Real Wealth Society

Thursday, May 11, 2006

The End of the American Economy By Andrew Fournier

05/09/2006

You cannot look at the world and think of it as separate countries. It is better viewed as a large nation with interdependent states. Every nation in this world relies on another for different reasons. Americans rely on other countries to supply the growing needs of the country. Every year we import billions of dollars of goods from China and increase the trade deficit. The current trade deficit with China was $202 billion in 2005 (Silva 11). The deficit continues to increase each year despite economic concerns about dependence on China. Compounding the situation is that the Unite States’ monetary system is not based on extrinsic value, but rather the guarantee of the government and the trust of the citizens, also known as intrinsic value. The United States’ monetary system was based and run by the gold standard. The fact that our currency is not backed up by equal value in gold is shocking. The habit of consuming without a strong production of US goods weakens the economy and increases our dependence on other countries. If the US economy collapses the countries that depend on the US’s consumption will also fail without the billions of American dollars. The American economy is primarily a consuming economy in that it does not produce enough goods to maintain its spending habits. This over consumption has the potential to cause a failure causing the American economy, and any other dependant economies to collapse.
The US currency has been backed up by gold and silver most notably with the Gold Standard. The Federal Reserve note was a piece of paper that said it represented a piece of the gold or silver. This was the main system up until the Federal Reserve decided to move from a commodity based monetary system to an intrinsic monetary system. In essence the current dollar is not backed up by something with extrinsic value; its value comes from the trust that you can exchange the money for goods. The Federal Reserve Act was signed into law by Woodrow Wilson in 1913 (McConnell 148). The Federal Reserve System was based on having a central bank which would issue paper money backed by commodities. The currency would be guaranteed by the Federal Reserve, not the Federal Government. By being able to issue money as needed the Federal Reserve became a lender of last resort.

Combining the note issuing function with the ability to mobilize existing reserves effectively has given the Fed the power to lend when all other lender’s power has been exhausted.

This excerpt show how powerful the newly created Federal Reserve System was. It could create money as it needed to lend out. Banks could issue paper money as long as it was backed by gold or silver (Greider 228). It wasn’t until the Federal Reserve act that there was a central currency for America. The United States abandoned the extrinsic approach to currency in 1933 an excerpt from William Greider explains this.

The United States would hang on to gold longer than others, but it too finally suspended the right of gold convertibility in the financial crises of 1933. Until then, citizens could turn in their reserve Notes for an appropriate quantity of gold. After 1933, the Fed’s paper money could be redeemed only with more paper money (Greider 283).

This is a key statement in that it shows how we discarded a currency of extrinsic value in favor of an intrinsically valued currency. The Federal Reserve became the controlling force in the flow of money. Money is no longer backed by gold or silver. The Reserve now creates and issues currency as needed. The key is that the money is liquid and accepted nationally. A worker is paid every Friday with the paper money. He then in turn can go to a grocery store and buy dinner with the paper money. The store owner knows that with this money he can then purchase goods. The cycle continues and money is traded for goods. The sponsors of the new system used the defense that money is “elastic.” The Federal Reserve would control the flow of money and in turn regulate the amount of inflation the country would have to bear. The Federal Reserve would control the discount rate, the rate a bank pays to borrow money, to regulate how much money is being loaned out. By raising the rates banks would be discouraged from borrowing and the outflow of dollars from the Fed would be controlled. As the banks paid off their loans the Fed would be able to lower the rates and in turn loan out more money (Greider 282). This means the purchasing power of America is regulated by the Federal Reserve. The Federal Reserve and the loss of extrinsic value in our currency is one of the factors that could lead to economic collapse.

The second factor is, America relies much too heavily on foreign nations for the importation of its goods. The nation’s current trade imbalance with China in 2005 is around $202 Billion (Silva 11). This is mostly due to consumers choosing prices over origination of goods. In China the average hourly wage for a factory worker is $0.64 an hour, in Mexico it is $2.48, and in the US it is $21 (Coy 46). These staggering numbers alone show how imbalanced the cost of manufacturing goods varies. Given a hypothetical product to be created, it takes 4 hours of labor to produce a widget. In America you are looking at approximately $84 in just labor costs. For the same widget to be produced in China it may theoretically cost $3.56 before additional expenses. For a company that is trying to make a profit and retain consumers; a cost of $3 is much better than a cost of $80 for labor. Companies need lower prices in order to attract more consumers and to sell a higher volume of goods. This is a perfect example proving that production cost may be a reason to ship an item 3,000 miles in order to sell it on American soil. The reverse is also true. If American goods are so expensive to manufacture, it will be hard to export them to other nations in the world due to the cost of manufacturing.
The deficit with china grows more every year. The cost of production is a fuel that helps the deficit grows.

Essentially, we have financed a surfeit of imports by issuing financial assets that represent a foreign-held claim on future U.S. output (Economic Trends 19).
This is an excerpt from the Federal Reserve Bank or Cleveland. It explains how America has financed the growing trade deficit. The US has essentially sold future work and goods to pay for our imports today. America is deferring payment and in turn racking up substantial amounts of debt. In 1999 the amount of US debt was $1.5 trillion. Another section of the article states that, “As a consequence, we became a net debtor nation in 1988 when foreign-owned assets in the U.S. began to exceed U.S.-owned assets in the rest of the world.” This is saying that foreign companies own more assets on American soil, than American owned assets in the world. Other countries are buying up American debt so that we can keep consuming their goods. Recent proof of this is an excerpt from MacLean’s magazine in 2003 stating:
The reason the greenback doesn’t collapse from non-stop bleeding is that it’s the world’s pre-eminent financial currency. As American consumers send money abroad to buy the things that define the American way of life, foreigners don’t dump those dollars; they invest them in what has been the most dynamic economy in the industrial world, buying US bonds, stocks and real estate (Coxe 45).
.
This has a compounding effect, similar to a large credit card; we consume billions of dollars worth of goods and charge the cost. America continues to spend and increase debt until we reach a critical point, essentially the bill comes in. The American economy runs by consuming and building debt, when it is no longer able to take on any debt is when the system begins to fail. The economy won’t be able to handle all the goods and services it has promised for many years. The foreigners continue to purchase assets in America causing a dependence on foreigners. The United States’ economy may be located on American soil but it is becoming controlled by a foreign market as different countries gain stock and power on Wal Street. The weak outflow of exports won’t be able to substantiate the needs of the foreign debt collectors driving America bankrupt.

Just as the American economy borrows from other countries, the citizens of the US borrow more than they can handle. One of the problems is that there are so many different ways to take out loans and to use assets to buy more. One main fuel of this fire is the housing bubble. “The value of real estate assets owned by Americans has zoomed to $19 trillion from $10 trillion,” stated on February 6, 2006 by David Rosenberg, Merrill Lynch & Co’s chief North American economist (Coy 9). He points out that the housing market is expanding too rapidly. The housing market has grown by billions over the past decade. This means that billions more resources, not currently available to a consumer, are now available to be spent. America will keep using house equity to take out new debts and loans. It allows a person who initially paid $100,000 for a house, to take out a $150,000 loan because houses are appreciating in value. The problem is that this is a volatile market. If the housing bubble were to deflate or even pop people would not be able to deal with the massive debt. The $150,000 loan may now be for a house that is valued at $75,000. The following excerpt is from Peter Thiel, the man who sold Pay Pal to EBay for $1.5 billion and runs a hedge fund in the stock market:
If housing unravels, I think there will be a recession in the US,” Thiel says. “Not just because fewer people will be working in areas related to real estate, like construction and mortgage brokers, but because people’s savings rate has gone down to something like minus %1 versus the low (but positive) two digits in the 1970’s and 1980’s. A negative savings rate is a very dangerous threat to the economy (Hahn 24).

Thiel points out some key situations as to why the economy could fail. He points out that the American people are no longer saving money. We are at a negative saving rate and this causes people to take on debt, or lose savings. The Bureau of Economic Analysis has published a summary of personal income and outlays. The personal savings as a percentage of disposable income was at -.3% (Bureau 6). Americans are spending more than they make. This equates to $235.2million of personal savings now being spent on top of the disposable income. Some may view this as a positive sign for the economy because it shows that Americans are able to spend more and invest in the economy. This is a wrong idea because it means that if the housing market goes under, the economy’s most robust sector would no longer be available. It also signifies that Americans are now spending so much of their money their savings are decreasing. This would cause a slowing of an already weak economy and a burial of citizens in debt.

Thiel is also quoted as saying:”Each of the past five times the yield curve has inverted, the economy came to a standstill or tipped into a recession.” (Hahn 25). He points out historical occurrences of recessions and a flat yield curve. The yield is the difference between rates of long-term and short-term investments (Cohen 220). When the rates become close or flat it indicates that a short-term investment has the same yield as a long-term investment. Every time the economy went into recession it was preceded by a flat yield curve. The US economy is already heading there; it currently has a flattening curve. The flat yield curve is a possible indicator for the economy to enter a recession given our foreign dependence, housing bubble, and negative savings rate.

There is an opposing view to the status of the economy. Many economic forecasters are more optimistic because they see potential for money to be made and the current strength of the economy. They, along with millions of Americans are oblivious to the factors coming together that will lead to the collapse of The US’s economy. Their first point is how the Federal Reserve is beneficial to our economy. The Federal Reserve is able to manipulate interest rates and slow down sectors of the economy. They are also able to help boost lagging sectors. By manipulating the money flow the reserve is able to manipulate the American economy. Diana Farrell wrote an article explaining how this deficit could help the American economy she wrote: “The declining value of the US dollar was supposed to restore balance to global trade by discounting exports from the United States while making its imports more expensive.” (Farrell 122). She continues by saying, “Any net negative impact that foreign affiliates may have on the trade balance is more an accounting anomaly than a cause for economic concern.” This represents the opposition. People who think the economy is going to collapse are oblivious and will not look at the reality of current events. She pointed out how the dollar would weaken and increase exports, but still America consumes. America is the purchasing powerhouse of the world; when the dollar weakens it symbolizes the current strength of America to the world. America loses purchasing power. This causes an even greater debt to build up. A weakening currency is never good for a primarily consuming economy. The second quote points out how the opposition denies the issues at hand. For example Farrell blames the negative impact on an accounting flaw and not the real reason; American dollars are leaving the country and building debt. She denies the fact that our trade deficit worsens every year even with a weakening dollar. When the optimists are in denial as to the real situation, the economy should be watched closer due to the potential for failure.

History is repeating itself. The introduction of paper money that isn’t backed up has been tried and has failed at least twice so far in history. The first use of paper money was in Sweden in 1661 (Paper Gains 91). The notion was introduced by Johan Palmstruch. He founded the Swedish banco in 1656. An excerpt from the Economist’s cover story explains the creation:
In 1656 he had founded the Stockholm Banco, a private company that
Intended to issue paper money, enjoying royal privileges in return for a
Royal cut. After sustained lobbying and a public-relations effort that would
be impressive today, an issue of bank notes followed in 1661. Here was Europe's first paper currency. (Paper Gains 91)

The system worked for a couple of years but was later doomed. Another excerpt details the demise of the bank:
Briefly, amazingly, the new-fangled money worked. But, heady with success, the venture over-reached itself, issued too many notes and crashed disastrously in 1667. Palmstruch was disgraced and--fickle government--sentenced to death, a fate later commuted to a prison term. But the genie was out of the bottle: paper money had arrived.

This is similar to how the American economy works. Just as the government of Sweden, the Federal Reserve Bank is able to create money as it is needed. When there is no value behind it the volume of money is easily increased. The American dollar is starting to become largely overvalued. Evidence of this is inflation is that the large volume of dollars is weakening the trade value of the dollar against foreign currencies. It takes more dollars to buy the same amount of goods. This causes a demand for more dollars to be put into circulation worsening the situation. The Swedish example shows how fast an economic system based on intrinsic value can fail.

The next big historical event was John Law and France during the 1700’s. John Law had created a scheme similar to Johan utilizing paper money to back up the economy. He started by founding the Bank of France issuing paper money backed by gold and silver (Gleeson 45). Since the public had confidence in the French bank it was generally accepted and the bank prospered. This is similar to America today; we trust our banks and place our money in them as well. He then overstretched himself and founded the Mississippi colony. His aim was to capitalize on the Louisiana colonies and the areas of the world that France controlled (Gleeson 45). He sold the idea of America being the next El Dorado. The price of stock in this new company soared from 490 livres to 3,500 livres. By year end they were up to 10,000 livres (Gleeson 46). The reserve company that was in charge of printing new money went into overdrive trying to keep up with the rapidly inflating stock prices. Millionaires were created daily and John rose to superstar fame. During the autumn of 1720, rumors about the prosperity of the new world as well as the inability of Law to cover the shares caused stock price to plummet 90%. This can be related to the American economy. The economy is reaching a point where the dollar may no longer depend on intrinsic value. It is backed by hardly any extrinsic value when comparing the dollars in circulation to our commodity reserves. The inflation that has occurred due to the Federal Reserve is similar to John Law’s printing company trying to keep up with the demand for more shares. America is a large stock company selling promises of great financial rewards; the foreign investors are similar to the people of France hoping to make millions off these false promises. It is when the investors lose their faith that the American economy will rapidly deflate similar to France. This is the main concern with the American Economy, if the investors lose their faith in America, the economy will collapse.

These three elements, the loss of extrinsic value, the dependence on foreigners buying debt, and the current citizen debt will come together over the next 3-5 years. They are all independent, however if one section failed a domino effect would rapidly follow. The economy is run by the Federal Reserve in that it controls the money flow of the country. The Federal Reserve can manipulate the money flow and control the banks lending and borrowing. If the economy is beginning to slow the Federal Reserve can lower rates causing the banks to borrow more (Greider 282). This habit of borrowing more should help ignite the economy because banks can lend more causing consumers to spend more and help build the economy. The only issue is that this usually causes inflation. More dollars are available and this causes the price of goods to rise. The next piece is that there is more money to purchase goods; the origination of goods is imperative. America primarily imports its goods and this means the available dollars go offshore. Manufacturers such as China, India, Mexico, and the Philippines all rely on Americans to purchase their manufactured goods. When the dollars go offshore they are reinvested by the foreigners into America. They buy American debt and help finance our spending. This causes Americans to also rely on the foreigners to help subsidize the debts. The foreigners buy up stock and bonds in American trusts essentially reinvesting our spent money. So now we have an excess of money and by spending it we send it to foreigners, who smartly, reinvest it and gain power in America. The final key to the puzzle will be the American consumers. This is a key piece because they rely on the banks to take out debt. By refinancing, or buying homes they borrow extra amounts of money relying on the fact that inflation will remain constant and the price of houses will continue to increase. This is compounded by the banks borrowing money that isn’t backed by any extrinsic value. This means the burden of all our trust lies on foreign investors and with the idea that dollars are liquid enough to use for trade. The reason this would cause the American economy to fail is because of several items. The American consumer will be too far in debt to purchase any goods. The value of the dollar will plummet due to it not being backed by any means of extrinsic value. The foreign investors that rely on America will lose their investments due to no consumers. The key is that America needs to find a way to subsidize the debt and curb consumer spending habits. These three pieces are all interdependent upon one another; if one was to fail the other two would soon also fail and cause an economic failure.

If the American economy fails it will cripple other foreign countries that rely on America. The immediate countries that would be affected would be China and India due to the trade deficit being over $200 billion dollars (Silva 11). If the economy were to fail China would have to forgive all debt due to America unable to repay the debt. The Chinese would also be affected because their main importer would no longer be able to finance any of the goods. The multi-billion dollar American Consumer would not be able to buy any more foreign goods. The American Government would also be affected. They rely on the Federal Reserve loaning money in the form of bonds to banks. These bonds help pay for the different military operations. If the economy were to collapse there would be no way to subsidize the billions necessary to conduct operations around the world. The United States is an integral part of keeping the world’s economy alive, if it fails, the world’s economy would suffer the effects.

There is a way to prevent the collapse. The first step would be to restrict the Federal Reserve’s power over the flow of money. If America returned to a system that was backed by extrinsic value as well as intrinsic the economy would stabilize. Having an economy that is backed by precious metals causes it to be much more stable due to the limits it imposes on the amount of dollars that are floating around. Another piece to saving the economy is the reduction of consumer debt. By not refininancing your home and borrowing more money it would alleviate the affects of a receding economy. By having less debt, the economy will be able to grow and become more fluid. The reduction of debt is integral because it allows consumers to have more liquidity in their asset holdings. As equity is gained, the amount locked in debt is freed. This surplus in funds will help the economy. The final piece to saving the economy is exporting not importing. Being import free is impractical and impossible, but by having a more exports the Economy will see an influx of real value. The new dollars coming into the economy would be earned and not subsidized debt. The greater exports would also help pay off the growing trade imbalance. A reduction of just 5% on the trade imbalance is $10.1 billion dollars. Over 10 years the trade imbalance would be cut in half. By reducing the imbalance the American economy reduces its reliance on foreign imports. These three actions could protect America from an economic failure.

In conclusion the American economy is currently robust, but has the potential to fail. The key elements of no extrinsic value in the currency, reliance on foreign investors, and large volumes of consumer debt will be the cause of the failure. The large volumes of intrinsic currency undervalue the dollar and its potential strength. This combined with an economy that relies on foreigners to subsidize American debt is troublesome. If economic collapse occurred the citizens of America would be locked into debt that they would never be able to pay back. This locks all the current money in non liquid assets. If money lost its intrinsic value, the value it runs on, it would no longer be an acceptable currency for trade. These three actions all depend on the intrinsic value of the dollar and the continuous buying of American debt. Once the system overloads the debt factor and the no value behind the currency would cause economic failure. Current economic forecasters are denying the status of America and the debt being built. This ignorance will only lead to an accelerated collapse since consumers trust the forecasters. Action needs to take place. America must return to an extrinsic value currency and reduce the amount of extra dollars currently in use. America also needs to rely more on American products and not buying foreign manufactured goods. The reduction of debt will be the final saving grace. If America were to move into action economic failure would not be a plausible idea. The collapse of the American economic system would also have world wide repercussions. The Countries that now rely on America to import billions of dollars in goods will face economic turmoil. This problem extends far beyond American borders as well because the world looks to the American dollar as a comparative scale. If the United States’ currency failed the world’s market would no longer have the billions of dollars that leave each year. The American citizens would riot and enter a state of anarchy due to the loss of structure. The American economy needs to be reevaluated due to the potential for failure. The American economy is primarily a consuming economy in that it does not produce enough goods to maintain its spending habits. This over consumption has the potential to cause a failure causing the American economy, and any other dependant economies to collapse.


Works Cited
Cohen, Marilyn. "Quest for Yield." Forbes 31 October 2005: 220.
Coxe, Donald. "The Sick Greenback." MacLean’s 10 March 2003: 45.
Coy, Pete. "Is the Bell Tolling for Housing?" Business Week Online 2 August 2006: 9.
Coy, Peter. "Just how Cheap is Chinese Labor?" Business Week 13 December 2004: 46.
Farrell, Diana. "A Silver Lining in the US Trade Deficit." McKinsey Quarterly April 2005: 122-125.
Federal Reserve Bank of Cleveland. The US as a Debtor Nation. : 1999.
Gleeson, Janet. "Currency Law." New Statesman 13 November 2000: 45-46.
Greider, William. Secrets of the Temple. 1st ed. Vol.1. New York: Simon and Schuster, 1987. .
Hahn, Avital, Louria. "Economic Iceberg Dead Ahead." Investment Dealers Digest 30 January 2006: 24-25.
"Paper Gains." The Economist 31 December 1999: 91.
Rankin, James, E., Armah, Michael. Bureau of Economic Analysis. Personal Income and Outlays: March 2006. 1 March 2006. 2 May 2006 .

8 Comments:

Post a Comment

Subscribe to Post Comments [Atom]



<< Home