Why the trade deficit matters

More than once, this blog has raised the question: do trade deficits matter? The implied answer has been no, because the economy has been racking up trade deficits for years, and has nevertheless been outperforming those of its Western European and Asian peers.

In a game of keep-up-with-the-Joneses, a person can win by working harder and winning more rewards in the free market than his peers; but he can also win by simply whipping out the credit card and consuming beyond what the frugal Joneses find prudent. In that game, the big spender eventually loses when he can no longer keep up with his credit card bills. That's when the repo man comes to pay a visit. What would the Joneses think then?

The above-linked WSJ article reports that:

In recent months, as home-price appreciation fell and borrowers faced rising interest rates, more people defaulted on their mortgages....Yesterday Accredited Home Lenders Holding Co., a subprime mortgage lender based in San Diego, reported a loss of $37.8 million for the fourth quarter, partly due to heavy repurchases of dud loans from large loan buyers, compared with a year-earlier net income of $43.3 million.

Subprime, did you day? The people who take out subprime loans tend to be poor or low-income, and reformed leftists are in the business of chastising the poor for their profligacy. The poor consumed too much? Off with their heads! Excessive consumption is the sole right of the well-off!

Hold on. These same overspenders, when they bought their homes, overfilled their carts at Home Depot and Bed, Bath, and Beyond, filling up their new digs with goodies. In the process, they maxed out credit cards the big banks were only too happy to give them. And their expenditures rippled through the economy. In short, they leveraged low interest rates for the benefit of large shareholders in companies like Home Depot, etc. Those shareholders, flush with rising portfolios, in turn bought luxury goods and second homes. Greenspan used to call it the "wealth effect."

What's this got to do with the trade deficit? Our trade deficit has been financed -- no free lunch, etc. -- by big foreign creditors like China and Japan, which have recycled our export dollars by buying U.S. treasury notes. This, in turn, has led to low interest rates -- which gives the profligate poor the chance to spend, and in turn makes billions for the likes of Home Depot as well as the big banks.

But just as easy credit has a ripple effect on the way up, it also ripples on the way down. Just as reformed leftists have to cross their fingers and hope that humans don't cause global warming, they had better pray that our creditors don't hit a bump in their business cycles and stop financing our trade deficits. If they do stop, expect a run on the dollar, a spike in interest rates, and real pain -- not Champaign -- to ripple throughout the economy.