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How The U.S. Became Uncompetitive & Why Deflation Might Not Be A Bad Thing

17 February 2010 2 Comments

This is a guest post by Mr Credit Card from www.askmrcreditcard.com. Mr Credit Card is going to expand on a subject I talked about earlier – deflation. Specifically, he is going to suggest how we have become uncompetitive in the global manufacturing market place and why deflation may not be such a bad idea. If you are looking for a credit card, he has compiled a list of the best credit card offers.

If you wish to write a guest post for 20smoney.com, see the guidelines here.

20sMoney recently wrote a blog about deflation and today, I would like to explore how our monetary policy is affecting our competitiveness in the global market place and why deflation may not be such a bad thing. There has been quite a bit of rumblings in the press lately (and it seems forever about the following).

China is manipulating its currency and it is undervalued – The US has a trade deficit with the rest of the world (ie we import more than we export). To put it in personal finance terms, we spend more than we save! Furthermore, the Federal Government has also been running budgets deficits for the longest time! Budget deficits in plain personal finance terms means we are spending more than we earn! Funny thing is that nobody can really pinpoint how much the Chinese Yuan is exactly undervalued! Essentially, we are trying to blame the Chinese currency for our costs structure.

Mainstream Press keeps speculating when will the housing market stabilize – Another favorite pastime of the press is that everyone keeps guessing when the bottom of the real estate market will be reached. Everybody wants the market to bottom up quickly.

We have to avoid deflation at all cost – Modern economist will tell you that deflation is to be avoided at all costs. They were glad that the Fed has flooded the market with freshly minted and printed dollars out of thin air. But is this really true?

Inflationary Monetary Policy – To really understand why are are not competitive in the global manufacturing market place, we really have to go back to the creation of the Federal Reserve Bank in the early 1900s. It was created in 1913 as a lender of last resort in the event that liquidity and availability of money dried up. But after it was set, it did not just become the lender of last resort. Instead it gave itself the power to manipulate interest rates via money market operations. By being able to set interest rates, it could effectively control the demand for money and hence indirectly influence money supply. If this privilege was not abused, it was OK. But the Federal Reserve (unlike many other central banks) has a dual mandate of keeping inflation in check and ensuring full employment. Often, these two goals are in conflict.

But with the power to manipulate interest rates (the Fed funds) and reserve requirements, the Fed got into the habit of lowering interest rates when the economy takes a downturn and “cushion” the pain of recessions. In an economy where interest rates and money supply were determined by the market, banks will often initially raise rates when they find that a business was not as profitable as it was when they started lending to it. So instead of rolling over a loan at the same rate, they would actually raise it to discourage the business from borrowing and forcing to return to more profitable levels. Only then will rates start to go down. But the FED’s intervention by setting Fed Funds rate and increasing money supply effectively disrupts this natural adjustment process. What ends up happening is that money supply is constantly being increased and we have a small inflation every year (around 2%). This was deemed to be “acceptable”. While 2% seems to be a small amount, over the last century (since the dollar was used), it has actually lost over 90% of its value! How could this be? Think about your parents days when they could go to the movies for a quarter? Or even in the 80s when a new American Made car would cost no more than $10,000. Look where starting prices are for cars these days. And real estate just keep getting more expensive (actually, they rise on average with the inflation rate).

The end result of constant money supply increase over the last century as resulted in “increased asset prices”, increased wages and obviously a decline in the value of the dollar.

Globalization – In the early 80s, China began opening up their markets and began trading with the world again. In the late 90s, the collapse of the Soviet Union and Eastern Europe resulted in a more globalized world. In a nutshell, the world and free markets were faced with a glut of labor. Economics tells you that when supply increases, prices go down. This event was a threat and opportunity to the developed western world. We had to work harder to increase our education levels and maintain our cost competitiveness and become more efficient. We did neither of those. Instead, life went on as usual. We instead ran budget deficits, had trade deficits, and constantly printed money and lowered interest rates when we hit a recession. It resulted in even more asset inflation.

The net result is that decades of “creeping inflation” in asset prices and wages simply made the US uncompetitive in the global manufacturing markets. The gap is so wide we have to outsource our manufacturing to become competitive.

70% of the US economy is consumption! – The result of outsourcing of manufacturing capabilities and continuous money printing and lower interest rates is an economy that has become solely about its people ‘consuming’ goods! And remember we as a nation spend more than we earn! How does this come about? Through credit, printing money. Look at the area that specialize in (credit cards). These days, 0% balance transfer offers are common much like 0% financing on cars are common! Mortgages became available to sub prime borrowers. Even credit cards for bad credit folks became available. The greatest absurdity of it all is that student credit cards became available even though most students do not have income (though that is about to change with the card act). Folks blame Wall Street securitization for much of the problem. But they would not be problems if interest rates were not super low and manipulated to start with.

How do we get out of our mess?

We obviously have other problems like entitlement programs, persistent budget deficits etc. But think about this, even if we could have a budget surplus and pay down our debt, we still have a situation where we as a nation have a trade deficit! We simply do not export enough. And to compound the problem, the cost differential between us and China for example is too huge a gap to bridge by simply readjusting exchange rates and any tariffs. They resulted from a century of “inflationary monetary policies” and it has finally caught up on us. We simply cannot have an economy which consist of 70% consumer consumption when we as a nation are paying more for our imports than we earn from our exports. We have to learn how to make things again and unfortunately we have to go through with a very painful employment or unemployment adjustment.

Perhaps, deflation is not such a big thing. Think about it, if a house just cost $50,000 like in the good old days, then we do not have to make so much to be able to support a family! But when a roof over your head cost $200,000, you need a decent salary just to live. And that decent salary is way above what lower cost countries pay their workers. Essentially, I think we have close this ridiculously wide wage gap between us and the rest of the world to make us competitive again and stop running an inflationary monetary policy. That only benefits real estate owners, owners of inflated stocks and any profession that “services” these folks.

Furthermore, I think deflation is nothing to be afraid of. Sure, many furniture stores will go bust. But we simply do not need businesses who can only survive if their customer has access to credit! Look at the computer industry. It is an industry that operates in a deflationary environment where prices keep falling. Yet, we see innovation and consumers seems happy with this situation (I’m sure you do not want to pay $10,000 for plasma tv like it was when it came out).

So I say let the real estate market deflate, do not fear deflation, stop printing money and take the near term pain of perhaps more unemployment. It will force a necessary restructuring of our economy. It hurts in the short run, but in the long run, we’ll be a more viable economy as a result.

2 Comments »

  • Ted said:

    I think your points are valid- but maybe hitting towards the extreme. I would rather see the wage gap close in our own country a bit more before we start 'falling' towards the rest of the world. IMHO- anyone who works a full time 40+ hour a week job, should be able to afford basics in life, including health insurance. I do fear that we are trying to hold up our economy without a great long term plan for how to make sure everything is sustainable. Seems to be way to much focus on getting re-elected in congress than to solve the issues.

    I love what you said about the computer industry. I feel like all industries need to follow that plan. Make better products, at reasonable prices, with innovation, that allows everyone to make some money. Thanks!