Why Manufacturing Jobs Are Leaving, And How It Could Destroy Our Currency

Ask anyone this question: "Why has America lost over 3 million manufacturing jobs in the last 15 years?" and I'll bet you good money that the most common answer you'll get is "free trade", or maybe "NAFTA".  It makes sense, right?  American companies can send jobs overseas, get the products built with cheap labor in countries with low regulations and nearly nonexistent labor laws, and then ship the products back to America for next to nothing.  Sure beats meeting the laws and regulations associated with hiring workers in America.  I mean, this is just common knowledge. Duh.

Well, this is a very solid argument.  But there's just one small caveat to it... it's completely and utterly wrong.  Free trade may have been a factor in speeding up the outsourcing, but not really.  If done right, free trade is a good thing and doesn't automatically lead to the deployment of manufacturing jobs to developing nations.  It only worked that way because it's a symptom of a much larger disease.  I'll try to explain this in a clear way, but I should warn you that it gets rather complicated.

For all intents and purposes, the United States is the only country that uses the American dollar.  Every dollar that leaves America must come back at some point.  That is, when America imports goods, we send dollars to the countries that we get the goods from.  Since those dollars cannot be spent in the foreign countries, they must eventually come back to America. Foreigners could buy up manufacturing plants in America, but if they move those plants overseas, any profit they make in the United States would have to be spent in the United States.

I'll put it another way.  Suppose an American exporter sells his goods to a Japanese importer and is paid in Japanese Yen.  The American cannot use the Yen to pay his workers, buy clothing and food for his family, or buy theater tickets.  If he wants to do any of those things he needs American dollars.  Therefor his Japanese Yen are of no use to him unless he uses them himself to buy Japanese goods or sells them to some other American importer for dollars.  The buyer of the Yen will use that currency to buy Japanese goods.  So every Yen that leaves Japan has to eventually get back to Japan in exchange for something that Japan produces, because Japan is the only country that uses the Yen as currency.  It works the same way with America.  Every dollar that we send overseas for goods has to eventually make it back to America.

You see, there really shouldn’t ever be a trade deficit of any major significance. This may seem strange, but it shouldn’t. Exports pay for imports, so they must eventually balance out. Think of a bartering society.  I can trade you 5 chickens for your goat.  My 5 chickens are my exports, and the goat is my import.  Your goat is your export and the 5 chickens are your import.  Because we both agree that 5 chickens is worth 1 goat (maybe I have too many chickens and you have too many goats.  Supply and demand dictates the value of the chickens/goat), neither one of us has run a trade deficit.  It's no different if we were countries instead of individuals.  Say my country has a lot of pens, but no pencils.  Your country has pencils but no pens.  So, we trade.  I give you pens and you give me pencils.  For both of our countries, our exports paid for our imports and we have no deficit.  When money gets involved, the situation is essentially the same.  I'll sell you pens for money that you earned by producing pencils and then use that money to buy your pencils.  That's how economies work regardless of whether there are 2 goods involved or 2,000.  My excess production/resources are traded to you for your excess production/resources, and there is no trade deficit.  It works the same way for nations as it does for individuals.  At least that's how it's supposed to work.

"But Chris, the U.S. does have trade deficits and we just racked a whopping one of 568 billion dollars in 2008!"  Well, two points need to be made here.  The first one is general while the second one is specific to the United States.

In general, it’s obvious currencies don’t leave and come back instantaneously. There will be up and down cycles. It’s also hard to account for every economic transaction taking place between individuals, companies and governments in one country or another. This is especially true, given there are often large black markets in even the freest economies. And finally, well, governments just lie sometimes. Shocking, I know. All of this becomes obvious when you look at the CIA Factbook for 2009, which says the world as a whole ran about a $133 billion dollar trade surplus. This is, of course, impossible.

Accounting errors can only account for small discrepancies though.  The United States is a very peculiar case.  We just so happen to hold the world's reserve currency.  To explain what this is and how it came about, we have to go back to the end of World War II. After the war, the Allied governments wanted to set up a system that would facilitate international trade and prevent the hyper-nationalistic protectionism of the 1930′s, which helped spur the Second World War. John Maynard Keynes and Harry Dexter White designed a system known as Bretton Woods, in which every country in the American sphere of influence tied their currency to the U.S. dollar at a fixed exchange rate and the dollar was in turn tied to gold at $35 per ounce.  Basically the dollar was valued at $35 per ounce of gold and every other currency in the world was valued at some fixed exchange rate with the US dollar.  All these currencies throughout the world could be exchanged for a certain number of American dollars, and those dollars could in turn be exchanged for gold at $35/ounce. Sounds like a good idea, right?

In reality, the system was doomed from the beginning.  The problem was simple: it relied on wise fiscal policy by U.S. politicians.  In 1971, after a decade of paying for "guns and butter" (the Vietnam War and the Great Society) by inflating the dollar, the U.S. government could no longer justify the $35/ounce exchange rate.  When foreign investors started requesting their gold in exchange for dollars, president Nixon responded by removing the gold standard.  From that point on the only thing that gave our dollar any value was the trust and confidence of the dollar.  It's called fiat money, and without the trust and confidence of its value you may as well have monopoly money or a dirty bar napkin with "IOU" written on it in sharpie.

The fixed exchange rate system was eventually replaced with floating exchange rates that had no gold backing. This allowed investors to set currency values by bidding on them in relation to each other. Now, this system works in principal, but unfortunately it opens up countries to currency attacks. If a government enacts poor policies, investors can leave that currency en masse. Or, as many leftists claim, powerful countries can simply de-fund weaker countries if they don’t like their policies; although whether this has ever actually happened is disputed. Regardless, it leaves countries vulnerable as illustrated by the most famous example of such currency implosions, the Asian Financial Crisis of 1997.

To avoid these crises (and store a “risk free” currency in case of other problems), governments started stockpiling dollars to act as a safety net in case their own currency was attacked. While the dollar was the reserve currency under Bretton Woods, as well as in the ’70′s and ’80′s, government stockpiles really accelerated in the 1990′s and 2000′s when China started taking off and the fall of communism brought with it a whole host of new countries, who, lacking Soviet support, needed to start stockpiling dollars.  America, as the world's economic leader, was seen as having the strongest currency and countries began to gather up dollars in their reserves.  If their currency was "attacked" at least they had dollars that were worth something.  But, as I said before, the dollar is only worth something because people think it's worth something.  Since leaving the gold standard, there is nothing of value that these little green pieces of paper represent.

So what does all of this have to do with disappearing manufacturing jobs and trade deficits?  As I pointed out earlier, we don't really have a trade deficit per se.  What we have is countries selling us goods for dollars.  But instead of those countries exchanging the dollars for our goods as would be normal, they're stockpiling them in their central banks because the dollar is the reserve currency and owning dollars is supposed to protect their money against any currency attacks.  Essentially, we have no trade deficit because the figures don't include our number one export: little green pieces of paper about the size of a dollar bill that are easy and cheap to print.  But remember, the dollar doesn't have anything of value behind it ever since we left the gold standard. Hopefully you can see where all of this is leading.

The dollars are no longer returning to the United States, or at least, a sizable portion of them are not. We buy toys from China and oil from Saudi Arabia and cars from Japan and electronics from Taiwan and cocaine from Mexico and they turn around and stuff those dollars into their central banks. This does two things: first, companies no longer have to buy anything from the United States with the dollars they receive (because foreign countries will buy the dollars to put in their reserves); they can simply outsource their factories and then sell the dollars they collect to the host country’s central bank, or other investors.  If these countries did not want to buy and stockpile the American dollars, those dollars would have to be spent in America on goods produced in America.  But the dollars are being funneled elsewhere and the result is that our manufacturing sector is hollowed out because foreign countries would rather hoard American dollars than spend them on American goods. Second, it gives the U.S. government a license to print an almost infinite amount of money without producing inflation. Or in other words, we pay for our imports with nothing more than thin, green pieces of paper that we can print for nothing.  And as long as those little pieces of paper don't come back to America, we don't see any inflation because there is no velocity.  We get a great standard of living, the rest of the world gets jobs, and all we have to do to keep the system working is to print paper (dirty bar napkins with "IOU" written on them in sharpie).

This is a great system, right?  Now we get to have Guns And Butter Part Duex and not see any inflation as a result.  How wonderful!  But as Herb Stein once said, "things that can't go on forever don't".  The dollar currently makes up about 64% of foreign reserves, with the Euro at a distant 2nd with about 26%.  This creates an extremely precarious situation.  While the dollar isn't sinking like a rock (yet), many foreign countries are worried about our bailouts, stimulus packages and gigantic deficits.  Foreign central banks are becoming so nervous they have started diversifying into the euro and other currencies. If we’re not careful, they will pull the plug and all those dollars will come rushing back to the United States. If this happens, the dollar will hyperinflate overnight.  And all it'll take is for one country to start sending dollars back to America or stop buying American debt.  That would start a domino effect where everyone starts trying to sell their dollars but nobody wants to buy them, the price of the dollar will fall through the floor and the whole house of cards --er, dollars-- will come crashing down.  Think of the housing crisis, except instead of houses it's dollar bills.

I'm actually surprised that the rest of the world hasn't realized that the dollars they're holding are worthless and they would be better off spending their money on themselves instead of financing our debt and consumption.  I guess the short term pain of dumping U.S. dollars currently outweighs the long term positive effects of having a stronger currency and being able to consume the goods that they work so hard to make.  It seems that politicians, no matter what country they're in, don't have the guts to make short term sacrifices for long term gains.  But eventually this will all happen.  Some event will take place and it will trigger a little bit of worry around the globe and within a very short period of time those dollars will all come back to America, the world will stop financing our debt and consumption, and we'll all be millionaires buying $10,000 loafs of bread. Or, you know, we could continue to run trillion dollar deficits forever, nobody will want to be paid back and everything will work out perfectly.  We'll probably find out in a few years.