In general, household expenditures will be based on their lifetime income or net worth. Early on in its life cycle, through education, the members of the household may increase their future earning power. If the net present value of the increase in future income exceeds the cost of educating, the household will invest in human capital. The household net worth increases relative to its current income. Since expenditures are a function of the net present value of future income, the household expenditures exceed their income during the early years. The households finance the excess consumption (i.e., its trade deficit in goods and services) through their borrowing (i.e., a capital inflow finances their investment in human capital). In the future, when their human capital and earnings power rises, the investment and borrowing used to finance past consumption will be repaid. Late in the life cycle, as the household is at or near retirement, its earned income declines. During these years, the household will spend well above its earned income. The household will be depleting its net worth during those years.

Similarly, if a company faces great future opportunities, it may choose some external financing to achieve its goals faster and maximize shareholder value. In this case, the “growth company” borrows money or sells new equities to finance its growth. On the other hand, if the company finds itself with a stash of cash and no great investment opportunities, returning its cash to its investors may be the proper policy. At this point, one may argue that the company has ceased to be a growth stock and has become a value stock. The lower growth prospect will also produce a lower Price Earnings (P/E) ratio.

The parallels between the household and a country or a business are straightforward. The gap between expenditures and production will be met through the trade balance, which is financed by capital inflows. Similarly, a growing country may find borrowing worthwhile. If the increase exceeds the cost, the investment is a worthwhile one and the country’s net worth to income ratio (i.e. P/E ratio) will rise as the trade balance worsens. Finally, when the country matures past its peak, it will maintain its standard of living by selling assets. It will finance its excess consumption over its “earned income” through asset sales. During this time, the trade deficit will be accompanied by a declining P/E ratio.

Whether we use the household or company analogy, we have developed two distinct alternative explanations of why a trade balance deficit may occur. The question is which one of the two alternatives is the relevant one to the US situation. One simple way to distinguish between the growth and value stocks or the stage of life is to focus on the economy’s P/E ratio. The household net worth to disposable income ratio will rise during growth stages and decline during value stages. Using the household borrowing analogy, if the money borrowed is invested and it earns a higher rate of return, household net worth will rise. The borrowed money finances investments that will result in a higher level of output and employment. Fig. 17.2 shows the household net worth as a percent of disposable personal income.

The data shows an uptrend that is not a smooth one, suggesting that there are periods of relative economic slowdown where the United States does not behave like a growth stock. The policymakers’ quest is to find the appropriate policy mix that prevents or minimizes the “value”—like periods of the US economy. The data also points to an upward trend suggesting that, secularly, the economy is behaving like a growth company. If that is the case, the trade deficit is a good thing. It means that capital is flowing in because it can earn a higher risk adjusted rate of return in the United States. This evidence contradicts the mercantilist view of the world that equates the trade deficit with an undesirable and unprofitable increased ineptness. We argue here that the foreign capital has financed part of the US expansion and prosperity, a good thing and a desirable one.

Looking at Fig. 17.2, we notice a few inflection points in the economy’s P/E ratio. It is apparent that once the Reagan tax policy was fully implemented, the P/E ratio rose and reached a new plateau and essentially remained there until 1995, when the Republicans took over Congress. Then in 2000, amidst the Y2K concern and the technology bubble bursting, the P/E ratio took a major hit. In time it recovered and got past its pre-1995 peak. The economy took another hit during the bursting of the housing bubble and the global financial meltdown, wherein again the data points to a complete recovery. The ratio of household net worth to income is once again at or near an all-time high. Notice the correlation of household net worth to income ratio and the policy inflection. We believe that the correlation is a causal one going from policy changes to the economy’s P/E ratio, that is, the household net worth to GNP ratio. If that is the case and adjustment is costly, our framework can anticipate the future path of these variables as the federal government alters its policy mix, a useful insight for top-down global macroinvestors.

Our explanation requires two distinct assumptions. One is that in the long run (by this we mean that the economy will approach its long-run equilibrium) PPP will be restored. Shocks will give rise to temporary disturbances that push the economy away from its old equilibrium and into a new one. If the world we live in were frictionless, all adjustment would be instantaneous. Unfortunately, that is not the case. Adjustment costs mean that it may take some time for the economy to reach a new equilibrium. The path the economy takes to reach the new equilibrium depends on numerous factors. Nevertheless, at any point in time, the value of the exchange rate may reflect adjustments to previous and current market conditions. If one believes our interpretation of major inflection points, it is easy to see two cycles of appreciation. One begins around 1983–84 when the Reagan tax rates were being implemented, and the other during 1995 when the Republicans took over Congress. As the economy recovers from the financial crisis and wealth traces hold ground, is it possible that a third cycle may be in the offing? The big question is what are the policies that will take us there?

Getting back to the previous two peaks, there are two different explanations that tell the same story. Early on, the US economy behaved like a growth stock. Investors, both domestic and international, flocked to the United States; the capital inflow produced a higher stock market. Early on, as net worth increased relative to disposable income, we saw the US trade balance worsen (Fig. 17.3).

The United States outperformed the rest of the world. As investors tried to acquire dollars to invest in the United States, the dollar appreciated above its purchasing power parity value. Over time, as investment continued, the rate of return in new investments declined and eventually the rates of return returned to their long-run equilibrium. PPP was once again restored. Since the price rule essentially eliminates monetary disturbances as the source of exchange rate fluctuations, it follows that the bulk of the fluctuations in the dollar will reflect the US terms of trade or relative rates of return. Thus, early on as the rate of return increases, the dollar appreciates. However, if PPP is to be restored, the dollar will have to experience a round trip. More important, the price rule insures that the fluctuations in the dollar will not alter in any significant way the underlying inflation rate. In both cases we see the exchange rate behaves like an inverted “V” (Fig. 17.1).

For example, a country may have a double-digit savings rate, say the highest in the world, and yet be a net borrower. All that this situation requires is that the investment rates exceed the country’s savings rate. One simple explanation for this scenario is that the economy is full of opportunities. Income and wealth may be rising. If the former rises faster, then the savings rate will rise. However, since wealth is rising, consumption also rises. Hence if the income does not rise fast enough to keep up with the increase in wealth and consumption, the savings rate will decline, and the trade balance will worsen. This is the scenario that we have in mind for the United States during the 1980s and 1990s. Fig. 17.3 shows a negative relationship between the trade balance and the ratio of net worth to GDP. China’s scenario, as we have discussed elsewhere, is a bit different, with income rising faster than wealth, and it leads to an increase in savings. The higher wealth leads to higher consumption. Finally, if the increase in savings exceeds the investment opportunities, the country will be a net saver, that is, exporter.

Now in a forward-looking world with well-developed capital markets, wealth is related to discounted value of income. Hence we expect to see a positive relationship between rising wealth and income growth. More importantly, there is another implication for the relationship between the trade balance and economic growth and/or employment. Unanticipated increases in economic growth that lead to an increase in the net worth to GDP ratio should result in a deterioration of the trade balance and thus produce a negative relationship between the trade balance and economic growth and employment. Fig. 17.4 shows the relationship between the trade balance and employment growth, while Fig. 17.5 shows the relationship between employment growth and real GDP growth. Figure 17.5 shows that the two variables are closely correlated as expected. Higher real GDP growth is closely correlated with a higher employment growth and vice versa. In contrast, Fig. 17.4 identifies an interesting relationship between the trade balance and employment growth. Notice the clear negative relationship between the spikes in the trade balance and employment growth, results that are counterintuitive in the context of the textbook traditional view. However, we have a simple explanation: an increase in output and employment also points to increased opportunities in the US economy, hence a capital inflow and that, in turn, means a deterioration of the trade balance. The relationships are not causal, but identified as correlations. However, it raises a warning flag. Protectionist attempts to improve the trade balance may lead to a lower GDP and lower employment. The best example of this type of policy mistake is none other than the Smoot–Hawley tariffs and their impact during the 1930s.

Mercantilists argue that exports create jobs and that imports cost jobs. While the statement may be true in a ceteris paribus world, not everything else is constant, in a mutatis mutandis world that need not be the case. As we have already shown, the data suggests that an accelerating US economy leads to higher employment and a deterioration of the US trade balance.

We know from the lifecycle consumption theory that, on average, all wealth will be consumed. Hence, all income will be spent. This means that the lifecycle budget constraint requires that the value of exports and imports over the lifecycle be equal. In addition, since the world is a closed economy, the sum of all imports has to add up to the sum of all exports. The world trade balance is zero. There is no intergalactic trade. Put another way, the lifecycle trade balance has to be zero. The net savings over the lifecycle has to be zero. A policy that promotes exports has to automatically promote imports, and no net jobs are created by promoting exports (Fig. 17.6). Both imports and exports tend to move together as the lifecycle theory predicts. Thus, job creation should not focus on the trade balance. In fact, policies aimed at promoting jobs and growth will, in the short run, lead to a deterioration of the trade balance. Attempts to improve the trade balance, promote exports, and/or restrict imports would only distort the economy and thereby retard economic growth.

Next we explore the relationship between the trade balance and the US share of the world real GDP and the stock market Morgan Stanley Capital Index (MSCI) index. The relationships reported in Figs. 17.7 and 17.8 are consistent with the previous relationships reported. The common element between the two figures is the negative correlation between the spikes in the two variables included in the figures. This suggests that an increase in the US share of the world income is correlated with a deterioration of the trade balance. However, the US share of the world income can only rise if the United States grows faster than the rest of the world. The result for Fig. 17.8 is also similar. An increase in the US share of the world equity market is associated with a deterioration of the trade balance. Since the US share of the world’s equity markets can only result when the US market valuation rises faster than the rest of the world, we can say that the an improvement in the US relative growth rate and relative stock market returns are associated with a deterioration of the trade balance. The correlations reported in Figs. 17.7 and 17.8 say more than that. They suggest that there is a positive correlation between the real GDP growth rate and the stock returns. It suggests that there is a positive correlation between the United States outperforming the World real GDP growth rate and the United States outperforming the world stock market returns. Fig. 17.9 confirms what Figs. 17.7 and 17.8 implied.

A trade deficit means that we have a capital inflow; we are borrowing from our trading partners. Pundits worry that we are living beyond our means and that our best days are behind us or that we are eating our way into the poorhouse. If that was the case, we would expect to see the market anticipate this and decline relative to the rest of the world whenever the trade balance worsens. The implication here is clear. It predicts a negative relationship between trade deficits and the US stock market relative to the rest of the world. Yet that is not what the data says.

There is another, alternative interpretation: the reason for borrowing is that there are great investment opportunities, and, by borrowing, we take advantage of these opportunities. Put another way, better days are ahead of us. The higher future return allows us to pay for the amount borrowed without sacrificing current consumption. The higher investment returns attract capital, and as the market anticipates the higher returns, valuations will rise and the United States will outperform the rest of the world. Hence, not only US investors, but also foreign investors will want to take advantage of the opportunities in the United States. Advocates of the “better days ahead” alternative theory predict a negative relationship between the trade balance, stock markets, real GDP, and employment growth relative performances. Figs. 17.417.7and 17.8 clearly support our views and contradict the alternative interpretation. As we argued, there is a distinctive and clear negative relationship between the trade balance as a percent of GDP and the relative stock market performance measured by the ratio of the United States versus the MSCI Rest of the World Indices. That is not all. As capital flows in, the demand for dollars will rise and a dollar appreciation is to be expected.

Next, we move to the relationships between the trade balance and the foreign exchange value of the dollar and terms of trade. We also examined the relationship between the US stock market as a share of the world market and the dollar index as well as the terms of trade. Unfortunately as Fig. 17.12 shows, if there is a negative correlations between the US dollar and the trade balance as a percent of GDP It is a fairly weak one. A much stronger correlation can be found between the terms of trade and the trade balance (Fig. 17.13). These results lend support to the view that it is real factors that determine the changes in the trade balance. As we have already mentioned, sometimes the exchange rate reflects changes in the terms of trade, and at other times, it reflects changes in the relative rates of inflation, or put another way, it reflects monetary shocks. This may explain the weak negative relationship. The monetary shocks are noise that obfuscate the true relationship. The negative relationship is not anything new or an unexpected result in the context of the traditional view. Where we part company is with the interpretation. While it may be true that a “cheaper dollar” may improve the trade balance, that may not be a desirable outcome if all of the relationships identified in this section hold up. The “cheaper dollar” may be reflecting a deterioration of the terms of trade in which case an improvement in the trade balance due to a weaker dollar may signal an economic slowdown, higher unemployment, a capital outflow, or a lower relative stock market. We do not think these are desirable changes in these variables. In turn, if our interpretation is correct, the rising dollar and a deteriorating trade balance is a bullish sign. It is a sign of an improving stock market relative to the rest of the world. Fig. 17.14 shows that, as expected, there is a positive correlation between the US dollar and the US relative stock performance. However Fig. 17.15 shows that the relationship is much stronger when the terms of trade replace the foreign exchange value of the dollar.

So far, we have provided a parsimonious explanation for the various relationships, and that is good for it suggests that our theory, at the very least, has a great deal of explanatory power. The exchange rate-based investment implication of this view of the world is straightforward: follow the money. Underweigh the economies whose exchange rate is expected to depreciate. More specifically, follow those whose terms for trade are expected to deteriorate and overweigh those whose economy is expected to appreciate. An obvious question is how can one tell which economy is going to do what? Our answer is that a top-down approach that pays attention to the policy changes, weather changes, and innovations may point the investors in the right direction. Also if adjustments are costly, returns cycles will be generated. So even if one misses the intimal turning point, there will be plenty of time for the astute and studious investor to take advantage of these cycles.