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12/22/2005
On Trade Deficits, Stock Market Crashes and the Spread of Rumor

It's an amazing fact that the three worst declines in the stock market in history occurred in conjunction with rumors, faulty economic reasoning, and destructive policies involving the US trade deficit. First the facts: The October 1929 crash occurred in conjunction with an increase in import duties on casein and carbide. Some DJIA prices which are too instructive not to memorialize:

Date   DJIA  Date   DJIA
22-Oct  326  29-Oct  230
23-Oct  305  30-Oct  258
24-Oct  299  31-Oct  274
25-Oct  305   4-Nov  258
26-Oct  299   6-Nov  232
28-Oct  260  13-Nov  199

Jude Wanniski, in a WSJ article of Oct 28, 1977, documents the tariff negotiations news that directly triggered the attack but we will have to go back to the newspapers ourselves for proper timing and correspondences with the DJIA. Fast forward to Oct 27, 1997, a day that will live in infamy when among other things the stock market closed early for the first time when it declined more than the allowed 6% as of 2:30 pm. I was there. Ahem. Not mentioned was that at 2:00 pm, the fates had it at knife edge with the Gods playing with the balances the way they usually day late in the day after a previous crash (see the Iliad for the comparable decision on the Hector Achilles battle). And at exactly 2 pm, a news story flashed across the screen that trade talks between Japan and the US had broken down, and a senator had said that a military war between the two countries would be appropriate if not resolved. Of course, it turned out that this has been said 6 months before in another context but what the H, it was good enough for an immediate 3% decline in the market the next one half hour.

Fast forward to Oct 19, 1987. Many of us were there as the average dropped 15% that day after 6% the previous day. And I was there the previous night also when Secretary of State Baker initiated an immediate 5% decline in overnight futures, and a crash in Hong Kong, and served as the proximate cause by stating that we would lower our dollar unilaterally unless Germany reduced their trade surplus. "Baker did it", the Chair of the Bundesbank said the next day, and the whole situation is documented in EdSpec.

Now the beautiful thing is that the greater the trade deficit the better it is for the US. The more we can buy cheap goods from other countries, the greater the spending power of our consumers. And the greater the advantages of specialization and free trade documented by Adam Smith in 1776 and known by all economists and almost every economics student since that time. Another way of thinking about it is that when conditions for investment in US are good, foreigners need dollars to invest in our companies and bonds. Who wouldn't with the rest of the world in such economic shambles and weak economics and job growth relative to the US. But the only way for them to finance this investment is by running a current account surplus with the US, which is our current account deficit. The beautiful thing about rumors about trade deficits is that you can always find someone that's hurt. According to the doomsdayists and the others who didn't take Economics101, if we're buying good in one field from abroad, then the workers in that industry in the US are hurt. And the dollars in the hands of the foreign exporters could be immediately thrown on the market and cause a terrible dollar fall and vicious circle of falling US asset prices.

And if you look at it from the other side, if we arrest the trade deficit by not buying from foreigners (that's the only way other than 20% interest rates, according to the doomsdayists), why then the American consumer is up the creek because he can't buy those cheap goods that keep our inflation down and provide the jobs in those fields where the American consumer does spend his money.

The whole area cries out for some kitchen talk about the how, why, and who of these and other rumors and we will not be completely reticent about this.

P.S. Here is  good link from the Congressional Budget Office on this subject for those interested in the accounting issues.

P.P.S. The accounting for trade deficits is highly technical, and a good thing to know empirically is that in years when our trade deficit was greatest, our economic growth was the greatest, and indeed every other measure of economic welfare for the US is better. However, it's also good to know about how the three deficits interact with investment and spending. If you don't have an economics text handy, this article is a good introduction (although written by a hard moneyist with an agenda).

 

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