundreds of hours boring economics books ad nauseam. For the sake of time, and sanity, we’ll keep it general and speak of what is happening now and why. We’ll also look at how things are about to change.

Our government has a huge responsibility when it comes to our economy. The Federal Reserve, with help from the Treasury and Executive branch, has the ability to steer our economy in which ever general direction they want. As recession began taking hold back in 2000, steps were taken by the President and the Fed to alleviate the lack of spending in the economy… spending capital is the locomotive behind economic growth. The President flooded the market with cash by cutting taxes and raising government spending, while the Fed cut interest rates thereby increasing money supply and big ticket spending activity (spending creates the need for new jobs, new jobs create new spending, creates jobs, rinse and repeat… etc…).

It was of utmost necessity that the US government went into debt during this period. What the governments plan was, and it has worked, was to finance an economic boom. Since the government doesn’t keep a savings account or a 401K, credit was in order. Flooding the market with money combined with government spending effectively halted the recession, turned our economy around, and got it back on its feet… as illustrated by the tightening of money supply we’re seeing today.

The grand result of this financing was huge debt, which we’re dealing with now (a broader tax base created by the boom will eventually lead to a diminishing of debt and a possible surplus in the treasury, as long as government spending is reigned in.) In a nutshell, we’ve got a budget deficit because we used debt to finance growth. Now, growth in the private sector has created a broader tax base capable of paying back the loans…and then some! This is what you’d call a good return on investment.

Our other deficit, trade, is the result of you and me. Americans love to spend money; in fact I just got a Dunkin Donuts coffee delivered to me mid-sentence. As said before, spending money is what moves economies. But, unfortunately, spending money on other countries goods hardly helps the situation (unless they’re spending more money on our goods than we are on theirs). Any red blooded American prefers to buy American made goods. But when comparing prices, as we red blooded Americans do, we almost always go with the cheaper one… which usually happens to be the Chinese version.

Chinese goods are selling like hot cakes (could someone inform me what a “hot cake” is?). American dollars are being shipped to Asia in return for deeply discounted products resulting in a huge trade imbalance. US imports from China rose by 37% in January and February while our exports to China fell by 10%. Their products are just so darn cheap....and for good reason.

Chinese workers are paid pennies per hour compared to Americans who make $12, $15 or $20 at the same job. The price of shipping goods from China to the US does eat into a small bit of the profits, but not nearly enough to make American goods comparable, price wise. But, more importantly, the Chinese currency is being manipulated giving them a huge edge in trade; further off-balancing prices. These price differences are what are causing our huge trade deficit. How do we fix this?

We can stop buying Chinese goods, but how can you pass up a deal? We can cry unfair Chinese labor conditions to the World Bank and the UN, but with 1.3 billion people competing for 650 million jobs the employers have the edge… and can pay dirt to these people. There’s only one answer.

China may seem like a market economy from the outside view, but in fact the nation is cold hard communist. And they have an ace in their sleeve that allows them to sell goods for almost nothing regardless of labor and shipping costs… the pegged yuan renminbi. The yuan (Chinese currency) is not freely traded as is the dollar, the euro, the British pound, the Swiss franc… or any other competitive currency. What is unique about the yuan is how they’ve valued it.

The yuan is pegged directly to the US dollar. No matter what the strength or weakness of the dollar is, the yuan remains fixed. While a strengthening dollar means a strengthening yuan (leading to higher prices for American goods and Chinese goods abroad), there is no difference in prices to us…they stay pegged too. Chinese goods do not get more expensive as the dollar appreciates. So they stay cheap, we keep buying. Here’s the kicker… not only is the yuan pegged, but it has been attached to the dollar at a deeply discounted rate, it is worth perhaps 40% more on the open market.

Should China freely trade their currency, prices of Chinese goods would increase greatly here in the US and our trade deficit would begin to balance as American consumers began buying more competitive American goods here, and Chinese goods would become more expensive in China compared to American goods there. Over time, the market would come to balance. So how the heck will this ever happen? Our government has been pressuring China to free her currency for roughly two years now. China’s reply “we’ll do it if and when we want to.” Rhetoric only goes so far. We’ve reached a point of action.

By the time July rolls around, the US Senate will have voted on a measure that will help balance the unfair playing ground created by China. The legislation will effectively give China a deadline to float (freely trade) her currency or face steep consequences in the form of trade tariffs.

Once passed, China will have six months to take action on the currency issue or will be slapped with an across-the-board 27.5% tariff on her goods (if she won’t un-peg the yuan, we’ll re-peg it with taxes). If China says no float, prices for Chinese goods will increase strongly. If China says she’ll float, prices of Chinese goods will increase…perhaps even greater than not floating the yuan.

Under normal circumstances, one should not support tariffs; they’re counter to a free market economy. But in this instance, China is not participating fairly in a global market economy and measures should be taken to “introduce” her to reality. We’ll likely see several results from this measure, only one of which we’ll see immediately. The dollar will strengthen as speculators buy on expectation of a shrinking trade deficit, the Chinese economy will slow down to normal growth and our trade imbalance will slowly equilibrate. The immediate effects will be seen in the dollar.

Once again, sell your euros and look into Chinese companies that trade on the US exchanges. Be sure they are not export related companies. The dollar value of Chi-Co’s will increase per share once the yuan is free floating…even though their real value won’t change. Beware Chinese exporters; in the long run, the prices on their goods here in the US, and abroad, are going to increase cutting sales volume and profitability. Welcome to the real world China, now we’re playing hardball.

Our bustling economy is prepared and capable of cutting our budget deficit with this new and larger tax base; as long as government realizes the pump is primed and we no longer need public sector spending (boom financing). The Fed afforded us with cheap money and created a great employment environment. The work of the Fed and the President in stimulating growth is done. We’ve turned from the bottom of the business cycle and are heading up… the trade deficit is finally being addressed and hopefully corrected… and the US dollar will once again reign supreme.

Luke Hodgens is the editor of
Powerhouse Profits a conservative investment newsletter. Click here to read more of his cogent analysis."