The causes of the Great Recession are rarely debated. Illustration: iStock
Illustration: iStock

America’s soaring trade deficit, now running at a record $1.32 trillion annual rate, requires the US to sell paper to its foreign suppliers in return for goods. Most of the paper the US sold to foreigners during the past few years was equity in US corporations, rather than government or corporate bonds. Valuations in the US stock market soared as the Federal Reserve forced interest rates lower, by reducing its short-term lending rate to zero and by purchasing $6 trillion of Treasury securities.

The result of this exercise is the worst inflation in forty years and a collapse of labor productivity that portends shrinking corporate profits. As the Fed raises interest rates (in the mistaken belief that higher rates will reduce inflation) and inflation eats into profits, the valuation of US stocks is falling. That raises the ugly prospect of a deficit death spiral.

With a net foreign asset position of $18 trillion, the United States can’t go on selling its assets to foreigners indefinitely. At some point the orderly sale of US assets might turn into a fire sale.

Foreign holdings of US stocks jumped from $8.5 trillion in early 2020 to $13.5 trillion today, while foreign ownership of US Treasuries barely increased. The Fed, that is, bought $6 trillion in Treasuries, real yields collapsed, and equity valuations soared. Foreigners shunned record low yields on US government paper and bought into the equity boom.

But the tech-heavy NASDAQ index has lost 21% during the year to date. Market leader Amazon showed its first loss in seven years in the first quarter, Netflix is losing subscribers, and Facebook and Google are struggling to maintain margins. Inflation is eroding profit margins. And the US registered a 7.5% annualized drop in output per manhour during the first quarter, the worst result since 1947. The discount rate on corporate cash flows (namely the term yield on Treasury securities) is rising, and earnings prospects are weakening.

What if foreigners stop buying US equities?

Several things can happen (and all of  them the probably will).

First, the US will have to sell more bonds to foreigners, and at more attractive yields. That means real yields will have to rise even further, putting more pressure on equity valuations.

Secondly, foreigners will cut the price at which they buy US assets, that is, the dollar will have to fall.

Third, Americans will buy fewer foreign goods, which means that demand will fall. That’s another name for a recession.

The trade balance doubled between late 2019 and early 2022 as Americans took the $6 trillion in federal stimulus provided during the Covid epidemic and bought foreign goods. The unprecedented increase in federal transfers to individuals kept millions of Americans out of the workforce. America’s fraying industrial infrastructure, meanwhile, couldn’t meet the surge in demand.

Fortunately for the United States, other countries – especially China – had the capacity to export to the US and wanted to run a trade surplus in order to save the proceeds. China’s vast demand for savings met America’s vast appetite for goods. With domestic demand depressed by the Covid epidemic and a weak property market, China relied on exports as a source of economic growth.

This extraordinary symbiosis between the US and China, given the tension between the two strategic rivals, allowed the US to consume vast amounts of Chinese products (about $700 billion worth at the present annual rate) and allowed the Chinese to invest a significant part of their savings in the United States.

For China, this dependence on the American market remains much smaller than during the 2000s, when exports as a share of China’s GDP peaked at 36%. The export share of GDP had fallen to just 17% in 2019, but rose to 19% in 2021 and probably is higher this year.

China will have to find other outlets for its savings. Economically ideal, but politically intractable, would be an accord with India.

But China will have to find domestic outlets for savings as well. That means strengthening its domestic equity markets and creating pension and other investment plans to channel household savings into its stock market. China’s chaotic regulatory approach to its big tech companies during the past two years has to give way to a predictable, market-friendly mode of supervision for this to occur.

Follow David P. Goldman on Twitter: @davidpgoldman