August 14, 2015

Trade Deficits -- Growth Stimulant or Depressant?


Understanding the impact of trade deficits and foreign debt on economic growth is vital to understanding the origins of America’s current economic problems and to designing trade and monetary policies that will put America back on the path to prosperity for all in the 21st century. 

Unfortunately, economists are sharply divided regarding the impact of trade imbalances on growth.
Progressive economists such as Scott and Baker generally say that trade deficits are the leading cause of slow growth, excessive unemployment and growing social inequality in the United States, that trade deficits threaten the nation’s long-term economic viability. 

In sharp contrast, conservative economists such as Riley, Griswold and Ikenson would generally say that trade deficits mean faster economic growth and falling unemployment, that the foreign loans used to finance these deficits are an important vote of confidence in America.

The 2015 Economic Report of the President by the Council of Economic Advisors presents both of these conflicting positions but fails to reconcile them or to provide meaningful policy options for action. 

This note reconciles the conservative and progressive views and presents a possible consensus position on U.S. trade policy for the 21st Century, one that could simultaneously increase business profitability, stimulate innovation, maximize employment, and reduce income inequality.

Implementing a policy along the lines outlined here would also reduce Government deficits while enabling Government to focus more squarely on providing the foundations for solid economic growth that is shared by all.

Conservative Arguments why Trade Deficits are Good

 Conservatives, who have a fundamental faith that unfettered markets are the best way to produce good economic and social results, commonly argue that America should welcome rather than discourage trade deficits. They generally show little concern that free trade agreements may well lead to larger U.S. trade deficits with the countries involved and to lower shares of manufacturing in total U.S. employment.

Conservatives support their positive view of trade deficits with charts that show higher trade deficits and higher economic growth rising and falling hand-in-hand (Fig. 1).

From 1970-1980, trade deficits were relatively small, so no clear relationship emerged between them and GDP growth. Starting in 1980, however, two very clear patterns began to emerge, patterns that demonstrate why the conservatives are right that GDP and trade deficits have tended to rise together, and why progressives are right that trade deficits hurt GDP growth.

How can such contradictory conclusions both be true?  The answer is quite simple. As with so many economic phenomena, conclusions depend heavily on perspective.  Here the key issue is whether one takes a short-term or a long-term view.
The conservatives point to the strong positive correlation between GDP growth and trade deficits over specific short-term periods such as the following cycles: [i]

  • 1982 - 1993:  Growth and trade deficits went up as the second oil crisis faded and the stimulus of the Plaza Accord kicked in, and they headed down with the Crash of 1987 and the following recession.

  • 1995 - 2005:  During the tech bubble, both indicators rose markedly, peaking around the year 2000, at which point the tech bubble burst. Reasonably parallel growth in the two indicators then resumed with the housing and stock market, peaking about 2005.

  • 2005 - 2008. Growth and trade deficits fell with the collapse of the housing and stock market bubbles, hitting bottom about 2009.

  • 2009 – Present: Growth rose slowly following the Great Recession, stimulated by natural recovery, fiscal and monetary stimulus, and a temporarily more competitive dollar. The trade deficit declined, reflecting lower aggregate demand as U.S. companies and households tightened their belts, borrowing and consuming less in order to “restructure their balance sheets” and get out from under the debts that had piled up during the mid-2000s housing and consumption boom.
Although the fit is far from exact for the individual boom-bust cycles, the data generally support the conservative view that higher trade deficits are often associated with higher rates of economic growth – and vice versa – at least during certain relatively short-term periods.

Before going on to the reasons that Figure 1 also supports the progressive view that trade deficits are bad for economic growth and employment, let’s look more closely at the short-term linkages between trade deficits and accelerated growth.

When the U.S. imports more than it exports, it can cover the deficits in various ways:

  • First, since the U.S. has the right to pay most of its trade deficits in U.S. dollars, the U.S. could simply print the needed dollars. However, this could easily lead to domestic inflation and to the world’s losing confidence in American dollars.

  • Second, the U.S. could draw down its foreign exchange reserves which, by definition, must be in convertible currencies other than U.S. dollars. However, since America can print its own convertible currency, its official reserves of foreign currency are very small.

  • Third, the U.S. can borrow money from abroad, using credits from foreign governments and private investors to cover trade deficits. And this is exactly what it does.
Herein lies the reason that GDP growth cycles have tended over the past 30-40 years to move in tandem with trade deficit cycles. Additional credit (and debt) flowing into the United States to cover the deficits means that America can temporarily live beyond its means, spending more on consumption and investment than it produces as GDP. When domestic expenditure exceed domestic production, this stimulates economic growth and employment.

These clear logical linkages between trade deficits and economic growth indicate that the conservative side may indeed be right.

But wait. There is a dark side to this strategy that explains why the progressive view is also right—that trade deficits can be very harmful to economic growth and to employment over the longer term.
Given that America has had an almost unbroken string of trade deficits for some forty years, we clearly need to look at the long-term implications of these deficits before deciding on a national trade policy for the 21st century.

Progressive Arguments why Trade Deficits are Bad

We all know that allowing debts to mount up year after year will almost certainly end badly. Families have a limit; so do countries. The U.S. has clearly not reached that limit as a country, but as indicated in Fig. 2, it has clearly been moving in that direction.

Prior to the late 1980s, America was the world’s largest creditor (including both equity and portfolio investments). Since then, however, its liabilities to the rest of the world have increased far more rapidly than its assets. This has increased sharply the ratio of net foreign liabilities to GDP, making America’s “net international investment position” (NIIP) ever more negative.

As worrisome as the message of Figure 2 may be, the reality of the impact of trade deficits on America’s economy and society should be of even greater concern.  Let’s return to Fig. 1, which at first glance seems to support the conservative position that trade deficits and the associated foreign financing flows stimulate growth and employment.

This time, look not at the rough parallels between the ups and downs of GDP growth and trade deficits. Look instead at the dotted lines which show the average 40-year trends in trade deficits and GDP growth. This reveals a totally different picture.

Over the long term, rather than stimulating economic growth, growing trade deficits have been associated with falling GDP growth.  During the 1970s, trade deficits averaged only 0.2% of GDP, while GDP growth averaged 3.2% per year. In contrast, between 2000 and 2013, average trade deficits shot up to 4.1% of GDP while growth slowed to less than 2 percent per year. In short, over the past 40 years, higher trade deficits have meant a sharp reduction in average growth, not an increase as some conservative economists might suggest.

As with any statistical analysis, it is vitally important to show not only mathematical correlations between raw numbers, but also to look for reasons why variables might be positively or negatively correlated.

The above analysis of the conservative position suggests that injections of credit to finance trade deficits explain why, over relatively short time periods, GDP and trade deficits would tend to expand in parallel.

But why would this short-term relationship flip in the longer term?  Why after some point should more foreign debt have a negative rather than a positive impact on economic growth and employment?

The Misuse of National Accounts Identities

The traditional explanation given by economists, particularly the more liberal ones, is that the standard national accounts equation shows that there is a mathematical link between higher trade deficits and lower GDP growth:

GDP = Consumption + Investment + Exports – Imports       (a)

Since imports appear on the right-hand side with a negative sign, increasing imports must reduce GDP, all other things remaining equal – or at least so it would appear.

However, this logic is flawed and leads to bad policy conclusions. As Riley has rightly noted, this formulation makes it appear as though “exports add to GDP and imports subtract.” He goes on to say that, if this were true, “Americans would be richer if the Navy torpedoed ships loaded with products before they could reach U.S. ports.”

Using the standard national accounts formula when analyzing the links between trade deficits and GDP growth is wrong because, in addition to implying a mechanical linkage that does not exist, it confuses GDP as production with GDP as expenditure, and it examines GDP at a point in time rather than as a dynamic process over time.

For analyzing links between trade deficits and economic growth, we have to focus on the production of GDP over time – on the growth of total value added by all sectors in the economy such as agriculture, mining, energy, manufacturing, and transportation. 

Equation (a), however, refers only to the expenditure of GDP on consumption and investment at a given point in time – a totally different concept than the production of GDP over time. Equation (a) only says that, if a country spends more on consumption plus investment than it produces, it will import more than it exports, which by extension means that it may well to borrow to cover the difference. A more useful presentation of equation (a) would be:

GDX = GDP + Imports - Exports       (b),

where GDX is gross domestic expenditure (consumption plus investment). This formulation makes it clear that it is gross domestic expenditure, not gross domestic product, that increases as the gap between imports and exports rises.

The External Deficit Doom Loop – the real reason trade deficits hurt long-run economic growth

The reason that persistent trade deficits will almost certainly reduce rather than increase GDP growth and employment can be summarized with this simple example: If America borrows money from China to pay China to produce goods that could be produced competitively in America, America’s economy will produce less, GDP will grow more slowly, and unemployment will be higher.
America has gotten itself into this unfortunate situation largely because of what might be called an External Deficit Doom Loop (EDDL)

The EDDL is an ongoing process with neither beginning nor end, one that affects virtually all aspects of the American economy and society.  However, our story must start somewhere, so given that the exchange rate determines the relative prices and thus the competitiveness of all American goods and services (including wages) compared to foreign goods and services, let’s start with the overvaluation of the dollar[ii] that began in the mid-1970s following the first oil crisis (see the first step in the presentation of the external deficit doom loop in Figure 3.)[iii]

1. Exchange Rate Overvaluation. Rather than implementing policies that would allow the dollar to move to levels that would balance its external trade despite sharply higher oil prices, America understandably and to a considerable degree justifiably chose to borrow to cover the resulting trade deficits.[iv] Interestingly, most of the money was borrowed from the very countries that were enjoying large trade surpluses with America because they had raised oil prices as members of the OPEC cartel. The parallels between the OPEC money flowing into the U.S. during the oil crises and the Chinese money flowing into the United States starting in the late 1990s are painfully clear.

2. Trade Deficits. Sharply higher oil prices, combined with high rates of inflation in the United States, led directly to a substantial overvaluation of the dollar. This in turn led to rising trade deficits, not only with the OPEC countries, but with others as well. In 1972, America experienced its first trade deficit in nearly 100 years (the last one occurring during Reconstruction after the Civil War), and with the exceptions of very small surpluses in 1973 and 1975, America has had trade deficits every year since 1972 (see Figure 1).

3. Foreign Capital Inflows. The next step in the doom loop that has trapped the American economy is the inflow of foreign capital to cover the external deficits. Although conservatives tend to regard such foreign capital inflows as “good news” for the economy. When foreign direct investment brings not only capital but access to technology and markets that U.S. firms do not already have, it can indeed be good news. 

However, when foreign direct investment simply means that China use America’s trade deficit dollars to buy America’s productive assets such as happened with its purchase of the pig farms owned by Smithfield, America is simply paying the price of living beyond its means, squandering its real assets on excessive consumption of foreign goods. Warren Buffett’s comments in his 2003 Fortune magazine article  about “Thriftville” and “Squanderville” immediately come to mind. Foreign capital inflows can lead to other highly unfavorable developments for reasons that will become clear as we continue around the loop.

4. Shift from Productive Investments to Hot Money. One common development rarely noted regarding international capital flows is that the composition of these flows changes rather dramatically depending on whether the country is running significant trade deficits or surpluses.

For China, which has long enjoyed substantial trade surpluses, capital flows are dominated by direct investments in factories and other directly productive projects. Over the same period, however, the United States has seen substantial trade deficits, and foreign capital inflows have generally gone into portfolio investments and loans. This pattern reflects the fact that, almost by definition, production in deficit countries is less competitive and thus less profitable than in countries with trade surpluses. The dominance of portfolio and loan-based flows over direct investments has three potentially negative consequences.

First, unlike direct investments where future capital outflows depend largely on the profitability of the investment portfolio, loans involve contractual repayment obligations that must be met regardless of the profitability of the investment.

Second, portfolio investments and outright loans tend to be more short-term and speculative. Funds not tied to specific physical investments can easily become “hot money,” fleeing at the first signs of trouble.

Third, when the foreign loans are used primarily to finance consumption of imported goods rather than productive investments, they generate no direct benefits that can be used to help meet repayment obligations.

Incidentally, the impact of trade deficits on the composition of foreign capital inflows is by no means unique to the United States. Similar patterns can be seen, for example, in the Asian Crisis of 1997, and in the ongoing Eurozone crisis where portfolio investments and loans flooded into countries like Greece, Spain, Italy and Portugal from financial institutions in countries like Germany and France.

5. Money, Credit, Inflation and Financial Market Volatility. One of the most damaging links in the external deficit doom loop is the impact that the inflow of foreign credit has on domestic inflation and financial sector stability. The damage is perhaps seen most vividly in the case of government borrowing from abroad to finance budget deficits.

When the U.S. Government, for example, borrows funds domestically, this simply shifts purchasing power from private to public hands within America. Such borrowing may “crowd out” more productive private sector uses of the funds, but domestic borrowing per se does not generate a net increase in domestic purchasing power. Consequently, such borrowing has a limited impact on domestic inflation, and thus on the cost of producing U.S. exports.

In contrast, when the Government borrows more from abroad than it repays, total purchasing power circulating within the economy increases immediately by the amount of net borrowing. In the early 1970s, foreign borrowing by the Federal Government accounted for only about five percent of total government borrowing. 

However, since about 2007, government borrowing from foreign sources has accounted for 45-50 percent of the stock of total publicly-held government debt– and has equaled 30-35 percent of GDP, representing a significant percentage increase in the amount of money circulating in the economy and thus to inflationary pressures.

Even if this were the end of the story, the implications for the international competitiveness of U.S. manufacturing would be highly negative in the absence of compensating changes in the exchange rate. But this is not the end of the story.

When the government increases its net borrowing from China by $100 billion, for example, most if not all of this money immediately goes to pay employees, contractors, and suppliers.  Most people receiving the money will immediately deposit it in banks. Under America’s fractional reserve banking system, the banks can then lend out roughly $90 of every $100 deposited, holding back only about 10 percent as mandatory reserves. 

If the deposit-and-relend process were to continue until no further loans could be made given reserve requirements, the original $100 billion dollars would grow to about $1.0 trillion of additional money in circulation. In fact, using rather conservative assumptions, it can be shown that the majority of the credit expansion that has taken place over the past 10 years could be explained by the expansion of credit based on net borrowing from abroad.

The negative significance of the dramatic expansion of credit in the American economy relative to GDP can hardly be overemphasized.

Between 1950 and 1970, for example, total credit market debt in the United States fluctuated in a narrow range, averaging about 150 percent of GDP (Fig. 4).  But this changed dramatically between the mid-1970s and the mid-1980s – precisely the period when America began to run external trade deficits almost every year. 

Within about 10 years, the ratio of credit market debt to GDP rose from the long-term average of 150 percent to 200 percent. Then, between 1985 and 2008, just before the house of credit cards collapsed and America fell into the Great Recession, the ratio of credit to GDP exploded from 200% to over 350%.

By this point America – and most of the developed world – was deeply addicted to the debt. Like the meth or crack addict who constantly needs an ever-larger hit just to avoid depression and to function “normally,” the world economy in general and the American economy in particular became addicted to debt. Unfortunately, America has become the lead addict on behalf of the world. Although America has frequently been referred to as the world’s “engine of growth,” in reality it is the consumer of last resort for the world’s excess of production over domestic demand. To fulfill this role, America has become the world’s borrower of last resort and the world’s largest debtor.

If the growing mountain of credit and debt within the United States had actually increased the overall rate of economic growth, we could probably say that this was a healthy development. However, as was seen in Fig. 1, average GDP growth has actually been falling. 

The amount of credit required to produce a dollar of GDP more than doubled between 1970 and 2008, indicating a dramatic decline in the efficiency of the financial sector.[v] The fact that the increasingly large “hits” of credit being injected into the American economy have had increasingly less impact on America’s economic growth is a clear sign that America is like a crack addict when it comes to debt.

The other big problem with America’s addiction to foreign capital inflows is that, both directly and through the money multiplier effects of fractional reserve banking, foreign capital inflows have increased the risk of financial instability, particularly the risk, as Kindleberger once noted, of “manias, panics, and crashes.”

Financial manias, which are almost always preceded by a sharp increase in credit, can be very exciting for investors. Consequently, no one, including otherwise intelligent bankers and Federal Reserve officials, wants to take away the punch bowl of excessive credit. As Chuck Prince of Citigroup famously said about the time of the 2008 Crash, “… as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

Today we know the hangover was not worth the party. We are still paying for the excesses of that wild journey into darkness – a journey financed in large measure by the surge of foreign capital into America during a string of notorious bubbles that our policy makers did not want to burst. To avoid a repeat of that disaster, we must learn from it. Only by doing so can we avoid another trip around the external deficit doom loop and into the pit of financial excess.

6. Business Profits Fall. Once the EDDL was in full swing, the rapid growth of credit-fueled domestic inflation in America relative to the rest of the world eroded the international competitiveness of U.S. manufacturing companies. Their profitability fell – far more rapidly than might be expected. Assume, for example, that the real value of the dollar has fallen by 10 percent because of a 10 percent increase in domestic price levels. 

However, if the nominal exchange rate does not fall by a comparable amount, thereby offsetting the 10 percent increase in domestic prices over world prices, manufacturers who could previously sell a product for $100 and make a profit of $10 would have to cut their price by about 10 percent to $90 – at which point, not 10 percent but 100 percent of their profits would disappear! [vi]

Many manufacturers today in America have profit margins on value of output considerably smaller than 10 percent, and for them, the 10 percent “tax” imposed by the overvalued dollar can turn a profitable business into a loss-maker. Furthermore, the overvalued dollar “tax” also affects domestic producers who sell only in the domestic market. For example, if a Chinese producer can profitably deliver a shirt to the U.S. market for $10, a domestic shirt producer who can’t meet this “China price” will not be able to sell his shirts, even within America.

Businesses today complain loudly about the severe burden imposed by the 35 percent corporate income tax rate. However, the CIT only takes 35 percent of the profit actually earned. If the profit is zero, the tax is zero. In contrast, the overvalued dollar tax today takes about 15 percent of the selling price, not the profit actually made – even if the profit is already zero.

7. Productivity Growth Declines. Some argue that the eclipse of American manufacturing by other countries like China is driven by the fact that America is not investing enough in R&D.  America does fall seriously short in this area, but what sane business person would invest in plant, equipment, training, and R&D when, even with a world-class operation, the overvalued dollar makes it impossible to compete effectively in domestic markets against imports, much less with exports to world markets? The overvalued dollar will have to be fixed before America sees major new investments in the manufacturing sector.

8. Jobs and Income. As the profits of America’s manufacturing sector fall, plants begin laying off workers, moving production overseas, and even closing plants entirely. Unemployment rises while wages and family incomes fall, exacerbating income inequality and reducing aggregate demand for the output of American factories. This, combined with the falling demand for new capital equipment and for American exports, creates another vicious cycle of declining demand, declining GDP, and rising unemployment.

9. Government Revenues, Expenditures and Deficits. The Government plays a critically important role in the external deficit doom loop, both as victim and as villain. As victim, the Government suffers in two ways. First, as economic growth declines, both personal and business income growth rates decline or may even become negative. This reduces the tax base and thus Government revenues. Second, with rising rates of business failure and joblessness, the Government faces increased demand for bailouts for businesses and for income support programs for individuals, increasing government expenditures. The combination of falling revenues and rising expenditures quickly produces rising government deficits – a trend seen clearly following the Crash of 2008.

10. Government Foreign Borrowing. Rising budget deficits quickly turn the Government into a villain in the EDDL story. In the 1970s, only about five percent of all government debt was held by foreign buyers (Fig. 5). Consequently, the impact of government debt on total credit in the U.S. economy was minimal. 

However, as noted above, the share of government debt rose dramatically during the 1970s with petro-dollar recycling. By the end of the decade, about 20 percent of U.S. Government debt was held by foreigners. The share stabilized at this level until the Tech Bubble began in the mid-1990s.

Within about five short years between then and the Tech Wreck, the share of U.S. Government debt held by foreign lenders rose from 20 to 35 percent.

 The Government’s dependency on foreign lenders dropped to about 30 percent with Y2K and with the end of the Tech Boom. However, China’s trade surpluses with the United States began to explode during the mid-2000s and Japan’s trade surpluses with America remained sizeable. Consequently, China and Japan became major buyers of U.S. Government securities. This had several important consequences:

  •  First, the share of publicly held U.S. Government securities owed to foreigners rose to nearly 50 percent, an unprecedented level for the United States, and the share has remained between 45 percent and 50 percent since then despite the Crash of 2008.
  • Second, the flood of money from abroad, most of which was financed by America’s burgeoning trade deficits with China and Japan, led to the explosion of credit within the United States that fed directly into the housing and stock market booms that preceded the Crash of 2008.   
  • Third, the money coming into the United States seeking to buy dollars and dollar-based assets for return and safety has kept the value of the U.S. dollar above the level that would balance imports and exports.
This sets off the next round of the external deficit doom loop. If domestic prices in America have increased more rapidly than prices in key trading partner countries during the previous EDDL loop, the exchange rate will be more overvalued than before in real (price-adjusted) terms because of excessive credit circulating domestically, the result of excessive foreign capital inflows. And in nominal terms, the market exchange rate will be more overvalued if investors have brought more foreign capital into the United States to purchase dollars and dollar-based assets than was needed simply to cover existing trade deficits.

With the dollar ever-more overvalued in both  nominal and real terms, imports will be “too cheap,” U.S. exports “too expensive,” and the trade deficit will again reach new heights, driving another cycle of the external deficit doom loop that has already taken place far too often since the 1970s.

Policy Conclusions and Recommendations

Even though conservative economists argue that trade deficits and economic growth generally seem to rise together, while progressive economists argue that trade deficits are bad for growth and bad for employment, this paper finds that both sides are right.

The two positions are consistent with each other because, in the short term, trade deficits and the associated financing inflows do have a stimulative impact on the economy, but in the longer term, trade deficits clearly harm domestic economic growth and employment.[vii]

This finding holds the promise of providing a basis for a consensus on American trade policy for the 21st century. Regardless of our individual positions along the political spectrum, we all agree that the present and future well-being of our country and its people is the top priority. 

From America’s experience over the past forty years, it is obvious that trade deficits, excessive foreign capital dependency, excessive domestic credit, repeated financial crises, slowing economic growth, excessive unemployment, large budget deficits, and increased long-term indebtedness to foreign countries, many of whom are far more concerned about their own welfare than they are about ours, is a dead-end road.

America has become addicted to debt, both domestic and foreign. In small doses over limited periods of time, debt can be good for economic growth. But over longer periods, debt dependency depresses economic growth and could ultimately endanger America’s strength and sovereignty.

We all would agree, I believe, that any policies implemented should give top priority to America’s international strategic, political, economic and social strength – subject only to the caveat that our actions as a nation contribute to a level global playing field and do not seek to harm the people of other nations.

The world’s global trading system has done wonders for people around the world, lifting millions if not billions out of poverty. Expanded global trade has also given those in developed countries like the United States sharply improved access at lower cost to some of the finest goods and services ever available.

At the same time, however, cross-border financial flows have grown far more rapidly than the flows of real goods and services – a clear reflection that the global financial sector is becoming addicted to casino-type speculation rather than to intermediating at the lowest possible cost between those who have capital to invest and those who need capital to produce real goods and services.[viii]

Given the obvious damage that excessive financial flows have done in terms of generating speculative financial crises such as the Crash of 2008, the dismal aftermath of such crises such as the Great Recession, and the undeniably negative impact of excessive trade deficits on domestic economic growth and employment, it seems fair to suggest that a core element in America’s trade policy for the 21st century should be a mechanism that would moderate these flows, keeping them at levels consistent with balanced trade in real goods and services.

This goal could easily be attained as outlined elsewhere in this blog (see post of May 1: Balance U.S. Trade with a MAC Attack on Currency Misalignment).

American Needs a Competitive Dollar-Now!


[i] These ranges must be interpreted with caution for two reasons: First, the data are three-year trailing averages; the data point plotted for 2008, for example, is actually the average for 2006-2008. Second, cycles in trade deficits and GDP growth rarely coincide exactly because they are driven in different ways by factors that are often not highly correlated.

[ii] An “overvalued” currency is one that results in an excess of imports over exports, resulting in trade deficits that are both sustained and significant.

[iii] Although the EDDL is presented here as a circular process, this is strictly a presentational simplification. In reality, all points connect to all points on the circle. The EDDL is really a network of interactions, not a simple circle.

[iv] The decision not to balance external trade with a substantial devaluation of the dollar during the OPEC oil crisis was understandable because a sharp devaluation would have been highly unpopular with the American public and justifiable to the extent that a substantial devaluation could have triggered a sharp recession or even a depression, the cost of which would have significantly exceeded the cost of borrowing from abroad to cover the deficits.

[v] The only economic reason for having a financial sector is to bring savers and spenders together at the lowest possible cost. The massive computerization of America’s financial sector should have resulted in a dramatic decline in the share of GDP needed to intermediate between savers and spenders -- between creditors and debtors. However, precisely the opposite is true. Maintaining the financial sector required only 3.6 percent of GDP in 1950, but by 2014, this share had nearly doubled to about 6.3 percent of GDP. A key reason for this growing inefficiency of the financial sector is the dramatic increase in the share of loans made by financial institutions to other financial institutions, and the dramatic decline in the share of total loans made to non-financial institutions – the businesses who actually produce goods and services for intermediate and final consumption for sale in domestic and international markets.

[vi] The calculations here obviously depend on many other assumptions regarding developments in other markets, but the basic message is clear.

[vii] National and global conditions have a tremendous impact on the speed with which the depressive effects of the external deficit doom loop overwhelm the short-term stimulative effects of trade deficits and external financing. Furthermore, national and global conditions change over time, which helps explain the significant disconnects in Figure 1 over time between trade deficits and economic growth. Given the variance and unpredictability of the factors driving the short-term and long-term effects, it would be irresponsible to claim that a bright line separates short-term and long-term effects. 

[viii] The rising dominance of financial over real flows is seen in two particularly relevant indicators. First, according to data from the Bank for International Settlements, enough foreign exchange to finance the entire annual U.S. trade deficit flowed across U.S. borders in 2013 in less than half of one day, and enough flowed across our borders in four days to finance all U.S. imports and exports for an entire year. Second, between 1975 and 2009, for example, world trade increased by about 15-fold, but global foreign exchange reserves grew by almost 45 times – three times faster than global trade. Why did this happen despite the fact that computerization of global financial flows over this period should have reduced the need for such flows sharply?

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