imagine our world had just two countries: the u.s. and china. the u.s.’s trade deficit grows because we are importing more than we are exporting. as we import (purchase) more chinese goods we must buy the chinese yuan (and sell u.s. dollars) to pay for them, thereby pushing up the value of the yuan versus the dollar (or, conversely pushing DOWN the value of the dollar versus the yuan – the same thing). thus over time imports will rise in price (inflation) as the dollar falls in value versus the yuan, all else being equal (which it never is, of course). bondholders want to be paid a premium to inflation to be induced to hold onto a bond as opposed to cash (bonds are more risky than cash). consequently, even if this premium remains steady, higher expected inflation will lead to higher overall bond yields.
one of the reasons that “headline inflation” numbers have remained tame (as opposed to “real inflation” numbers, which are much higher) even as our trade deficit has grown is that the foreigners we “owe” money to (china in the previous example) have been taking the money we pay to them and recycling it back into our economy via investments – more specifically, they’ve been buying a lot of our government debt. in order to buy this debt they have to sell their own currenty and buy dollars, a process that mitigates what would otherwise be a disaster for our currency and interest rates.
what our trading partners either don’t realize or don’t want to think about (the latter most likely – they’re not clueless) is that we’ve been printing money like mad over the last god-knows-how-many years and inflation is higher than the “headline” figures. consequently, these foreign debtholders are being paid back with dollars of diminished (and diminishing) value, but for now they’re looking the other way.
why? because their own economies are dependent on enormous exports to the u.s. (that is, they rely on america continuing to live beyond its means) and the moment this little game of chicken is over, everybody – including their economies – will lose. in fact, the music stopped a long time ago… but people are still dancing.
