[Joshua.Jaouli]

Professor Herbener,

I finally finished all your lectures and I think they are amazingly clear and informative. So thank you very much for these awesome lectures.

Couple questions on the current crisis and how it will end.

I read alot of stuff from Peter Schiff and he is often saying we are heading for a dramatic decrease in our standard of living, a sovereign debt crisis and a currency crisis because of our consumption based economy, reckless government spending, etc.

I know we still are the world’s largest exporter but we do run gigantic trade and current account deficits. I was wondering how do we rectify this problem in order to fix our balance of payments?

Secondly, I know we need to save alot more and cut back on government spending dramatically, but if the Fed began to raise rates today it seems to me the results would be horrific.

If we had much higher interest rates, it seems the banks would fail, we would have another wave of foreclosures and rising rates would cause massive amounts of default on credit cards and other consumer loans which would crush the retail portion of our economy, while leading to widespread unemployment (20%+ even by government measures).

Is there any way to avoid this happening, or am I totally wrong on my assumptions on what would happen to the US economy with lets say a Fed Funds Rate of 6%?

After all my reading, I am thinking that the correction after 30 years of reckless monetary and fiscal policy in the US is going to be orders of magnitude worse than the Great Depression.

Lastly, I have been reading alot of stuff by the author of Currency Wars, Jim Rickards, and he says because the US has the largest gold reserves that we can ultimately back our currency with this and he calls it the “nuclear” option that we can wield on the world.

I don’t understand how this would help us, because I am under the impression if we had to settle our balance of payments in gold bullion, we would be drained of gold in a matter of months and if we tightened in order to stem the outflow, the catastrophic results I said above would occur. Am I wrong on my thinking when it comes to this?

Thank you very much.

[jmherbener]

A Balance of Payments Account simply records the transactions between people in one country and people in other countries. In the unhampered market, such accounts would indicate the differing preferences of people. For example, if Americans preferred foreign made goods relative to Chinese preferences for American made goods, then the BoP Account would show a Trade Deficit (i.e., net inflow) for the U.S. and a Trade Surplus (i.e., net outflow) for China. To take another example, if Americans have high time preferences and the Chinese low time preferences, then the BoP Account for the U.S. would show a net inflow in the Capital Account and the BoP Account for China would show a net outflow in the Capital Account for China. These are examples of natural and healthy results of the division of labor.

A BoP Account always balances. The account is split into the Current Account and the Capital Account. Any deficit in the Current Account is balanced exactly by a surplus in the Capital Account. Here is a brief discussion of the BoP:

http://www.econlib.org/library/Enc/BalanceofPayments.html

The problems we face are created by government policy, at most the BoP are a symptom of bad policy. The BoP are always “settled,” i.e., always in balance. The government has to settle its own financial affairs, not the BoP.

If interest rates rise back to historical levels, capital values will collapse. This will reveal the extent of mal-investments and set in motion a liquidation and reallocation process. Whether this process is smooth and quick or rough and prolonged depends on the extent of government interference with it.

If the dollar were redeemable for gold again, foreigners would have incentive to drain our gold reserves if the government undervalued the dollar in terms of gold. If the government redeemed an ounce of gold for $35, then its gold hoard would be quickly redeemed. But if the government redeemed the dollar at the current ratio of currency outstanding (which is around $1 trillion) to its gold hoard (which is 250 million ounces), then an ounce of gold would be redeemable at $4,000. Given gold’s current price of around $1,600 an ounce, it would be ruinous to redeem.

Take a look at Joe Salerno’s article on BoP:

http://mises.org/daily/6050/

[Joshua.Jaouli]

I understand what you said Professor Herbener, but my question is this. I apologize if I wasn’t clear above.

If foreigners decided tomorrow to say “You know what, we are not going to finance US current account deficits by recycling the dollars back into Treasuries but we are going to sell the dollars on the market from now on”, wouldn’t that immediately put upward massive pressure on interest rates in the US and immediately lead to the collapse I’m talking about?

What I mean is, aren’t we too reliant on foreign nations who sell us goods, which we then pay for with US dollars, which they then recycle into US treasuries? If they decided to no longer recycle our dollars into treasuries then wouldn’t we immediately have a currency crisis because with us running $50B a month trade deficits, that’s alot of dollars that foreign countries like China, Japan, South Korea and Saudi Arabia would be selling onto the foreign exchange market and would immediately cause the dollar to plunge on foreign exchange markets and cause the cost of living in the United States to rise dramatically?

Whereas if we were not running trade deficits then there would be no dollars to sell on the open market because foreign central banks wouldn’t have accumulated such a large amount of dollars because we would have paid for exports with exports.

And what I’m saying is under a gold standard, we would have never gotten into this position because the classical gold standard was responsible for keeping trade and current account deficits in check, vs the system we have today which seems completely unsustainable and it makes me think the adjustment process for us to repair our balance of payments (saving more, investing in capital and manufacturing alot more, deleveraging, etc) is going to be an extremely long and painful process.

[jmherbener]

If foreign demand to hold dollars collapses, then the foreign exchange value of the dollar will fall, which will prompt a repatriation of the dollar resulting in price inflation in America. But this scenario has nothing to do, per se, with U.S. trade deficits, foreign Treasury holdings, and so on. Accounts such as these result from people acting on their preferences. If their preferences change, then the patterns of exchange and production change, which then change the accounts. If their preferences do not change, then the pattern of exchange and production do not change and the accounts do not change.

Foreigners prefer to sell us more goods than we sell them and to buy from us dollars. They want to hold additional dollars and until that preference changes, the dollar’s exchange value will not collapse, no matter what the size of our trade deficit. If our trade deficit grows it means that foreigners want to hold additional dollars. Here is a story about the significant increase in foreign holding of dollars since the crisis:

http://www.federalreserve.gov/pubs/ifdp/2012/1058/ifdp1058.pdf

What checked profligate monetary inflation and deficit spending under the classical gold standard was the redemption of each currency at a fixed rate for gold. When people called into question the fixed rate of redemption of a currency for gold (e.g., after a government inflated its currency), this led to adverse trade flows, devaluations, and so on.

When the U.S. runs a trade deficit with China, the dollars the Chinese do not desire to hold they use to make financial investments in the U.S. Markets bring people with different preferences into mutually advantageous relationships. Americans save little and consume lots. Chinese save lots and consume little. When we come together in a market economy, the Chinese will produce more goods for us than we do for them and they will invest more in America than we invest in China. That’s what both groups of people want to happen. Our trade deficit is balanced by our capital inflow and China’s trade surplus is balanced by their capital outflow. These trade accounts are sustainable because they reflect people’s preferences. There is no problem here until the government crowds out Chinese investment in American private enterprise with Treasuries. That’s where the problems originate, not in imbalances in trade accounts.

[porphyrogenitus]

I think one of the things JNJ is getting at is among the reasons “Americans save little and consume lots” are the policy distortions created by the things he’s talking about, and as illustrated in Roger Garrison’s power-point here: Credit expansion creates not only malinvestment, but by artificially lowering interest rates, dis-incentivizes savings and incentivizes a high-time preference and thus overconsumption (higher present consumption than there would naturally be under a truly free market).

It creates a tug-of-war that contributes to all the “structural deficits.”

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