1. Gold Trade created equilibrium in the trade deficit. Here's how it worked. Gold leaves the country to pay for the commodity. Since gold leaves credit would have to contract. The economy would recede. Price would become cheaper and gold would enter back into the country as exports of cheap products were purchased by foreign countries with gold payments. The inflow and outflow gold would seek equilibrium. A country experiencing a trade imbalance would accumulate more gold, the surplus would be credit, expanding credit would fuel an economic boom, provoke inflating prices, and inflated prices would slow down exports and import rise.
2. Gold reserves prevented budget deficits. With only a limited amount of credit available to the government, borrowing would drive up interest rates making it more difficult for business to borrow money. The government would crowd out the private sector with its borrowing. Government deficits also tend to result in trade deficits and gold outflows. Initially the government spending would stimulate the economy and import increase inline with the growth of the economy; however, as gold left the country recession pressures would return, gold would leave the country, interest rates rise, and price fall. Recognizing the undesirable effect deficit spending would have on the economy the government would attempt to maintain balanced budget as long as the country was at peace.
3. Brett Woods created a fixed exchange rate system in which the U.S dollar was pegged to gold at $35 per ounce. The value of the dollar was back by the gold reserves of the United States. The 1960s represented a breakdown with heavy investment overseas and rapidly increasing expenditures from the Vietnam War contributed to the country's balance of payments. Foreign countries found themselves holding dollars and began exchanging the dollars for the gold reserves.
In 1971 the gold flow was small but by 1973 the flow was a torrent. In 1973, Nixon suspends the gold for dollars policy and opened competition for currencies to be traded against other foreign currencies.
4. Credit overheated when backed by the dollar and not gold creating a $3 trillion bubble.
5. Bubble economies overheat, hyper-inflate, and burst leaving their governments in political disarray and deeply in debt.
6. Large inflows of foreign investment are stored in banks and banks use the money to create credit. Monetary authorities sell bonds yielding rates to the public to soak up the undesirable liquidity and reduce the money supply. Foreign assets in banks cause the money supply to rise.
7. Asia monetary authorities failed to regulate their foreign inflow of money and banks generated credit leading to hyper inflated land prices.
8. Debt has replace gold as a debt reserve. Credit There is now currently $2.3 trillion in debt. Credit held off deflation. Foreign countries allowed debt instruments to be used for goods and services but eventual the credit will be no good. Credit can not extend forever.
9. New currency to purchase foreign assets is possible as government issues bonds to create high powered money. In 1980, the U.S had $4 trillion credit market and by 2001, the credit amount was $29 trillion.
10. The imbalance of trades created a credit expansion. For example, Japan banks used the trade imbalance to increase the money supply 356% in the 1960s. At the end of 2001, the U.S held $2.3 trillion indebtedness to the rest of the world or 23 percent of GDP and $500 billion surplus is reinvest back into U.S dollar dominated assets. One could argue that credit growth is equivalent to GDP growth and therefore manageable. Growth is a function of corporate profitability and profit alone sustains the growth not debt with debt provide short term benefits. Private invest rises more than consumption during strong economic growth and personal consumption makes up the majority of demand in all major economies. 1990s experienced larger GDP than normal as an increased share of private investment purchased software and equipment for the dot.coms and telecoms. As financial credit worthiness worsen, credit extension slowed down expanding only 2 percent in 2002. Hard hit by credit troubles companies were quick to fire employees unemployment between Oct 2000 and June 2002 rose to 8.4 million and the rate rose to 5.9%. Consumer indebtedness is fueling consumption in the U.S. Consumers are have a hard time servicing their debt and borrowing 78% of GDP. Debt can not expand faster than income indefinitely. The sharp debt is occurring at a time when interest rates have never been cheaper. Pressure starts to mount against the consumer as interest rise and interest payments become a heavier burden. Without new loans to refinance old loans they must declare bankruptcy. The bubble does not recede slowly, it crashes. Switching to the government sector, in 2005, a federal debt of $8 trillion will expense the government $500 billion in interest payments, 4.5% of GDP with little doubt the government can service its debt. Systematic banking crisis accompany economic crisis, for example, 30 percent of banks fail in the great depression. Duncan points out that the risk is the $150 derivatives market meltdown.
11. Surplus nations earn their surpluses in US Dollars. By investing their dollar surpluses in US dollar assets, the trading partners of the United States helped fuel the stock market bubble, facilitated the incredible misallocation of corporate capital, and, by acquiring Fannie Mae debt, contributed to the dangerous rise in US property prices. Where did the money go? U.S bond market total $2.5 trillion a $400 billion increase 2001 to 2002, commercial paper $1.32 trillion, mortgage related securities $1.01 trillion, new issues corporate bonds $388.2 billion, Fed agencies long term new issues $453 billion and $659 billion short term, treasury gross coupon issuance $233 billion, and municipal issuance $196 billion. Surplus nations need $500 billion of investment vehicles each year in the financial, corporate, and household sector. At present 40 percent of privately held U.S treasuries is held by foreigners. The risk occurs should the foreign country decide to sell off for political or economic reasons. For this reason it is unlikely the percent will exceed 50 percent. Surplus nations would need look too the private sector to spend $250 billion dollars and the $800 billion U.S budget deficit play a part of a safe dollar denomination asset. Between 2000 and 2002, U.S equities markets lost $8 trillion in market capitalization or 48 percent drop but still maintaining a P/E of 26. Surplus nations are less prone to invest in a market with high P/E ratios seeking a 15 P/E viewing the stock market as overvalued. The remaining major investment is direct investment through purchasing U.S companies and U.S companies must maintain the attraction by keeping their earnings high. A slowing economy will deter foreign investment.
12. China's bubble: In China, the loan growth of the commercial banks has amounted to approximately 15% per annum for almost 15 years. To extend loans, banks must have deposits. Much of the deposits the Chinese banks have extended as loans were earned when Chinese businesses exported their goods to the United States. In 2001, China’s surplus with the US was equal to 7% of China’s GDP. China’s GDP growth that year was 8%. Without its trade surplus with the US, China’s economy would have grown at a much slower pace-if at all-both because the exporter’s profits would have been much worse and also because the banks would not have had enough deposits to allow them to expand lending so rapidly.
13. The Asia Crisis countries avoided deflation by devaluing their currencies and exporting deflation abroad. For example, the devaluation of the South Korean Won after the Asia Crisis contributed to the downward pressure on global semiconductor and steel prices. If the surplus nations can not invest into dollar denominated assets the must convert their dollar surplus into their own currencies and the conversion would cause their currencies to appreciate and slow exports and increase imports and cause their economies to recede and depress and recycle the world dollar surpluses. In light of the weak financial condition of many of the largest businesses, very few corporations will have the debt-servicing capacity to issue large amounts of new debt. Only the U.S government will have the debt-servicing capacity to issue large amounts of new debt.
14. Deflation occurs when supply exceeds demand. World War I, when the began and 1917 when the U.S entered the war, U.S gold reserves rose 64%, as Europe exchanged its gold for U.S goods. Once the war end, gold continue to flow into the U.S as allies repaid their war debt. The credit base double during this time period, industrial machinery and equipment output rose by 205% and all producer durables increased by 257%. This surge in industrial capacity created an oversupply by 1926 and as a result the wholesale price declined. In 1921 the fed sold large amounts of government debt and caused credit to contract by 8% through the economy into a brief recession. When the dollar earnings of the surplus nations are deposited into their domestic banking systems, those dollars, being exogenous to those banking system, act as high powered money and spark off an explosion of credit creation. Excessive credit creation permits over-investment, which, in turn, causes excess capacity and deflation. So long as the huge US current account deficits continue to flood the world with dollars, global deflationary pressures are very likely to continue to build, as reckless credit creation results in more industrial capacity than can be absorbed at the prevailing price level.
15. Falling product prices make it impossible for businesses to repay their bank loans. A similar process occurs when excessive credit creation causes asset price bubbles in the stock market and the property market. Rapid loan growth causes asset prices to rise. Frequently banks accept the inflated assets as collateral for additional loans. This process continued for so long in Japan that the imperial gardens in Tokyo came to be considered as valuable as California. Eventually, it becomes impossible to pay the interest expense on such extraordinarily overvalued assets. The owners default, the banks then refuse to make new loans, the house of cards in asset prices begins to shake, panic sets in, the bubble pops and banks fail.
16. During 1999 and 2000, the final two years of the New Paradigm Bubble, imports into the United States jumped by $307 billion, an increase of 33% over the level of 1998. Then in 2001, US imports fell by $79 billion, or by 6.3%. The impact of that decline in US demand on the rest of the world was extraordinary.
17. That year, the economic growth rates of all the United States’ major trading partners decelerated abruptly. Stock markets experienced a spiral downward affect, commodity prices fell, and government finances came under strain all around the world. The same consequences can be expected during the second phase of the recession, when the US consumer is finally forced to stop spending more than he earns.
At that time, imports into the US will decline and all those countries that rely on exporting to the United States will suffer. China will be one of the hardest hit since it a leading supplier of cheap consumer goods to the US. When China’s exports to the US decline it will not have the cash to act as an engine of growth for the rest of Asia. Asia should not harbor false hopes of China replacing the Unites States as importer of last resort. Instead, Asian policy makers should recognize that the era of export led growth will end once the US current account deficits can no longer be financed and they should act now to develop sufficient domestic demand.