by V. Kumar

Created on: October 09, 2009

Increasing trade deficit of the US economy had been baffling economic experts the world over before 2008. The way it was rising unabatedly was a phenomenon that seemed impossible to explain. This trade deficit of United States neither caused inflation nor an economic downturn till late 2007, creating questions about its sustainability, as well as raising questions over our understanding of modern economic phenomena. Finally, when the economic downturn did arrive, it is still not perceived as an outcome of unsustainable US trade deficit, as the primary blame for it has been cornered by the over-enthusiastic sub-prime housing credit market and financial agencies that made it possible.

The first decade of the twentieth century will always be remembered for the awareness it created about two major blind spots in our vision and understanding of economic processes. The first is the sustainability of constantly rising trade imbalances, reflected by surplus of China and OPEC and deficit of United States. The second is the puzzle of asset pricing during phases of bubble formation and its aftermath, as evidenced throughout the global economy in the booming asset bubbles till late 2007 and their subsequent bursting with a resultant global crisis.

Many people still do not see the link between US trade deficit and the subprime crisis. Some see it, but are not willing to agree, while others see it, understand it and are ready to agree provided there is sufficient evidence. Empirical evidence is scarce primary because of the overemphasis of current economists in mathematical modeling of human behavior, and the inability of such models to properly cover the 'human' decision making that is behind speculative investing and sub-prime housing investments.

During the period from 2003 onwards till end of 2007, US Economy witnessed a rising US trade deficit that was closing towards the US $ one trillion mark. During the same time, China had achieved the impossible by keeping its currency fixed, behaving like an open economy and taking its forex reserves to a mind boggling figure of over two trillion. The OPEC countries were reaping the benefits of crude prices which had inflated over 300% in a short duration. The puzzle was that in spite of this mammoth deficit, the US dollar was not weakening, nor was any other adverse impact observed in US or global economy.

The answer to this puzzle lies in the balancing of the US current account deficit by its capital account surplus that was

• 1
• 2
• Next Page >>